The much-anticipated Royalty Review Advisory Panel report has received wide acclaim – and deservedly so. It put forward solid principles to shape a modern royalty system. But the real test will be in the design details that emerge in the next two months. Much could go wrong.
The much-anticipated Royalty Review Advisory Panel report has received wide acclaim – and deservedly so. It put forward solid principles to shape a modern royalty system. But the real test will be in the design details that emerge in the next two months. Much could go wrong.
The panel recommended no major changes to the oil sands regime.
But it suggested modernizing royalties on conventional oil and gas wells. The key principle that the panel recommended was that a modern royalty emulate a “revenue minus cost” approach. Under the modern royalty framework, starting in 2017, companies will pay only a minimal, flat royalty rate until their total revenues equal their costs. Companies receive a drilling and completion cost allowance based on the type of well they are drilling and the average cost of drilling a well in the province.
There are five key principles that the “calibration team” proposed by the panel should focus on to create a truly competitive royalty system.
First, it should recognize that companies don’t drill holes in the ground and see oil and gas flowing the next day. It takes time to recoup an investment. And time is money. If the committee wants to account for all costs, it should include this cost of capital. The calibration committee should create a royalty design that allows companies to carry forward expenses at the same interest rate the government borrows at.
Second, not only does oil or gas not flow right after drilling, it may not flow at all. That will leave companies with bum wells and worthless allowances that they were banking on using. Companies will know they face the risk of holding worthless allowances, so might hold off on risky wells. Norway gets around this problem by allowing companies to claim royalty credits no matter if their well produces.
Third, the panel suggested that the royalty system apply on a well-by-well basis. But in today’s oil and gas system, the exact area where one well begins and another ends is not always obvious. The solution to this is to allow companies to apply credits they earn on one well against royalties due at another.
Applying credits from one well to another would also solve the problem of what to do with allowances from bad wells. This is how the Australian system operates. Companies can only get their money back from poor investments if they keep investing. The calibration team should allow companies to transfer allowances within the company.
Fourth, one of the most enlightened ideas of the review panel was recommending that the modern royalty framework consider the cost of new environmental regulations. Alberta has a new greenhouse gas pricing plan that all oil and gas producers will face on their emissions.
Allowing conventional oil and natural gas companies to deduct the cost of credits from royalties they owe will blunt some of the cost of the greenhouse gas cost. Oil sands companies can already deduct greenhouse gas costs from royalties they pay. Adding the costs for conventional wells would level the playing field in the province among all companies.
Fifth, the most notable absence from the panel’s report was on what the final royalty rate should be. Companies will pay a flat five percent on the value of production until their total revenues equal costs. But after that, what should companies pay?
Should rates go up or down with commodity prices? If the new royalty only applies after companies cover their costs, then why does it need to vary? The calibration team should recommend a single, high rate that gives a fixed share of above-normal profits to the province and gives certainty for companies.
The wide acclaim for the Royalty Review Advisory Panel’s report was justified. It put forward the principles of a best-in-class royalty system. It’s now time to apply these principles to the real world.
Benjamin Dachis is the co-author, with Robin Boadway, of the C.D. Howe Institute study Drilling Down on Royalties: How Canadian Provinces Can Improve Non-Renewable Resource Taxes.
Published in the Edmonton Journal
