It is widely known that the energy shocks of 1973 and 1979 triggered significant changes throughout the world economy. What is less widely recognized is that the oil shocks, by affecting the price of electricity generation, dramatically altered the international competitiveness of industries whose production processes use large amounts of electricity.
Furthermore, the energy shocks did not increase the price of electricity in all countries equally because some nations are blessed with sufficient hydropower or low-cost coal to prevent electricity prices from rising as sharply as in nations more dependent on oil-generated power. As a heavy user of electricity, the primary aluminum smelting industry provides a leading example of the effects of such variations in energy costs.
Primary aluminum is produced from bauxite ore. Bauxite is mined from ore deposits and converted first into alumina by the Bayer process. Alumina is then converted into primary aluminum using the Hall-Heroult smelting process. This smelting stage, more than any other stage of the production process, is extremely energy-intensive and makes heavy use of electricity. Even though oil prices in the mid eighties are below the peak they reached in 1980, there has been no return to the cheap energy of the 1970s: in real terms the price declines still left 1985 oil prices about 70 percent higher than their 1972 level. For the energy-intensive aluminum smelting process the energy price increases since 1972 have been significant; more important, the differences in electricity prices among regions remain. Hence, the restructuring of the primary aluminum industry—that is, the shift of production from one region to another—begun in the 1970s is likely to continue.
Restructuring has occurred mainly in the six countries that account for about 90 percent of primary aluminum production. With the rise in energy costs, three of these producing areas—Japan, the United States, and Western Europe—have become high-cost locations for primary aluminum production relative to three others—Australia, Brazil, and Canada (the so-called ABC countries). These changes are largely the result of the post-1972 differences in the price of electricity. These differences, in turn, have been greatly affected by public policy decisions.
Electric power—the key input for aluminum smelting—is produced either by government-owned or government-regulated suppliers. In most countries, aluminum smelters are one of the biggest industrial users of electric power. In making decisions about electricity rates, governments are inevitably making decisions about the aluminum industry: whether to promote its growth in the low-cost power countries, and whether to maintain its existing size in the high-cost power countries. Governments also influence their aluminum industries by the more general measures of taxes, exchange rates, tariffs, and industry subsidies. The provision of electric power, however, is the element that makes government involvement in the aluminum industry distinctive.
The adjustment process
Before 1980, the construction of new capacity to serve a growing demand was the main method by which the geographical distribution of aluminum capacity changed. That has not been the case since 1980, however; demand has been in constant flux, but the trend in aluminum consumption has been flat, showing practically no growth. The hope remains that the no-growth era reflects only the recessions of the early 1980s and that, in due course, aluminum consumption will resume its growth. Forecasts of the long-run growth of aluminum consumption, however, are not clear about such a trend and in fact show wide variation.
The growth of demand will determine, in part, the rate at which new capacity is constructed in the countries with available low-cost power. The process is not a mechanical one, but one which responds to the differences in electricity prices among nations (see table 1). Major concessions on power costs thus can speed up the process of building new smelters.
Primary aluminum production in Canada demonstrates how responsive new capacity construction can be to changes in electricity prices. Hydro-Quebec, Canada's leading hydropower producer, offered 8-mill power to new smelters for the first five years of their operation, which has led to a wave of planning for new smelters. Brazil has made comparable concessions. Because the particular arrangements in the two countries are sometimes tailor-made for each company and involve long-term contracts, exact comparisons are not possible. Still, there is obviously a market for new capacity, albeit an imperfect one, and concessions in one country tend to be matched in others. Such a competitive process can accelerate the relocation of smelting capacity.
The other way in which smelting capacity shifts its geographic distribution is by the closing of smelters in high-cost countries. Japan is the best example, with more than half of its 1975 capacity closed by 1983 in response to the high price of electricity. However, a government and industry plan for the closing of the smelters provided aid to those who suffered the losses. Concurrently, Japanese producers began building smelters in Brazil; as a result, the shift from high-cost to low-cost locations was partly internalized within the individual firms.
The United States has lost competitiveness for the construction of new smelters and may be in the process of losing competitiveness for the operation of existing smelters. The highest-cost smelters have been closed, but there are others that are on the margin of international competitiveness. Their fate depends on future decisions on electricity rates, which are complicated in the United States by the great diversity of suppliers of electric power. Some suppliers have given high priority to keeping their smelter customers in operation by granting concessions on electricity rates; others have not.
Western Europe also has a diversity of smelters, but in this case the diversity stems largely from national differences in the supply of electric power. The region as a whole has lost international competitiveness, but few smelters have closed. In contrast to Japan, Western European smelters have received subsidies or concessions on electricity prices that have permitted their continued operation.
Effects of public policy
The world aluminum industry was particularly vulnerable to the energy shocks of the 1970s not only because of its extensive use of energy, but also because of the great expansion of the industry in the 1960s in countries that even then were high-cost locations. The expansion reflects a view that it was important to locate smelters close to the market—that is, the fabricators in the industrialized countries. The lower level of energy prices and their smaller variation among locations in the 1960s meant that the cost penalty of a location close to the market was small.
In addition, at that time there were large infrastructure costs in locating production in Brazil and Australia, two of the low-cost power countries; in Canada, the third ABC country, Alcan dominated the industry. All of these factors may have discouraged earlier shifts to low-cost locations.
Public policy also played a role in concentrating investment in the United States, in Western Europe, and particularly in Japan. The growth and continued existence of the Japanese primary aluminum production capacity required tariff protection, an undervalued yen, and low-priced oil. The rounds of tariff reductions and the rise in the yen in the early 1970s made the industry noncompetitive even before the oil shocks. In Western Europe the promise of low-cost nuclear power led to policies to encourage the expansion of smelting capacity, particularly in the Federal Republic of Germany and the United Kingdom.
Table 1. Price of Electricity to Aluminum Smelters (in 1982 dollars)
In the late 1970s, when nuclear power turned out to be much more expensive than anyone had forecast, the aluminum smelting industry in Western Europe might well have been noncompetitive even without the oil shocks. In the United States, smelter capacity expanded mainly because more firms were entering the market in response to the high growth rate of aluminum demand. This concentration of investment was perhaps the least affected by public policy.
In Japan and Western Europe, public policy after the oil shocks had to cope with the question of how to deal with an industry that had become internationally noncompetitive. As indicated earlier, the Japanese response was to close smelters under an explicit policy that involved measures to shift the resulting losses to the economy generally rather than have them borne entirely by aluminum producers and their workers. Losses were shared among the shareholders of the aluminum companies, the industrial groups to which these companies belonged, the financial institutions that had made loans to the companies, and the government.
Incentives or pressures to reduce capacity were provided both by market forces and subsidy schemes. Although the reductions in capacity may not have proceeded as fast or been as extensive as the loss in international competitiveness required, the adjustments were surely in the right direction. It may well be that relying on market forces alone would have brought about an even quicker adjustment by the industry to the energy shocks. In that case, however, the concentration of losses among the aluminum companies alone might have resulted in an effort to obtain subsidies to keep the smelters in operation.
A case in point
The case of Western Europe represents just such a policy—the use of subsidies to offset and nullify the loss in international competitiveness and continue the operation of existing smelters. The rationale for such a policy is primarily to maintain employment, but in some countries, particularly West Germany, there are additional justifications; smelting operations may provide demand for high-cost coal or nuclear power generation. Apparently, aluminum fabricators also favor domestic sources of supply (which is not surprising when the costs of such a supply are subsidized).
Subsidizing an industry that has lost its international competitiveness is an inefficient use of resources. Although there are social costs from unemployment that could justify the subsidization of the smelters, that argument could be applied to almost any industry. It is peculiarly puzzling to find it applied to aluminum smelting, which is not very labor intensive.
The difference in policy response between Japan and Western Europe probably is a reflection of general economic policy. Japanese industrial policy is more explicitly aligned with the promotion of resource reallocation to favor industries that are internationally competitive.
In contrast, Western European policy is more concerned with maintaining employment in specific industries and in using subsidies to achieve that objective. There are, of course, wide variations among nations and industries in Western Europe. And as the current disputes over agricultural, coal, and steel subsidies in Western Europe show, there are indications of change. But the case of the aluminum industry suggests that Japan has a comparative advantage in the flexibility with which it alters its economy to fit its changing international competitiveness.
U.S. policy
Much U.S. policy is the result of decentralized decisions by the various suppliers of electric power to aluminum smelters, decisions in which the suppliers have used various pricing policies, although the price of power has climbed sharply, resulting in the closing of some smelters. That situation may be changing, however, as electricity prices have continued to increase. More smelters are closing, and the suppliers of power are considering special rates to keep their smelter customers in operation. In contrast to Japan, there has been no federal policy in this country to assist the aluminum industry in its adjustment.
An observer might think that formulating public policy in the ABC countries would be simpler because it is easier to adjust to winning than to losing. Each of these countries apparently had large supplies of low-cost power and thus was in a position to attract smelting capacity. And yet in each of the three, the aluminum industry is a subject of considerable controversy.
The factor market
The textbook theory of international economics assumes that factor markets—markets for labor, capital, land, and energy, for example—are competitive. But the key factor market in aluminum smelting is the one for electric power, which is highly imperfect on both sides of the market. On the seller's side are the power agencies in the three low-cost power countries; on the buyer's side are the few large multinational aluminum companies. There are rents to be gained on the limited number of low-cost power sites. The combination of rents, imperfect competition, and public agencies is bound to lead to controversy.
The competition among countries for smelters can drive the price of electric power below its long-run marginal opportunity cost. Such an outcome may have occurred in Canada, while some Brazilian economists think this may have occurred for the very large-scale power projects in northern Brazil.
A related issue is whether countries that have gained competitive advantage have given away too much to the industry. That question has arisen in Canada because Hydro-Quebec has been eager to use cheap hydropower as an instrument of economic development. The policy question is whether in the long run this policy serves the best interests of the province.
For Brazil, the investment in smelters is part of a major development effort for the northern part of the country. The project involves the construction of bauxite mines, alumina plants, and smelters as well as transportation facilities and even housing, and it extends to iron mining and other industries. Aluminum projects, however, are only a small part of the strategy for the development of northern Brazil, the "Great Carajas Program," involving an investment of $62 billion.
Given Brazil's general economic difficulties in recent years, it is not surprising that some of the larger projects have been delayed. And there has been considerable criticism of the export-oriented, capital-intensive character of the development plan. The aluminum projects have not been spared that criticism. Even so, they have moved toward completion, perhaps because the close link to the world aluminum and capital market provided by the participation of Japanese and big six companies has insulated the aluminum projects from the country's more general economic problems.
Australia raises a quite different set of questions. The country is generally classified as one that has gained international competitiveness. Certainly the pattern of new aluminum smelter construction suggests that this is so. Yet this common view may not be accurate.
It may also be that Australia had a competitive advantage but managed to bargain it away. In Brazil and Canada, the process of dividing the rents has been limited to the supplier of power and the primary producers. The unique feature in the process in Australia was the addition of labor unions as significant rent-seeking participants—so significant, in fact, that Australia's competitive advantage may well have been squandered.
Uncertain outlook
Policy is shaped by national institutions and the direction of general economic policy, as well as by the particular position of the national aluminum industry in the world market. The aluminum industry demonstrates the importance of factor markets and government intervention in those markets. Economic purists may bemoan such intervention, but it may actually have a less distorting impact on trade than those older instruments of trade policy, tariffs and quotas.
Resource misallocations seem modest when compared, for example, with those occurring in agriculture, an area in which traditional protectionism operates. And it is interesting to note that despite the great changes in international competitiveness, the commitment of nations to free trade has been strong enough that no quotas for primary aluminum have been established, nor have tariffs been raised.
If the primary aluminum producer nations that lose international competitiveness maintain or even expand their aluminum industries, those that have gained competitiveness will lack the markets to expand their industries. Among the nations that have gained competitive advantage, there is intense rivalry, for if one nation expands at a rapid rate, less of a market would remain for the others.
It is generally assumed that the world aluminum market will coordinate and harmonize the decisions of various national aluminum industries. But with public policy playing such a major role, the proposition that the market will bring about an efficient allocation of aluminum production among nations must be verified empirically and cannot be assumed.
Merton J. Peck is acting dean of the Yale School of Organization and Management, and Thomas DeWitt Cuyler professor of economics at Yale University. This article is excerpted from the introductory chapter of Merton J. Peck, ed., The World Aluminum Industry in a Changing Energy Era, to be published by RFF in the summer of 1988.
A version of this article appeared in print in the May 1988 issue of Resources magazine.
