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Royalty is the price that the owner of a natural resource charges for the right to develop the resource.

What are Royalties?

Royalty is the price that the owner of a natural resource charges for the right to develop the resource.

Ownership:

The right to levy royalties derives from ownership. In most jurisdictions around the world, including Canada, the government owns and manages resource development on behalf of its citizens. In these cases, it is government that charges the royalty. In Canada, natural resources are owned by the provinces. Thus, it is the government of Alberta that charges royalties on behalf of the citizens of Alberta.1, 2

A Royalty is not a Tax:

Economists distinguish between royalties and taxes.3 In the strict sense, a royalty is not a tax. While there are many grey areas, taxes are ultimately levied to cover costs; e.g., police and fire protection, education, and health care. Royalties, however, have nothing to do with costs and are levied simply as a right of ownership.

The Fiscal System:

Royalties are not levied in isolation of taxes. The combination of various types of royalties and taxes is known as the Fiscal System. In determining the appropriate level of royalties, the full fiscal system must be taken into account in order to ensure that the combination of royalties, taxes, and other fiscal levies contribute to the health of the oil and gas sector and to that of the economy as a whole. This does not imply that the sector is better off – “healthier” – if royalties are lower. It means that they must be at the right level – too high will result in underinvestment, while royalties that are too low can result in inflation and reduced competitiveness.

There is a wide range of royalty and tax combinations employed around the world. This is reflective of the fact that royalties are not the only means available for the resource owner to collect its share. Each system is specifically designed to reflect the resource characteristics, policy objectives, and even culture of each jurisdiction. For example, some jurisdictions; e.g., Canada, are net oil and gas exporters while others such as the United States, are net importers. Jurisdictions that are net importers often have special provisions,
including lower royalties, to encourage domestic production. Net exporting jurisdictions or jurisdictions with attractive resource bases and market conditions tend to have higher royalties.

Figure 1 on page 5 illustrates the various fiscal system components applied around the world. Generally, the figure shows that some fiscal components apply before a discovery of oil or gas is made; e.g., bonuses and land rental fees. Others apply largely before production begins; e.g., cost-bases fees such as import duties or asset/property taxes. The majority of the fiscal levies, such as royalties, apply after production begins.
Some jurisdictions (e.g., China, Mexico, Saudi Arabia, and Venezuela), have national corporations that can be considered part of the overall fiscal system. This is referred to as state or government participation; whereby, in addition to royalties and taxes, the state obtains a share of the corporate profits. In these cases, however, the state must also pay its share of costs. Such corporations are typically set up where the host oil and gas industry is relatively underdeveloped or if domestic policy prohibits private, particularly foreign, corporations from owning domestic petroleum resources.

Moving from left to right in Figure 1 shows a graduation of fiscal systems from “regressive” to “progressive.” Regressive systems are those fiscal systems where a higher proportion of the government share is taken early prior to project payout – the point where costs have been recovered. Regressive systems are characterized by “fixed,” upfront, or non profit sensitive, fiscal elements such as asset taxes, import duties, bonuses, and fixed royalties. As the combination of fiscal elements moves to the right in the figure the system becomes more progressive, indicating that the government share increases with profitability. In this progression, royalties move from fixed to sliding scale, normal corporate income tax is applied, and certain “special” levies or windfall profits taxes are also applied.

The progression from left to right also indicates a progression from a low level to a higher level of risk sharing for government. The essential issue in fiscal system design is financial – how will risks and rewards be shared between owners and investors. Bonuses represent no risk for government in that government receives its revenue from the bonus payment even if the investment ultimately turns out to be a failure.4 Sliding scale royalties based on price or production represent some risk that production or price might be lower than anticipated. Profit sharing systems also include cost risks; e.g., government’s share might be lower if costs increase. Full risk sharing is represented in the case where the government (through a state corporation) invests directly in the same proportions as the private sector investor. The notion of risk has with it the balancing notion of reward; systems where government accepts more down-side risk typically include a higher upside share.

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