By Pooja Chatterjee
In order to appreciate the India context of Shale Gas Development it will be appropriate to start with a discussion on Canada.The fiscal regime in Canada is a blend of royalties and income taxes. “Royalties have been the traditional reward to landlords of all types relating to natural resources since time immemorial. In some countries like the US and Canada, royalties are not regarded as a tax but as a reward to the landlord for giving rights to an investor.” The advantage of royalties for the government is that the risk of petroleum exploitation is with the gas producer/ investor. The principle behind royalty tax is similar to severance taxes: tax is paid either on volume or value of production.
“The royalty rate is a percentage of production value that accrues to the landowner. Higher severance taxes may lead to lower royalty rates as the tax is shifted back to the landowner. Bonuses represent cash payments made at the initiation of the contract. Higher severance tax rates reduce bonus payments if royalty rates are not reduced. Rental payments are penalty payments for not drilling within a specified time and are usually related to bonus payments. Rental payments may be reduced by higher severance taxes. Higher severance tax rates raise the operating costs leading to earlier abandonment of existing fields for a given price projection.”
Horn River (in Alberta) is one of the largest shale gas plays in Canada. British Columbia comes a close second with the Montney shale play. Both the provincial governments rely on royalties rather than taxes as a fiscal tool. “The royalty rate in Alberta is based on a single sliding rate formula sensitive to price and production volume.” On the first year of production, royalty rate is 5% and ranges to 36%. This lower range was introduced in 2011 as the royalty structure was changed in 2009 to high ranges of 5% to 50%. This resulted in drastic reduction in investments in Alberta and business moved to neighbouring provinces and to US. The front-end rate is applicable in the first 12 months of production, 500 million cubic feet equivalent of natural gas, whichever comes first. “As an incentive, new shale gas wells are allowed to extend the 5% royalty rate up to 36 months with no volume limit.” In British Columbia “the royalty rate for all conservation (or associated) gas is 8% while the royalty rates for non-conservation (non-associated) gas vary based on the development date and range from 9% to 27%.” Shale gas gets special incentives including the “Two-per-cent Relief Royalty Program which allowed a 2% royalty rate for all gas wells drilled for one year between Aug 31, 2009 and Jul 1, 2010.” In addition, there is royalty credit based on the location and depth under the Deep Royalty Credit Program for deep well production (depth of 1,900 meters or more for horizontal wells).
Alberta is the classic example of things going wrong when the fiscal regime is drafted without taking an informed decision. “Investors assess opportunities on the relative attractiveness of economic return based on factors such as prices, resource potential, and costs. If these factors are relatively similar, investment decisions among competing jurisdictions are based on the perceptions of the broad business climate.” The global recession and emergence of United States as competent source of shale gas altered business decisions. Alberta’s geology and location make it an unlikely candidate for low-cost production. It remains to be seen whether changes to the fiscal regime will make Alberta competitive for investment compared to other shale gas plays in North America.Lessons to be learnt – choosing the right regime for India
There is no doubt that shale gas has been successfully developed in North America. Shale gas is a game changer and US with its technological developments and know-how has emerged as a leader in this sector. It is further evidenced by the U.S.-China Shale Gas Resource Initiative and the shale gas accord between U.S. and India. However, blindly emulating their fiscal regime could prove to be difficult and foolhardy. Governments can achieve their fiscal objectives with whichever fiscal system they choose as long as the system is designed properly. And designing a proper system requires identifying the externalities and adapting the fiscal regime around such externalities.
Some of the widely acknowledged truths about the shale gas industry in general and in India in particular are:
a) The current policy allows the oil companies to only produce conventional oil and gas from their authorised blocks. Since shale gas comes under unconventional gas, any testing or exploration of this gas would be impossible as it is not covered under the licence terms. A separate bidding would have to be set up as any unwarranted windfall would mean flouting the terms and the conditions under the licence.
b) The Indian exploration and production sector (E&P) is smaller and less mature compared to the North American sector.
c) Production profile of shale gas sector is steeper and shorter than conventional fuels, i.e. the output of gas will be high in the first few years or so and then will fall steeply. Shale wells might have a life of 8-12 years, compared with 30 to 40 years for a conventional gas well. Even this may be overstated.
d) India lacks the technology and the knowledge required to extract gas from shale and would therefore need major foreign investment and investors.
e) It is difficult to estimate the cost of extracting shale gas: coupled with the use of expensive and specialist technology it should be expensive to develop a shale gas field. However, much of the cost also depends on the geology of the shale gas plays and the number of wells in the same play.
f) The shale gas sector in the United States developed at a fast pace due to the easy and low-cost access to the gas transport network, something India would have to work on as well.
g) Shale gas production in the United States developed largely in areas with low population and therefore disruption to the local community was minimal. In India, shale gas production could face opposition not only from landowners but also from local communities. Another important difference between U.S. and India and indeed every country around the world is that while the surface rights remain with the landowner, the sub-surface rights vest in the Government. Therefore, the government would be auctioning (leasing) blocks to the gas producer. Land acquisition is a state subject, so the fiscal policy would have to set out division of revenues between the Central and the State Government to remove political barriers.
Recommendations
International companies always compare fiscal regimes of different countries when deciding to invest in the energy sector. Companies always want to recover their costs as soon as possible especially when the shale gas well has a short life. One of the reasons why North America makes such a fascinating study is because the neighbouring countries United States and Canada have had such different outcomes to their fiscal regimes. While U.S. has flourished, Canada has stumbled to be as competitive as U.S. The combination of provincial royalty and provincial and federal income tax regimes have failed to protect Canadian taxpayer interests and delivered an artificial financial windfall to investors who can get raw resources out of Canada and into foreign (including US) processing plants, as quickly as possible.”
Shale gas sector is all about ‘learning by doing’. And this paper offers the following recommendations:
a) The fiscal policy should include either a royalty tax or severance tax, apart from corporate income tax. These earnings should be shared between the State and the Central Government to incentivise the state government’s participation in acquiring land. The earnings through tax will also help the Government to improve essential services and infrastructure. However, the Government should also be wary of exceedingly taxing economic rent. Taxes add to the overall cost of doing business and the mind-set of cashing in on the shale gas bonanza could spell doom for investments.
b) Alternatively, the Government could tax corporate income over and above the normal income tax that companies pay for their commercial activities, as has been done in Norway. Norway phased out royalties completely by 2006. In 1996 Norway figured out that “it was impossible to get the design of royalty regimes right, when ‘right’ means fair to both the taxpayers who own the resource and the private investors who put their capital at risk when invest in partnership with the state.” Now Norway’s sovereign wealth fund earns more from the difference in the corporate income tax that oil and gas companies pay than it did from royalties. The fiscal regime in Norway ensures that the taxpayers lose no economic rent compared to the Canadian fiscal regime.
c) The Government should also tread carefully while considering tax exemptions. A front-end and back-end tax exemption together would eliminate the benefits of severance tax or royalty. Further, the shale gas plays are most productive in the first year and then production drops sharply. The government take would decrease if there is a tax holiday in the initial years and the risks in earning adequate revenue would increase.
d) The government would also need the money to restore the society and the environment to its pre-shale gas development stage, to the extent possible. Much like the decommissioning fund that has been set up in several countries to avoid the liability shifting to the State after production stops, the Government should set aside a part of the revenues earned against any claims and liability in the future. This fund should also be ring-fenced against any insolvency claims. The fiscal policy could also stipulate provision of financial security if there is any doubt of the gas producer defaulting on its obligations.
e) There should only be a back-end exemption for low-producing wells if it is uneconomical for the producers to extract gas from shale. If prices are high, then taxes should be paid.
The Home-run
“Having the lowest royalty burden does not necessarily make a jurisdiction more attractive for investment. The timing of when royalties are paid to governments and maximum royalty rates impact investment decisions; and taxes.” Competitiveness of the shale gas sector should be the primary objective of India’s fiscal regime. There should also be continuous monitoring of the shale gas fiscal regimes of shale gas producing countries around the world to ensure that India’s shale gas sector remains an attractive place to invest. Whatever fiscal model the Indian policy makers decide to implement, sustainable solutions have to be devised soon to meet the September 2011 auctioning of blocks deadline.
NUTSHELL:
This is the final part of a very interesting analysis of India Shale Gas Development by Pooja. In her first article she discussed the options available in the USA. In this article she has broadened the scope of analysis with a focus on Canada. With shale gas as a game changer, Pooja argues that for success in its shale gas sector India necessarily has to ensure competitiveness and effective strategy in its administration fiscal regime. To learn more about this article and to view Pooja's professional profile, click here-->
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