The carbon tax is neither as ruinous nor as revolutionary as political protagonists on each side would have you believe. To control carbon emissions in any way that doesn’t invoke Stalin entails two choices; either control the quantity of carbon or control its price. What you can’t do is control both.

A tax on pollution will place a price on expelling carbon while an emissions trading scheme will control the quantity. This is the central difference between a tax and an emissions trading scheme.

A tax is probably simpler to implement but, because it involves the scariest word in politics (T-A-X), emissions trading has been the favoured method of pollution control worldwide. In reality, there isn’t much difference between the two.

In Australia, we’ll be initially using a price-based measure so let’s have a quick look at how it will work before examining the impact on some of our recommendations.

How is it being done?

From 1 July 2012 the 500 biggest emitters of carbon will be taxed on the amount of pollution they release. They’ll pay a carbon price of $23 a tonne, which increases to $25 a tonne by 2014, at which point a trading scheme will be established.

There are two impacts to examine; a massive, multibillion dollar compensation package and the change in relative prices the tax delivers. The compensation package may grab the headlines but by far the more important development will be the change in relative prices forced by the tax.

Who will be impacted?

The most significant impact is to make carbon intensive activities more expensive. This will reduce the volume of such activities and create a financial incentive to find alternatives to them. The number of industries affected is wide, but two in particular will undergo significant change; coal and gas.

Eventually, coal will become a fuel of the past. Brown coal (lignite), known in less polite mining circles as ‘shit coal’, is amongst the dirtiest, most destructive forms of power generation imaginable. Economically, it’s a rather marginal proposition because of its low energy content. Even a modest carbon tax should see brown coal power generation shut down over time, eliminating lignite as a fuel source.

The government has indicated it will buy out output from brown coal generators over the short term and will probably pay asset owners to close these plants over the next few years. Black coal, however, is a different story.

High quality black thermal coal isn’t as dirty as many think and is still eminently profitable. It isn’t going to disappear but the price incentives will probably mean new generation will come from less polluting sources like gas.

We’ve argued that gas is best placed to become a primary generation fuel (see The case for LNG part one and part two). The carbon tax will hasten this shift by narrowing the cost difference between coal and gas. We expect gas prices in the domestic market to rise markedly over the years ahead as more gas is needed to fuel more generators, benefiting sellers of domestic gas, including Origin Energy, Santos and AWE. That’s partly why Origin and AWE currently sit on our buy list.

In a post tax environment, coal quality is going to be crucial to project economics. Gassy coal mines—those that cannot contain methane that is trapped within the coal seam—will also become marginal propositions. But high quality coal producers will, at worst, face only slightly lower margins. To underscore this point, consider that the very day after the carbon tax was revealed, a bid was made for Macarthur Coal. Coal miners with quality assets such as New Hope Corporation, Coal and Allied and Whitehaven Coal will continue digging coal for decades to come, carbon tax or not.

LNG producers face more uncertainty. Though encouraging a switch from coal to gas is part of the design of the scheme, LNG producers will face higher costs, a particular concern to those exporting their output. Origin Energy’s Grant King believes this will change after 2014 following a review but, for now, LNG counts as one of the losers from the tax.

Airlines will also be hit. Domestic fares will incur the tax (although international fares are spared), which will reduce margins, sales volumes or both. Virgin Blue and Qantas can thus add the carbon tax to a long and growing list of woes.

Steel producers OneSteel and Bluescope Steel—amongst the heaviest emitters in the land—have every reason to fear a carbon tax. Fortunately for them, the taxpayer will chip in 95% of the cost of the scheme, at least for the first two years. You won’t hear any complaints there. Ditto aluminium producers and refiners of bauxite. Alumina, for example, is heavily compensated.

Building and construction companies, including cement and brick makers have mixed fates; cement makers like Adelaide Brighton will be generously compensated; bricks will not. A strange twist of injustice thus befalls Brickworks. Voluntary emission reductions made by Brickworks in earlier years mean it’s ineligible for much compensation now. Profits are estimated to fall in its Austral Bricks division as a result but that assumes behaviour doesn’t change to maximise savings when it probably will.

Sweat the big stuff

Endless columns have already been written about the carbon tax and a vast number of companies have (and will) released statements, objections and declarations for and against the tax.

Our best guess is that once things die down, businesses will quickly get to grips with a scheme that will have far less impact than many claim.

The day the carbon tax was announced, the share prices of steel companies fell only marginally. Coal companies, alumina producers, building products groups, cement makers and airlines – all claiming calamity – suffered only minor falls. Some falls no doubt occurred in expectation of the announcement rather than following it, so this may understate things. But destructive share price falls were strangely absent.

Members, when assessing companies, are best advised to concentrate on far more important issues like management quality, competitive position, growth strategies and valuation. The carbon tax, with generous helpings of compensation, is largely a sideshow. Don’t let it, nor CEOs and politicians bleating about it, distract you from the real task of investing.