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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Ben Smith: What the government should do with its mining tax

Keep it.

And make explicit and compulsory its 40 per cent contributions to the mine's cost.

Ben Smith is brilliant, and knows the ground better than perhaps anyone.

The paper he delivered to last week's tax conference is below.

And below that (over the fold as they say), one choice extract about "sovereign risk"

Ben Smith on the RSPT



"Sovereign risk 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. The greater the perceived probability of this occurring, the more investors will discount potential favourable outcomes and the less likely they are to supply finance for projects.

The mining industry is, by its nature, a prime target for these kinds of actions. It undertakes investments that are risky and many of these will fail or be only barely profitable, but the visible result is the projects that are successful and that may earn very high profits. It is tempting for governments to raid those profits, especially in countries where the capacity to raise revenue by other means is limited and where political and social stability is weak.

In countries with more stable processes of policy formation and a much broader revenue base, the more likely reason for policy action to expropriate mining profits 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. Other things equal, the countries posing the greatest sovereign risk concerns are those that initially promise the most generous tax regimes. Mining companies then need to consider how long they are likely to be able to exploit that situation before life becomes more difficult.

In the current case, there are two questions.

First, will the retroactive application of the RSPT to existing projects make investors more likely to fear similar actions in the future? Secondly, does the structure of the RSPT itself make it more or less likely that investors will fear future action that reduces after-tax profitability? These are, of course, questions to which nobody knows the answer. Reports of what suppliers of finance are alleged to have said don‟t provide reliable information even if they are true. Markets are known to over-react to news and to take some time to digest its true consequences. Given the mining industry‟s strong and vociferous reaction to the RSPT proposal and its essentially false representation of the effects on new mining investment, it would be surprising if there were not some short-term alarm in financial markets. In the longer-term, a calmer appraisal of the situation will determine people‟s risk perceptions.

Of the two questions posed in the last paragraph, the first is probably the less important. The current Australian government has demonstrated that it is prepared to act to secure rents that it sees as the property of “the Australian people”. If one had previously held the naïve belief that no Australian government would ever do such a thing, presumably one would now think it more likely than before that some future Australian government might also do so. The more important question, though, is how likely is it that a future Australian government would feel justified in acting in this way? If the perception is that the new tax provides a more reasonable sharing of the benefits of Australia‟s resource wealth between mining companies and the community than the existing regime, arguably the risk is reduced rather than increased.

This is not to say that a future government might not be tempted to increase the RSPT tax rate, say to 50 per cent. With a pure Brown Tax, this would mean that it was taking 50 per cent of the returns from projects to which it had contributed only 40 per cent of the cost. The best protection against this (as with the Goods and Services Tax, but with much better reason) is to make it relatively difficult to change the legislation determining the tax rate."


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Wednesday column: No way back, no way out - the miners don't want a deal

I've come up with a way out - something designed to give the mining companies what they say they want while giving the government what it wants.

But there's no point. The mining companies don't really want what they say they want. Not yet. Not by a long shot. Not while there is a chance of toppling the government.

Their behaviour makes sense on two levels. Most simply, no-one likes paying more tax. Company directors are required to maximise after-tax returns. But more profoundly, if Australia's proposed super profits tax can be stopped before it starts it won't be mimicked worldwide. Governments far more cash-strapped than Australia's are waiting to see what happens. If Rudd wins, India, Canada, Peru, Chile and the nation that's hosting the World Cup might follow, making mining less profitable all over.

But still incredibly profitable. The Treasury official who consulted with Australia's miners David Parker told a Senate committee last week that some of the projects whose numbers he examined had "a payback period of less than six months... that is, they return all their capital in less than six months - and they have an internal rate of return in excess of 400 per cent".

Treasury believes that if all of such a project is worth doing, so too would 60 per cent of it after that government had imposed itself as a 40 per cent partner. The (smaller) investment would be recouped just as quickly at just as sharp a rate of return.

So what's the miners (stated) gripe? It is that the government isn't actually planning to put up 40 per cent of the costs as a genuine partner would. It is promising to come up with them in time by subtracting them from future tax payments (or the tax payments of other mines owned by the same company).

To the extent that it delays coming up with the 40 per cent it will compensate the miners it eventually pays by giving them interest, calculated at the government bond rate.

Ken Henry says the bond rate is the right one because what the government is offering is mathematically the same as a AAA rated government bond.

It is not called a bond because then the government would have to deal with Barnaby or Andrew Robb or someone firing up a debt truck and going on about the debt that will be left to our children (notwithstanding the quick payback period of many mines).

But Henry reckons it is the same and any half-decent financial institution can make it so. As he put it to a group of economists last month, "the people we call financial engineers can translate theory into practice at the speed of light".

It is not particularly difficult financial engineering. The Bendigo Bank will advance me money against the proceeds when I eventually sell my house and is prepared to wait.

But Andrew Forrest of Fortescue Mining has told the stock exchange a government guarantee is "of little value to banks and project financiers".

"Who believes that companies could fund 40 per cent of an investment on the strength of some future unbudgeted government tax credit," he asks.

I'm suggesting the government short-circuit the argument and set up a company that would do just that.

For a fee this off-balance sheet government authority will come good with 40 per cent of a mine's development costs upfront, relying for the bulk of its income on the tax receipts the government will send its way when they arrive and borrowings at the government bond rate.

The bonds it issues would be popular. Amongst banks and super funds there's a shortage of AAA-rated investments.

Miners may well choose not to use the authority and avoid paying the fee. The big ones are awash with cash and wouldn't need it. But they wouldn't be able to claim they couldn't get finance.

In reality this complaint matters little to most miners (although if it does matter I have solved their problem).

What worries them much more is a higher average tax rate that would still leave them extraordinarily profitable and spread worldwide.

And given that that is the point of the super profits tax it is hard to see how the government can satisfy them. And in any event it is hard to know who to satisfy. Many of the mining companies scarcely talk to each other let alone like each other. Who would the government reach agreement with? If it found negotiating with the Coalition over the emissions trading scheme impossible it would find this worse. As soon as it gave one company what it said it wanted another would disown the "deal".

There's nothing fundamentally wrong with what the government is proposing - nothing to negotiate away except the tax itself.

And just as there is a lot at stake for the miners worldwide, there is a lot at stake for government - for the idea of government.

If our government can't pull this off, can't exercise its sovereign right to introduce economic reform in the same way as have other governments when they reduced tariffs, taxed offshore petroleum and taxed goods and services, it will have diminished what is seen as possible.

The Hawke and Howard years will be seen as high water mark for what Australian governments used once to be able to achieve.

There's really no way out and not much of a way back.

Published in today's SMH and Age


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Believable statement? Rio says Australia number one sovereign risk worldwide

From Business Spectator today:

"Global miner Rio Tinto Ltd has described Australia as the company's top sovereign risk and says it is reviewing all of its capital spending plans in Australia as a result of the federal government's proposed resource super profits tax (RSPT).

"This is my number one sovereign risk issue on a global basis," Rio chief executive Tom Albanese said, noting that the tax had set up the prospect of a long period of uncertainty which was corrosive to new investment.

"If we are dealing with a, say, two-year extended period of time... in that period, we'd be asking our managers to evaluate it on a worst-case basis," he said, adding that capital would shift in the meantime to other resource-rich nations like Canada.

Mr Albanese said the miner's Australian managers had been asked to review all projects under a worst-case tax scenario.

Speaking to journalists after arriving in Australia ahead of Rio's annual general meeting, Mr Albanese warned the miner's operations in Western Australia's Pilbara region would not have achieved their scale under such a tax.

"If the tax had been in place 10 years ago, we would not have made the investment ... in the Pilbara," he said."

HT: Chris Joye


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