With Gillard as our new PM, a compromise has been done on the RSPT, rewarding the big mining companies for their negative campaigning. In this first post-mortem, I have some mopping up to do regarding two as yet undiscussed ‘reports’ brought out on the old RSPT, one by Ernst and Young and one directly brought out by BHP.
Ernst and Young, paid by the Chambers of Minerals and Energy of Western Australia, put out a report in June by two relatively unknown American economists that is completely devoid of any new calculations on the RSPT but nevertheless talks loudly about potential job losses in mining. Its main point is that the RSPT reduces the pay-off on mining projects and that this might mean mining companies put greater priority on other investment projects overseas. Even if this were true, it would merely mean that the projects would be postponed, not cancelled, but it is in any case an empirical question relating to how profitable future projects actually are.
The KPMG reports from May, using data on actual projects obtained from the Mining Council, basically finds that with a properly implemented RSPT, nearly all currently planned Australian mining projects remain too profitable to walk away from.
BHP wielded out a short paper by Professor Jerry Hausman, an econometrician from MIT. Professor Hausman also doesn’t calculate anything new, but nevertheless calls for adjustments to the implementation of the RSPT. Professor Hausman does not take a stand on whether he thinks the RSPT is going to lead to more or less mining activity, but wants to make the RSPT far more complicated by taking account of ‘option values’. Professor Hausman essentially recycles an old 1997 paper of his on the optimal taxation of profits that has been roundly ignored in policy circles.
What is Professor Hausman on about and are there any merits to what he says?
Professor Hausman’s main point is that mining companies have the option to wait with their investments until they learn more about the price of minerals. That option to wait is worth something, because if a mining company finds out over time that the mineral price is far less than previously thought, they can decide not to invest, saving them from huge losses, whilst if the price turns out to be high, they are more certain of big profits. Hence mining companies can rationally wait with investments, even on projects with positive Net Present Values. Professor Hausman’s point is that the option to wait is not calculated and included in the design of taxes.
The first thing to say is that calculating the option value of waiting for mining investments is nearly impossible for any tax authority. It is hence not done anywhere, meaning that Professor Hausman calls for the impossible. By the same token, someone who never does anything in life should then be taxed for the things he could have done, i.e. his ‘untaken options’. Basing taxes on what people could have done is the typical suggestion of a detached academic: valid in theory but entirely impractical, and of course not even mentioned in the re-negotiated tax accord.
The second thing to say is that Professor Hausman hasn’t actually calculated whether ignoring the waiting option value makes any difference to future Australian mining investments. The main reason why the option of waiting is irrelevant to the debate is that the option value of waiting is also affected proportionally by an RSPT: all possible future projects are affected proportionally by the RSPT and hence if the decision to wait was optimal before, it will also be optimal after the introduction of the RSPT. Professor Hausman’s equations, which by the way are not in his 1997 article, are thus essentially wrong because they presume a fixed value of the option to wait.
The third thing to say is that Professor Hausman has not really thought through what the elements of uncertainty are in Australian mining. One major element of uncertainty is whether a proposed mine actually is as rich in minerals as hoped for. That type of risk does not change with waiting. Professor Hausman’s back-of-the-envelope guess about the importance of waiting, based on the US telecom business where uncertainty is all about very volatile future prices, is hence wholly inappropriate for the Australian mining business. Professor Hausman displays a lack of understanding on many other fronts too. He for instance claims that companies under the RSPT would not sell-on loss-making projects but simply axe them entirely in order to receive 40% of the loss. He notes that is inefficient if the loss-making project is valuable to someone else. What he misses is that a company can claim 40% on the net loss, meaning that a company would effectively pocket 60% of the on-sale price. Also, Professor Hausman calls for the RSPT to be done at the point of the mine-gate, which is exactly what is already proposed.
Finally, Professor Hausman mentions that sovereign risk might deter future investments, not having noticed that tax rates have changed very often in the past already. Royalty rates have increased dozens of times in the past decades, company tax rates have changed, income tax rates have changed, etc. Hence in no sense is it true that the RSPT increases the sovereign risk of future tax changes. On balance, you might think the reverse if the Royalty rates will be fixed where they are, which is what the Treasury was aiming for. In short, Professor Hausman has little idea what he is talking about but has netted a fat pay-cheque from a big mining company that muddles the waters. Part of a highly profitable campaign, one might add.