Resource Nationalism: The new global economic rent – by John Lee and Johan Erasmus

John Lee is Executive Director, Tax, Ernst & Young LLP and Johan Erasmus is Senior Manager, Tax, Ernst & Young LLP. This column was orginally published in December 2010.

The global financial crisis led to massive budget deficits as many governments injected cash to their economies by way of massive stimulus packages. At the same time, minimized tax collection during and after economic crisis reduced government revenues dramatically.

The relatively swift rebound of the mining and metals industry attracted the attention of deficit-strapped governments and resulted in the industry becoming an early target to replenish national treasuries.

Our company’s report Business Risks Facing Mining and Metals identifies resource nationalism as the fourth-greatest strategic business risk the sector is facing (up from ninth place in 2009). The report identifies how mineral-rich countries are renewing efforts to ensure that they are extracting sufficient economic rent, including royalties, taxes and duties, for the right of a mining company to exploit their resources.

In some instances, governments are even looking to replace and repair other areas of lost revenue with further imposts on the sector, obtaining a larger share of higher mineral prices.

Resource nationalism could also result in an imposition of greater controls on foreign participation, a tendency for increased state ownership, disincentives for out-of-country beneficiation and expropriation of mining rights if development is not achieved within an agreed time frame (i.e., “use it or lose it”).

The trend has a global reach and affects both developed and developing nations around the world. Some examples of recent events include:

Quebec – Significant proposed amendments to the Mining Duties Act.
Australia – Proposed introduction of the Minerals Resource Rent Tax.
China – Planned new resource tax on coal mining revenues.
Brazil – Proposed tax on shipments of iron ore and potential changes to mining royalties are currently under review.
India – Windfall tax on “super profits” on mineral exporters.
Ghana – Plans to increase royalties on mining.
Russia – New nickel and copper export duties are expected to come into force as early as December.

With established mining and metals countries asserting their resource nationalism, there is a concern that other countries will also implement similar policies without fearing a loss of foreign direct investment. The short-term impact would be a reduction in returns to the overall sector and possibly a shift in investment to other sectors.

The industry’s primary concern over resource nationalism is the manner in which proposed changes are made to the economic rent extracted by governments. Since mining is a long-term investment that is especially capital intensive, the industry uses detailed models to evaluate the feasibility of the projects. Known taxes and/or royalties are factored into the cash flows used by these models.

Therefore, where changes are made to the economic rent when the capital has already been expended, it impacts the project’s rate of return and in some cases its viability and may force management to curtail operations or even abandon the project. At the same time, mining companies could be forced to pass the additional cost on to their customers in order to maintain after-tax returns.

The mining and metals industry should address this reviving trend by assessing how political risk affects corporate strategy and business processes. Accordingly, mining companies should develop guidelines and procedures to factor greater political risk into their investment decision-making process. In circumstances where mining companies have existing operations, they should monitor the political environment in order to adjust capital management and expected returns based on business objectives and risk tolerance.

To limit the challenges associated with resource nationalism, mining and metals companies need to forge strong, transparent relationships with foreign governments to communicate their needs and to facilitate the development of projects. Companies should work to demonstrate to their host governments the value that mining companies bring by developing resource properties, such as:

Infrastructure development (e.g., power generation plants)
Social and community development projects
Local beneficiation of minerals
Job creation and skills transfer to the local community
Long-term commitments to projects with concomitant contribution to economic growth.
Furthermore, the companies should demonstrate that health, safety and environment are of their highest priority.

Large capital investments made by mining and metals companies are immobile, and therefore increasing royalties or renegotiating contracts can increase the sovereign risk for the investors. This means governments should be striking a balance of mutual gain while remaining an attractive investment target. Those mining companies that demonstrate a sustainable business case to their host countries will most likely succeed in reducing the risk of resource nationalism and in pursuing their global growth strategies.