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The Progressive Economics Forum

The Conference Board on Potash Royalties

A week ago, the Government of Saskatchewan released the Conference Board of Canada’s report on the possible Potash Corporation of Saskatchewan (PCS) takeover. It provides 77 pages of useful information, but is disappointingly thin on policy recommendations.

The Conference Board downplays concerns about BHP leaving Canpotex after acquiring PCS. It argues that, with or without Canpotex, profit maximization would motivate BHP to adhere to “market discipline” about potash supply and pricing.

Basically, it assumes that BHP would run the mines in the same way as PCS. (I do not often agree with Roger Phillips, but he wrote a rather good op-ed questioning this assumption.)

If so, the main consequence of a takeover is that BHP could write off the costs of developing its Jansen Lake mine against profits from existing PCS mines. The Conference Board estimates that this writeoff would reduce Saskatchewan’s potash royalties, which mostly consist of a profit tax, by $2 billion over the coming decade. (If BHP built Jansen without acquiring other mines, it would have to wait years longer to start writing off the capital costs against future profits from Jansen.)

Furthermore, BHP could deduct the costs of financing the takeover from profits for corporate tax purposes. The Conference Board notes that “this revenue loss depends on a myriad of factors” and makes no attempt to estimate it.

Nevertheless, the Conference Board sees BHP’s bid as relatively benign, especially compared to the alternative possibility of a Sinochem takeover. Representing Chinese consumer interests, Sinochem might be more willing to undermine profits by supplying additional potash. That approach would more sharply reduce Saskatchewan royalties.

The Conference Board concludes that, rather than trying to obstruct BHP’s bid, the provincial government should focus on royalties. But it emphasizes the “policy risk” of royalty changes: “a punitive regime in one area may tarnish the province’s overall reputation in capital markets . . . It is already seen as a high tax jurisdiction in potash.”

The Conference Board does not deny that Saskatchewan could realistically collect higher royalties from potash. It simply claims that businesspeople would dislike higher royalties.

Royalty Options

Despite this deference to perceived business perceptions, the Conference Board puts forward a good suggestion: “making the impact of capital expenditures on potash royalties project-specific, rather than company-specific.”

In collecting resource rent, there is a case for allowing producers to first deduct capital costs. This approach failed in Alberta’s tar sands because companies could always write off some new development against profits from existing operations to avoid ever paying royalties. But for potash, it is pretty easy to distinguish one mine from another.

There is no reason to allow companies to write off capital spending at one mine against profits from another mine. Making writeoffs project-specific would prevent BHP from counting Jansen development against existing PCS mines. But this reform would make sense even without a takeover.

However, allocation between mines is not the only problem with these writeoffs. The depreciation rate is a whopping 120%. As Reuters notes, “For every dollar a miner spends on expansion, it collects C$1.20 in credits against the production [profit] tax.” Depreciation in excess of 100% seems difficult to justify.

Not only is capital investment deducted from profits, but profits from potash production above the 2001-2002 average are not even counted for the profit tax. For new entrants, which had no production in 2001 or 2002, annual production above 1,000,000 tons of K2O (less than one-tenth of Saskatchewan’s peak output) is exempt from the profit tax.

The Conference Board muses, “Another option would be to revisit this policy framework to make it more sensitive to production rather than prices. But such steps may involve serious policy risks.”

As far as I can tell, making royalties “more sensitive to production” is code for ending the royalty holiday on increased production. Since potash companies get to write off new investments, they could indeed make do without a royalty holiday on the production flowing from those investments.

To the extent that writeoffs and holidays are maintained, they argue for a higher royalty rate on profits in excess of those amounts. The profit tax currently tops out at 35%, which might almost be reasonable if that rate applied to all profits. But if it only applies to the economic rent remaining after capital costs are deducted, then a higher rate is warranted.

Whatever the cost of increased production, today’s potash prices clearly create windfall profits on 2001-2002 production levels. As long as the profit tax only applies up to this threshold, the rate should be much higher.

Like the Conference Board, both of Saskatchewan’s main political parties seem reluctant to talk about reversing any of the incredibly generous writeoffs and holidays given to potash companies in 2003 and 2005. But even if those unnecessary incentives were continued, there are other viable means to collect higher royalties.

Comments

Comment from mike rielly
Time: October 12, 2010, 4:22 pm

I loved Economics in U but am obviously a “peon” when compared to you, and associates, but a surf’s thoughts should perhaps be considered.
Conference Board ASSUMES, Not sure if anything of this magnitude should be assumed. BHP could leave!
Yes, allow capital cost deductions for producers..this encouages investment. Deductions over 100%, ludricous, not even sure about 100%.

Simply, update the 2110-2002 average, all aspects of all. All life subjects,including Economical ones have been updated, why not profit tax?
In conclusion, reasonable Royalties, yes, it creates investment.
And…of course, Parties in Saskatchewan reluctant to “rock the write-off boat” (2 BILLION $). Typical Politicians… Not unique at all to economic issues.
Hope I did not infect your article, was not my intention…Man on the street opinion.

Comment from travis fast
Time: October 12, 2010, 7:00 pm

Erin could not the citizens of Saskatchewan just shuttle all these complications to the side by simply re-nationalizing the Pot Ash industry? If BHP will pay X dollars it must think it can recover that outlay over X years. If the government of Sask bought it it could recoup their investment in a more timely fashion (they wont pay royalties) and have a cash cow going forward. So what gives?

Comment from Erin Weir
Time: October 12, 2010, 11:37 pm

Provincial ownership is a legitimate policy option, but not a means of avoiding complications. It is important to think through how a provincial equity stake would work.

You seem to be proposing that the Saskatchewan government borrow $40 billion (about two-thirds of provincial GDP) and buy PCS. Even if that happened, it would still make sense to raise royalties for the Mosaic and Agrium mines.

The notion of recouping the public investment faster by not paying royalties is a false economy. When PCS was a Crown corporation, it paid the same royalties as the private potash companies.

By putting up $40 billion, the provincial government could collect all future PCS profits. My contention is that, by just raising royalties, it could collect most future potash profits. I would have to be convinced that the former is a better deal for the people of Saskatchewan.

Comment from Travis Fast
Time: October 13, 2010, 6:03 am

OK what am I missing here.

Presumably private investors think they can can pay 40 billion receive a reasonable rate of return (defined as above financing costs) and pay royalties.
So Financing + ROI + royalties = total gross revenue after operating costs (less financing) and labour compensation.

So whether or not a nationalized PCS pays royalties to the government and remits the ROI portion as a separate accounting identity or the government simply takes ROI + royalties is simply an accounting issue. The fact remains that as owner the Sask gov would get the ROI + royalties. As a non-owner it can collect royalties only.

Now you say that Sask gov can effectively collect the future profits of a privately owned PCS through increases to the royalty regime. If this were the case why would any private investor pay 40 billion?

What am I missing?

Comment from Erin Weir
Time: October 14, 2010, 7:20 am

Since the Saskatchewan government can collect royalties either way, the question is whether the remaining profits (ROI) are worth at least $40 billion. BHP management evidently believes so. However, the same conclusion does not automatically follow for the provincial government.

1. A critical issue is whether the ROI would exceed financing costs. The Conference Board reports that BHP’s cost of capital is 6%. The Saskatchewan government’s long-term bond rate is probably lower. But if a province of that size wanted to borrow $40 billion all at once, I suspect that the interest rate would be significantly above 6%.

2. There is some uncertainty about the extent of future profits. BHP mitigates this risk on a corporate-wide basis by investing in different commodities. Acquiring PCS would help BHP further diversify. Conversely, greater confidence about future potash profits would be needed for the Saskatchewan government to invest all of its eggs in that basket.

3. BHP’s calculation likely assumes current royalty rates. If royalty rates increased substantially, the reduced level of future profits might no longer be worth $40 billion. If the government knew that it wanted to raise royalties, the government would be unwise to first pay $40 billion for PCS assets.

I am in favour of seriously examining options for provincial ownership in the potash industry. But I do not see that (rather remote) possibility as an easy or obvious alternative to reforming royalties.

Comment from Travis Fast
Time: October 14, 2010, 12:13 pm

Thanks Erin. I was wondering what the dynamics were and I take your political and economic point on royalties.

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