PETROLEUM ROYALTIES IN WESTERN AUSTRALIA



PETROLEUM ROYALTIES IN WESTERN AUSTRALIA

A Discussion Paper

Department of Minerals and Energy

Government of Western Australia February 1994

CONTENTS

Page

1. Introduction

1.1 Resource Ownership 1

1.2 Allocation and Royalties 1

1.3 Resource Value 2

1.4 Government Policy 2

1.5 Petroleum Royalty Legislation in Western Australia 2

2. An Ideal Royalty System

2.1 Economic Efficiency 3

2.2 Equity 4

2.3 Administrative Efficiency 6

2.4 Stability 6

2.5 Transparency 6

3. Royalty Options

3.1 Well-head Value 6

3.2 Resource Rent 7

3.3 Production Sharing 7

3.4 Accounting Profit 8

3.5 Composite Systems 8

4. Evaluation Of Options

4.1 Well-head Value 8

4.2 Resource Rent Systems 9

4.3 Production Sharing 11

4.4 Accounting Profit Royalties 11

4.5 Composite Systems 12

4.6 Evaluation Summary 13

5. Summary 14

Appendix 1 15

This paper was prepared by

The. Royalties, Economic Polity and Public Affairs Division

of the Department of Minerals and Energy

with valuable assistance from

the Department of Resources Development and other agencies.

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1. INTRODUCTION

1.1 Resource Ownership

Under Australian legislation, the ownership of petroleum resources has been retained by the Government on behalf of the community when land has been leased or sold to private individuals or organisations. However, the discovery and extraction of these resources is not undertaken by the Government, but by private sector companies. In return for the right to extract and sell these non-renewable resources, the Government demands compensation or a purchase price. This purchase price is termed a "royalty".

The distinction between a royalty and a tax is important in the debate on appropriate royalty systems. A tax is a general revenue raising measure levied on economic activity to fund government spending. However, a royalty represents the compensation to the community for the loss of an asset. The critical issue for a royalty is thus not the amount of government revenue required in any period, but the appropriate price to charge for the depletion of this capital asset

1.2 Allocation and Royalties

The seller of any capital asset operating in a free market economy needs to decide the price required for sale, while the operation of the market will decide to whom that asset will be transferred. In a perfectly competitive market the two issues will be inseparable, but in discussion over the sale of community assets, they can be regarded as a two step process.

In a competitive and open market where potential buyers have knowledge of the likely asset value, the Government can dispose of resource rights using a cash auction process. As long as rights to the asset are then freely tradeable, firms which are able to exploit the resources most efficiently would tend to acquire them from those who were less capable. The critical factors in the operation of the market then become the conditions upon which the rights are allocated and the subsequent competition for them.

Competition in the market place is needed to ensure that the cash auction bids reflect the expected present value of future revenue streams for those rights. Under such conditions, the Government would have been fully compensated for the transfer of rights. Thus both allocation of resource rights and the price paid for access to the resource would have been simultaneously determined.

Auctioning or cash bidding has been used in the United States to allocate petroleum rights on the offshore continental shelf. Such a system is well suited to a region where information about petroleum resources and geological understanding is substantial. Under such circumstances there is a high probability of a petroleum discovery and provided there are a large number of companies competing to acquire those rights, cash bids are likely to be a fair reflection of the value of the resource.

In frontier areas, competition is generally low and information about the quantity and value of petroleum resources is minimal. Under these conditions, cash bids are at best a guess as to the value of the resources and hence the government may prefer to postpone payment for the resource until the value can be better measured. In this situation, the allocation of resource rights and their pricing through royalty payments becomes a two step process.

In Western Australia, with the exception of some small areas on the North West Shelf, the vast majority of petroleum sedimentary basins have only been lightly explored. There is also a limited number of exploration companies active in the State, and therefore conditions necessary for an efficient cash auction process do not exist

While in the United States cash bidding has frequently been used as the sole means of allocating petroleum rights, it is more common to use cash bidding in association with a royalty system operating over the project's life.

In most conditions there is not sufficient knowledge of the value of the petroleum resources prior to the allocation of extraction rights to warrant a cash bid as the sole royalty measure. If a pure cash bid system is not favoured then, irrespective of the type of royalty system used, it is highly desirable that the system be set and publicised before the allocation process so that companies can evaluate the effect of the system as, part of their investment decisions.

This paper does not examine the allocation of rights to extract resources but concentrates on the choice of an appropriate royalty system to accompany the allocation process.

1.3 Resource Value

The approach most commonly used to provide community returns from a resource with an unknown initial value, but with some probability of a future high value, has been to require payment in the form of royalties after resource delineation and production has taken place. If this approach is to have any of the benefits of a market price mechanism, it follows that the royalty paid should bear some relation to the real value of the resource. If the royalty charged is low, then the government is effectively foregoing revenue by selling the community's resource too cheaply. This may have the effect of encouraging over-development and rapid exploitation of the resource to the detriment of future generations. If the royalty charged is too high, then the level of resource development and associated economic activity will be reduced.

The real value of a resource is defined as its economic or resource rent. While this rent can only be known with certainty at the end of a project life, it can be estimated during the development and extraction process. In principle, the calculation of economic rent provides a way to establish a price which relates directly to the realised economic value of the resource.

The term “resource rent” was defined in Taxation of Mineral Rents by Garnaut and Clunies Ross as following:

Mineral tent may be defined as the returns in excess of those necessary to attract factors of production into the mining activity in the long run. It is the revenue remaining after all costs have been deducted. These costs include exploration outlays, expenditures on mine establishment and cash operating costs. Unlike the accountant's notion of costs, economic costs include the retums to capital invested which are just sufficient to attract the capital to the enterprise.

Based on this definition, the calculation of a resource rent involved an estimate of the rate of return required to maintain capital investment in the enterprise. This rate of return is a legitimate cost of production representing the cost of capital.

Determining what might be a normal return on investment in a particular project can present difficulties. In attempting to establish a rent-based royalty for an industry, greater difficulties would arise as an industry wide rate of return needs to be estimated for a royalty system to be apply uniformly across all projects. In an industry where exploration and market risks are very high such as the petroleum sector, the return required from successful projects will be well above market interest rates. For industries where exploration and development risks are lower, a lower return on capital will usually attract sufficient investment.

The rate of return established must be sufficient to maintain long term investment in the industry without distorting the overall industry investment patterns.

1.4 Government Policy

Traditionally in Australia, State and Commonwealth governments have placed great emphasis on attracting exploration and petroleum development investment with a view to promoting economic development. Economic growth provides opportunities for increasing employment in an expanding population and potential for a higher standard of living. These objectives have been explicitly stated by most governments.

The types of royalty arrangements, in the widest sense, which are most compatible with growth objectives, are those which maximise returns to the community without reducing the incentives to explore for and develop petroleum resources, and without providing incentives for inefficient behaviour. This requires a framework which is economically efficient in that it encourages firms to maximise their own net income, while maintaining a fair return from such development for the community. In other words, a combination of efficiency and equity are required for petroleum to achieve a growth objective which will be supported by the community in the long term.

1.5 Petroleum Royalty Legislation in

Western Australia

There are five separate Acts governing the collection and assessment of petroleum royalties in Western Australia:

1 . The Commonwealth Petroleum (Submerged Lands) (Royalty) Act 1967 covers production from fields originating from the North West Shelf project areas covered by permits WA-I P and WA-28R This is an area of Commonwealth Government jurisdiction in which a well-head value royalty system is used combined with the Commonwealth petroleum excise regime. Royalty revenue is shared between the State and the Commonwealth.

2. The WA Petroleum (Submerged Lands) Act 1982 covers petroleum fields located within a defined Territorial Sea as well as certain tenements ("subsisting" permits) located within State “inland waters". In the Territorial Sea and "subsisting" permit areas, the State Act provides for a well-head value royalty system with the revenue shared between the State and the Commonwealth. Commonwealth excise also applies to oil produced in excess of 30 million barrels for any single field.

3. The Commonwealth Petroleum Resource Rent Tax Assessment Act 1987 applies to all offshore waters located seaward of the Territorial Sea other than the North West Shelf project area. The Commonwealth administers a resource rent tax which is effectively a royalty introduced to replace a well-head value royalty and excise system. Revenue is not shared with the State.

4. The WA Petroleum Act 1967 applies to onshore areas and coastal waters landward of the Territorial Sea other than "subsisting" areas under the WA Petroleum (Submerged Lands) Act 1982. The State administers a well-head value royalty system retaining all revenue. The Commonwealth excise regime also applies to this area.

5. The Barrow Island Royalty Variation Agreement Act applies only to Barrow Island. The Resource Rent Royalty revenue is shared with the Commonwealth. This regime was developed in negotiations between the company, the Commonwealth and the State. It replaced the ad valorem excise system that had applied to all areas in WA.

The recommendations contained in this paper for changes to the royalty arrangements are intended to only apply to the WA Petroleum (Submerged Lands) Act and WA Petroleum Act areas.

2. AN IDEAL ROYALTY SYSTEM

2.1 Economic Efficiency

From a theoretical perspective, royalty arrangements should be designed to maximise economic growth thus ensuring optimum employment and investment. Economic growth was cited by the Western Australian Government in the Mineral Revenues Inquiry' as a prime objective for the development of a suitable royalty system.

'Mineral Revenues Inquiry, 1986. Paul Bradley.

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The economic development goal will be achieved if the royalty system used is economically efficient.

Assuming that a company seeks to maximise its net income (after tax) from its investment, then it can be shown that a payment based on the project's real resource value or economic rent is the most efficient form of royalty system. This is because, in aiming to maximise net income, the decisions made by a developer will not be affected by the royalty system used. In other words, the royalty system based on economic rent will not have any distortionary effect on investment decisions.

This assumption of economic efficiency rests on the theoretical model of firm behaviour which assumes profit maximising decisions. Under this model, if companies are fully compensated for their investment and risk, any economic rent remaining may be appropriated by the resource owner without affecting the companies' investment decisions. Thus 100% of the rent could theoretically be collected by the community

It has been suggested that this model of firm behaviour does not fully explain the decisions made by companies involved in exploration. A common philosophy in this sector is that such exploration companies are seeking "bonanza" prospects with high levels of economic rent rather than projects with "normal" rates of return. It is the small probability of a high return or the speculative nature of the industry which attracts these companies to this activity. In this case such investment would not take place if the government was to capture 100% of the economic rent.

In practice, there is another reason why the community's share of any economic rent needs to be lower than 100%. This is because the principal problem with implementing economic rent systems is overcoming the difficulties of accurately measuring rent. In a theoretical sense it is possible to measure rent if full details of a company's attitude to risk and its cost of capital known. This means that for rent to be accurately measured, the parameters which define rent in the royalty system need to be set on a case-by-case basis. For practical purposes a government cannot do this as it must set up a uniform system in advance of projects commencing and therefore a single set of parameters will be inappropriate for many projects. This results in the need for the government to be conservative in its definition of rent to avoid overestimating rent from some projects and thus collecting

more than the project can afford to pay. By defining rent generously and then sharing the resultant rent with the company, the government can avoid deterring investment. Therefore it is usual for governments to take a share which is less than 50% of the measured rent.

Theoretically, a royalty system which incorporates the philosophy of the Barrow Island Resource Rent Royalty (RRR) or the Commonwealth's Petroleum Resource Rent Tax (PRRT) would most closely approximate an optimal arrangement. There are three critical factors which would determine the degree to which this optimum is reached. These relate to the proportion of rent recovered by the government, the threshold carry forward or compounding interest rate and the constraints placed on exploration deductibility

In theory, royalty systems based on factors other than economic rent are sub-optimal in efficiency terms. This is primarily because they have an inappropriate revenue base and hence they have the potential to affect investment decisions made by companies for marginal production projects. The extent of the distortion created by such systems depends upon the level of royalty collection. There is very little hard evidence that planning or investment decisions on new projects in Australia have been adversely affected by ad valorem or volume-based royalty systems. The very limited amount of this evidence is almost certainly because the impact of royalty levied is relatively low when compared to other factors such as prices. In other words, the effect on investment decisions is minimal because royalty payments are not a significant cost factor in many projects. However, the effect of this relatively low level of royalty collection can be that in times of extremely high prices and profits, governments will face public pressure to increase the rate of return to the community from the more valuable resources.

The imposition of petroleum excise in the 1970s was an example of the effect of such pressure. Excise was introduced by the Commonwealth Government during a period of high prices when there was a perception that the return to the community was inadequate in comparison to the windfall gains producers had made following rapid price rises. The oil excise was hence applied to capture an increased proportion of the rent for the community, implying that the royalty system was not performing this function.

Royalty systems can be ranked according to their theoretical efficiency. The efficiency ranking will depend upon the structure of the royalty as well as the base on which it is assessed. A royalty based on economic rent over the life of the project will be more efficient than one which is based solely on some other measure of resource value such as accounting profits, while this profit-based system will be more efficient than one based on the value of production without any allowance for costs. This in turn will rank above one based on the volume of production. This ranking occurs because each royalty system is less able to differentiate between the revenue and costs of the project than those ranking above it.

In summary, while it is not practical to implement an optimal petroleum royalty system for each project, royalty systems based on economic rent will meet a government's economic growth objectives better than those which are not based on rent. The extent to which a resource rent-based system distorts investment decisions will, of course, depend upon the specifications used in the resource rent regime and the philosophical attitude of investing companies. Other royalty systems may only have a minimal distortionary impact on investment and output (and hence be reasonably efficient) provided that the rates are set at low levels.

2.2 Equity

Equity considerations arise through attempting to strike a balance between the rights of the private sector and the community over the value of the resources. Ideally, a royalty system will deliver outcomes that are equitable both in the present and the future.

An equitable royalty is one which treats producers equally and provides a fair and reasonable share of the returns between producers and the community. Equity also implies that producers in equivalent situations should be treated the same and there should be a recognition of the differences in the quality of petroleum reserves such that companies given access to high value reserves should pay a higher royalty. For convenience in this paper, equity is considered as three separate issues: producer equity; community equity and intergenerational equity.

Producer Equity

For equity to exist between producers, royalty provisions need to be uniformly applied. This demands an element of "ability to pay" in the system design. This form of equity means that a royalty system will return a higher amount 6om profitable projects without removing the incentive associated with windfall gains.

Vertical equity requirements can be best met by a royalty system which is based on the economic rent of a project. Any other royalty system does not take into account all revenue and costs associated with separate projects.

The system must also be levied on the total project costs and benefits rather than any periodical proportion. Financial benefits from production should be gained over the whole life of the project with the extraction of the total resource taking precedence over any strategy to maximise short-term revenue.

A second element of producer equity relates to the royalty and taxation regimes in other producing areas. Petroleum exploration is very capital intensive and the companies involved generally operate nationally and commonly internationally. To attract such investment to a country or state it follows that the expected net returns must be comparable with other regions. While these returns are a product of a complex production, revenue and cost structure, the taxation regime plays an important part in the cost structure and is hence a factor in investment decisions. Similarly, while royalty is generally a less significant factor, it is nonetheless taken into account and hence reasonable comparability between local and other petroleum areas is desirable. A very high royalty regime would clearly need to be matched by very favourable compensating factors.

Community Equity

This refers to the community's share in the value of petroleum recovered. While again this can only be determined in a theoretical sense based on the economic rent from a project, the actual proportion to be captured by the community will depend upon the attitude to risk of the community and the company, and the royalty rate.

Nearly all State governments in Australia have as an overall objective the collection of a "fair" return for the recovery of the community's non-renewable resources. No State has been able to rigorously define "fair" but it is seen as being that proportion which can be sustained on economic, social and political grounds. Again this can only be determined from the economic rent of a project. With many projects undergoing stages during development and market downturns

when the rent from a project will be zero, this implies that the community return during such periods should also be zero. Industry has argued that the community is unlikely to accept that production should proceed when there are no royalties being paid and hence it is unlikely that a royalty system that results in no return to the community could be sustained on a long-term basis.

Intuitively, for an industry where there is a small number of profitable projects paying rent-based royalties and a large number of projects making a very small or even negligible return, rent-based royalty systems are unlikely to be perceived by the community as providing a "fair" return over the longer term.

Intergenerational Equity

The concept of intergenerational equity emphasises the balance between the needs of current and future generations.

Resource pricing policies are a factor in determining whether or not production occurs in the present generation or future generations. Low resource factor prices biased towards present production and consumption and as a result, future generations may lose out because there is a strong incentive to over-consume resources.

A royalty may be used as a deterrent to the present generation from excessive consumption at the expense of future generations or to ensure that the returns from extraction of a non-renewable resource are collected and converted to some other form of capital asset.

Heritage Funds have been used by state and provincial governments in the US and Canada' as a way of ensuring that royalty payments (which represent a return for the depletion of the community's capital stock of petroleum and mineral resources) can be used to contribute to the accumulation of other physical capital, such as infrastructure. This means that the draw down of the State's resource asset base may be matched by the build-up of other capital assets, thus maintaining the State's capital base for future generations.

A Heritage Fund was proposed for New Zealand and has also been suggested in Australia, but governments are generally opposed to such a concept on the grounds that it limits the ability of the government of the day to allocate its revenue among competing priorities. Depending on expenditure allowed from a Heritage Fund there is a potential for over-expenditure in certain areas

In practice, it may also simply become a bookkeeping exercise with treasuries reallocating expenditure from these areas to maintain the government's spending priorities.

2.3 Administrative Efficiency

Economy of administration is a worthwhile objective of both government and developers. Government and industry costs are a function of the complexity of the rules developed to define the royalty base, the extent of duplication with other information requirements and the need for reviews by either developers or the government. The extent to which payments can be avoided will also affect the government's administration costs and this will be a function of the complexity and the attitude of industry to the impost.

While simplicity is generally associated with lower cost administration, simple systems are abstractions from a much more complex situation and can create many anomalies requiring review and negotiation. These costs, involving senior company and government staff and legislative amendments can in the long run be more expensive than more complex systems that have industry support and are more sensitive to company and market conditions.

A significant factor in the cost of administration can thus become industry acceptance and hence the costs of ensuring compliance.

2.4 Stability

Where royalty revenue forms a significant proportion of government revenue it can be expected that Treasuries will place a high priority on revenue stability. Stability not only makes the forecasting and budgeting process easier, but it avoids the political penalties attached to the significant reductions in government services needed to match revenue during depressed royalty payment periods.

In Western Australia, royalties (petroleum and minerals) are the third highest source of State-raised revenue after payroll tax and stamp duty. Petroleum royalties were 22.84% of total payments in 1992-93 and are forecast to increase substantially in the future.

During the Mineral Revenues Inquiry conducted in 1984-86, State Treasury emphasised the desirability of royalty revenue stability. There are a number of options to stabilise revenue including the use of a stabilisation fund or the purchase of annuities. These will overcome

volatility problems but they are not widely used, possibly because they require a sacrifice by the government of the day during the booms in price cycles when the community is expecting higher service delivery.

Rent-based systems are not stable on a project-by-project basis, with royalty payments fluctuating with both project costs and revenue. State governments have only a residual claim on the available rent after the project participants have received the threshold rate of return and all other claimants have been paid, hence introducing a further variable into the system.

While the stability of royalty revenue is an important criteria to the State it may also be of concern to companies in the longer term. This relates to the pressures for changes to the system flowing from any volatility in payments. This may be the case with rent-based systems. For example, in any high royalty payment years, there will be companies arguing for lower payments while in low payment years the community may express concern at the low level of industry contributions. In the longer term there may thus be pressures for a "smoothing" down on the royalty payment stream.

Potentially, therefore, revenue from rent-based systems may not be stable and hence the potential for change can increase the sovereign risk.

2.5 Transparency

Transparency, for royalty systems, requires that the system rules be open, certain and clearly visible to the government, community and industry so that everyone is aware of the method for determining the price being paid for the resource. Transparency assists industry in evaluating the arrangements and inhibits bureaucratic interpretation.

3. ROYALTY OPTIONS

Petroleum legislation in Australia includes two main royalty systems based on well-head value and resource rent. Other options used overseas which could be applied in Western Australia include production sharing and accounting profit systems.

3.1 Well-head Value

Well-head value royalty systems originated in the USA and are based on a specified proportion of a defined "well-head value" with the most common proportions being 1110th (10%), 1/8th (12.5%) and 116th (16.7%). The concept of well-head value is very similar to mine-head value the value of the petroleum product recovered from a well and available on the surface of the ground for transfer to another owner. Generally speaking, oil and gas recovered need further processing and transport before an actual sale occurs. Well-head value is derived by taking gross value of petroleum recovered and subtracting all costs incurred by the developer between the well-head and the point of sale. These costs are incurred in the processing, storage and transport of the petroleum recovered.

Well-head value royalty systems have been used throughout Australia including the large oil fields of Bass Strait. While well-head value is a commercially accepted approach to royalty calculation, it is not a rigorously defined concept and considerable negotiation is generally involved between government and the developer in defining the method by which wellhead value will be calculated. In Western Australia, the defined location of the well-head and the methodology for calculation of wellhead value are included in a royalty schedule negotiated with each producer.

1

While well-head value is an ad valorem system it is not a gross value 'approach as a significant proportion of costs are deducted in calculating the royalty base. Depending upon whether the project is located onshore or offshore and the nature of the products recovered, deductible costs can vary up to a limit of 50% for oil projects or 90% for gas projects of the gross value of production. These limits ensure that deductions will never exceed sales value and the government will always receive a royalty on production. Costs which cannot be deducted include exploration, drilling and the other costs associated with recovery. up stream of the wellhead. Well-head value royalty systems thus lie somewhere between a gross value and a net value system.

3.2 Resource Rent

A resource rent-based approach to royalties was first introduced by the government for the Barrow Island project in 1985. This resource rent royalty (RRR) replaced the well-head value royalty and Commonwealth excise regime that, in combination, threatened the shutdown of parts of the project. A similar rent-based approach was adopted by the Commonwealth as the petroleum resource rent tax (PRRT) in 1984.

This regime also replaced a well-head value excise regime.

Two major petroleum producing areas were excluded from the original PRRT regime, namely the Woodside Project Area in the North West Shelf and Bass Strait. Bass Strait has since moved to the PRRT system, leaving the North West Shelf project as the only exception in Commonwealth offshore waters. PRRT does not apply to areas within State jurisdiction.

PRRT is levied at a rate of 40% of net income, with this being defined as the revenue accruing to a project net of all costs. No distinction was made between operating and capital expenditures. In periods when project expenditures exceed revenues, the negative cash flow is carried forward at a threshold accumulation rate reflecting the estimated cost of capital in the industry and the companies risk premium, to be deducted when net revenue again becomes positive. Negative cash flows can be accumulated until they are fully claimed.

Since 1984 a number of modifications have been made to the PRRT, the most notable relating to the accumulation rates which have been adjusted from a single rate to separate rates for exploration and the development expenditure and the exploration deductibility provisions have also been varied.

3.3 Production Sharing

The separate retention and marketing of a proportion of production by the government has not been used as a royalty system in Australia, but is commonly used in other countries including Indonesia and Malaysia. In these countries, the governments have set up a marketing or petroleum company which is primarily responsible for ensuring that the nation receives its share of production and that this is marketed to ensure maximum return to the community.

A form of production sharing was used in New Zealand where the government retained a share of petroleum projects which was carried as a silent interest until a discovery was made. The Government was then able to choose whether to maintain an interest in the project by investing its share of development and operating costs or alternatively to sell its share hence capitalising on a proportion of the value of the resource at a stage when it could be better measured. The New Zealand government has proposed that this system be changed following widespread objection by industry to the involvement of government in company decision-making and investment decisions. The information gained by government also had the potential to lead to a conflict of interests in the allocation of surrounding areas.

3.4 Accounting Profit

Accounting profit royalties are based on a percentage of the accounting profit which is calculated using conventional accounting practice. Accounting profit differs from economic rent in the way capital expenditure is treated. While operating costs are deducted immediately, capital expenditure is depreciated (amortised) over a number of years on an historical cost basis and therefore makes no allowance for inflation. Calculation of accounting profit allows for borrowing and interest costs to be deducted but does not provide for any return on equity invested by the company.

3.5 Composite Systems

As an alternative to the application of a single royalty instrument composite systems can be developed which consist of combinations of instruments.

A range of options is available. The simplest is to have a choice of systems for a single period eg 5% of sale value or 2% of profit for a financial year. In this case there needs to be a determining factor to define which of the alternatives applies. The determining factor could be "the smaller", "the larger" a production level or any characteristic of a project.

A more complex approach is to have two systems added together such as 1% of sale value plus 3% of net profit.

Ideally, the two regimes used are complementary in that they combine desirable characteristics to form a system with better characteristics than either on their own.

The parameters of a hybrid system suitable for use in Western Australia have been developed by the Department and are set out in Appendix 1. This system comprises a 2% gross value royalty combined with a 30% rent-based royalty. The first tier ensures a small payment from all projects and is fully rebated against any payments made under the second tier. The rebate means that this is essentially an either or approach over the life of the project depending on the level of rent but in the short term the system has characteristics of both components.

The second tier rent base is calculated in the same way as the petroleum resource rent tax (PRRT). This allows for all project costs to be deducted in the year in which they are incurred as well as an allowance for a return on equity invested and unsuccessful exploration expenditure.

This hybrid combines key elements of the two existing regimes used in Western Australia. A resource rent royalty was first applied to Barrow Island in 1980 with the Commonwealth adopting its resource rent tax for offshore waters in 1984. The hybrid system includes the essential features of the current Commonwealth PRRT while the first tier ad valorem reflects the royalty system most commonly used in WA for petroleum and minerals.

4. EVALUATION OF OPTIONS

4.1 Well-head Value

Economic Efficiency

Well-head value systems are fairly difficult to evaluate in terms of the ideal royalty criteria as they are neither a gross value nor a net value system, but lie somewhere between the two depending on the extent of cost deductibility. A well-head value system is less efficient than a net value system as it does not allow for the deduction of all costs. As a consequence, it may distort investment decisions. This is particularly the case towards the end of a project life when unit operational costs are high and total revenue low. Under these conditions, the royalty can become a significant cost to the developer and may lead to early closure of the field. Petroleum legislation in Western Australia recognises this problem and provides for ministerial discretion to lower the rate of royalty when the future operation of the field can be shown to be jeopardised by the level of royalty payments.

In terms of a decision to produce, there is no evidence that well-head value systems have discouraged investment in particular projects. This may be because the rates applied are generally low.

The extent of inefficiency depends upon the level of the royalty rate and the extent of cost deductibility. With a large proportion of deductible costs and a low rate of royalty the impact on a firm's decision-making may be negligible and hence the system can be quite efficient. Such a system

can promote productivity improvements as any reduction in pre well-head costs is fully reflected in profits without a proportion being paid in royalties thus encouraging a company to lower the cost of its operations.

Equity

In recognising part of the cost structure of individual projects, well-head value systems have a degree of vertical equity but in not fully recognising all costs, are not as equitable as rent-based systems. We11-head value systems are widely used in Australia and overseas and the rates and deductions applied are comparable thus ensuring a degree of equity between the State and other petroleum areas. Well-head value systems as used in Western Australia with their limits on deductibility will always provide a return to the community whenever production occurs. Hence they are perceived to be fairer than rent-based systems where a considerable number of marginal projects will not make any return to the community.

Administrative Efficiency

The administration of well-head value systems is relatively efficient as they are widely used, have applied for many years and are well accepted by industry and government. While negotiations are involved in the establishment of a royalty schedule to define well-head value, negotiations are based on commercial principles with relatively few special accounting requirements needed. Because they have been used for many years, well-head value systems are relatively simple to administer, but considerable negotiation on royalty arrangements may be required in the establishment of the royalty schedule and sometimes towards the end of a field's life when royalty payments become a significant proportion of the cost structure.

Stability

Well-head value systems provide greater revenue stability than rent-based systems although they still fluctuate with revenue and cost variations. The more costs that can be deducted, the lower the stability of payments to government-

Transparency

Well-head value systems are reasonably transparent as they are based on an historical, commercial system which is fairly well understood. However, verification of the payments made requires the release of cost information which is often commercially confidential and hence well-head value systems are not very transparent.

4.2 Resource Rent Systems

Economic Efficiency

Resource rent systems in theory are economically efficient as they allow for a return on invested capital and off-site unsuccessful exploration. Investments are less likely to be inhibited, extraction will be more efficient and premature project closure is less likely. In addition, at reasonable royalty rates, companies still have a very strong incentive to be operationally efficient.

The operational efficiency of a rent-based system will depend upon the rate of royalty and company responses to this. The 40% proportion of rent collected by the Commonwealth under the PRRT has been criticised by industry as too high. It has the potential to lead to overcapitalisation or goldplating of profitable projects and a reduced emphasis on operational efficiency because a significant share of the benefit is transferred to the community. However, any rate less than 100% provides a benefit to the company above its costs of capital.

A high rate also has the potential to distort the investment decisions of exploration companies making PRRT payments. This is because any expenditure within the PRRT area may be claimed as a cost against revenue. This can lead to the "capture" effect where companies with income-producing projects in PRRT areas have an incentive to continue to invest in such areas rather than in other areas with a different royalty system. The exploration deductibility is thus likely to affect the pattern of investment.

Although rent-based, the PRRT is a less than an optimal royalty arrangement. Firstly, because there are no rebates at the end of a project's life for any losses that occurred, the system does not provide the equivalent of full loss offsets. Any losses, however, may be transferred to a company's future project(s), hence offsetting losses at some time in the future. Investment in exploration and development may be adversely affected by the understanding that those projects which make a loss may not be fully compensated (on a single project basis), whereas those which make a profit would be fully subjected to royalty.

The establishment of a single threshold accumulation rate across the industry also has the potential to distort investment. Unless the threshold rate is

equal to the company's required rate of return, the actual rates have the potential to affect investment decisions by that company. Theoretically, setting the threshold rate too high may encourage over-investment, while setting the rate too low would deter investment and hence reduce potential output.

Finally, as for all systems, the selection of a royalty rate is largely arbitrary. There is no sound theoretical basis for establishing a reasonable proportion of the rent which should fall to the company and to the government- This decision is more critical under a rent system as the rate of royalty has to be numerically high due to the smaller revenue base. It is possible that projects covered by resource rent systems with a very high royalty rate would appear unattractive to efficient firms, while looking reasonably attractive to inefficient enterprises.

A resource rent royalty system may not be neutral with respect to investment and exploration decisions (depending on threshold and royalty rates) but it will always have a lesser adverse effect on production than conventional well-head, ad valorem or other royalty systems.

In a study conducted by the Australian Bureau of Agriculture and Resource Economics (1991), the proportion of projects which moved from being economic to uneconomic following the imposition of a tax varied from 8% using a resource rent tax to 35% using a gross value ad valorem royalty arrangement. The difference between a resource rent tax and an accounting profit royalty (10%) was minimal, but the difference between these profit-based taxes and the ad valorem arrangements was clearly very significant.

Equity

A resource rent royalty system ensures the equitable treatment of producers, but may not be perceived to be fair to the community when there are no payments from a producing field over many years.

Administrative Efficiency

A resource rent royalty would involve higher administration and compliance costs than production-based royalties. Government administration costs may be lower than a wellhead or an accounting profits royalty because of the simpler treatment of capital expenditures (which are deducted immediately and not depreciated). However, company compliance costs may be higher as data requirements are likely to be additional to those already required for other reasons (eg tax). Canadian experience suggests that profit-based systems are more expensive to administer than well-head value arrangements, but evidence is inconclusive as to whether the PRRT administered by the Commonwealth is more cost effective.

Stability

A minimum return is not guaranteed by a resource rent royalty and this is the least stable royalty system in revenue terms. Analysis of a number of existing projects has shown that no royalty would have been paid under a resource rent royalty system (using the PRRT rules) even though the projects earned an accounting profit and would have paid substantial royalties under other systems. However, this may not be the case if lower threshold rates and a higher royalty rate than exist with the PRRT were applied.

Under a resource rent royalty, the government has, in effect, a lower payment status than equity holders. Royalties are a residual claim on company returns in that the government must wait until an above threshold profit is carried before receiving any royalties. The threshold level may not be reached for several years for many projects and for some projects no royalty liability will eventuate. The government is thus more vulnerable under a resource rent royalty than under a production-based, well-head or an accounting profit system.

At the project level, the revenue flow will be less stable and less predictable than either a well-head value royalty, an accounting profit royalty or a production-based royalty. As a threshold return must be generated on capital invested before any royalty is paid, revenue from new projects may be delayed for some years especially for projects with high initial capital and exploration costs and/or long lead times prior to commencement of production.

Sovereign risk is perceived to be greater with resource rent royalty. Companies believe governments will be unable to resist community demands and impose other royalties in the period before the threshold return is reached. Industry perceives some sovereign risk in such a situation because the government might feel obliged to modify previously agreed arrangements due to community demands for more immediate returns, particularly if the project yielded an accounting profit, but no resource rent royalty was paid.

Transparency

The resource rent royalty is not a very transparent system in its verification, being based on company information which is likely to be regarded as confidential. More importantly, the economic rent concept is also not well understood. Overall, a resource rent royalty is as transparent as an accounting profit approach, but less transparent than a production-based system. In terms of transparency, the difference between a resource rent royalty system and a well-head value system is likely to be small.

4.3 Production Sharing

Economic Efficiency

Production sharing has been widely used in petroleum producing countries and can vary significantly in the complexity of its arrangements. At its most basic the government simply receives a fixed share of the production of a project to dispose of as it wants to. The effects of this on the investment decisions of a company are similar to the effects of an ad valorem royalty. The company effectively faces a reduction in total revenue by the extent of the government’s share in production. This share does not take into account the costs of production and will impact on the decision to invest by lowering the net value of a project to the company. This will result in a lower level of investment in the industry as marginal projects become unprofitable and will not go ahead. In contrast, however, in the operating decisions of a company, a production sharing arrangement will not change the optimal output decision and will be more efficient than an ad valorem.

Because it influences the decision to invest in new projects and hence investment in the industry, production sharing is not an economically efficient royalty system.

Equity

Taking a uniform proportion of production is not equitable between producers as it does not take into account the different recovery costs or sale values. Hence, as a proportion of profit or rent, the community share may vary significantly.

Administrative Efficiency

The administration efficiency will depend upon the extent of government involvement in the decision-

making process and the information needs of government. Assuming the information needs are the same as those needed for company decision-making, the regime may be quite efficient in administration terms.

Transparency

In the past there has been significant opposition in Australia to production sharing and equity arrangements. These relate more to philosophical objections to the involvement of government in private sector activities. When based entirely on a proportion of production, the community share is readily verified and hence a production sharing system may be highly transparent.

Stability

The flow of revenue from a production sharing arrangement will be relatively stable as it is based on only two variables: the level of production and the price that the government can achieve in selling its share. This will be as stable as an ad valorem system and more stable than well-head, accounting profits and rent-based systems which have a greater number of variables influencing the royalty payments.

4.4 Accounting Profit Royalties

Economic Efficiency

In theory, royalties based on accounting profits are more efficient than production-based royalties as they are less likely to distort production decisions because project costs are taken into account. As prices and costs change throughout a project's life, royalty payments automatically adjust.

Investor awareness of this flexibility reduces risk and a marginal project is less likely to be regarded as uneconomic than if a production-based royalty applied.

Offsetting this advantage, there may be a marginally reduced incentive to improve efficiency in the project's operation. With profit-based royalties, benefits from improvements in the efficiency of operations are shared between the company and the government.

Accounting profit-based systems are less efficient than resource rent approaches because they do not provide for a return on equity invested and treat capital expenditure in a modified way (through depreciation).

Equity

Accounting profit royalty payments are always more equitable between producers as they reflect a project's capacity to pay and ensure the community receives a higher return for higher quality resources. As the accounting profit system automatically responds to changing market circumstances and changes in costs, it is more equitable than a production-based system.

Accounting profit systems generally do not allow unsuccessful exploration expenditure from outside a project to be deducted from revenue, nor is allowance made for a return on equity capital invested in the project. The denial of these allowances means that accounting profit systems are less efficient than rent-based systems. The extent of the difference is very difficult to evaluate and may not be very significant in practice.

Administrative Efficiency

Administration costs for government are higher for the accounting profit royalty system than for production-based systems but not necessarily for a well-head system. It can be difficult to calculate and verify relevant assessable profit, especially for a Vertically integrated enterprise that operates both a petroleum field and an associated downstream processing plant. For large companies with multiple projects, costs also must be apportioned.

Western Australian experience has shown that for the Argyle Diamond Mine Project, approximately half a man year is required to supervise the accounting profits royalty system, compared to more than ten projects in the same time if a gross value ad valorem royalty were applied. However, the Northern Territory Government, in selecting the accounting profit royalty system expected that additional administration costs would be recouped through additional revenue by a factor exceeding 10 to 1.

Stability

Revenue flows are less stable and less predictable under an accounting profit system than with a production-based system, but more stable than a rent-based system. Revenue varies not only with mineral and petroleum prices and output, but also with operation costs. However if an accounting profit system is used for a variety of resource commodities, revenue instability is lessened. Jurisdictions with a spread of commodities will experience less revenue instability especially if there is not a wide fluctuation in commodity prices at the one time.

An accounting profit royalty does not yield a guaranteed minimum return to government if the project fails to earn a profit or has very low profits in any year.

With an accounting profit royalty, government accepts. the risk that a project may not be profitable and may pay lower royal ties than a production-based royalty, but this may be offset by profitable projects where royalties are above minimum desired levels. In practice, the government's claim to royalty becomes a residual claim after all other inputs have been paid.

Other participants in the project such as labour unions and monopoly rail and port operators may seek to capture a part of the project's profit, hence eroding the government's royalty base. However, if royalty rates are set at low levels then the company, as the major beneficiary, has a strong incentive to resist such practices and maximise profits.

Accounting profit systems are less widely used internationally than production-based royalties and thus fewer comparisons are possible.

Transparency

Accounting profit is a widely accepted concept but the sensitivity of releasing such information to the community means that this system may not be transparent.

4.5 Composite Systems

The operation of a composite system depends on how the choice between instruments is made and how the instruments are interrelated. An example of a composite system is a combined ad valorem/profit-based system with an annual test as to which applies for that period. A test could be that the instrument which yields the greater revenue over the period will be applied for that period. The interrelationship between the two instruments could be that the ad valorem will be deducted in the calculation of the accounting profit royalty or it may be separated. In each year the system will have the characteristics of the individual instrument; however in the longer term the characteristics will be a combination of both if each system applies to different periods. ,

For example, if the profit system is applied to a significant duration of time the efficiency and equity features would derive from this regime. However there would be greater revenue stability because the ad valorem component had operated during the low profit years.

The hybrid system developed in this paper has characteristics of both the ad valorem and resource rent royalty systems. Given that the ad valorem, component is. fully rebated against the second component, the system will become a straight resource rent royalty for a project generating rent. For projects which are not this profitable, there will be low ad valorem payments only.

Economic Efficiency

Provided the ad valorem component is not set at a such a high level that it has an adverse effect on the investment decisions of the firm, any deleterious efficiency effects should be minimal. The efficiency gains will come from the second tier economic resource rent-based royalty. As the first tier can be credited against the second tier, and provided that satisfactory parameters are set for the threshold rate used to provide a return to producers, the economic rent approach ensures an efficient system.

Equity

The hybrid royalty also has the potential for a lower degree of sovereign risk to producers. This is because the consistent payment of a royalty under the first tier ensures that the producer will not come under community pressure for a royalty payment during depressed prices, but will also be seen to be paying a reasonable return under the second tier when profits are high. Community equity will thus be seen to be more satisfactorily obtained from the hybrid than under either a straightforward ad valorem or rent-based system.

Stability

The hybrid approach is more stable than a rent based approach because it incorporates the ad valorem base payment.

Transparency

In terms of transparency, the base level payment is well understood and accountable. However, the second tier rent-based payment is complex and the calculations are likely to be based on confidential information. This lack of transparency is a disadvantage of any approach which incorporates profit or rent calculations.

Administrative Efficiency

The administrative efficiency of a composite system will obviously depend upon the components of the sys tem. A rent-based system is fairly complex to administer, although it may be easier than the current well-head value system. Anecdotal evidence on this remains inconclusive but it is clear that any rent or profit-based system is more expensive to administer than a gross value or production-based system.

Advantages of hybrid

The hybrid proposed provides for lower royalty payments on marginal and low profit projects compared with the existing well-head value systems. It would therefore be attractive for frontier area exploration and encourage the development of otherwise marginal fields. The base payment would ensure that some payment is received by the community for all development thus providing a more stable arrangement than the PRRT system. The second tier would ensure that the community also receives a fair share from profitable projects and that developers are adequately compensated for their investments in this high risk industry. Because of the second tier it also offers significant economic efficiency advantages over well-head value systems by reducing the distortionary impact on investment decisions that is inherent in a well-head value system.

Commonwealth and Western Australian experience with the resource rent approach suggests that royalty collection based on rent is not particularly complex, but it is highly likely that separate accounting systems may need to be maintained to record cash transactions upon which a rent-based approach is developed.

The hybrid system described in Appendix 1 consists of a 2% ad valorem royalty and a second tier 30% resource rent royalty. The ad valorem component is rebatable against the second tier resource rent payments. For marginal projects which do not generate any economic rent, only the first level royalty will be paid while profitable projects will effectively only pay the 30% of resource rent (because the first level is fully rebated). The system thus provides a better alternative to the remote onshore areas which are likely to be marginal in operation.

4.6 Evaluation Summary

The extent to which each royalty system meets the desirable criteria cannot be measured in an objective manner. However, the systems can be ranked against each other for each criteria. Although there is an element of subjectivity involved, the graphical representation demonstrates the relative strengths-and weaknesses of each system (see table 1, page 14).

We11-head value systems are widely used, have a long history and hence have administrative advantages. They also provide a more stable revenue flow than rent-based systems and ensure a return to the community from all production. They are, however, relatively low in efficiency terms and they do not treat producers equitably.

Resource rent-based systems rank highly in efficiency and producer equity criteria but lowly in community equity; stability and transparency. While experience will improve their administration, they are not well understood within industry or government.

Production sharing arrangements appear to be the easiest to administer and offer significant stability and transparency features. However, because they fail to take into account any of the costs associated with discovery or production they are the least efficient and equitable among producers.

Accounting profit systems have similar characteristics to resource rent approaches with a fairly wide list of deductions from gross revenue. They are hence reasonably efficient and equitable among producers, but the deductions and complexity of accounting profit systems mean they score poorly on the other criteria.

A hybrid approach has the potential to incorporate desirable features of different systems. A hybrid of a resource rent and an ad valorem

Table 1: Comparison of Royalty Systems *

approach combines the efficiency criteria and equity features of a rent-based approach with desirable community equity and stability characteristics. While there are some disadvantages associated with the lack of understanding of rent-based approaches, the equity and efficiency advantages significantly outweigh these.

5. SUMMARY

In most areas of Western Australia prospective for petroleum, information about the quantity and value of petroleum resources is very limited. Royalty payments for the right to extract these community-owned resources are thus best deferred until after their discovery and definition when a much better estimate of value can be made.

This paper compares a range of royalty arrangements which are compatible with the twin objectives of economic growth and the collection of a fair return for the community.

Using five desirable features for a royalty system, the paper compares the two existing approaches with three alternative arrangements. The paper recommends the use of a hybrid approach consisting of a base level ad valorem payment and a second tier resource rent royalty. The parameters of such an approach suitable for Western Australia are outlined in detail in an appendix to the paper.

|Royalty System |Efficiency |Producer Equity |Community Equity |Administration |Stability |Trans parency |

|Well-head Value | | | | | | |

|Resource Rent | | | | | | |

|Production Sharing | | | | | | |

|Accounting Profit | | | | | | |

|Hybrid | | | | | | |

High Rating 0 Low Rating

[pic][pic]

|Royalty System |Efficiency |Producer Equity |Community Equity |Administration |Stability |Trans parency |

|Well-head Value |5 |5 |7.5 |7.5 |7.5 |5 |

|Resource Rent |10 |10 |2.5 |2.5 |2.5 |2.5 |

|Production Sharing |2.5 |2.5 |10 |5 |10 |10 |

|Accounting Profit |7.5 |7.5 |5 |5 |5 |5 |

|Hybrid |10 |10 |7.5 |2.5 |10 |5 |

High Rating 10 Low Rating 0

(The above table has been modified from the original by inserting scores out of 10 for each of the criteria rather than coloured circles as was the case in the original)

APPENDIX 1

KEY FEATURES OF A HYBRID ROYALTY SYSTEM

The parameters of a hybrid system suitable for use in Western Australia have been developed by the Department. The system includes a 2% of gross value royalty combined with a 30% rent-based royalty. The first tier ensures a small payment from all projects and is fully rebated against any payments made under the second tier.

The second tier rent base is calculated in accordance with the petroleum resource rent tax (PRRT). This allows for all project costs to be deducted in the year in which they are incurred as well as an allowance for a return on equity invested and unsuccessful exploration expenditure.

1. The hybrid royalty system is a two tier system designed to replace the current well-head royalty and crude oil excise regime.

2. The first tier is a fixed percentage (2%) of the gross sales value of the first saleable product. This represents the minimum royalty payable from all project production and is rebatable against any second tier (RRR) royalty payable.

3. If in any year there is no RRR payable from which to rebate the first tier payment, the first tier is carried forward indefinitely at the 10 year bond rate plus 5% and credited from the first year that RRR is payable.

4. The second tier (30%) is a Resource Rent Royalty (RRR) which is calculated on the project's annual excess of cash income over cash outlays. RRR is designed to be a royalty on the project's economic rent.

5. All project expenditures are deductible, including exploration costs accumulated within Western Australian jurisdiction (onshore and offshore), capital costs (as incurred), operating costs and abandonment/rehabilitation costs.

6. In any year where cash outlays exceed cash income, the undeducted expenditures are carried forward and compounded annually until fully utilised against future income streams.

7. General costs are carried forward and compounded annually at the 10 year bond rate plus 5%. Exploration costs are carried forward and compounded annually at the 10 year bond rate plus 15%.

8. Historical exploration expenditure can be claimed as a deduction for the five years preceding introduction of this hybrid system. For exploration expenditure following this introduction, costs incurred more than five years prior to the issue of a production licence are carried forward and compounded at a rate that compensates for inflation (represented by the Gross Domestic Product factor).

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