Reasons Why the Energy Sector Attracts a Special Tax Regime in the Form of Resource Rent Tax and Reasons Why This Tax is Thought to be Desirable
Reasons Why the Energy Sector Attracts a Special Tax Regime in the Form of Resource Rent Tax and Reasons Why This Tax is Thought to be Desirable
The energy sector is dominated by a host of externalities, positive as well as negative, yet it is a necessity within the community for general day to day living along with providing for economic development. The industry left on its own, would see a culmination of the negative external effects, so it warrants Government intervention as a means to correct the various distortions. For example, renewable energy which may be considered as providing positive or at worst neutral externalities, due to its infancy and intermittent resource availability is burdened with high investment costs and long payback periods in contrast to the incumbent fossil fuel systems that have long experience as well as a known level of energy availability. To get around such issues Government policy and legislation has provided for incentives enabling investment in the renewable energy sector as well as a carbon pollution tax to allow an internalisation and so greater equity with the negative externalities of the fossil fuels.
In a similar vein to these incentives, the present work will deal with the advent of the Resource Rent Tax and its application to the energy sector. It has been applied to Commonwealth Territory offshore petroleum fields and is about to be applied to the coal and iron ore resources nationally. Consideration will be given to the reason and the logic, through a number of steps to enable a clearer understanding of the ideology behind taxing the high resource rents available. The paper will begin with a look at Australian minerals and their life cycle. It will then consider ownership of these minerals and how property rights place conditions on their exploitation. A discussion will follow of the aspects that need to operate together to provide for a sustained working tax throughout the life of an energy resource extraction project Subsequently it will look at the various taxation formats and their feasibility in relation to stability and market distortion. It will then summarise these points and consider the working format of a Resource Rent Tax and where it has been used by the Commonwealth Government as well as how it may benefit Switzerland’s energy sector that is dominated by hydro-electric power.
Minerals – fossil energy and ores
The main mineral resources mined in Australia, effectively fall into two groups; the ores of either metallic or non-metallic format and the fossil fuels.
Energy minerals constitute the following categories, without dwelling into undo detail:
Mineral ores, in particular the metals are mined and reduced to particles, the ores are then smelted using thermal energy from the energy minerals, these include:
All the minerals require energy for their extraction and subsequent processing. The ores may be reused, recycled or for that matter reprocessed, provided additional energy is available. They may produce pollution externalities during processing as well as end of life cycle waste; however within this context they have recyclable lives.
On the other hand, energy minerals have a one off use, the energy content is depleted and in all cases they produce undesired solid, water and air-borne pollution. They are consumed in one of the following ways:
1 - the conversion into another energy form; e.g. thermal electric generation
2 - directly used for thermal energy; e.g. iron ore smelting
3 - refined into consumable commodities, e.g. motor vehicle engine oil, which again requires energy for processing
(Boyle et al. 2004, pp158-170 & 227, Hogan et al. 2010, pp-7-10)
In terms of what the Australian community consumes as well as what is exported, Australia has an abundance of base metal stock, notably lead, zinc, it has in excess of 33% of the known world’s resources in the following: nickel, rutile and uranium ( uranium as yellowcake, given that it is not refined to a usable grade). Of the energy fuels Australia has the following world economic demonstrated resources (EDR) i.e. reasonably certain about underground stocks:
Natural gas 1.4%
Black (high quality) coal 6%
Brown (low quality) coal 25%
Although oil and natural gas are depicted as a small percentage, domestic consumption places Australia as a net importer of oil and net exporter of natural gas and coal (Hogan et al. 2010, pp-7) and (Cuevas-Cubria et al, 2011pp 40, 45 and 53).
Ownership and property rights
In demonstrating, desirability for the Resource Rent Tax format in place of other taxation methodologies, it would warrant the consideration of what the broader Australian community values, how does society view the extraction and domestic use or offshore sale of fossil resources ? Are these resources to be used for the benefit of a few opportunistic firms or would a return to all concerned be appropriate ? Henry et al. describe how a new uniform tax by the Commonwealth Government would provide the community an “....appropriate return on its non-renewable resources ’’ (Henry et al. 2009, p 47). Garnaut in his short treatise on resource rent taxation notes that “... under the constitutions of Australia and most other countries, most minerals are owned by the state, and their extraction is dependent on an exclusive licence provided by the state” (Garnaut A, 2010, p2).
To control, yet encourage mineral extraction, in relation to Garnaut's argument above, Sinner et al. detail how property rights and licensing granted by State or Commonwealth Governments is used as a policy instrument to:
- prescribe the provisions under which mining is allowed.
- limit exclusive right to firms seeking to profit from an operation
- allow economic rent collection by the firm from the resource
- the format may apply to both the public enterprise as well as private
(Sinner et al., 2010, p6)
Given these (mineral) rights to a resource and prior to allocation of project funding, firms would seek additional investment security. Consider the cost to BHP Billinton with the installation of a rail road to transport iron ore from Mt Newman to Port Hedland. There are a few decisions made in anticipation of the capital outlay for a rail line that will only have one purpose, in transporting material to the sea port for export to possibly just one country. Firstly, that the supply contract with the overseas export concern is ratified so that they may have a clear income stream from which to finance the project. Secondly, there is an understanding that the applied tax regime will be maintained or will be stable for the life of the mined resource. If either of these items were to flounder during negotiations then it would have planning implications as well as to deter further mining projects (Hausman, 2010, p2). Therefore, clearly ratified property rights and ensuring stable taxation throughout the project life provide for security of income and allow ease of investment.
Other Taxation Considerations
The preceding stable taxation issue provides revenue to the community whilst at the same time placing a known liability on the firm, in addition to this other concurrent tax implications need to be addressed. Regarding the noted Australian community ownership of the minerals, the gain of resource rent by the firm needs be divided and distributed equitably, so questioning what percentage should be taxed? If a high taxation yield close to 100% of rent is taken, there is little incentive for additional private funding or further exploration for new resources. On the other hand, if little or no rent is drawn as tax, then the community misses the benefits (Tomaras, 2011, p9).
The second question pertains to the attractiveness of the tax system to the risk averse investor, given that considerable funding has been placed with, say an unsuccessful exploratory drilling venture, how best to make an allowance for this sunk cost loss and yet allow further exploratory work that may lead to production and hence mineral rent taxation (McHugh, 2011).
Lastly, given that an operation has produced for a given period or maybe a new production establishment is about to be launched, yet the characteristics of working the mine or oil well make it a marginal operation, what format of tax will allow continuation. Traditional specific and ad valorem royalties simply make these operations un-economic and so simply leads to them being shut down. A format is required that allows a sliding tax scale that takes from rent yet is proportioned to the money flow (McHugh, 2011).
Traditional taxing regimes do not necessarily provide a favourable outcome for all parties which would include the investor, Government and so the community. Henry et al. whom provided a review of Australian taxation and reflected upon a broad spectrum of contemporary taxation inefficiencies. Section 6.1 “Charging for non-renewable resources” discusses the inadequacy of the current resource tax and royalty, and depicts a growing profit margin portrayed against a virtually constant tax revenue (Henry et al. 2009, pp 47-48).
To enable a clear understanding of the direction that the Commonwealth Government is endeavouring to adopt, the various mineral tax formats used over the years, are summarised below as described by Hogan 2003 and Garnaut 2010:
Flat fee “.... once-for-all payment for rights to extract minerals from leased area” (Garnaut A, 2010, p2) used in Canada and USA , attempted in Australia using competitive bidding for offshore but was unsuccessful.
Ad Valorem royalties, used by the States to tax a percentage of mineral value as it comes out of the ground.
Progressive profits tax, taxes the corporate income at a higher rate when such income exceeds a given value in any one period.
Brown Tax, that taxes corporate income flow rate, but provides for repayment to investments that have a loss during a period
Resource Rent Tax, is geared to allow losses to accrue in a period with interest until a positive return negates the cumulative previous periods losses at which point the resource rent is taxed at 40% (Hogan, 2003 p. 11) and (Garnaut A, 2010, pp 2-3).
One methodology for assessing feasibility as reviewed by Garnaut entails:
stability - allowing a tax policy to operate for the period (or life) of the investment with which it was established for. Investors would reconsider if taxation policy changed within the life of a project.
neutrality - a policy that does not place onerous decision concerns about project investments, it has been established that taking from economic (resource) rent has minimal effect upon long run investment decisions.
maximise (tax) return - to ensure that the community may benefit from the exploits of the land.
Garnaut then applies the criterion to the various tax forms:
neutral tax format - Flat Fee as well as Brown tax, where under certain conditions Brown tax is completely neutral. Resource Rent Tax fares second in this regard.
tax stability - Resource Rent Tax along with Progressive Profits Tax provides an appreciably stable tax format.
Brown tax fares next.
Ad valorem royalties which are the traditional resource tax method are seen as an unstable tax form.
(Garnaut B, 2010, pp 7-8).
Resource Rent Tax (RRT)
To allow for all the inefficient effects of traditional specific and ad valorem taxes, as well as providing for the corporate sector to be able to operate their capital in a more proficient way with respect to marginal operations. Garnaut and Clunies Ross in 1975 (Banfi, 2009, p2304) developed a taxation system that addressed the various arguments and that would bring neutrality to the taxing of mineral resources (Garnaut B, 2010, pp 11-12).
The taxation method allows a firm's sunk costs in exploration and establishment of a project, to be carried forward along with an interest rate of 25%. This is carried for as many years as it is required for a project to obtain profit. At which point it allows the accrued losses to be deducted against positive cash flow. Once the investment has reached a break even point then a tax rate is applied to the economic rent flow of 40% (Resource rent, 2011).
The RRT allows a structure that successfully combines and accounts for the issues noted earlier. It provides the stability on which long term projects may be designed around, similarly assuring the Government of continual revenue with which to fund projects. It does not take away from normal profits and yet allows considerable “super” profit to be retained by the firm, therein it is viewed that it has minimal distorting effect on decisions. As it is a profit flow tax, it decreases according to the amount of economic rent a marginal operation is able to obtain, allowing for the best possible exploitation of the resources without imposing undue taxation on diminishing rent (Freebairn et al, 2011, pp 11-12). Risk is taken on by the Government, in the event that an exploration should be unsuccessful, as it will lose out on any forthcoming revenue (McHugh, 2011).
Considered workable, the format has been in place since 1987 for the majority of offshore petroleum and gas wells controlled by the Commonwealth Government. Known as the Petroleum Resource Rent Tax (PRRT), for its operating period it has performed well, yet experience during this time has provided opportunity to review its function and suggest that slight changes would allow for efficiency gains (Hogan, 2003. p59) .
Lastly, the Henry Review suggested the use of RRT, from which the Commonwealth Government is to introduce the Mineral Resource Rent Tax (MRRT) to replace royalties, aimed at coal and iron ore with a 30% rate on economic rent effective from July 2012.
Switzerland, obtains 55% of its energy from large hydro electric generation facilities, the remainder is 40% nuclear and the final 5% from municipal waste thermal and renewable sources. The authors note that contemporary taxation by the Cantons (unified councils) is based upon a fixed fee for each kW of gross capacity, irrespective of consequential energy usage and so resource (water) consumption. Tax on water usage is purely a means of returning funds back to the community, the format provides between 10 – 20 % of total revenue for the Cantons. Although there is no issue with the taxation format, the efficiency of the process is being questioned.
The current system of taxing kW capacity is not sympathetic to the differential cost structure of the various generators as they do not share similar characteristics, some are continuous run of river low capacity units, others such as the Bieudron Power Station that are stored capacity at very large elevation also have large turbine capacity and from an engineering perspective provide for higher machine efficiency, yet are penalised by the incumbent tax system.
Banfi et al. consider the benefit of using a tax on the water resource scheme and although mention the possibility of various schemes place emphasis on Garnaut and Clunies Ross's Resource Rent Tax (RRT). Stating that it is linked to the resource being exploited, strengthening competitiveness of the generators, as well as being neutral to investment as it does not discourage capacity increases or efficiency improvements (Banfi et al, 2010).
Mineral resources have been defined into energy minerals and mineral ores (inclusive of uranium). Community ownership of these minerals along with Governmental licensing and so control, were then explained so ensuring that a firm understood its obligations with respect to resource extraction, subsequent sale and collection of economic rent. Taxation methods were then embraced and considered with reference in particular to stability and neutrality. From this, it was shown that the Resource Rent Tax (RRT) fares best under most conditions.
The RRT has been used in various forms directly within the energy sector. In this vein, three were noted, the PRRT used by the Commonwealth Government over the last twenty years that has provided considerable positive experience. The contemporary Henry Review of Australia’s tax system made reference to use of a RRT with the coal and iron ore mining, with which the Commonwealth Government has now established the Mineral Resource Rent Tax. The presentation of the Swiss hydro- electric system with the authors explicitly emphasising the benefits of the Garnaut and Clunies Ross's RRT applied to the water resource, in place of the outdated taxation of generator capacity
The arguments in conjunction with the cited examples suggest that considerable merit may be attributed to the use of the RRT, not just within the energy sector but with diverse mineral extraction projects and one which provides balanced benefits to the participants in the energy sector and the Commonwealth Government.
Banfi, S., Filippini, M., 2010, resource rent taxation and benchmarking – A new perspective for the Swiss hydropower sector. Energy Policy issue 38, Dec 2009, pp 2302-2308
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