How to Negotiate the Right Mining Agreement

How to Negotiate the „Right‟ Mining Agreement BY JENIK RADON COLUMBIA UNIVERSITY Background  Done right, natural resource extraction can be a boon for social and economic development  Success stories of Botswana, Chile and Norway  Negotiating the right contract is vital to a government‟s effort to reap the benefits of its natural resources. How governments can develop their resources 1. STATE COMPANIES, E.G. SAUDI ARABIA, BRAZIL (SEMI) 2. PRIVATE INTERNATIONAL MAJORS, E.G. US, CANADA, UK, 3. COMBINATION OF 1 & 2, E.G. NIGERIA, AZERBAIJAN, KAZAKHSTAN Legal and Regulatory Approaches to Resource Exploitation  Many developed countries use unilateral licensing/leasing approach  Many developing countries use consensual approach and prefer mining agreements  Political will of host country to develop resources is key and expressed through regulatory instruments, by contractual means, national policies and guidelines How Mining Companies determine a host country‟s political will  First policy instrument to be consulted is Mining Code (MC):     MC addresses core issue of mineral exploration and exploitation rights such as property rights and form of agreements MC has the force of law as opposed to „soft‟ guidelines Majority of countries have MCs (E.g. Australia, Botswana, Brazil, Chile, Indonesia, Papua New Guinea) Caveat: MC can be outdated and therefore does not represent present political will any more Mining Codes  There is not a „one-size-fits-all‟ MC  MC must consider the economic, historical, sociological, administrative and political setting of a specific country  MC must balance host country‟s interests with mining companies‟ concerns Mining Agreements  May be used instead of or in addition to M  Mining Agreements may be defined as: Agreement between a nation-state and a private entity about the development of resources and the production, processing, transportation, and marketing of goods from resources.  Address issues absent in MC  Reassure foreign investors Why do contracts matter? Contract terms determine (1) how much a producing country earns from it natural resources; (2) the regulatory power of government to enforce environmental, health and other standards, if legal and regulatory system not well established Key Issues of all Mining Agreements  How profits are divided between government and          participating companies How costs are treated, expensed or depreciated What to treat as costs, e.g. Expat housing, best technology Taxes, royalties, excess profit taxes Stabilization, what kind Timing Uncertainty about development and exploration costs complicates negotiations abandonment Balance needed between country‟s and investor‟s interests Takes into consideration the communities or entities not party to the deal but who will be interested or affected by it Contractual Systems  To achieve such balance of country and investor interests the choice of contractual system is crucial  4 basic contracts: or license agreement  Joint venture (JV)  Production-sharing agreement (PSA)  Service Agreement  Concession The four basic contractual provisions •C O N C E S S I O N O R L I C E N S E A G R E E M E N T • JOINT VENTURE (JV) • PRODUCTION-SHARING AGREEMENT (PSA) • SERVICE AGREEMENT Bilateral Agreement v. Unilateral Permit SHOULD GOVERNMENTS RELY ON MINERAL AGREEMENTS, PERMITS BASED ON THE MINING CODE OR ON A HYBRID SYSTEM? Concession or License Agreements GRANT MINING COMPANY EXCLUSIVE RIGHTS TO EXPLORE, DEVELOP, SELL, AND EXPORT NATURAL RESOURCES FROM A SPECIFIED AREA FOR A FIXED PERIOD OF TIME Different Ways of Granting Mineral Exploitation Rights  Licensing system based on MC and national regulation  Systematic use of MAs which complete the national MC  Hybrid system where national regulations and MAs both apply Australian Licensing System  Combines contractual and legislative tools  Creation of a right to explore or mine is subject to licensing by federal and territory governments  Governments own the minerals  Special negotiating rights granted to Aborigines in areas where they hold a claim or interest in the land  Government ad hoc agreements are justified by the idea that the state mining acts are inadequate to accommodate large-scale mineral projects Australian Licensing System Advantages  Provides government Disadvantages with a means of coordinating regulatory controls and create unique legal regime for each project  Provides opportunity to maximize local industry participation  Require TMC to develop infrastructure Australian Licensing System Advantages Disadvantages  Provides TMC with  Expensive and time high level of protection from arbitrary government action consuming  High degree of complexity  Overrides MC and can undermine rule of law („one-off‟ law) Chilean Licensing System (Hybrid)  Hard minerals are exploited under a concession     regime Grant of mineral rights through legislative provisions Separate grant of authorization to invest in mining project to foreign investors Mineral ownership is transferred by the state to the miner Mining concession issued by courts to first petitioner Chilean Licensing System Advantages Disadvantages  Impartiality of body  First-come-first-serve granting the concession approach may not favor most efficient or profitable bidder Indonesian Licensing System  Mineral rights licensing system regarding the TMCs is essentially provided for in model mining agreements: the Contract of Work  Government ownership of minerals which cannot be transferred to TMC  Under Mining Law Minister of Mines can designate other parties to carry out mining operations as contractors for the government or state companies Indonesian Licensing System  A Contract of Work (COW) is a model agreement issued by the state, within which the foreign company is given right to operate as a concession holder, but for and on behalf of the government  Mining authorization is just a permit to undertake the mining activity. The holder of such a mining authority has always to observe the prevailing laws and regulations Papua New Guinea Licensing System  Small and medium-scale mining projects regulated by MC  Mining agreements for major projects  Mineral resources are owned by the state  Ming agreements are not enacted into law anymore to allow for changes, ease renegotiation, and ensure confidentiality Mining Agreements IN THE ABSENCE OF A MODERN REGULATORY FRAMEWORK MA IS AN APPROPRIATE VEHICLE TO EXPRESS POLITICAL WILL MA CAN FILL GAPS IN MC ALLOW GOVERNMENTS TO EXPRESS THEIR CURRENT POSITION AS OPPOSED TO OUTDATED MC A SINGLE MA CAN REPLACE A MULTIPLICITY OF PERMITS AND ADMINISTRATIVE AUTHORIZATIONS GIVES INVESTOR MORE CONFIDENCE IN STABILITY OF THEIR RIGHTS ISSUES WHICH ARE TOUCHED UPON SUCH AS INDIGENOUS AND ENVIRONMENTAL RIGHTS CAN BE INCLUDED Hybrid System  Provided that a modern and comprehensive MC exists, a      system where a permit is based on the MC may work best Avoids „one-off‟ agreements and provides consistency and certainty MA requires expertise and negotiation skills which cannot be found everywhere MA can fill voids of MC Co-existence of MA and MC allows to tailor permit to project characteristics. Clear delineation between MA and MC and their relationship needed Different Types of MA SERVICE CONTRACT PRODUCTION-SHARING AGREEMENT JOINT VENTURE THE KEY FACTOR THAT DIFFERENTIATES ALL OF THE ABOVE FROM COLONIAL CONCESSION SYSTEM IS THE CONTROL AND OWNERSHIP BY THE STATE IN THE MINING VENTURE Concession or License Agreements Advantages Disadvantages  If production occurs, government earns royalties based on gross revenue and/or profit tax based on net income; both are based on the quantity produced and the price at which commodity is sold  Risk that government will not realize full potential from auction system Joint Ventures •N O S I N G L E D E F I N I T I O N ; H I G H L Y F L E X I B L E TOOL • 2 OR MORE PARTIES WISH TO PURSUE A JOINT UNDERTAKING IN SOME STILL TO BE CLARIFIED FORM • LOW SUCCESS RATE; LESS COMMONLY USED • INDONESIA: JV BETWEEN RIGHTS HOLDER AND TMC (LESS COMMON THAN CONTRACT OF WORK) • AS NAME IMPLIES, IN JV THINGS ARE DONE JOINTLY; THEREFORE, MATERIAL ISSUES NEED TO BE RESOLVED PRIOR TO ENTERING INTO A JV; REQUIRE LONG NEGOTIATIONS TO ENSURE THAT ALL MATTERS ARE THOUGHTFULLY ADDRESSED. Joint Ventures  Cooperation between investor and host country  State and mining company share equity  Partners share losses and profits in proportion to their participation in the mining venture  The owner of the mining title, installation and production may be the host country or the mining company, depending on the agreement Joint Ventures Advantages  Government is not alone Disadvantages  Risks and costs are also in the decision-making and responsibility for a project  Government can count on expertise of oil company  Government shares profit, on top of taxes or royalties shared  Responsibility also brings with it potential liability, incl. for environmental damage  JV is inherently ambiguous and can complicate negotiations which tend to be lengthy; require more legal advice than any other agreement Joint Venture Characteristics         Pure JV All costs/risks Shared Typical JV Government carried through Exploration Full carry JV Former Soviet Union type JV Government carried Government carried through through exploration and rehabilitation and development development until cash flow from operations NOC←------------------------------------------------------------------------------------------------→IOC Risk sharing Service Contracts Service Contracts  Mining company conducts mining activities on behalf of the government  Key characteristics     Contractor works under government‟s mandate and is paid for its work Government maintains ownership and title of minerals Contractor performs part or the whole of services needed for mineral exploration and exploitation Government is intended to provide the whole financing for the service it contracts out Production-Sharing Agreements FIRST USED BY INDONESIA IN 1966 AFTER INDEPENDENCE TO REPLACE OLD COLONIAL LAW (“LICENSE CONCESSION”) BASIC CONCEPT: STATE RETAINS OWNERSHIP OF NATURAL RESOURCES AND NEGOTIATES PROFIT SHARING SYSTEM NOW COMMON FORM OF AGREEMENT, ESPECIALLY IN CENTRAL ASIA AND THE CAUCASUS PSA RECOGNIZES THAT THE OWNERSHIP OF THE NATURAL RESOURCES REST WITH THE STATE BUT AT THE SAME TIME PERMITS FOREIGN CORPORATIONS TO MANAGE AND OPERATE THE DEVELOPMENT OF THE OIL FIELD. MINING COMPANY CARRIES MOST FINANCIAL RISKS OF EXPLORATION AND DEVELOPMENT OFTEN GOVERNMENTS CONTRIBUTE TO THE SHARE CAPITAL OF THE CONSORTIUM Production-Sharing Agreements EXACT SPLIT OF SHARES IS THE RESULT OF HARD BARGAINING FINANCIAL TERMS: HOST GOVERNMENT OFTEN EARNS SIGNING BONUS, REGULARLY WAIVED FOR A GREATER SHARE OF FUTURE PROFITS; OIL COMPANY IS FIRST ENTITLED TO COST RECOVERY ; DEFINITIONAL PROBLEMS OF WHAT IS A CAPITAL COST. WHAT REMAINS IS SHARED ACCORDING TO THE AGREED PERCENTAGE DIVISION WITH THE HOST GOVERNMENT. FOREIGN COMPANY IS REQUIRED TO PAY TAXES BUT OFTEN WAIVED AND INCLUDED IN THE COMPANY’S PORTION OF THE AGREED PERCENTAGE SPLIT. PSA ARE RARE IN MINING BECAUSE GOVERNMENT DOES NOT HAVE A MAJOR INTEREST IN RECEIVING THE ACTUAL PRODUCTION OF MINING ACTIVITIES AS IT HAS IN PETROLEUM Production-Sharing Agreements Advantages  Government shares Disadvantages  Government generally has potential profits without having to make a direct investment  PSA can be enacted into law to provide legal security (Azerbaijan and other former Soviet republics) less knowledge about potential of oil field than oil company  If government holds significant share, it will face conflict of interest: it has to balance the desire for higher profits with the enforcement of environmental and other regulations Production-Sharing Agreements Advantages Disadvantages  PSA grants oil companies a say in environmental and other standards when these standards have been incorporated as contractual provisions; violating a contractual provision is less costly than violation of a regulation because only in case of a serious or material breach of contract is the termination of the agreement a possibility Production-Sharing Agreements Advantages Disadvantages  Violation of a legal statute is an offense, subjective to legislatively approved sanctions and penalties  Making contracts into law creates a legal infrastructure of exceptional situations; little possibility of developing a coherent and comprehensive legal system Production-Sharing Agreements Advantages Disadvantages  PSA positive legal discrimination for oil companies; investors in other sectors will invariably lobby the host government for similar special treatment Contractual Provisions COMMON PROVISIONS FOR CONCESSION OR LICENSE AGREEMENTS AND PRODUCTIONSHARING AGREEMENTS Parties  Host government should not assume contractual liability as a direct party to an agreement to avoid direct responsibility and unlimited liability  Instead, it should engage a state-owned enterprise as a separate legal entity as contractual partner to limit its liability; in case of liability only the enterprise‟s assets can be seized  Mining companies usually create local subsidiaries with limited or no assets of their own  Government should require guarantee from parent company so it can tap into its resources to cover potential liabilities Accounting Methods  To determine profits, there must be a decision on accounting methodology  Still no international accounting principles; only national standards  Accounting standards leave room for discretion and can lead to serious disputes; e.g. they don‟t have provisions prohibiting any particular type of expenses; clarification in contract needed  Accounting standards do not provide resolution for intercompany pricing, which can inflate costs and decrease government compensation Recovery of Costs  How companies account for their costs determines the taxes companies pay and the royalties they share with governments  2 types of costs   Current operating costs: expensed in the year in which they are incurred; immediate reduction in taxable profits Capital investment costs: long term and can be depreciated over a set period of time: quick depreciation means less profits and decreases incentives to continue operations Recovery of Costs  Depreciation period is important: Companies will want to make up this investment as soon as possible. There are a number of dangers if this is allowed to occur:    Companies will have less to lose if project fails or discontinues Profits for the year will be low Government will receive lower returns on its tax or profit sharing terms Taxation or Compensation  Taxation of production matters because income from oil production often accounts for biggest portion of government budget  Profit tax    Can come in form of corporate income tax or as part of the amount government agrees to take from any profits Tax inspectors need to collect production and sales data and audit company expenses Problem of transfer pricing: oil sold to subsidiaries may be priced above or below market price Taxation or Compensation  Royalty or excise tax which is normally a percentage of the value of the production    Often imposed on top of other taxes Easy to administer Can be inefficient, however, because they tax production without regard to profit; when project is marginal, excise tax may discourage further investment  Bonuses  Signature bonus: one-time payment before exploration starts  Production bonus: continued fixed payments  Bonuses are fixed payments and do not take profitability of project into account Service Agreement  SIMPLE: Payment for services, effectively set fee  CHALLENGE: Most energy companies reluctant to sell services and/or technology know-how as earning more limited Environment  Government must have objective standards for environmental protection and must not lower them in the hope of increasing profits  When environmental standards are covered by contractual agreements, oil companies can interpret, negotiate, or even veto environmental standards  No reason why environmental standards should be lower in developing countries considering that oil and gas are in such high demand  Governments must take into account that companies prefer to pay relatively low noncompliance penalties over investments in pollution control   Fines should be high enough to act as deterrent Restoration of polluted area by companies should be mandatory Work Program  A work program details a company‟s exploration or development plan  Companies tend to slow down projects they deem too expensive  Governments should insist on a work plan that specifies clearly the circumstances under which a project could be delayed or discontinued Stabilization  Stabilization provisions protect oil companies from the cost of governmental or legislative changes affecting contract terms during life of agreement  Stabilization provisions are extremely disadvantageous for governments because it freezes the legal and regulatory situation of the country for an extended period of time (“Contractual Colonialism”)  Variation clause/Renegotiation preferable if circumstances change substantially Arbitration  Arbitration clauses provide for the settlement of conflicts between host country and mining company by an arbitration court  Types of disputes need to be clearly defined in MA  Institutional or ad hoc Price  Method of determining market price is critical as it directly impacts compensation of government  A contract should specify what prices serve as benchmark (e.g. price established by spot market in the particular region)  Governments should never accept as contract price the price paid between related companies; this price is likely to be well below market price Termination  Considering the significant amount of investment, the mining agreement needs to address under what circumstances it can be terminated  Examples:   Repeated and/or severe environmental violations If companies no longer develop the mine  Other questions:  Ownership of mine after termination  Can government pursue other developing companies? Outside Experts  Inevitable and necessary since government officials cannot possibly know, understand or supervise every of complex natural resource development process  Governments have to ensure that foreign experts who negotiate contracts are truly independent  Outside experts must be evaluated, selected, then managed and directed  Avoiding conflict of interests + ensuring trust are KEY factors Governing Law  Commonly chosen jurisdictions are the U.S. and the U.K. or continental European jurisdictions such as Switzerland  Regulatory authority must be retained by the host country, i.e. under no circumstances should a foreign law become the valid law of the host nation: this would violate state sovereignty  Government may have to give assurances that laws are stable Transparency  Mining Agreements are complex and can be subject to abuse and corruption  Transparency will prevent governments from agreeing to terms the public cannot accept  To avoid corruption all contractual systems and most terms should be disclosed; no need for full confidentiality.  Contract transparency is key to curb corruption “biggest obstacle to social and economic development” (World Bank)