Fair and transparent fiscal terms key to accelerating transition resource investments

The race is on in the exploration and development of transition resources required for global decarbonisation. However, the investment environment needs to be more conducive, and the establishment of fair and transparent fiscal policies could be the key, says Wood Mackenzie, a Verisk business (Nasdaq:VRSK).

The energy transition needs significantly more investment in developing transition resources which include lithium, graphite, nickel, copper, cobalt and bauxite (aluminium). The balance between the resource rent potential and government terms will determine where capital will be allocated.

Wood Mackenzie senior vice president Graham Kellas said: “The search for, and development of, new transition resource deposits is underway and must pick up pace in coming years. But the history of engagement between extractive resource owners and investors is characterised by tense negotiation and renegotiation over fiscal terms, local content, and social development issues.

“Fiscal reviews should be guided by a key principle: transparency. The licence to operate requires all stakeholders to understand the terms agreed between the government and investors. The policies also need to address what a fair share for government is under high prices and low prices and from high quality and low quality resources. They must reflect the country’s economic and geographic circumstances.”

Wood Mackenzie has highlighted four fiscal recommendations to accelerate resource investments:

• Remove indirect taxes; focus on local employment and growing local supply instead.

The delay between mining activity starting and taxable income being generated is often seen as far too long for many developing countries. As a result, many impose indirect taxes, such as VAT and import duties, which generate income for the government even before a commercial project is established. Negotiating and administering these costs can be time consuming. Governments should instead focus on the benefits of local employment, and growing supply.

• Focus on long-term fiscal vision which include royalty in the early stage of sector-building, with the aim of transitioning to profits-based taxes as the sector matures.

Royalty is the most common fiscal term applied in extractive industries. It also guarantees the resource owner a share of revenue regardless of the costs of production. At very low rates, this is unlikely to deter investment in a project. But royalty can compound uneconomic production when prices are low. To minimise this risk, royalty rates can be linked to prices.

However, higher commodity prices will inevitably result in supply sector inflation. Higher prices for local labour, goods and services means economic growth. But it can clash with a royalty rate that is reducing the incremental price left for the producer to cover extra costs. As the petroleum sector discovered in the 2000s, today’s windfall price can quickly become a breakeven price. A longer-term and fairer solution may be to transition from a royalty-based policy to a profits-based taxation system.

• In immature sectors, depreciation may be necessary to ensure tax is payable in the early years of a project, but this should be balanced by low tax rates. In mature sectors, immediate capital allowances could co-exist with higher tax rates.

Within profits-based tax systems, depreciation of capital costs can be an investment deterrent. The longer it takes to recover upfront capital costs, the more the tax resembles a quasi-royalty. Immediate capital cost recovery is rare in resource taxation, although it is a feature of the UK’s petroleum fiscal system and drilling costs in the US, with a positive impact on project economics.

A profits-based tax system, targeting resource rents, is most likely to attract investment. But many governments suspect that companies use every means possible to ensure that taxable profits occur as late as possible, if ever. They consider the use of tax havens, opaque transfer pricing, intra-company loan arrangements and excessive cost claims as attempts to deny the host country its fair share of the resource rent. They may be legal but are far from the spirit of partnership required for a harmonious, long-term relationship. A new approach to sharing revenue via the tax system is needed to create the new business environment.

• By financing a host government’s equity position in new projects, the rich, carbon-emitting countries that will benefit from new transition resource supplies can help to ensure project success.

State participation via an equity interest is common in petroleum projects but less so in mining. When it goes well, the state company acts as the interface with other government entities and helps to minimise disruption and disputes.

Instead of being carried by its private investor partners, host governments may turn to organisations such as the World Bank for loans to fund equity in projects. COP26 reinforced the principle of a ‘just transition’ for developing economies. These equity stakes could be funded by the developed economies under highly favourable repayment terms – or even no repayment at all – as part of that principle.

Kellas said: “The world needs a lot more transition resources, as soon as possible, and this requires a massive injection of investment, spread across the globe. To ensure this is achieved – and sustained – resource owners and investors need to reconsider their traditional, often adversarial, approach to mining agreements. Win-win solutions may not be easy, but they are achievable. And necessary.”