CREEPING NATIONALIZATION AND CONTRACT RENEGOTIATIONS: EXPERIENCE OF THE PAST FIVE YEARS

• Jurisdiction: Derecho Internacional

International Mining and Oil & Gas Law, Development and Investment
(Apr 2009)
CHAPTER 6A
CREEPING NATIONALIZATION AND CONTRACT RENEGOTIATIONS: EXPERIENCE OF THE PAST FIVE YEARS
Craig Andrews
Principal Mining Specialist
World Bank
Washington D.C.

Craig B. Andrews is a Principal Mining Specialist with the World Bank, Washington D.C. Mr. Andrews is responsible for Bank mining projects in countries in Africa, Latin America, Asia, and Central Asia. These projects involve support to governments for mining regulatory and taxation reform, revenue management, good governance and transparency in the sector, institutional strengthening and capacity building, earth science and environmental management systems, measurement of benefits and impacts of natural resources projects, and small scale mining. In addition to his work on Bank projects Mr. Andrews is a frequent speaker at international conferences, contributor to industry publications, and an active participant in professional societies and study groups. Prior to joining the World Bank in 1992 Mr. Andrews was manager of international business development for the Broken Hill Proprietary Company Ltd. based in San Francisco, California. Mr. Andrews is a graduate of Claremont McKenna College and Georgetown University.

Abstract

This paper reviews the economic and political factors at work in terms of renegotiations of mining contracts over the past five years. It finds that the rapid increase in commodity prices was a principal factor in the initiation by governments of renegotiations. It also finds that renegotiations are often called for by new governments anxious to redress the supposed errors of previous governments. The renegotiations most often center on adjustment of the tax regime as negotiated in the original mining contract. The traditional mix of royalty, profits based taxes, and other levy has not proved itself to be sufficiently sensitive to rapid increases in commodity prices. Thus, the perception is correct that company profits increase faster than government revenues during a period of rising commodity prices. As a means to increase the proportionate sharing of the benefits streams during commodity price booms, the paper suggests a combination of a sliding scale royalty on net profits, an adjustable tax rate on profits, and/or a rate of return based tax system. It is recognized that these flexible tax regimes would pose implementation difficulties in some countries with weak institutional tax administrations. However progressive and flexible the tax regime, there will always be a danger of unilateral renegotiations due the highly politicized nature of natural resource exploitation.

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Introduction

The phenomenon of the obsolescing bargain in terms of mining deals is well known. A company and a government negotiate in good faith a contract whereby the company invests - at its own expense and risk - in exploration and, if it is lucky, the development and exploitation of a mineral deposit. In return, the contract typically provides for a royalty, income and profits taxes, social and physical infrastructure, and other benefits to the government. But, the original deal in the majority of cases rarely survives more than a few years. While we most often associate renegotiations of contracts with a government initiative, companies have also requested renegotiations due to unfavorable market conditions or other business considerations. This, for instance, happened back in the 1980s with the Selebe Phikwe mine in Botswana. However, most public attention is focused on government initiated renegotiations since these are often highly politicized and well reported in the national and international media. Invariably, the aim of the renegotiations is to secure a better "deal" for the party which initiates the process - the government or the company. Unfortunately, the renegotiations are oftentimes forced on the other party (most often the company) and end up being unnecessarily rancorous and contentious. This gives rise to accusations of non-respect for the principle of sanctity of contract, rule of law, and creeping nationalization.

This paper discusses the issue of creeping nationalization, with specific reference to renegotiation of mining contracts which has occurred over the past several years. In laying out the discussion particular attention will be paid to the political and economic drivers for the renegotiations process and some of the specific tax and "government take" issues which seem to be emerging. Finally, the paper will propose some flexible tax arrangements which governments and companies can adopt to lessen the agony of the renegotiations process which is, in any event, inevitable over the lifetime of a mining operation.

Economic and Political Drivers of Renegotiations

Graph A below demonstrates the correlation between commodity prices and the instances of renegotiations. The evolution of metals prices and energy prices, expressed as an index developed by the International Monetary Fund, is charted from 2005 through January, 2009. Over the past five years we have witnessed an extraordinary increase in the prices of mineral commodities and, in the past six months, an even more extraordinarily rapid decrease in the prices. With the benefit of 20/20 hindsight, we now know that the rapid run-up in prices was due in large measure to excessive speculation through various derivative minerals funds. Commentators and business schools will be discussing for years the reasons for the bull and bust market in mineral commodities and industries. It seems clear at this writing that a combination of factors has resulted in a nearly perfect storm of illiquidity, de-capitalization, and depressed prices which has afflicted the worldwide minerals industry. Lack liquidity in the market which means that companies cannot raise short term trade finance to facilitate international commerce in mineral commodities and, longer term, cannot mobilize finance for exploration,

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development and operations. This is compounded by the effective de-capitalization of the value of mining companies' stock values which has damaged the smaller companies in particular but also the larger mining companies as well. Finally, low commodity prices will cause the deferral of new expansion plans if expectations of weakness persist longer term. This will be the most important effect of the current crisis which could lead to shortages of mineral commodities, especially in markets such as China and India which continue to grow and which need mineral commodities. This in turn could spark a new inflation in the commodity prices, but this is still in the future. For the present, the industry is in crisis and has had profound effects on the process and results of various renegotiation efforts of mining contracts.

Annexes A and B are compilations of published articles since 2000 pertaining to mining contract renegotiations.¹ The results are presented on Graph A (renegotiations indices 1 and 2) which present graphically on a logarithmic scale the number of articles pertaining to re-negotiations for the years 2005-2009. It will come as no surprise to you that these are closely correlated with the rise and fall of commodity prices. Obviously, this is a crude measure of the reality as some articles are reporting events not exactly in synchronization of the actual events. Also, the process of renegotiations is lengthy and there may be several articles in any given year which report on the same re-negotiations. But, the correlation is both empirically and intuitively correct: rising commodity prices cause a government to initiate re-negotiations of mining contracts to extract a greater share of the benefits streams. The reverse is also true: the falling market since late 2008 has seen a remarkable reduction in the number of reported instances of re-negotiations and, in some cases, those that were underway have been rapidly concluded or terminated altogether. Governments realize that they need foreign investment to develop the resources and are now in the mode of encouraging, rather than discouraging, investment.

Table 1 also provides details of some of the main reasons for the re-negotiations, principally adjustments reported to the fiscal dispositions of the contract so the government achieves a greater share of the revenues and benefits streams. Typically, governments seek to increase royalty rates, corporate profits taxes, and do away with stability clauses. Additionally, some...