Are royalties just RENT CONTROL for mineral and energy resources?
And are there ways to more commercially price our resources?
My colleague Tim Helm and I have a new report out for Prosper Australia on how to more commercially price our collectively-held rights to our mineral and energy resources.
Grab your copy below. Go on. I’ll wait.
I hope the report is clear enough. Here I want to explain details a little more.
The basic story is that underground resources are owned by the state. As your property title will say, such rights are reserved. Companies that extract mineral and energy resources hold a lease granted by the state to use our collective property.
So the state is the landlord and the resource company is the tenant or leaseholder.
The difference between a housing landlord-tenant relationship and a mining landlord-tenant relationship is that with mining, the tenant brings the capital, not the landlord.
So it is more akin to a caravan park, where the tenant brings their house with them and pays for it. Except that with mining, much of the capital investment can’t feasibly be towed away.
Let’s consider this question.
If you owned the property rights to the state’s minerals, how would you price those rights?
What we currently do in Australia is price those minerals at a fixed percentage of the value of the resources (the income to the leaseholder) in the form of a royalty. This is the rent paid by the leaseholder for those mineral rights.
A rent that doesn’t rise or fall with the market price, but instead only rises or falls with the tenant’s income, is a form of rent control. It’s exactly the type of rent control we use for public housing tenants.
This is not the ideal commercial arrangement for resource landlords because, as we know, rent controls favour tenants at the expense of landlords.
What resource pricing options are there?
Separately pricing the rent for the mineral and energy resources from the return on the capital invested by the mining tenant is a genuinely tricky problem.
This is why a popular approach is to avoid pricing altogether by the state becoming the mining company itself. This is how the Norwegians began with Statoil (now Equinor) and how the Gulf nations now run their oil and gas industries. Seizure or acquisition of private mining companies by the state is extremely common.
Another way is to try to tax excess profits, or super-profits as they are called. Australia has the Petroleum Resources Rent Tax (PRRT), which tries to do this for offshore oil and gas deposits. Because excess profits are an accounting construct, there are many margins to game this figure, with often hidden accounting rules that reduce taxable excess profits, such as generous allowances for escalating costs over time and including exploration costs from other projects.1
A final way to price mineral and energy resources is to use royalties. Since it is relatively easy to monitor what gets physically extracted from a mine, or put on a ship or in a pipe, just charge a rent for the resource based on production output or production revenues.
Royalties are typically set either at dollar value per unit of resource output or as a fixed percentage of the value of the resource produced up to a particular part of the production chain.
But even though the fixed percentage royalty varies with market prices of the resource, it doesn’t account for the fact that when resource prices rise the rent rises more than in proportion to the price.
To see why resource rents should rise more than in proportion to the price of the resource, let’s look at a simple housing example.
If you have a home at one location with a market price of $1 million that costs $500,000 to build, the land (resource rent) value is $500,000. If that same house was at a location where the market price was $2 million, the land value would be $1.5 million.
When the market price doubles, the land value triples.
Land is a leveraged bet on the underlying asset, as I explained in this post, and so are the rights to mineral and energy resources.
Historically, prices of mineral and energy resource markets have varied quite a lot. But royalty incomes haven’t risen and fallen more than proportionally as they should.
However, royalties can be enacted so that their rate per dollar of resource value varies with the market price. These are known as variable royalties.
How do variable royalties work?
In 2022 Queensland enacted a textbook example of variable royalties for coal by copying the structure of rising marginal rates that we use for income taxation.
The coal royalty is 7% of the market price when the coal price is below $100/tonne, but rises to 12.5% of any value above $100, 15% of any value above $150, 20% of any value above $175, 30% of any value above $225, and 40% of any value above $300.
If the coal price is $100/tonne, you pay a $7 royalty or 7% of the market price.
If the coal price is $500/tonne, you pay a $129.50 royalty or 25.9% of the market price.
This is a more commercial market-based way to price our collective resources.
In our new report, we propose a general version of the variable royalty approach whereby rates don’t need to be referenced to a series of nominal benchmarks (equivalent to tax brackets).
Instead, you take a long-term market benchmark, in our case the 10-year median market price in a relevant resource market, and you scale the current royalty percentage rate based on the deviation of the current market price from that long-term benchmark.
This way, rather than needing to update the nominal thresholds to avoid bracket creep of royalties, you let the market reveal what is abnormally high or low short-term price variation.
This variable royalty formula is:
So if we have a 7% base rate royalty for coal, we simply apply this scaling factor so that when prices rise to abnormally high levels, the rent the state charges for resources scales more than in proportion. When market prices fall to abnormally low levels, the royalty rate also falls.
In our report we apply this variable royalty approach to historical price patterns of coal, iron ore, and gas, applying a base rate equal to typical current royalty rates, to see what the counterfactual history would have been.
We find two interesting things.
First, the royalty is often lower with this variable royalty than if applying the base rate only. We explain that:
A variable royalty with base rate equal to the existing fixed royalty rate would have been lower than the latter for around 15% of the past decade for coking coal, and for around 38% of the past decade for thermal coal. For iron ore, a variable royalty would have been lower than the fixed-rate royalty for 40% of the decade, and for gas, it would have been lower for more than half of the period (58%).Â
Second, because price variation above the long-term median is much larger than price variations below the median, the total revenue raised from a more commercial variable royalty is much higher on average.
Over the decade to 2023, variable royalties for coal would have raised an additional $38 billion (in 2023 dollars), which is 71% more than the $53 billion that would have been collected under a 9% fixed rate. Over the same period, variable iron ore royalties with a 7.5% base rate would have raised an additional $33 billion, or 33% more than the estimated $101 billion raised from the fixed-rate royalty.
The charts below summarise how variable royalty prices compare to fixed royalties and the effect of this on the market price (net of royalty) received by leaseholders.
So what?
Australians should charge a market price for our mineral and energy resources.
If nationalising mining companies is politically undesirable, and taxing accounting profits is difficult, then royalties can be designed more commercially to track market fluctuations in the value of the resource rent.
Pricing this way also de-risks mining leaseholders, minimising variation in the net price they receive by reducing royalty rates when market prices are low, and increasing them only when market prices are high.
Since variations in market pricing over time are asymmetric (they can rise above the median more than they can fall), this approach ultimately earns much more revenue for the resource landlords of the country, the Australian people, over the long run.
2% of net profits on gold seems ridiculous. Nz has exported gold since our earliest days, why do we not have an soe or commercial royalty level?