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C.D. Howe Institute Rethinking Royalty Rates

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C.D. Howe Institute Rethinking Royalty Rates NO. 333, SEPTEMBER 2011 C.D. Howe Institute Institut C.D. HOWE Institute FISCAL AND TAX COMPETITIVENESS Rethinking Royalty Rates: Why There Is a Better Way to Tax Oil and Gas Development COLIN BUSBY BENJAMIN DACHIS BEV DAHLBY In this issue... Provinces should reduce their reliance on royalties and increase their reliance on auction payments in the conventional oil and gas industry. THE STUDY IN BRIEF THE AUTHORS The system of taxing oil and gas in Canada consists of two main elements: an auction payment, known as a bonus bid, where firms purchase rights to explore and drill for Crown-owned OF THIS ISSUE resources for a specified period of time; and royalties that apply to the value of resources extracted. Governments levy these resource taxes –– over and above other taxes on income –– to capture an appropriate share of the revenues earned from the extraction and sale of a natural resource. COLIN BUSBY is a Senior Policy Analyst at In 2007, Alberta announced it would increase royalty rates on oil and gas production, which the C.D. Howe Institute. reduced the rewards to companies from oil and gas extraction, and therefore reduced the amount BENJAMIN DACHIS is they were willing to pay to explore and develop new resource projects. Because government revenues from resource extraction rely on both up-front auctions and royalties upon production, a Policy Analyst at the any increase in the latter should naturally reduce government revenues from the former. This C.D. Howe Institute. Commentary investigates the effect of royalty rate increases on bonus bids and the mix of revenue BEV DAHLBY is a tools that apply to the development of natural resources. Professor of Economics, University of Alberta, To measure the effect of the change in Alberta’s royalty rates, we look at its effect on bonus bid values by comparing bonus bids near Alberta’s borders with British Columbia and Saskatchewan, and Research Fellow, provinces that did not change their royalties. Comparing bids for otherwise similar geographical C.D. Howe Institute. and geological areas –– where resource deposits are of similar quality and labour and capital are mobile –– we find that Alberta government revenues collected through bonus bids declined by nearly as much as the projected increase in royalty payments. Rigorous external review We recommend that provinces reduce their reliance on royalties and increase their reliance on of every major policy study, bonus bids in the conventional oil and gas industry. Increasing reliance on bonus bids could make undertaken by academics government revenues more predictable and help policymakers better understand that resource revenues are akin to asset sales. Further, increased reliance on bonus bids will reduce the economic and outside experts, helps distortion caused by royalties. Where possible, provinces should also adopt less distortionary cash- ensure the quality, flow taxes. integrity and objectivity of the Institute’s research. ABOUT THE INSTITUTE The C.D. Howe Institute is an independent not-for-profit organization that aims to raise Canadians’ living standards by fostering economically sound public policies. It is a trusted source of essential policy $12.00 intelligence, with research that is rigorous, evidence-based, and peer-reviewed, recommendations that ISBN 978-0-88806-847-7 are relevant, constructive, and timely, and communications that are clear, authoritative and practical. ISSN 0824-8001 (print); ISSN 1703-0765 (online) ESSENTIAL POLICY INTELLIGENCE Essential Policy Intelligence C.D. Howe Institute he oil and gas sector is Western development business was relocating to other provinces and shutting down because of the Canada’s engine of economic higher royalty rates, the Alberta government Tactivity, and reaping a share of reversed the increase in the maximum royalty rate the resource profits generated by that on conventional oil and gas (Alberta 2010). sector is crucial for provincial finances. With resource prices rising yet again as the Designing the tax policies to accomplish world economy emerges from the 2008/09 this task is, however, a daunting financial crisis and as pressure increases to make royalty payments more responsive to oil and gas challenge, involving multiple tax prices, policymakers must understand how the instruments and potential tradeoffs fiscal instruments the public sector uses to tax oil between tax instruments and and gas production — namely, royalties and economic activity, revenues, and the auctions — affect total net provincial revenues in provinces’ fiscal positions. present-value terms. Indeed, comparing our estimates of lost bonus revenues from potential Because Canada’s Constitution grants provinces future production from oil and gas projects to the ownership over natural resources within their Government of Alberta’s estimates of total respective borders, provinces allocate the rights to increases in royalty revenues from existing wells, oil and gas deposits to private producers — we find that, in fact, Alberta’s 2007 royalty usually through an auction –– and then tax the increase led to little total net revenue increase for production from those deposits through royalties. the province. Rather, increased royalty revenues In theory, auctions capture the expected future were offset by up-front losses on auction revenues value of deposits, and royalties capture the realized –– which, for private bidders, represent the net value of production. In this Commentary, we present value of profits from a well over and above assess the interdependence of the government expenses, royalties, and a reasonable rate of return. revenues from these tax tools: an up-front auction In particular, by comparing otherwise identical and production royalties. resource bonus bids in Alberta, British Columbia, As resource prices have risen over the past 10 and Saskatchewan, we can isolate the effect of years, a debate has intensified over whether the Alberta’s royalty change from other factors that public is receiving its “fair share” of the profits of might have influenced firms’ bonus-bid decisions. the oil and gas sector. In Alberta — the province Even though the three western provinces possess most dependent on that gas sector and on the different types of resources and resource tax government revenues derived from it — this structures, most of these discrepancies remain debate seemed to culminate in October 2007 with fixed over time, allowing us to separate these the announcement of a substantial increase in factors from the change in the royalty rates by maximum oil and gas production taxes, or royalties, comparing otherwise identical bids by location, that would be more sensitive to upward resource geology, and company type.1 price movements and larger producing wells Although this Commentary is a case study of the (Alberta 2007a,b). In March 2010, however, in tax instruments used in the oil and gas industry in response to declining resource prices in 2008 and Western Canada, its lessons apply broadly to any 2009 and concerns that the exploration and natural resource region. Accordingly, policymakers Thank you to the C.D. Howe Institute staff and members of the Fiscal and Tax Competitiveness Council and many reviewers who provided valuable comments. Many individuals provided valuable data and information that made this paper possible. The authors thank these individuals for their help, but absolve them of any errors in this paper. 1 As we discuss in more detail in the Appendix, our results are not influenced by the emergence of shale gas as a potential viable energy resource in British Columbia — or elsewhere. Commentary 333 | 1 C.D. Howe Institute should think twice about trying to increase Columbia spreads recognition of these revenues revenues from non-renewable resources through over a nine-year period based on the recommendations higher, economically distorting royalties when a of the provincial auditor general. For instance, competitive bidding process is in place for upon the sale of crown lands for resource exploration and production. exploitation, the province recognizes only 1/9th of the revenues in that year and counts the remaining revenues over the following 8 years. The Taxation of Non-renewable Natural Resources in Western Canada Alberta: Provincial revenues from auctions of land rights and royalties in Alberta totalled approximately Alberta, British Columbia, and Saskatchewan $6 billion in fiscal year 2009/10 (Figure 1b), collect revenues from natural resource extraction representing about 20 percent of total provincial activities — over and above traditional income or revenues. Of this amount, about $750 million property taxation — through two means: up-front came from auctions. Annual bonus-bid revenues bonus bids to explore for new deposits (licences) peaked in 2006, with $3.4 billion in total or production (leases); and royalty payments revenues. Although total bonus-bid revenues are upon production.2 less than royalties, Alberta collected $13.4 billion in total bonus bids from 2003 through 2010. Revenues from Oil and Gas Taxation Saskatchewan: Revenues from non-renewable resources, including potash, totalled $3.4 billion Revenues from oil and gas resources fund a significant in fiscal year 2009/10, or one-third of share of provincial budgets in Western Canada — Saskatchewan’s total revenues. Excluding potash, currently 10 percent in British Columbia and non-renewable resource revenues were nearly 20 percent in both Alberta and Saskatchewan. A $2 billion that year (Figure 1c).
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