Jenik Radon

1
How to Negotiate the Right Mining Agreement

• By
• Jenik Radon
• Columbia University

2
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
  governments effort to reap the benefits of its
  natural resources.

3
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

4
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

5
How Mining Companies determine a host countrys
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• Caveat MC can be outdated and therefore does not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

6
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 countrys interests with
  mining companies concerns

7
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

8
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

9
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 countrys and investors
  interests
• Takes into consideration the communities or
  entities not party to the deal but who will be
  interested or affected by it

10
Contractual Systems

• To achieve such balance of country and investor
  interests the choice of contractual system is
  crucial
• 4 basic contracts
• Concession or license agreement
• Joint venture (JV)
• Production-sharing agreement (PSA)
• Service Agreement

11
The four basic contractual provisions

• Concession or license agreement
• Joint venture (JV)
• Production-sharing agreement (PSA)
• Service agreement

12
Bilateral Agreement v. Unilateral Permit

• Should Governments rely on mineral Agreements,
  permits based on the mining code or on a hybrid
  system?

13
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

14
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

15
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

16
Australian Licensing System

• Advantages

• Disadvantages

• Provides government 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

17
Australian Licensing System

• Advantages

• Disadvantages

• Provides TMC with high level of protection from
  arbitrary government action

• Expensive and time consuming
• High degree of complexity
• Overrides MC and can undermine rule of law
  (one-off law)

18
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

19
Chilean Licensing System

• Advantages

• Disadvantages

• Impartiality of body granting the concession

• First-come-first-serve approach may not favor
  most efficient or profitable bidder

20
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

21
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

22
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

23
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

24
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

25
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

26
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

27
Joint Ventures

• No single definition highly flexible 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.

28
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

29
Joint Ventures

• Advantages

• Disadvantages

• Government is not alone 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

• Risks and costs are also 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

30
Joint Venture Characteristics

• Pure JV Typical JV
  Full carry JV Former Soviet
  Union type JV
• All costs/risks Government
  Government carried Government
  carried through
• Shared carried through
  through exploration and
  rehabilitation and development
• Exploration
  development
  until cash flow from operations
•  
•  
• NOC?----------------------------------------------
  --------------------------------------------------
  ?IOC
• Risk sharing

31
Service Contracts
32
Service Contracts

• Mining company conducts mining activities on
  behalf of the government
• Key characteristics
• Contractor works under governments 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

33
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

34
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 companys
  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

35
Production-Sharing Agreements

• Advantages

• Disadvantages

• Government shares 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)

• Government generally has 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

36
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

37
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

38
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

39
Contractual Provisions

• Common Provisions for concession Or License
  Agreements and Production-Sharing Agreements

40
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 enterprises 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

41
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 dont
  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

42
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

43
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

44
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

45
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

46
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

47
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

48
Work Program

• A work program details a companys 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

49
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

50
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

51
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

52
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?

53
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

54
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

55
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)