Wednesday, July 07, 2010

Wednesday column: The deal didn't end sovereign risk, it brought it on

Just for a moment in his three-hour grilling before a Senate committee Monday Ken Henry gave the game away.

Asked what had gone wrong with the Resource Super Profits Tax he helped design, he said in his view "nothing has gone wrong with the integrity of that particular recommendation".

It merely lacked sufficient acceptability "at this time".

Asked whether he expected that to change he said he didn't know.

And in saying so put sovereign risk back on the table, where it has almost always been.

Because there is only one way to effectively kill sovereign risk as it's defined by the mining companies, and the mining companies themselves don't want it - it's to tax them properly.

This isn't just conjecture, it's an important finding from tax research - one the mining companies act as if they understand...

Resource economist Ben Smith from the Australian National University outlined the paradox at last month's tax conference.

Sovereign risk (as defined by the mining companies) arises from the concern that a future government will take actions that reduce investment returns below what was expected given the policies in place at the time they were undertaken.

It's expensive where it exists. It makes investors less likely to fund good-looking projects and less-likely to believe good-looking forecasts.

It can never be entirely eliminated, whatever the form of government. Dictatorships can change rules at will. Democracies elect new governments every few years often with mandates to overturn the policies of their predecessors.

Smith makes the point that in countries such as Australia the most likely reason for a rule change that will make mining less profitable is "a perception that the existing regime has not served well as a means of returning to the community an adequate share of the value of the resources being exploited".

In other words, as he puts it, "all things equal the countries posing the greatest sovereign risk are those that initially promise the most generous tax regimes".

Australia had been set to effectively kill sovereign risk. We were to tax mining profits at such a high rate (40 per cent) that the perception our tax take was inadequate would have withered away.

Our offshore petroleum take has been 40 per cent ever since that tax began two decades ago. As a result offshore projects face next to no sovereign risk (except for the North West Shelf which had been exempted and always faced the massive risk that it would lose the exemption which it now has).

So low has been the perception of sovereign risk at the 40 per cent rate offshore that Australia's biggest-ever development, the gigantic Gorgon gas field off Western Australia went ahead last year with no concern the tax rate would rise.

The Gillard compromise on what will be an effective tax rate of 22.5 per cent for coal and iron ore reintroduces sovereign risk the 40 per cent universal rate would have killed off.

Don't trust for a moment the protestations of resources minister Martin Ferguson on Monday that Gillard compromise won't be revisited. He is a sincere man, but he won't always be resources minister. Our goods and services tax rate looks low by international standards. One day a future government will push it up. We might even vote for it. The only (partial) guarantee we could ever get that that wouldn't happen would be to have the rate set where it should be.

The Gillard resource tax compromise isn't set where it should be, in part because the rate will be seen to be low and the design less than elegant, and in part because of the huge range of minerals for the moment left out.

BHP pays the South Australian government an embarrassingly 3.5 per cent royalty for the uranium it extracts in the state's north. As a result of the Gillard compromise it has escaped paying a super profits tax of 40 per cent, but regained a huge sovereign risk. The risk that it'll one day be paying more for South Australian uranium will now be acutely apparent to its funders. After all Queensland pushed up its rate for high value coal to 10 per cent two years ago.

The truth is miners don't mind facing sovereign risk as much as they say. It's part of their business plan. Ben Smith says they seek out low-tax high sovereign risk locations in order to exploit them "before life becomes more difficult".

But they know what's coming.

Which brings us to what's likely to happen. Expect piecemeal royalty hikes state by state, mineral by mineral, in a fairly uneven and unedifying way.

Or perhaps something else. Most miners have probably been made worse off as a result of the Gillard changes. Some 49 per cent of mining companies make no profit according to official statistics and so would have faced no resource charge under the Super Profits Tax as it was, and would have had royalties refunded. Others, including many gold miners, make low profits and would be in the same situation.

What if a future government (maybe even a Gillard government) offers them the opportunity to switch to a super profits regime? It'd be voluntary, but once they had made the choice there would be no turning back. They would escape state royalties in return for knowing that if their mines did turn good they'd be paying Australia a fair share.

Many might take it up. It's hard to imagine them campaigning against it. And they would be freed from the treadmill of sovereign risk.

Published in today's SMH and Age

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