On the draft coal policy
Saturday, 14 July 2007
Forrest Cookson
THERE is an important ongoing effort to prepare the National Coal Policy. Reports on this activity have "stakeholders" agreeing on a royalty rate in the range of 16-30%; much higher than the current level of 6%. These proposed higher rates reflect a failure to appreciate the prices and costs in the coal sector. This note is divided into four parts: (1) What is royalty as currently defined in Bangladesh law? What rates are typical around the world for coal mines? (2) Why should royalty be paid? (3) What is the impact of royalty on the finances of a large open pit mine such as the proposed Phulbari coal mine? (4) What is a reasonable royalty to pay?
The conclusions of this note are:
1. At 6.0% Royalty a large open pit mine has a return on equity of 25%, appropriate for a high risk project. The return to the private sector for the total investment in the project is 14%. At 16% royalty the return on equity declines to 15% - with all the risks involved no one will invest, better to put your money in the bank or the stock market. The return to total investment declines to 11%. At a 30% royalty the return to equity is negative and the total return to the private investors is 6.0%! The "stakeholder" demand to increase the royalty rate does not consider the impact on the return to investors.
2. At 6.0% royalty the mine pays 18% of its sales value in taxes [VAT, Corporate Tax, and royalty]. In contrast a manufacturing establishment pays 9.0-10% of its sales as taxes. If anything the mining sector is overtaxed! We note in addition there is a substantial payment by mine employees of personal income taxes to the Government.
3. If Bangladesh wants to develop its coal resources then there is no scope for increasing the royalty rate. Indeed an increase to 16% or even higher as proposed in drafts of the coal policy will block all investment except by these who intend to manipulate the system in some way. That is, all reputable investors will not participate; those that do will have some trick to defraud Bangladesh.
4. The imposition of a royalty, taxing the resource more than other economic activities slows the development of coal mines. This is a dangerous choice. Coal resources are urgently needed to provide fuel for the power sector.
What is Royalty?
In Bangladesh law royalty is an ad valorem tax levied on the value of minerals at the mine. The rate is 6.0% for an open pit coal mine. For example, if coal is sold for export at $55/mt fob and the costs are $10 to move the coal from the mine to the port then the value of the coal at the mine face is $45/mt and the royalty is $2.70. If the coal is sold at $40/mt to a domestic power plant delivered to the buyer at the mine the royalty is $2.40.
What are typically rates for coal? Here are the rates from a recent World Bank publication :
Africa : on market value 2.0-8.0%
Asia : on market value 1.0-10%
Australia : on market value 7.0%
Latin America : 5.0% on sales
USA: 2.0-7.0% on sales
Canada : mostly on profit
See James Otto et al Mining Royalties, World Bank, 2006
Why should there be a royalty?
Royalty is an extra tax imposed on the mining sector. Why should this tax be imposed? Economists prefer that all enterprises should be treated equally; imposing different tax rates on different sectors is very poor economic policy leading to distortion of resource allocation. Of course Governments love to do this, but they do not do it very well and inevitably generate more losses than gains. With variability in prices profits swing up and down. This variability is part of the economic process and it is poor practice to increase taxes on rising prices. There are many difficulties: What if the price declines? What if the costs rise? If coal prices rise it is likely to be connected with increase in the oil price leading to higher mining costs. If one taxes when prices rise it makes calculation of the return to the project much more uncertain. If there is going to be a royalty it is preferable to keep it constant. The corporate tax will tax profits arising from higher prices in an equitable way.
What is the impact of royalty on the return?
I have used the sales and cost data for an open pit mine similar to the one proposed by Asia Energy. Three cases were calculated corresponding to 6.0%, 16% and 30% royalty rate, 6.0% is the legal rate, 16% and 30% are the rates suggested by some as acceptable to the stakeholders. The key results are given in Table 1. The return to equity with a 6.0% royalty is a reasonable 26%; for 16% it falls to 15% and at 30% to zero!
Assumptions: Debt 70% equity 30% of capital cost
Investment per metric ton $80
Interest on loans 9.0%
Mine face selling price $45/mt
Table 1
Impact of different levels of royalty ($ per mt)
Table 1 illustrates the real issues in discussing royalty and taxes. What return on equity is needed by an investor? On a high risk, long term project such as a coal mine in Bangladesh, 26% is a reasonable target. Typical target returns to equity in manufacturing are 20-30%. Bangladeshis can earn almost 15% on a saving certificate on a risk free basis. A royalty of 16% already makes the project impossible as a return on equity of 15% is far too low. With a 30% royalty return to equity is zero! It is very difficult to increase the royalty without reducing the return on the project to an unacceptable level. Anyone who argues for increasing the royalty needs to demonstrate that the return on the project are unreasonably high at 6.0% at a $45 price. No such argument has been made because it is wrong!
One should be clear on the significance of the return on equity. Risk arises from lower selling prices, higher costs, or delays in implementing the project. The equity holder gets what is left!
Table 2 compares a typical manufacturing establishment with the coal mine. The representative manufacturing establishment pays 10-11% of the sales revenue in VAT and income tax. The open pit mine pays almost 18% of sales value including a 6.0% royalty. The estimated return on equity for a coal mine is 26% with a 6% royalty and 24% for a typical manufacturing establishment, i.e. essentially the same.
Table 2
Comparison of mine and manufacturing establishment
The mine is more capital intensive than the manufacturing establishment and pays a higher share of its sales as taxes.
There is no scope for significantly changing the royalty rate without destroying the investment potential in mining.
What should the royalty rate be?
If there is to be a royalty its purpose should be to reduce investment in mining to preserve the resource. Any royalty reduces investment in exploiting the mineral and hence economic development. The danger with a royalty on coal resulting in slower exploitation is that future international agreements connected with global warming may limit the use of coal leaving Bangladesh with a lot of coal in the ground! The coal is probably more valuable now!
Delaying use of coal is a very unattractive idea. Instead good policy should use it is fast as possible! The 6.0% royalty rate is consistent with world practice; is consistent with a return on equity that is appropriate; and is the value in the existing law.
The idea of rising the royalty to 16%, 20% or even higher is economic nonsense. Such a royalty rate will lead to no development of the coal resource. An outcome of little or limited development would be a great loss for the economy. The resulting shortage of energy would slow economic growth. Further for projects which are far along in development raising the royalty violates the Foreign Investment Protection Act that forbids changes in taxes or regulation that effectively destroy an investment. The proposal for changes in the royalty rate have no analytical basis and represent wishful thinking. Bangladesh deserves better analysis.
The weight of evidence is compelling that a 6.0% royalty rate is appropriate.
THERE is an important ongoing effort to prepare the National Coal Policy. Reports on this activity have "stakeholders" agreeing on a royalty rate in the range of 16-30%; much higher than the current level of 6%. These proposed higher rates reflect a failure to appreciate the prices and costs in the coal sector. This note is divided into four parts: (1) What is royalty as currently defined in Bangladesh law? What rates are typical around the world for coal mines? (2) Why should royalty be paid? (3) What is the impact of royalty on the finances of a large open pit mine such as the proposed Phulbari coal mine? (4) What is a reasonable royalty to pay?
The conclusions of this note are:
1. At 6.0% Royalty a large open pit mine has a return on equity of 25%, appropriate for a high risk project. The return to the private sector for the total investment in the project is 14%. At 16% royalty the return on equity declines to 15% - with all the risks involved no one will invest, better to put your money in the bank or the stock market. The return to total investment declines to 11%. At a 30% royalty the return to equity is negative and the total return to the private investors is 6.0%! The "stakeholder" demand to increase the royalty rate does not consider the impact on the return to investors.
2. At 6.0% royalty the mine pays 18% of its sales value in taxes [VAT, Corporate Tax, and royalty]. In contrast a manufacturing establishment pays 9.0-10% of its sales as taxes. If anything the mining sector is overtaxed! We note in addition there is a substantial payment by mine employees of personal income taxes to the Government.
3. If Bangladesh wants to develop its coal resources then there is no scope for increasing the royalty rate. Indeed an increase to 16% or even higher as proposed in drafts of the coal policy will block all investment except by these who intend to manipulate the system in some way. That is, all reputable investors will not participate; those that do will have some trick to defraud Bangladesh.
4. The imposition of a royalty, taxing the resource more than other economic activities slows the development of coal mines. This is a dangerous choice. Coal resources are urgently needed to provide fuel for the power sector.
What is Royalty?
In Bangladesh law royalty is an ad valorem tax levied on the value of minerals at the mine. The rate is 6.0% for an open pit coal mine. For example, if coal is sold for export at $55/mt fob and the costs are $10 to move the coal from the mine to the port then the value of the coal at the mine face is $45/mt and the royalty is $2.70. If the coal is sold at $40/mt to a domestic power plant delivered to the buyer at the mine the royalty is $2.40.
What are typically rates for coal? Here are the rates from a recent World Bank publication :
Africa : on market value 2.0-8.0%
Asia : on market value 1.0-10%
Australia : on market value 7.0%
Latin America : 5.0% on sales
USA: 2.0-7.0% on sales
Canada : mostly on profit
See James Otto et al Mining Royalties, World Bank, 2006
Why should there be a royalty?
Royalty is an extra tax imposed on the mining sector. Why should this tax be imposed? Economists prefer that all enterprises should be treated equally; imposing different tax rates on different sectors is very poor economic policy leading to distortion of resource allocation. Of course Governments love to do this, but they do not do it very well and inevitably generate more losses than gains. With variability in prices profits swing up and down. This variability is part of the economic process and it is poor practice to increase taxes on rising prices. There are many difficulties: What if the price declines? What if the costs rise? If coal prices rise it is likely to be connected with increase in the oil price leading to higher mining costs. If one taxes when prices rise it makes calculation of the return to the project much more uncertain. If there is going to be a royalty it is preferable to keep it constant. The corporate tax will tax profits arising from higher prices in an equitable way.
What is the impact of royalty on the return?
I have used the sales and cost data for an open pit mine similar to the one proposed by Asia Energy. Three cases were calculated corresponding to 6.0%, 16% and 30% royalty rate, 6.0% is the legal rate, 16% and 30% are the rates suggested by some as acceptable to the stakeholders. The key results are given in Table 1. The return to equity with a 6.0% royalty is a reasonable 26%; for 16% it falls to 15% and at 30% to zero!
Assumptions: Debt 70% equity 30% of capital cost
Investment per metric ton $80
Interest on loans 9.0%
Mine face selling price $45/mt
Table 1
Impact of different levels of royalty ($ per mt)
Table 1 illustrates the real issues in discussing royalty and taxes. What return on equity is needed by an investor? On a high risk, long term project such as a coal mine in Bangladesh, 26% is a reasonable target. Typical target returns to equity in manufacturing are 20-30%. Bangladeshis can earn almost 15% on a saving certificate on a risk free basis. A royalty of 16% already makes the project impossible as a return on equity of 15% is far too low. With a 30% royalty return to equity is zero! It is very difficult to increase the royalty without reducing the return on the project to an unacceptable level. Anyone who argues for increasing the royalty needs to demonstrate that the return on the project are unreasonably high at 6.0% at a $45 price. No such argument has been made because it is wrong!
One should be clear on the significance of the return on equity. Risk arises from lower selling prices, higher costs, or delays in implementing the project. The equity holder gets what is left!
Table 2 compares a typical manufacturing establishment with the coal mine. The representative manufacturing establishment pays 10-11% of the sales revenue in VAT and income tax. The open pit mine pays almost 18% of sales value including a 6.0% royalty. The estimated return on equity for a coal mine is 26% with a 6% royalty and 24% for a typical manufacturing establishment, i.e. essentially the same.
Table 2
Comparison of mine and manufacturing establishment
The mine is more capital intensive than the manufacturing establishment and pays a higher share of its sales as taxes.
There is no scope for significantly changing the royalty rate without destroying the investment potential in mining.
What should the royalty rate be?
If there is to be a royalty its purpose should be to reduce investment in mining to preserve the resource. Any royalty reduces investment in exploiting the mineral and hence economic development. The danger with a royalty on coal resulting in slower exploitation is that future international agreements connected with global warming may limit the use of coal leaving Bangladesh with a lot of coal in the ground! The coal is probably more valuable now!
Delaying use of coal is a very unattractive idea. Instead good policy should use it is fast as possible! The 6.0% royalty rate is consistent with world practice; is consistent with a return on equity that is appropriate; and is the value in the existing law.
The idea of rising the royalty to 16%, 20% or even higher is economic nonsense. Such a royalty rate will lead to no development of the coal resource. An outcome of little or limited development would be a great loss for the economy. The resulting shortage of energy would slow economic growth. Further for projects which are far along in development raising the royalty violates the Foreign Investment Protection Act that forbids changes in taxes or regulation that effectively destroy an investment. The proposal for changes in the royalty rate have no analytical basis and represent wishful thinking. Bangladesh deserves better analysis.
The weight of evidence is compelling that a 6.0% royalty rate is appropriate.