STATE EQUITY IN THE MINING INDUSTRY
OPEN SOCIETY FORUM
The Government and the Hural should keep in mind a number of considerations as they move to amend the Minerals Law to impose a requirement of 51 percent equity ownership by the state of all strategic resources.
- By law and the Constitution, the people of Mongolia already own 100 percent of all strategic resources. What the Hural and the government must do is to provide the investment framework to develop those resources in an orderly and prompt fashion. If Mongolia wishes to develop any of its resources, rather than leave them in the ground, then however structured or however labeled, Mongolia must establish an investment framework that will attract the necessary capital, management skills, and technology for such development.
- In principle, the state could provide the capital, management skills, and the technology. It does so in Erdenet, but the capacity of the state to raise the necessary capital and to provide the necessary management services to develop large mineral deposits is limited. Even if the state had such resources, depending upon the nature of the deposit and the proposed mining program, the government would still have to pay others for the technology and mining services to efficiently develop the resource.
- Given the limitations on its capacity, the government as a practical matter needs to turn to private investors to fully realize the potential of its resources. The only feasible way to do so is to give the private investor a share of the proceeds from particular projects sufficient to induce the private investor to provide the required services, technology and capital. The central issue for fiscal policy is to determine what set of incentives are sufficient to attract the necessary investment over a wide range of resources and periods of time.
- The state can realize the value of the resource in many ways: through taxes, royalties, fees, social charges, equity, or retained ownership interests. But the question is whether what remains for the investor is sufficient to obtain the development that the state wants. This is an empirical question which could be addressed on a project by project basis, but to negotiate individual regimes would have significant transaction costs, require government resources that are in short supply, and would lend itself to “favoritism.” And once negotiated the set of such one-off negotiations would leave Mongolia with a variety of regimes which would be difficult to administer and to police. Instead, what is desirable is a flexible but principled system of regulation and taxation including any provisions for state equity which can adjust itself to a variety of different mining projects.
- In prescribing any minimum share of state ownership, the government and Hural must confront what costs it will have to bear and how those costs are to be financed. That choice itself will significantly affect the distribution of costs, benefits, and risks between the government and the investor. If it had the cash, the government in the case of an existing property could purchase its interest in the market like any other investor, but then it would receive no special value from its ownership interest. It could just as well purchase overseas bonds or equities. Alternatively, the state can be responsible for bearing its share of the capital costs and operating costs going forward so that the government would realize the difference in the market value of the resource and the cost of development. This is what is proposed for Oyu Tolgoi although the investor has agreed to “carry” the government’s interest.
- One result of either of these arrangements is that the government increases its exposure and the exposure of the economy to the risks of mining. The equity invested by the government could be lost or impaired if the project is not profitable either because of mining developments or changes in commodity prices. These same circumstances would lead to a loss of tax and royalty revenues from the project. Thus, by investing its funds into mining the government becomes more exposed to the future risks from the mining sector on which it is already heavily dependent. The funds used for state investment could be used in other sectors that would diversify the economy and the risks the government faces.
- In the case of Oyu Tolgoi, the government has been offered a “carried” interest in which the investor finances the government’s acquisition of its interest by lending the government its share of the investment and then collecting the loan out of the future dividends owed to the government. The loan is made on a non-recourse basis so that if the mine does not turn out to be profitable – an unlikely but not impossible prospect – the government does not have to pay back the loan. Although this avoids diverting government resources into the investment, it is not costless. Under the carried interest the government receives no revenue until the loan and interest is paid back so that any return is postponed until late in the investment. This contrasts, for instance, with royalties which are payable from the beginning of production, income taxes payable from the moment of profitability, or withholding payable from the first distributions of profits to the investor.*
- If the interest is “free”, it becomes simply an additional tax on profits. For instance with a 30 percent tax rate and a 51 percent carried interest, the investor could pay to the government 66 cents out of every dollar of profit – and this is without taking account of any windfall profits tax.
- One advantage of government ownership is assurance of the government’s access to information and to control over critical investment decisions. Management responsibility, however, has to be allocated carefully unless the government intends to become the operator. The success of major international mining companies is in part due to their strong management skills, and one of the advantages of permitting foreign investment is the ability to take advantage of those skills both to implement the project and over time, to train Mongolians in those valuable skills. To the extent that the investor is asked to take the financial risk, the investor will reasonably expect to control the expenditures of its dollars, and this is in the interest of the government as a more efficient operation will generate higher revenues.
- Even without majority ownership, the government can guarantee its access to information and control certain central decisions through properly drafted shareholder agreements, operating agreements, investment contracts or legislation. Through legislation the government can protect its interests with respect to labor and social issues, environment, water rights, and land use – provided, of course, that the government has not entered into an excessively generous stabilized investment agreement. And most importantly, if the law and investment agreements are properly structured the government can prevent the transfer, direct or indirect, of the license or operations to entities which may be of concern to the government because of their lack of expertise, financial capacity, reputation concerns, or perceived national security risks. There is nothing about an equity interest that necessarily enhances the rights of the government in these areas, and standing alone an equity interest may not provide full protection. It would not for instance prevent a change of control effected through changes in the ownership chain upstream of the investor which would force the government to operate with new partners it did not choose.
- It is also worth remembering that having the state hold an equity interest can in some instances result in negative environmental and social effects. The enforcement of environmental laws in China for instance, has often been thwarted by local authorities who hold interests in the affected industry. Holding an equity interest, especially one with active powers, can create a conflict of interest between the ownership interest of the state and the regulatory interest of the state. This conflict can be managed but it is certainly increased where the government has a significant equity stake.
- There are other alternatives for the country to control its resources other than an equity interest in the investor. Through a production sharing agreement it is possible to have 100 percent government ownership of the resource and to continue to hold that interest until the resource is sold to a third party buyer. Although the government retains ownership of the resource, financing and management remain the responsibility of the investor. In the case of a production sharing agreement the government either by rule or through bidding has to determine what percentage of the product ultimately sold is for the account of the investor and what the rules are for recovery of the investor’s costs. These together with the income tax rules will determine the split between the government and the investor just as the set of tax rules determines the split. The only formal difference is one of title in the resource — does it pass when the resource is mined or when the resource is sold to the third party user. The investor, however, is wholly responsible for management and costs and subject to the split of the return takes on the project risk. In that sense, it is no different than if the investor had a mining license allowing it to exclusively develop the prospect, but the investor never “owns” the resource.
- Government ownership can be one element of a fiscal or contractual regime but it is only one element. It must be evaluated in the context of the other elements in order to set the proper balance of risks and awards to attract investment while permitting the people of Mongolia to realize the full value of their natural resources. Mongolia can have a net income tax, a royalty, certain fees, a windfall profit tax, and equity ownership, but at some point the total burden will prevent investment. Whatever the attractive ring of “owning” 51 percent of the resource, one must dig deeper and consider the trade off between this and other fiscal measures to determine what set of rules, tax and ownership, are most likely to attract the necessary investment for Mongolia to fully realize the potential of its natural resources. A hundred percent of zero is zero.
* Because of existing double taxation treaties, the withholding tax on dividends which the government can impose is limited with respect to certain countries, e.g., Canada. The carried interest avoids this limitation.