Ai Group Survey: business pricing responses to Australia s carbon tax, the first six months

Ai Group Survey: business pricing responses to Australia s carbon tax, the first six months Australia s carbon tax January 2013 The introduction of the carbon tax on 1 July 2012 was one of the largest national policy changes for Australian business of recent years. This report examines key impacts on Australian businesses over the initial six months of the carbon tax. It presents the results of our multi-stage research project comprised of three cross-sector surveys undertaken in June, July and November 2012, supported by an in-depth survey conducted in July and August with a small number of manufacturing businesses. The Australian Industry Group has long considered that market-based approaches to the reduction of Australia s contribution to greenhouse gas emission are most likely to meet national objectives at least cost. At the same time we have a number of concerns about the design and implementation of the carbon tax. We are particularly concerned about the initial fixed prices, which are high by international standards. This imposes an additional cost burden on Australian business at a time when local and global conditions are highly challenging due to a variety of other factors. Recent developments in the local and global economies and in international carbon markets show that our concerns were well-founded and remain valid. Key points 1. Businesses estimate the carbon tax increased their energy costs by an average of 14.5 per cent In our survey of 485 businesses conducted at the end of November 2012, the carbon tax was estimated to have increased energy prices from 1 July by an average 14.5 per cent. This result was broadly consistent across sectors: Manufacturing businesses reported that their total energy input costs increased by an average of 14.5 per cent as a direct result of the carbon tax. For businesses in the services sector, the increase was reported at 13.6 per cent. Businesses in the construction sector reported that the carbon tax had increased their total energy costs by 14.8 per cent. On the other hand, the direct cost burden of the carbon tax remains unclear for a significant minority of businesses, with a third of manufacturers and construction firms and just under half of services businesses unable to estimate the direct impact of the carbon tax on their own energy costs, six months after it commenced. These estimated increases have not been reflected in the Australian Bureau of Statistics (ABS) Producer Price Index (PPI) data on electricity prices to date, which show an increase of only 6.7 per cent in the September quarter of 2012 when carbon pricing was introduced. However the PPI data 1

does highlight the role of pressures beyond carbon, with electricity prices for manufacturers increasing by a total of 17.2 per cent over the year to the end of September and by 28.8 per cent since September 2010. The biggest of these other pressures is the rising cost of electricity networks, the poles and wires that deliver power. The high profile of the carbon tax appears to have led to some over-estimation by businesses of the specific impact of the carbon tax on energy prices in this first phase of its implementation. According to our November survey, manufacturing businesses attributed close to 85 per cent of their total electricity cost increases since 1 July 2012 to the carbon tax. However, other data suggest that for smaller electricity users, networks will account for close to one half of the total electricity cost increase from 1 July 2012. For example, IPART raised regulated electricity prices for NSW households by 18 per cent on average from 1 July 2012, with 8.9 percentage points of this increase due to carbon pricing and most of the rest to cover rising network costs. The November survey was the most recent component of Ai Group s multi-stage research program over the first six months of the carbon tax undertaken to assess its impact on business prices and costs. Data collected from across our carbon tax research program also suggest that: 2. Around half of all businesses (49 per cent) experienced an increase in some of their input costs (energy and other inputs) immediately after the carbon tax was introduced on 1 July. Input prices increased immediately for 61 per cent of manufacturing businesses, 36 per cent of services businesses and 52 per cent of construction businesses. The cost burden of the carbon tax has fallen very unevenly across industry sectors, with large differences in input price increases and an even larger difference in businesses ability to pass on these price increases to their customers. Many businesses have not been able to pass on their increased costs. Major considerations that affect each business ability to pass on increases in costs to their customers include price expectations and pricing power among their customers; local demand conditions; and competition from imports. While most of the pricing and cost effects are as anticipated by the carbon tax policy-designers and by Ai Group, some sectors have been especially squeezed. In particular, food manufacturers were the most likely to see immediate input price rises and the least likely to be able to pass on their higher costs through the supply chain to the end consumers of their products. The impact of the carbon tax on production costs and profitability for niche groups such as food producers is probably greater than was anticipated. Crucially for these businesses, this has come at a time when business competitiveness is under pressure on a number of fronts (including from the ongoing strength of the Australian dollar and relatively strong growth in unit labour costs). While competitive grants are available to businesses such as food processors under the Clean Technology Program for capital investments to help reduce their exposure to carbon pricing, they are not covered by the more comprehensive assistance program available to the most emissions intensive industries. The evolving impact on these sectors will be closely watched. 2

Key findings from our business surveys This paper is the second research publication by Ai Group that contributes to understanding the impacts of the introduction of the carbon tax had on business prices and costs. It follows on from research that we released in July 2012 1, based on a survey conducted in June 2012. We surveyed businesses again in July and November, and supplemented this with a smaller, in-depth research module conducted in July and August. In our first research paper, we found that immediately prior to the introduction of carbon pricing, 42 per cent of Australian businesses across the manufacturing, services and construction sectors (comprising around 90 per cent of the private sector economy) planned to try to recover their input cost increases by immediately raising their selling prices. Input price rises Based on the July survey, we found that 49 per cent of businesses across the manufacturing, construction and services sectors reported that prices rose for at least some of their inputs immediately from 1 July as a result of the carbon tax. Input prices increased immediately for 61 per cent of manufacturing businesses, 36 per cent of services businesses and 52 per cent of construction businesses. For many other businesses however, there was considerable uncertainty about the impact of the carbon tax on input pricing immediately after its introduction. Around a fifth of respondents in our more detailed research module, conducted with a small number of manufacturing businesses in July and August, indicated they did not yet know the extent of carbon tax price impacts on their business (e.g. because they had not yet got their power bills) by the end of July. This in-depth survey confirmed that the most consistent source of carbon price pressures on manufacturers input costs is through electricity and gas prices. 91 per cent of these manufacturers said electricity retailers had raised prices to cover carbon costs, while 81 per cent said gas retailers have raised prices to cover carbon costs. Nearly 60 per cent of this group indicated they had also experienced significant carbon-related price increases on other key business inputs. The electricity cost impact reported in the in-depth survey appears to be nationally consistent and is in line with expectations, at around 2.1 to 2.3 cents per kilowatt hour. Gas price impacts vary more, from $1.18 to $2.08 per gigajoule; the lower end of this range of gas prices is more common, with the variation relating largely to the greater emissions intensity of certain gas fields. In our November survey we asked specifically about business energy costs. All businesses will have gone through at least one post-july billing period for their energy use during this time. But even so, a third of manufacturers and construction firms and up to half of services businesses did not yet have enough information to be able to quantify the increase in their total energy costs as a result of the carbon tax. Among those businesses who were able to quantify their energy input cost increases, manufacturing businesses reported their total energy input costs had increased by an average of 14.5 per cent p.a. since 1 July 2012 as a direct result of the carbon tax (as attributed by businesses answering our survey who felt able to quantify the impact of the carbon tax on their energy input costs). Services businesses experienced an average increase of 13.6 per cent p.a. in their total energy costs and 1 Ai Group (July 2012), Selling price intentions in response to the carbon tax, www.aigroup.com.au/policy/reports 3

construction businesses had an average increase of 14.8 per cent p.a. in their total energy costs, as a direct result of the carbon tax. These estimated increases have not been reflected in the ABS Producer Price Index (the PPI data series, see below) data on electricity prices to date, which show an increase of only 6.7 per cent between the June and September quarters of 2012, when carbon pricing was introduced. However the PPI data does highlight the role of pressures beyond carbon, with electricity prices for manufacturers increasing by a total of 17.2 per cent over the year to the end of September and by 28.8 per cent since September 2010. It appears likely that the high profile of the carbon tax may have overshadowed other important cost drivers in electricity pricing. Both business and households will have seen an increase in generation costs of around 20 per cent, but final bills also incorporate substantial costs for maintaining electricity networks (poles and wires), along with state-based retail and green scheme charges. Network costs are rising significantly in most regions, but particularly NSW and Queensland. The Independent Pricing and Regulatory Tribunal (IPART) increased regulated electricity prices for NSW households by 18 per cent on average from 1 July 2012, with 8.9 percentage points of this increase due to carbon pricing and most of the rest due to network costs (see figure 1). Similar factors also affect electricity pricing for businesses, although for larger users energy costs are a bigger part of the bill than network charges. Figure 1: drivers of increases in average regulated retail prices in NSW from 1 July 2012, including inflation (% p.a.) 20% 15% 10% 5% Retail Network Green schemes Carbon price Generation 0% -5% Source: IPART, Fact sheet: Changes in regulated electricity prices from 1 July 2012, June 2012. Pricing pass through We compared business intentions to increase prices (immediately pre-carbon tax) with businesses initial experience of input price increases (post-carbon tax). This comparison shows a large variation in pricing pass-through at a sector level. This variation in pricing pass through across sectors broadly follows patterns that were anticipated by Ai Group before the commencement of the carbon tax. Sectors ability to pass on costs reflects current factors including: The level of trade exposure in the sector, through either export activity or import competition; The willingness of a sector s customer base to accept price rises of any sort; General demand, competitive pressures and margin compression for each sector more broadly. 4

In the manufacturing and construction industries in particular, we found a significant gap between the proportions of businesses that experienced increases in their input prices from 1 July as a result of the carbon tax, and the proportion that were planning to increase their selling prices in response. This gap appears to be indicative of the competitive pressures facing each sector, due to their high level of trade exposure and/or the extremely competitive nature of their market at present, with customer bases that are reluctant to accept any price increases. The largest such gap was evident between input price rises and selling price rises among food manufacturers. Our deeper analysis with a small group of manufacturers suggests this is likely due to a combination of direct trade exposure and, most significantly, intense pressure from major food retailers to keep prices down. Among services businesses, there seems to be a stronger ability to pass on the price increases that have so far eventuated from the carbon tax. This is likely due to the lower trade exposure of the services sector. Carbon tax impact across sectors: Ai Group research on business pricing responses This section presents detailed results of Ai Group s business surveys in the first six months of the carbon tax, for each of the manufacturing, services and construction industries. Manufacturing Input price rises After the first full quarter of power bills (as reported to us in November 2012), two thirds of manufacturing businesses were able to quantify the increase in their total energy input costs as a result of the carbon tax. They reported an average increase of 14.5 per cent p.a. in their total energy costs, with almost half (47 per cent) reporting an energy cost increase of between 1 per cent and 20 per cent p.a. Another 4 per cent of manufacturing businesses reported they had not yet experienced an increase in their energy costs as a result of the carbon tax by the end of November. The monthly Ai Group Australian PMI confirms that input price rises for manufacturers peaked in July and August, before moderating back to its recent average later in 2012 (see figure 6). A similar proportion of manufacturing businesses (61.3 per cent) reported that at least some of their input prices had risen immediately from 1 July 2012 as a result of the carbon tax. Of the businesses reporting a price rise, 76 per cent said prices had risen for less than half of all their business inputs, 18 per cent said prices had risen on more than half of their business inputs and 7 per cent reported price rises on all of their business inputs. The remaining 40 per cent of businesses had not experienced any input price rises as of 1 July. In our more detailed follow-up survey (conducted in July and August with a smaller sample of highly engaged businesses), 91 per cent of manufacturers said their electricity retailers have raised prices to cover carbon costs, and 81 per cent said their gas retailers have raised prices to cover costs. The electricity impact appears nationally consistent and in line with expectations, at around 2.1 to 2.3 cents per kilowatt hour. Gas price impacts appear to vary more, from $1.18 to $2.08 per gigajoule; the lower end of this range for gas prices is more common, with the variation relating largely to the greater emissions intensity of certain gas fields. The results in figure 2 below show a spread in the percentage increases in energy prices, but these reflect a largely very similar absolute increase; the initial prices paid by businesses of different size and energy intensity are the main source of variation. 5

Nearly 60 per cent of responses in our follow-up survey indicated significant carbon-related price increases on other key business inputs. These included freight; paper and packaging; bottled gas; refrigerants; flour and gluten; and waste disposal. Waste costs in particular were unexpectedly high for some otherwise well-prepared businesses, whose largely inorganic waste streams were charged by some landfill operators using default factors assuming a much higher organic component. Putrescible waste decays to release methane a potent greenhouse gas. There appeared to be more variation in the cost pass-through for non-energy inputs. Around one fifth of this smaller group of follow-up respondents indicated that they did not yet know the full extent of carbon tax related price impacts and anticipated further pass throughs across their various inputs. Pricing pass through Our broad results over the first six months show a large gap between the proportion of manufacturing businesses experiencing immediate input price rises as a result of the carbon tax (61 per cent) and the proportion of manufacturing businesses planning to increase their selling prices as a result of the carbon tax (40 per cent). This is yet another source of unwelcome profit squeeze for these businesses. It highlights the competitive pressures that prevent many tradeexposed businesses from passing on the higher cost of doing business, particularly in the current environment of a high Australian dollar and weak local demand for goods. Manufacturers responses in the follow-up survey highlighted this situation: We are highly trade-exposed, competing against plants in China and India which are lower cost [producers]. We can raise our prices, but not without reducing our competitiveness. The market is extremely competitive [ ] our ability to pass through costs depends on whether our competitors are putting through similar increases. The pricing story and the extent of the profit squeeze varied significantly across key manufacturing sub-sectors. Our broad survey results show food manufacturers appear to be facing the greatest profit squeeze as a result of the carbon tax, with over 90 per cent reporting price rises for at least some of their inputs, but only 10 per cent of food processing businesses being able to pass those costs on to their customers. This story seems to have been replicated, albeit to a lesser degree, among businesses in basic metals, chemicals and machinery and equipment manufacturing (see table 1 below). Follow-up responses from food manufacturers indicated that major food retailers and those in the food service industry would not tolerate price increases, leaving manufacturers to improve energy efficiency, cut other costs or accept lower margins. Basic metal manufacturers also cited customer resistance to price increases as the key inhibitor to pricing pass-through. Some other manufacturing sectors had a smaller gap between the incidence of input price rises and selling price rises, including miscellaneous manufacturers (such as pharmaceuticals) and transport equipment. Demand for these goods may be relatively inelastic (that is, less likely to change with an increase in price) due to the limited availability of substitutes and greater consumer brand loyalty. In the case of wood products and furniture and construction materials, more businesses indicated their intention to increase their selling prices than had experienced input price rises from 1 July. This may simply reflect the very small sample sizes in these sub-sectors or it might indicate a stronger ability for these businesses (due to better demand conditions for example) to pre-empt any input price rises that still lie ahead for them. Follow-up responses suggested actual and anticipated carbon price impacts have had a limited and mixed impact on investment decisions relative to other pressures, such as the high Australian dollar 6

and increasing international competition. Just over 32 per cent of this smaller sample had increased investment in energy efficiency to reduce carbon price impacts. In contrast, just over 20 per cent reported that they had or were planning to scale back or dropped specific investments (rather than their overall level of investment) because the carbon price had either reduced the money they had available for investing in capital or had reduced the attractiveness of particular projects. Table 1: Input prices and selling price intentions, manufacturing Increase in total energy costs due to carbon tax (as reported in Nov) Input price rises experienced from 1 July (as reported in July) Selling price rises planned from 1 July (as reported in June) (% of respondents) (% of respondents) (% of respondents) Yes price increases 66.0% 61.3 39.5 No price increases 4.0% 32.5 51.5 No response / not applicable 30.0% 6.2 9.0 Yes responses by sector: (average % increase p.a.) (% of respondents) (% of respondents) Food & beverage 15.7 90.9 11.1 Basic metals 14.2 71.4 52.9 Chemicals, petroleum & coal 12.0 70.6 38.8 Machinery & equipment 12.6 66.7 38.8 Miscellaneous manufactures 12.8 64.3 58.3 Fabricated metals 14.8 60.3 38.8 Textiles, clothing & footwear 9.5 57.1 33.3 Wood products & furniture 17.0 44.4 50.0 Transport equipment 14.0 37.5 25.0 Paper, printing & publishing 16.3 37.5 14.3 Construction materials 20.7 16.7 60.0 ALL MANUFACTURERS 14.5% p.a. average 61.3% of respondents 39.5% of respondents If yes to a price increase, then: (% of respondents) (% of respondents) Price increase on less than half of all items/services Price increases on more than half of all items / services Price increases on all items/services 76.0 27.0 18.0 22.0 7.0 51.0 7

Figure 2: Average increase in total energy costs as a result of the carbon tax Construction materials Wood products & furniture Paper, printing & publishing Food & beverage Fabricated metals ALL MANUFACTURERS Basic metals Transport equipment Miscellaneous manufactures Machinery & equipment Chemicals, petroleum & coal Textiles, clothing & footwear 0 5 10 15 20 25 Average increase in total energy costs due to carbon tax, % p.a. Figure 3: Australian PMI: manufacturing input costs and selling prices 80 70 60 Diffusion index 50 40 30 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Input prices Average selling prices 8

Services Input price rises After the first full quarter of power bills (as reported to us in November 2012), around half of services businesses surveyed were able to quantify the impact of the carbon tax on their total energy input costs. These businesses said their total energy costs had increased by an average of 13.6 per cent p.a. as a result of the carbon tax. A far higher proportion of services businesses reported no increases in energy costs (7.1 per cent) or unknown increases (9.5 per cent) than did manufacturing or construction businesses. A third reported an increase in their total energy costs of between 1 per cent and 20 per cent p.a. This suggests services businesses were either less affected by energy price rises or were less aware of the impact that energy price rises were having on their business costs than were their counterparts in manufacturing and construction. It also reflects the fact that for most services businesses, energy costs typically account for a much smaller share of their total input costs than is the case for many manufacturing or construction businesses. Across the services sectors, the largest average increase in energy costs was in the property and business services sector (up by 22.3 per cent p.a.) followed by transport and storage businesses (up by 17.8 per cent p.a.). Interestingly, small services businesses reported a higher average increase in total energy costs (17.1 per cent p.a.) than did medium (10.9 per cent p.a.) or large services businesses (11.0 per cent p.a.). This difference in average energy price increases according to business size suggests customer size and bargaining strength is relevant to the way in which higher energy costs are being passed through to businesses, putting smaller firms at risk of another cost disadvantage. In addition to these increases in energy costs, just over one-third (36 per cent) of services businesses reported that their input costs had increased immediately from July due to the carbon tax. 70 per cent of these businesses reported that price increases were restricted to less than half of their inputs. The service sub-sectors with the highest proportion of businesses reporting immediate input price increases due to the carbon tax were transport & storage (65 per cent); accommodation, cafes and restaurants (40 per cent); and communication services (38 per cent). This may be due to the relatively higher fuel and electricity (or other energy) intensity of many businesses in these subsectors. Businesses in the retail trade (23 per cent); personal & recreational (27 per cent); and property & business services (31 per cent) sectors were the least likely to report input price increases in July to the carbon tax. Output price rises and pricing pass through 77 per cent of services businesses that reported their input costs increased immediately in July due to the carbon tax also reported that they intended to increase their selling prices in response. In total, 40.3 per cent of services businesses had planned to increase their output prices due to the carbon tax. This suggests that in sectors that are less trade-exposed (as are most services), price pass-through is easier to implement. 9

Table 2: Input prices and selling price intentions, services Increase in total energy costs due to carbon tax (as reported in Nov) Input price rises experienced from 1 July (as reported in July) Selling price rises planned from 1 July (as reported in June) Carbon tax price rises (% of respondents) (% of respondents) (% of respondents) Yes price increases 41.7 36.3 40.3 No price increases 7.1 53.4 50.8 No response / not applicable 51.2 10.4 8.9 Yes responses by sector: (average% increase p.a.) (% of respondents) (% of respondents) Transport & Storage 17.8 65 47 Accomm., Cafes & Restaurants 15.5 40 22 Communication Services 16.9 38 82 Wholesale Trade 8.6 35 46 Health & Community Services 9.2 33 33 Finance & Insurance 13.0 33 22 Property & Business Services 22.3 31 24 Personal & Recreation Services 9.4 27 33 Retail Trade 16.0 23 48 ALL SERVICES BUSINESSES 13.6% p.a. average 36.3% of respondents 40.3% of respondents If yes to a price increase, then: (% of respondents) (% of respondents) Price increase on less than half of all items/services Price increases on more than half of all items / services Price increases on all items/services 70.0 46.0 17.1 21.0 12.9 33.0 Figure 4: Average increase in total energy costs as a result of the carbon tax Property & business services Transport & Storage Communication Services Retail trade Accommodation, restaurants & cafes ALL SERVICES Finance & Insurance Personal & recreational services Health & community services Wholesale trade 0 5 10 15 20 25 Average increase in total energy costs due to carbon tax, % p.a. 10

80 Figure 5: Australian PSI: services input costs and selling prices 70 Dif fusion Index (Points) 60 50 40 30 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Average Selling Prices Input Prices Construction After the first full quarter of power bills (as reported to us in November 2012), most construction businesses had a better understanding of their cost changes as a result of the carbon tax, and particularly of their energy costs. Only 1.5 per cent of construction businesses reported that their total energy costs had not increased as a result of the carbon tax. The average increase in total energy costs attributable to the carbon tax was 14.8 per cent p.a. for construction businesses. Just over half (50.8 per cent) reported an increase in their energy bill of between 1 per cent and 10 per cent p.a., but a rather high proportion 20 per cent of construction businesses or one in five reported total energy cost increases of 20 per cent p.a. or more. Among construction industry businesses, 52.1 per cent reported that input prices had risen immediately for at least some of their inputs from 1 July as a result of the carbon tax. 63 per cent of these businesses said prices had risen on less than half of their inputs, 23 per cent said prices had risen on more than half of their inputs and 14 per cent said prices had risen on all of their inputs. This compares to 44.0 per cent who had planned to increase their selling prices for at least some of their items from 1 July as a result of the carbon tax. 40 per cent of these businesses had planned to spread the input price rises across all of their selling items and services, while a third planned to raise prices on less than half of their services. The construction sector is not trade exposed in the same way as manufacturing, but it faces difficult demand conditions at present. Inflexible terms in existing long-term contracts are also likely to inhibit price pass throughs in the near term. 11

Table 3: Input prices and selling price intentions, construction Carbon tax price rises Increase in total energy Input price rises Selling price rises costs due to carbon tax experienced from 1 July planned from 1 July (as reported in Nov) (as reported in July) (as reported in June) (% of respondents) (% of respondents) (% of respondents) Yes price increases 64.5 52.1 44.0 No price increases 1.5 44.3 26.0 No response / not applicable 34.0 3.6 30.0 Total energy cost increase 14.8% p.a. average If yes to a price increase, then: (% of respondents) (% of respondents) Price increase on less than half of all items/services Price increases on more than half of all items / services Price increases on all items/services 63.0 23.3 13.7 33.0 27.0 40.0 Figure 6: Australian PCI: construction input costs and selling prices 80 70 Diffusion index 60 50 40 30 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 PCI input prices PCI selling prices (unadjusted) 12

Carbon tax context: national price increases for business and consumers in Q3 The main way the carbon tax is passed on to the majority of businesses and to all consumers is through energy prices, and particularly through electricity prices. Treasury modelling released in 2011 (and re-stated in 2012) estimated that the total price effect of the commencement of the carbon tax would add a one-off, additional hit of 0.7 percentage points to consumer inflation (CPI) in 2012-13. Further, smaller, one-off increases in inflation are expected, as the fixed price increases slightly ahead of its scheduled move to market-based pricing from 2015. The introduction of the carbon tax on 1 July 2012, combined with the continuing rise in networkrelated costs, resulted in the single largest price increase recorded in Australia for household electricity and gas prices in Q3 2012 since the early 1980s, with consumer prices rising by more than 18 per cent p.a. in Q3 2012 for both electricity and gas (see figure 7). This latest increase in household electricity prices came on top of other significant increases over the past decade. National average electricity prices for households increased by 30 per cent between 2000 and 2005, and then by another 50 per cent between 2005 and 2010. The latest rise takes electricity pricing 40 per cent above 2010 levels, and 168 per cent higher than in 2000. Retail gas prices have increased by a similar margin (151 per cent from 2000 to 2012). In comparison, all average consumer prices (headline CPI) increased by 46 per cent from 2000 to 2012. These latest energy price rises have been possible because energy takes a very small direct share of total household consumption (just 2.2 per cent of aggregate national household consumption expenditure in Q3 2012, down from 2.5 per cent in the 1980 s and earlier), and because households have been compensated by Government for the additional cost of carbon emissions in their energy bills. A dramatic increase in investment in energy distribution infrastructure accounts for much of the total cost increase over this period. Figure 7: Price increases for household electricity and gas supplies 20 18 16 Q1 2010: Network investment cost increases passed through to users Q3 2012: carbon tax related price jump 14 12 % p.a. 10 8 6 Q1 2008: Drought related wholesale price increase 4 2 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Headline CPI Electricity Gas & other fuels Source: ABS, Consumer Price Index (CPI), September 2012. The impacts of these energy price rises have been somewhat limited by the small direct share of energy in total household consumption (just 2.2 per cent of aggregate national household consumption expenditure in Q3 2012, down from 2.5 per cent in the 1980 s and earlier), and the 13

carbon component of the latest rise has been more than fully offset for most households by Government compensation via tax cuts and benefit increases. Recent falls in national electricity demand suggest these price rises are influencing consumer behaviour, although other factors are also contributing to this trend. For the majority of businesses that are not direct emitters of carbon and do not participate in the carbon emissions permits system (with its attached offsetting assistance measures), there has been no compensation for rising energy costs equivalent to that received by households. Industries that are highly emissions intensive and trade exposed (EITE) qualify for assistance that significantly offsets the direct and indirect impacts of the carbon tax, but the overwhelming majority of businesses do not meet these tests and do not receive compensation. Instead, businesses are expected to either pass on their increased costs to consumers where possible, to absorb the price rises themselves, or to act to reduce their exposure to carbon costs. Any resulting pricing passthrough allows the incentive effect of the carbon tax to spread throughout the economy, via marketbased price signals. Some forms of compensation would risk blunting these price signals, rendering the carbon tax less effective in its stated aim of changing resource use and consumption preferences across the economy. The household assistance package and assistance for EITE industries are designed to avoid this risk, letting prices adjust and leaving abatement incentives in place. Nonetheless the flow of price changes and business adjustments take time. Evidence to date indicates that after only one full quarter of experiencing the carbon tax, the pricing signals - and therefore the response process - are only just beginning to operate. The ABS publishes detailed producer pricing index (PPI) data each quarter for major inputs and outputs in the manufacturing industry that enable an analysis of this process (these data are not, unfortunately, available at this level of detail for all industries). The PPI data show a rather complex story for manufacturers input pricing in Q3 2012, with the carbon tax interacting with a range of other pricing pressures including changes in commodity prices (see figure 8). Figure 8: Price increases for manufacturers inputs and outputs 25 20 15 Commodity price spikes Q3 2012: carbon tax related price jump 10 % p.a. 5 0-5 -10-15 Commodity price slumps -20 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 All manufacturing inputs Manufacturing inputs: Gas Manufacturing inputs: Electricity All manufacturing outputs Source: ABS, Producer Price Index (PPI), September 2012. 2 2 In the September quarter edition of the PPI, the ABS stated that: the ABS will not be able to quantify the impact of carbon pricing, compensation or other government incentives and will not be producing estimates of price change exclusive of the carbon price or measuring the impact of the carbon price. Any changes in the 14

Although electricity prices increased sharply for manufacturers in Q2 2012 (up by 17.2 per cent p.a.), average prices for all inputs actually fell by 1.8 per cent p.a., due to price falls in many mining and agricultural products from their recent, very high pricing levels. The input price falls were led by: imported inputs (down by 1.2 per cent p.a.), agricultural inputs (down by 4.3 per cent p.a.), coal input prices (down by 3.5 per cent p.a.), iron ore input prices (down by 10 per cent p.a.), primary metals prices (down by 10 per cent p.a.) and basic non-ferrous metals prices (down by 9.5 per cent p.a.). These price falls in other inputs helped to cushion the impact of rising energy input costs at an aggregate level, and were largely passed on almost immediately by manufacturers, with average output prices (for all manufacturing) falling by 1.5 per cent p.a. in Q3 2012. The same PPI data show that over the pricing cycles (which largely reflect the fortunes of commodity markets, which then flow through into inputs for all businesses) manufacturers output prices rarely rise by the same extent as their input prices (see figure 8). This gap between input price rises and output price rises reflects the pressure placed on many businesses to absorb their cost increases. In 2012, the aggregate indexes for both input prices and output prices have fallen for manufacturers. This long-term pattern of cost absorption is evident in our own research, including in our monthly Ai Group Performance of Manufacturing Index (the Australian PMI, see figure 3 above). In the national data, this has already contributed to a further decline in nominal profits and profitability (profit ratios) for manufacturers in Q3 2012 (see figure 9). Construction businesses have also faced higher costs, but so far seem to have been able to protect their profit margins to a greater extent by passing on their increased costs. In aggregate however, profit margins have been trending down for construction businesses over the past two years (see figure 10). Our research indicates businesses in these two major sectors have been more directly affected by the introduction of the carbon tax than have services businesses, as was anticipated by the Treasury modelling. These cost increases arising from the carbon tax are not occurring in isolation; they come on top of existing margin pressures and an existing downward trend in output prices, which is especially evident in manufacturing. prices charged by companies for their outputs, paid by companies for their inputs or paid by consumers, will be reflected in the suite of price indexes compiled and published by the ABS. Further information on the expected impacts of the introduction of carbon pricing is available in the publication Strong Growth, Low Pollution Modelling a Carbon Price (The Treasury, 2011). 15

10.0 9.0 8.0 Figure 9: Profits and profitability, manufacturing 0.13 0.12 0.11 $bn per quarter, nominal, trend 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.10 0.09 0.08 0.07 0.06 0.05 0.04 Profits to sales ratio 0.0 1996 1998 2000 2002 2004 2006 2008 2010 2012 Corporate profits (left) Unincorprated profits (left) Profit margin (right) Source: ABS, Business Indicators, September 2012. 0.03 5.0 4.5 4.0 Figure 10: Profits and profitability, construction 0.12 0.11 0.10 $bn per quarter, nominal, trend 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.09 0.08 0.07 0.06 0.05 0.04 0.03 Profits to sales ratio 0.0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Corporate profits (left) Unincorprated profits (left) Profit margin (right) Source: ABS, Business Indicators, September 2012. 0.02 16

Ai Group research methodology In June 2012, 621 businesses answered this survey question: Are you planning to increase any of your selling prices from 1 July 2012 as a result of the introduction of the carbon tax? 200 manufacturers 191 services businesses 230 construction businesses In July 2012, 527 businesses answered this survey question: Did any of your input prices increase in July 2012 as a result of the introduction of the carbon tax from 1 July? 194 manufacturers 193 services businesses 140 construction businesses In November 2012, 485 businesses answered this survey question: How much have total energy costs for your business (including electricity, gas and all carbon-based fuels) gone up since 1 July 2012 as a result of the introduction of the carbon tax? 187 manufacturers 168 services businesses 98 construction businesses A more detailed research module was conducted in July and August to supplement these broader results with more in-depth responses from a smaller sample of highly engaged businesses. 33 manufacturing businesses responded. These were largely medium to large entities who had previously expressed an interest in pricing impacts of the carbon tax. These businesses primarily operated out of Victoria (60 per cent) or had sites in multiple locations around Australia (25 per cent). Ai Group Economics and Public Policy Research Teams Dr Peter Burn Director of Public Policy (02) 9466 5503 Tennant Reed Principal National Adviser, Public Policy (03) 98670145 Katrina Buxton Senior Adviser, National Public Policy (03) 98670210 Julie Toth Chief Economist (03) 98670124 David Richardson Senior Economist (02) 94665456 Dr Sze-Young Lim Senior Economist (03) 98670231 Chris Lill Economist (03) 98670261 Colleen Dowling Senior Research Coordinator (03) 98670280 Lisa Walker Research Assistant (03) 98670108 For further assistance from Ai Group s Economics & Research Team, please email economics@aigroup.asn.au. 17