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Do Newfoundland and Labrador Royalties Subsidize Offshore Oil and Gas Investments? An Independent Assessment of the Claims Made in Mintz and Chen (2010) and Mintz (2010)

Lead Researcher and Department
Wade Locke, Department of Economics, Memorial University

Summary
Validating the accuracy of any analysis that proposes to offer insights into the incentive effects of a royalty system on investment is not simply an academic concern. If the analysis is based on an incorrectly specified model, it reduces the potential contribution to public policy debates. This paper evaluates the relevance of the Mintz and Chen (2010) and Mintz (2010) analyses for Newfoundland and Labrador. These researchers, utilizing the Marginal Effective Tax and Royalty Rate (METRR) approach, have argued that Newfoundland and Labrador's generic offshore oil royalty distorts, that is, subsidizes marginal investments. The implicit subsidy in their model arises from the fact that the return allowances permitted for royalty calculations under Newfoundland and Labrador's generic fiscal regime exceed the risk free discount rate needed to preserve the present value of royalty write-offs, a prerequisite for maintaining the investment neutrality of the fiscal system.

If the findings of Mintz and Chen (2010) were correct, then the Government of Newfoundland and Labrador would have to consider raising the effective royalty rates applicable to its offshore projects. These higher effective rates would be needed to capture a fair and enhanced share of economic rents; to remove the suggested distortions; and to reduce the implied excessive investment in that sector. To overcome these deficiencies, Mintz and Chen (2010) recommends that Newfoundland and Labrador adopt a royalty system similar to the 25% flat rate oil sands royalty that was in place in Alberta before 2009.

In assessing the contribution of Mintz and Chen (2010) to enhancing our understanding of the incentive effects contained in Newfoundland and Labrador's offshore oil fiscal regime, it is important to realize that the perceived subsidy effect identified by the authors is contingent upon the profit sensitive royalty rates being non-zero for marginal projects. For a marginal offshore oil project, earning a 6% after-tax-and-royalty rate of return, the profit-sensitive royalties under the Newfoundland and Labrador system will not come into effect. For these marginal projects, the royalty rates for both Tier 1 and Tier 2 royalties will have values of zero. Since zero multiplied by anything remains zero, the subsidy effect perceived by Mintz and Chen (2010) is non-existent. Since Newfoundland and Labrador's profit-sensitive royalties are not triggered by marginal projects earning a 6% after-tax-and-royalty rate of return, the subsidy through the return allowance claimed by Mintz and Chen (2010) disappears. It is important to recognize that the profit-sensitive royalties become effective for infra-marginal projects (that is, those that earn above normal economic profits that have a rate of return of 11%). However, positive economic rents invalidate the use of the METRR, which is the basis for the analysis undertaken in Mintz and Chen (2010).

The world modeled by Mintz (2010) abstracts from uncertainty and risk. Investment is envisioned in terms of 'exploration and development' and ignores geological risk. The presence of risk is the real world for offshore oil and gas investments; especially given the large capital outlays, the long lead times, the irreversibility of investment, and the uncertain outcomes characteristic of investments in Newfoundland and Labrador's offshore.

Either the project is truly marginal in the Newfoundland and Labrador context, implying that the profit-sensitive royalties are zero and no subsidy would exist or, alternatively, the project is not marginal and it earns positive economic rents, which invalidates the METRR approach utilized by Mintz and Chen (2010) for analyzing Newfoundland and Labrador's offshore oil investments. When one takes into account risk and prospectivity, Newfoundland and Labrador's fiscal regime is neither significantly more onerous nor obviously more generous than comparable fiscal regimes in Canada and around the world.

Without adjustments to their research, this assessment brings into question whether the Mintz (2010) and Mintz and Chen (2010) analyses make significant contributions to the public policy debate in Newfoundland and Labrador with respect to the appropriate structure of the offshore fiscal regime. Their findings that the Newfoundland and Labrador fiscal regime subsidizes offshore oil and gas investment are not supported by their analysis. Based only on the research presented in Mintz and Chen (2010) and Mintz (2010), there is insufficient evidence to justify changing the royalty system or for adopting the flat rate oil sands royalty in Newfoundland and Labrador.

http://www.mun.ca/harriscentre/reports/wade_report_final.pdf

Dates
2010

Keywords
Offshore oil and gas investment, Royalties, Geological risk, Prospectivity, Public policy debate

Locations
Newfoundland and Labrador, Canada
St. John's
Avalon Peninsula

Industry Sectors
Oil and gas extraction (Mining, quarrying, and oil and gas extraction)
Economic research and development (Professional, scientific and technical services — Scientific research and development services — Research and development in the social sciences and humanities)
Provincial and territorial public administration (Public administration)

Thematic Categories
Economic Research (Economy)
Oil and Gas Industry (Industries)
Taxation and Fiscal Policy (Economy)
Provincial government (Government)

Departments
Economics, Faculty of Arts (STJ)
Harris Centre (STJ)