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  • Writer's pictureVoytek Chelkowski

The paradox of carbon tax.

Ensuring a just and equitable transition toward low-carbon shipping

Ensuring a just and equitable energy transition in shipping is a must if it is to be truly sustainable and it takes time to get this right. Yet, time is not our friend when it comes to the environment and, paradoxically, when we account for dry bulk shipping economics, time may work against a just and equitable transition too.

Time is not our friend

Ensuring a just and equitable energy transition in shipping is a must if it is to be truly sustainable. A transition where the rich will get richer, and the poor get poorer will not work, and it takes time to get this right. Yet, time is not our friend when it comes to the environment. Missing the targets set by the Paris Agreement may produce grave consequences, especially for developing countries. Understandably, the tension between the ‘E’ and the 'S’ of ‘ESG’ (Environmental, Social, Governance) grows more evident every day.

There is a frustration that regional governments act (e.g., EU ETS), while the IMO is moving at a far slower pace. One of the key elements slowing its pace is a concern about the increase in the cost of maritime transport consequential to the introduction of market-based measures, necessary to create a level playing field between green and fossil fuels. How do we ensure that it will not disproportionately affect developing countries and disturb existing trading patterns? And, how can we agree on the right way to divide and recycle the future revenues back to the system?

We must keep in mind that the IMO, a consensus-driven organization, needs to bring more than 171 countries on board. Reaching a consensus on such important issues across such a broad forum does take time. But, in balancing these important issues, assessing the cost of the time of prolonged uncertainty due to pushing back this consensus may be just as important. Paradoxically, viewed through the lens of dry bulk shipping economics, the time taken to discuss these issues may well work against a just and equitable transition.

There is more to freight than meets the eye

While it may be obvious for those familiar with dry bulk shipping economics, there is more to freight than the cost of fuel and the future carbon tax. The key element that drives the volatility of freight, somehow forgotten in this debate, is the cost of the time of shipping assets, expressed in time charter rates (see Fig.1) . These rates are not established on a ‘cost-plus’ basis. Instead, they are driven by the dynamics of ‘hockey stick’ economics. The key to ‘hockey stick economics’ is the interaction between the supply of ships that transitions from perfect elasticity to perfect inelasticity and inelastic demand for dry bulk freight.

Fig. 1: Estimated average annual share of the cost of time and fuel in the voyage freight for the exports Capesize iron ore from China to Brazil. Source: Clarksons Research & Baltic Exchange

Demand for dry bulk freight is derived from the demand for commodities. And, as freight represents a small fraction of the delivered value of commodities, demand for bulk freight is highly inelastic. Even in the case of iron ore exports on long hauls where its share in the cost of delivered value is higher than in other commodities, history shows that volatile swings of freight barely move the needle on the shipped volumes (ditto the data for the past 8 years on iron ore exports ex Brazil).

Enter ‘hockey stick’ ship supply. During times of underutilized fleet, the drop in time-charter rates has no effect on the increase of seaborne freight. The supply is perfectly elastic. However, as the world runs out of available ships and their utilization reaches more than 90%, freight rates go into wild swings, producing volatility unmatched by any other commodity. The reason is simple enough. You don’t build ships overnight. So long as the shortage persists and demand remains strong, high rates will persist. In the past 20 years, hockey stick economics delivered swings that made headlines for affecting the cost of ocean transport of commodities. Firstly, during the period referred to as the ‘super-cycle' between 2004 and 2008, and secondly during the post-Covid recovery in 2021.

Balancing carbon tax and hockey stick economics

The shipping industry is ready to decarbonize. The call for action signed by the leaders of the industry demonstrates just that. To scale up the necessary investment and accelerate decarbonization, besides technological breakthroughs, the shipping industry needs a clear pathway toward a level playing field. The incoming EEXI and CII regulations represent good progress but are insufficient to de-risk the long-term investment in green shipping assets. The lack of clarity in that regard produces continued uncertainty that, next to other macroeconomic and shipping market-related factors, delays the necessary renewal of the dry bulk fleet at a time when its growth remains at a two-decade low.

Fig. 2: Average annual Capesize time charter rates. Source: Clarksons Research & Baltic Exchange

The low growth of the late 1990s and early 2000s colliding with the insatiable demand for bulk commodities from the emerging Chinese economy produced a super cycle that sent the Capesize time charter rates to a 5-year average of $71,500 per day, as compared to about $20,000 average since 2018 (see Fig. 2). Of late, the world had a taste of the interaction of the prolonged low fleet growth with the post-Covid recovery that moved the rates from single digits, in January 2021, to about $70,000 per day in October 21' and about $15,000 today (see Fig. 2).

To place these numbers in the context relevant for market-based measures, a freight disadvantage on Capesize iron trades from South America vs Australia to North Asia, resulting from an introduction of a $100 carbon tax, would equate to an increase in time charter rates by about USD 12,000 per day. If the dry bulk freight market were to experience the violent swings of 2021, the corresponding impact of charter rates on the cost of freight may be disproportionately greater than that following the introduction of a carbon tax.

The paradox of carbon tax

Over the past 12 months, the dry bulk market has not been spared from the adverse effect due to the softening demand from China, inflation, and the looming recession. This apparent softening may be misleading for long-term fleet development. All recessions have one thing in common- they eventually come to an end, and this one will be no different. Ensuring the dynamics of the dry bulk fleet renewal are set in motion so that we do not run out of ships when the world economy recovers in a few years, is a must. And, a clear pathway toward pricing carbon will reduce the uncertainty that stands in the way of setting these dynamics in motion.

Time is not our friend, not only when it comes to the environment, but a just and equitable transition too. Failing to act urgently on market-based measures now, may cost those who wish not to be affected by the shipping energy transition far more than the fear of the increased cost of ocean transportation due to a carbon tax. As President Roosevelt noted, “The only thing we have to fear is fear itself”. When we account for shipping economics, the paradox of a carbon tax is that time may prove that the only thing we should have feared, was the fear of its introduction itself.

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