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June 5th, 2009:

Carbon Duties: Heat Rising On Developing Economies

Tom Holland, SCMP – Jun 05, 2009

You probably don’t spend much time wondering what Tung Chee-hwa is up to these days, so it’s unlikely you noticed in April when Hong Kong’s former chief executive cropped up in New York, warning that a proposed United States tax on imports could spark a heated trade dispute with China.

If you think his warning was old news, you’re wrong. Mr Tung is well ahead of most of Hong Kong’s business and finance community in waking up to a new danger. With good reason: under the most likely scenario, Orient Overseas (International) (SEHK: 0316) Ltd, the shipping company controlled by Mr Tung’s family, could be one of the biggest losers from a new tax.

Mr Tung is worried about proposals to slap a carbon duty on imports from the mainland.

With December’s Copenhagen climate conference fast approaching and developing economies, led by China and India, fiercely opposed to accepting reductions on their own emissions of greenhouse gases, calls are mounting for the US and Europe unilaterally to impose carbon taxes on imports from unco-operative countries.

If they do, the effect on Asian companies’ earnings could be devastating.

In a new research report, Simon Smiles, the head of thematic research at investment bank UBS, has estimated the bottom-line impact on Asian corporations of three different carbon pricing schemes.

Under the first scenario, Asian countries introduce their own domestic carbon pricing regimes, either through cap-and-trade programmes or through direct taxes. In this case, the heaviest blow would fall on the profits of big domestic emitters like power generators, steel mills and cement companies.

Assuming that domestic pricing aims for a 20 per cent reduction at a relatively conservative cost of US$9 a tonne for overall carbon emissions, Mr Smiles calculates that the earnings per share of Hong Kong-listed mainland power producers such as Datang International Power Generation (SEHK: 0991) would be wiped out entirely, with the companies plunged deep into loss. However, the chances that Beijing will impose a meaningful domestic pricing system any time soon are negligible.

As a result, the second scenario, under which the US and Europe introduce their own pricing schemes and simultaneously impose carbon duties on products imported from Asian countries in order to level the playing field for their domestic producers, is far more likely. This outcome would deal a disproportionately harsh blow to the earnings of airlines and shipping companies that do business with the US and Europe.

According to Mr Smiles’ research, Cathay Pacific Airways (SEHK: 0293)’ earnings could fall 8.1 per cent, while OOIL’s earnings would slump 9.7 per cent.

The most damaging scenario, however, is the last. In this one, the developed world concludes that it is impossible to mitigate climate change unless China and India begin to reduce their emissions and so introduces a flat tax on goods imports intended to force their hands.

Mr Smiles estimates that this could result in an 8.5 per cent duty on all imports from China, which would be enough entirely to wipe out the profits of computer manufacturers such as Lenovo Group (SEHK: 0992, announcements, news) and which would eat deep into the earnings of supply-chain manager Li & Fung and clothing company Texwinca (SEHK: 0321) (see the chart).

Such an extreme scenario is unlikely. But the second possibility – an equalising carbon duty on imports to level the playing field for developed-world producers – is looking increasingly probable.

US Secretary of Energy Steven Chu is in favour of such a scheme, and legislation currently before the Congress allows for equalising duties on imports of iron, steel, aluminium, cement, glass and a range of chemicals.

Mr Tung is right to be concerned, and investors in Hong Kong stocks should be worried.