1. Envecon 2011 The impact of transport costs on trade Robin Smale, Vivid Economics The Royal Society, March 2011 robin.smale@vivideconomics.com +44 844 8000 254, +44 7823 329054

2. The effects of shipping costs on trade How shipping costs affect markets for iron ore, grain and oil economic impacts of cost increases on transport and product markets the impact on freight rates of higher bunker prices on selected routes —Capesize iron ore shipping —container shipping the impact of higher freight rates on selected trade and product markets —iron ore in China —a selection of other commodities and markets conclusions

3. The magnitude and distribution of impacts within and across markets can be described 3 Figure 2This illustration shows how the burden of costs is distributed for a fuel cost increase Source: Vivid Economics revenue raised or payments to fuel suppliers costs borne by overseas producers due to loss of profit margin costs borne by overseas producers due to loss of quantity costs borne by consumers gains to overland producers due to change in profit margin gains to overland producers due to change in quantity costs borne by ship owners In the longer term a change in fuel costs will alter patterns of trade as the competitiveness of producers in different locations changes

4. The cost pass-through of increased freight rates into product prices varies across products and markets 4 Product market Cost pass- through (%) Product market Cost pass- through (%) Wheat South Africa 10–40 Iron ore China* 52 Wheat Kenya50–75Furniture EU60–90 Wheat Algeria 50–75Apparel EU10–40 Barley China10–25 Crude oil South Korea* 111 Rice Philippines 5–20 Crude Oil US* 73 Maize Saudi Arabia 90–100 Table 2Cost pass-through can range from around 10 per cent to over 100 per cent Source: Vivid Economics *the estimates for these markets were made with a detailed quantitative model, while the others are estimates based on market research This is driven by import market share, maritime cost share and the intensity of competition Factors that determine cost pass- through are:  how freight rates respond to increased bunker price;  share of maritime transport costs within product prices (a function of distance and efficiency); and  the ability of maritime importers to pass on costs to local consumers  in turn, this depends upon the share of imports in the local market, the cost structure of local and importing firms, and the intensity of competition

5. The effects of shipping costs on trade How shipping costs affect markets for iron ore, grain and oil economic impacts of fuel prices on transport and product markets the impact on freight rates of higher bunker price on selected routes —Capesize iron ore shipping —container shipping the impact of higher freight rates on selected trade and product markets —iron ore in China —a selection of other commodities and markets conclusions

6. Bunker price exhibits substantial volatility over time Figure 3Bunker price generally rose until mid-2008 before falling sharply; bunker price for Singapore is presented and the relationship is similar for other bunker sources Source: Vivid Economics and Clarksons data 6

7. The spot freight rate on the Brazil to China iron ore route peaked in 2008 Figure 4Volatility in spot iron ore freight rates has been increasing over time and movements in freight rates are similar across routes, suggesting a global market for Capesize vessels Source: Vivid Economics and Clarksons data 7

8. Higher bunker price is associated with higher spot freight rates on the Brazil to China iron ore route 8 Figure 5The relationship between spot freight rates and bunker price is positive but there is substantial volatility Source: Vivid Economics and Clarksons data

9. Container freight rates show a different pattern to the freight rates for bulk commodities Figure 6Container freight rates on front-haul and back-haul routes do not always move in tandem Source: Vivid Economics and UNCTAD data 9

10. Bunker price appears correlated with the EU to Asia container freight rate, but there is a lot of variation 10 Figure 7Bunker price appears to be a smaller influence on freight rates for containers than for the bulk commodities Source: Vivid Economics and Clarksons data

11. The elasticity of the freight rate to bunker price is found to differ across shipping markets 11 Shipping market Vivid Economics estimates (average for all routes) UNCTAD estimates Panamax grain0.19N/A Capesize ore0.961.00 Containers0.120.19-0.36 VLCC0.370.28 Table 1A 10 per cent increase in the fuel price would increase the selected freight rates by between one and ten per cent Source: Vivid Economics and UNCTAD (2010) It is estimated using statistical analysis of past data the equations as estimated include a range of other variables in addition to fuel price —global fleet size for the relevant vessel type = shipping supply —total global trade in the cargo = demand for shipping —volume of trade on connected container routes —climatic effects for grain markets

12. The effects of shipping costs on trade How shipping costs affect markets for iron ore, grain and oil economic impacts of fuel prices on transport and product markets the impact on freight rates of higher bunker price on selected routes —Capesize iron ore shipping —container shipping the impact of higher freight rates on selected trade and product markets —iron ore in China —a selection of other commodities and markets conclusions

13. Domestic production accounts for two-thirds of the Chinese crude iron ore market by weight 13 The low iron content of domestic ore means China is nevertheless dependent on imported ore for half of its iron requirements Figure 8Proportion of Chinese market for non-agglomerated iron ore by producer country, average 2005–07 Source: UNSD COMTRADE database, US Geological Survey Land producers gross weightadjusted for metal content

14. Large firms, both domestic and foreign, supply most of the Chinese iron ore market The three largest iron ore producers account for about a third of the Chinese market and half of imports. Rio Tinto is the largest private supplier to the Chinese market. Chinese state-owned enterprises as a whole hold a larger market share than any foreign company Source:InfoMine, UNSD COMTRADE database, US Geological Survey. Note proportions are estimated from aggregate import figures due to lack of data on destination of production from individual mines and companies. Figure 9Proportion of Chinese market for non-agglomerated iron ore (adjusted for metal content) by controlling interest 14

15. It costs around twice as much to ship ore to China from Brazil than from India or Australia 15 Chinese iron ore has a much lower metal content than imported ore Country of origin Clarksons freight rate to China ($ per tonne) (2005 to 2007 average) Metal content of ore (%) Implied freight rate ($ per tonne of metal) Australia16.2662.526.02 Brazil38.8365.958.92 China-32.9- India20.1864.031.53 Iran22 (assumed)48.245.64 Rest of the World35 (assumed)58.959.44 South Africa27.1263.242.91 Table 5Freight rates for iron ore are converted into an equivalent freight rate per tonne of metal Source: Vivid Economics calculations from Clarksons and the US Geological Survey data

16. Cost pass-through of increased shipping costs is estimated to be between 50 and 60 per cent InitialFinalChange Spot market including Chinese state-owned firms Market Size (million tonnes p.a.)412.3407.7-1.13% Price ($ per tonne)111.9113.51.42% Domestic market share46.0%59.6%13.64% Land-based market share46.3%60.2%13.92% Sea-based import market share53.7%39.8%-13.92% Average added cost for sea importers ($ per tonne) 3.07 Cost pass-through for sea importers 51.7% 16 Chinese producers increase their market share by around 13 per cent Table 6A 10 per cent rise in the cost of bunker fuels increases the average freight rate to China by around $3 per tonne of metal Source: Vivid Economics calculations

17. Profit margins for foreign producers fall by up to $3 per tonne of metal, while those for Chinese producers rise by around $1.50 Origin Original market share (sales in China) Change in market share in percentage points Change in margin ($ per tonne of metal) Spot market including Chinese state-owned firms Australia29.4%-0.9%-0.9 Brazil8.3%-2.4%-4.1 China46.0%+13.6%+1.6 India11.2%-6.5%-1.4 Iran0.4%-0.4%-2.8 Rest of the World2.7%-2.7%-4.1 South Africa1.6%-0.9%-2.7 17 Foreign producers with less production and which are further away suffer greater falls in export sales Table 7Reductions in profit margins are smaller but those in export volumes are larger if state-owned Chinese firms do not participate in the spot market Source: Vivid Economics calculations

18. 18 Producers who are smaller and further away are more affected Indian firms suffer greater output losses than Australian or Brazilian ones because Indian mines are smaller and have higher costs Australian producers suffer smaller reductions in profit margins and output than Brazilian producers because of the shorter sea route most of the increase in Chinese production is because the small privately owned mines increase output aggressively as the rise in price improves their competitive position significantly as their original margins were very small —if the small Chinese firms are not able to expand output, or if control of iron ore production in China is less diffuse than is presumed, then the impact on foreign producers will be less —in the extreme case where small Chinese mines could not increase output, then cost pass- through would be close to 100 per cent and there would be minimal loss of Chinese sales in exporting countries Australian producers suffer a smaller decrease in export sales and profit margins than Indian or Brazilian producers

19. The effects of shipping costs on trade How shipping costs affect markets for iron ore, grain and oil economic impacts of fuel prices on transport and product markets the impact on freight rates of higher bunker price on selected routes —Capesize iron ore shipping —container shipping the impact of higher freight rates on selected trade and product markets —iron ore in China —a selection of other commodities and markets conclusions

20. Higher fuel prices will change transport and trade patterns; with the extent of changes depending upon the market 20 Shipping market Elasticity of freight rates to bunker price Cost pass-through of freight rates into product prices marketper cent pass-through Capesize ore0.96China iron ore52 Containers0.12 EU furniture60-90 EU apparel10-40 VLCC0.37 US crude oil73 South Korea crude oil111 Panamax grain0.19 Wheat South Africa10–40 Wheat Kenya/Algeria50–75 Barley China10–25 Rice Philippines5–20 Maize Saudi Arabia90–100 Table 8Higher fuel prices will lead to higher freight rates, and some of this cost will be passed on in the form of higher product prices for the cargo carried Source: Vivid Economics calculations Any burden is shared between shippers, cargo producers and cargo consumers in different proportions across markets

21. Regional changes in production costs would affect trade by a similar mechanism Carbon prices are currently low but moving upwards Countries and regions have adopted unilateral strategies Inter-country differentials may change over time and may grow, with prices of $70/tCO 2 or more in 2030 suggested by some For example, differential carbon pricing may change commodity prices and trade flows Source:Vivid Economics for The Climate Institute Figure 9Real price tags on carbon dioxide in the power sector 21

22. Conclusions 22 The impact of higher bunker fuel prices differs markedly across different cargo types and geographical markets a ten per cent increase in bunker fuel prices will increase freight rates by between one and ten per cent for the vessel types and routes which formed part of this study the rate of cost pass-through of higher freight rates into product prices ranges from nearly zero to over 100 per cent depending upon the nature of the market —it is important to consider the competitive structure of the market under analysis and not assume that any increase in freight rates will be fully passed on to consumers long term changes in the price of fuel will lead to shifts in the global pattern of trade and the demand for shipping; although in many cases the magnitude of the impact will be small