Today, the Alberta Government announced new reclamation guidelines for oil sands mining operations and for coal mines. Reclamation liabilities associated with the activities from the oil sands should be front-of-mind for the Government, and with activity growing all the time, the liability held by the Province in excess of escrow holdings is also growing. Pembina’s figures for the scale of the current un-funded liabilities are $15 billion (full Pembina report here), and I have to agree with them that to shift further into the future the collection of payments sufficient to provide full financial security for the Province is simply not an acceptable solution. At first blush, it appears that this continues a disturbing trend of the Government implicitly subsidizing activity in the oilsands through either under-valued resources or through risks and liabilities borne by those who own the resource and on whose behalf our Government is supposed to be acting. It turns out, on further investigation, that we might be better off fiscally collecting the costs later since we will end up paying for less of them in gifted bitumen through the royalty regime. However, I believe that the costs of deferring the liabilities, in terms of both the incurred risk and the signal it sends to companies doing business here, is much higher than the potential savings on royalties or the potential increase in investment.
Deferring a payment is not going to appreciably increase investment – not when you are talking about lucrative, multi-billion dollar projects. Capital markets are not perfect, but they are reasonably good at tabulating the present value of future costs. For example, when Imperial Oil decided to invest $8 billion in the Kearl project, you can rest-assured that their models took careful account not just of the operating and capital costs of the mine and their oil and carbon price forecast, but also of the future reclamation expense. Think that’s not an issue for the oilsands industry? Read here, where Suncor’s Kirk Bailey, Executive VP Oil Sands talks about the value of their TRO process in, “improving our economics by moving the liability of reclamation off our books more quickly.” So, deferred payments for reclamation security will improve near-term cash flow, but they will not appreciably change the investment go/no-go decision for oilsands projects since the net present value of these costs should not be affected assuming that the end-of-mine-life liability is fully secured by either up-front or deferred payments.
There is a difference in royalty treatment with respect to when costs are incurred, because oil sands royalties have always “recognized any new environmental fees or levies as an eligible cost of doing business, and therefore deductible in determining royalties on oil sands projects.(page 12)” If the payments are incurred up front, my reading is that these payments would fall under the attributable costs of a project, and would therefore extend the period over-which the facility would be subject to the gross revenue royalty of 1-9% until costs had been fully paid back. If the costs are incurred later in the life of the project, they would still be attributable against the earned revenues of the project in the year the costs are incurred, and thus would be deductions against the higher of the same gross revenue royalty or the net revenue royalty of 25-40%. So, a cost incurred at start-up, if the escrow payments are attributable (and I hope someone from the Alberta Government or industry will clarify this) as environmental costs, would end up being paid for almost fully with bitumen that would otherwise collect a royalty. If the payments are made later, the Crown share of these costs would decrease somewhat. So, simply collecting the costs up-front is not necessarily a winning proposition for us, the resource owners.
In deferring a payment, there is always a risk that the holder of the liability will not be around or sufficiently solvent to cover the costs when the time comes. The companies operating in the oil sands are large and seemingly very stable, but the energy business is not known for long-term stability. Imagine if we were, today, trying to collect deferred liabilities from those extracting natural gas in the province and you will immediately understand what I am talking about. While I agree that it is a remote possibility, I believe that it is very important to consider the ability to enforce the escrow payments once the majority of the value has been extracted from the mine and after much of the un-funded liability has been incurred. It also behooves the government to consider how these rules would work in both environments of high and low future oil prices (see gas example above) It might do the Alberta Government well to send a representative or two to Ottawa to talk to those whose pension liabilities were to be covered by the fortunes of what was then Canada’s largest publicly traded company, Nortel. Of course, they could also take a slightly longer trip to Ecuador, and return via Washington to inquire as to how well the Canadian government would fare in trying to extract payments for environmental harm from US companies. I expect we would fare better than the Ecuadorians, but the risk is not completely absent.
So, the remaining question, and I believe it is a valid one to consider, is whether the increased risk of the deferred security payments is worth the small change in royalty treatment and the minuscule change in project bankability. My inclination is that it is not, and that the impression we give through these deferrals is that the environment is of secondary concern and may be placed on the back burner to improve the investment environment. We hear from both government and industry officials that over half of the world’s investable oil is here in the Province of Alberta. It is important that we feel that we can set reasonable conditions under which these mines will operate and show the world and the companies that wish to operate here that we are committed to the environment. If a company proposed to hire only young workers, and made a reqeust to not fund their pensions until a few years short of retirement, I don’t think we would allow them to do business in that way in our province and we would likely point to Nortel. We should not allow similar behavior on our Crown land by those extracting our most valuable resource.
Hi Andrew,
I really appreciate both your blog and Twitter feed — great to see somebody from the academic community engaging students and the broader public alike using social media.
You raise an important question in this post with regards to whether, when it comes to royalty collection, Albertans might receive more of their “fair share” by collecting liability costs later. I confess that I hadn’t considered this angle, and I wonder whether or to what extent this was factored into the government’s approach. A good question to put to them.
It would be interesting to have Andre Plourde run the numbers to give a sense of the benefit, if any, in order to juxtapose it against associated risks with this approach. A risk that I see, and which you did not mention, is tied to the basic underpinnings of the policy: an asset to liability approach.
It strikes me that one of the most likely scenarios in which a company would abandon an oilsands operation is when the asset, the oilsands resource, has dropped in value to a point at which the operation is no longer economically viable. In this situation, there would be accrued liability that the government had assumed could be covered off by the value of the asset. Oops! Albertans would be on the hook for clean up costs.
Given the volatility of oil prices and an increasingly uncertain energy future (especially looking more than 20 years out), it seems that this approach may not be all it’s cracked up to be – for Albertans at least.
You also note, “The companies operating in the oil sands are large and seemingly very stable, but the energy business is not known for long-term stability.” It has been brought to my attention that “big” companies often create distinct subsidiaries for mega-projects, in part to shelter the parent company from liabilities. I just took a quick scan of Alberta Environment’s 2010 Environmental Protection Security Fund report and wonder whether this is the case for Imperial’s Kearl Mine, which is secured not by Imperial Oil Ltd. but by Imperial Oil Resources Ventures Ltd. Just how large and stable is IORV Ltd.? And how distinct is it from Imperial Oil, legally speaking? In other words, while most Albertans would, at first blush, think that the mine is backed by a large and stable company, if things go sour in the oilsands business will the liability really be backstopped by Imperial Oil Ltd.?
Keep up the blogging – it’s very insightful.
Cheers
Dan Woynillowicz
Pembina Institute
Hi Dan,
Glad I could drag you out of the weeds. I have done some asking around and have more to do with respect to the royalty treatment. It seems that the royalty attribution, under the current system at least, occurs when the reclamation expenses are incurred, not when the letters of credit are secured for the security deposits. Under the new system, that apparently gets murky. More to learn about this.
I think your point on the asset:liability approach is crucial. The asset is exposed to the price of oil and any oil sands regulation whereas the value of the liability is not to any meaningful degree. As such, future changes in the value of oilsands on the market could leave Alberta hanging with the liability.
I did some asking around regarding the IORV structure, and the liability in the case of joint ventures would be joint and several and so would follow up to the ownership of IORV or Athabasca Oil Sands, or Syncrude. Syncrude may be a more interesting example because of the ownership of Syncrude in part by COS Trust, which does not have other assets or significant cash holdings. A significant change in the potential cash flow from Syncrude assets could leave the province unable to recover reclamation expenses. The idea that you could sell the mine with the attached liabilities seems far fetched, and one need only look at the Giant mine in the NWT for an example. Imagine a company looking at the GoA and saying, “we will keep that mine running, and secure all of those jobs, but we could invest our money in a new mine with no liability encumbrances…so help us out here, okay?” I fear that we would be on the hook.
Will keep looking into these questions. Thanks!
Andrew
Professor Leach, thanks for your thoughtful analysis of our new reclamation security program for coal and oil sands mines.
I did ask some of my colleagues to have a look at your post and see if we could address your questions. Below is based on information I got back (and if errors exist they’ve been created by me in misinterpreting what was explained to me; my colleagues make admirable efforts to dumb it down for me, but that’s a task that can try the patience of a Kindergarten teacher).
The reclamation security program changes are part of an overall program to increase oversight *and* transparency in government management of oil sands reclamation.
The question of appropriate timing of reclamation security payments was examined relative to the ability of the mine operations to generate the revenue required to post security. We sought a balance between ensuring revenues are available to pay for reclamation security deposits, that the annual increments of deposits would be manageable, and that the funds are not being collected unnecessarily early – or too late – in the development lifecycle.
The program does in fact address future price fluctuations through a “Forward Price Factor”, which reduces the asset value if future prices are projected to be lower (potentially triggering security earlier) but does *not* provide credit if the future price is higher.
With respect to the Pembina liability numbers, we will have actual numbers from the industry, submitted as part of their Mine Financial Security Program Annual Reports, which will provide a grounded starting point for discussions on what the potential liability is, each year.
On royalty deductions for reclamation and reclamation security: Actual reclamation costs are allowable costs for royalty calculations – provided that those costs are incurred at a time when revenues are being generated by the project. Costs of getting reclamation security instruments (for example, a Letter of Credit) are allowable costs, but not the face value of the Letter of Credit.
To get into finite detail, there are a “Standard” and a “Guide” that lay out how the program works, and contain all the formulas, processes and calculations.
Here’s a link to download the Standard: http://environment.alberta.ca/03403.html
Here’s a link to download the Guide: http://environment.alberta.ca/03405.html
Dr. Leach, I hope either what I’ve relayed here or information in those documents furthers your analysis and answers at least some of exacting questions you raise.
As you note in your following post, I personally suspect this will be in line for a close look by the Office of the Auditor General, which had critically commented on our former reclamation program. (Typically the OAG does report on Government responses to its recommendations.) Assuming that does happen, Albertans will know from an independent analysis if we have achieved our goal.
They will also know from industry action on reclamation going forward.
– David Sands, for the Government of Alberta
Hi David,
Thanks for taking the time to comment on my post, and please pass on my thanks to those who offered to help.
I agree with you on the royalty issue, and the same holds true for tax purposes, as far as I can tell. As such, that is a non-issue it would seem.
I think that my disagreement with the policy choice comes largely in terms of the Government position that there is a need to find the appropriate timing of reclamation security payments. I think the starting point should be that the security deposits follow the incurred liability which would fall to the Province if, for whatever reason, the Province had to step in to take over the mine. In my view, any change to this approach “relative to the ability of the mine operations to generate the revenue required,” amounts to an implicit subsidy through incurred unfunded liability (i.e. we are effectively under-writing the liability on behalf of the project proponent). As you suggest, this is likely not an issue in a world of rising oil prices, where the mines become more profitable over time as we have generally seen in this province to date. However, the issue arises when/if, as can happen with energy markets, the bottom falls out. It can also be an issue if, and I hope it never comes to this, some of the environmental monitoring requires the province to prematurely halt operations as a result of lease term violations. The Crown, and by extension the government, should have the option to terminate the leases of those who do not respect the terms, and I fear this would be even less likely with a large, unfunded liability in the balance. Now, I don’t wish either of these events on the Province, but I do think we should make sure that we recognize the possibility in our planning. As you correctly pointed out to me online, the likelihood that the deferral of letters of credit has a meaningful effect on investment is small, so by collecting security commensurate with incurred liability, the risk of a future shortfall is eliminated at little cost.
I think the more important point to consider here is the impression given by the deferred security payments. The fact that, as a Government, we are using deferred environmental security payments as a means to guarantee sufficient revenue to the mining operations continues to send two messages. First, it continues to tell the world that this is a marginal resource that is barely breaking even. Second, it tells the world that Alberta is prepared to mortgage, if not forego, the reclamation of the environment to allow this (now seen to me marginally profitable) resource extraction to occur. I simply don’t believe that either of those are true, and I think that if anything, continuing down this path hurts the future value of the resource to a much greater degree than might be obvious at first blush.
I hope we will see the OAG look into measuring the unfunded liabilities, and I hope, as you suggest, that there will be greater transparency to come in the program. I am looking forward to seeing the MFSP Annual Reports.
Thanks for taking the time to respond. While I may not always agree with you, I greatly appreciate your willingness to engage in discussion on key issues for the province.
Andrew
Hi David,
You said “With respect to the Pembina liability numbers, we will have actual numbers from the industry, submitted as part of their Mine Financial Security Program Annual Reports, which will provide a grounded starting point for discussions on what the potential liability is, each year.”
Pardon my ignorance on these issues, but are you saying that the governments estimate of the liability is going to be based off of a companies estimate? If so, is this not a huge conflict of interest?
Good point Alastair. I will hope that David responds as well. My take would be that the conflict of interest is muted to a degree by the fiduciary responsibility of the corporations. The reclamation liabilities appear on their books (although need only reflect the amount they expect to have to pay, not their estimates of the total cost of reclamation to GoA standards) and the shareholders would demand that the figures be a reasonable estimate since it is their dollars at stake. I expect though, that the Auditor General would have some issue with exactly the conflict you bring up. The GoA should have developed the capacity to assess these liabilities well, and so should be able to provide benchmark estimates.
Andrew
Alastair, that may be addressed in the two documents I linked to above, and to be sure I need to return your question to smarter people than me.
However, I’m also going to (perhaps foolishly) venture this one my own as well: We have the numbers. If costs of current reclamation have an impact on royalties due (and the operator is now measured on reclamation activity under eight standards instead of the previous three) to game the system they’d have to understate what they’re spending on reclamation and thus pay more in royalties. That’s to attempt to unfairly reduce a far-future book liability – against the odds of either Government (or the Auditor General, or their own auditor) or other operators noticing their numbers are wonky.
I am sure my program colleagues will have a much more sophisticated explanation, and perhaps a killer app, but I’m saying we’ll have everyone’s numbers: Dollars, acres, level of reclamation, in front of us. If anyone sticks out sorethumb-wise, we either have a new BATEA or a cheat, no? (I’m hoping for a BATEA, they make better headlines than the latter.)
I stress, I’ll put your question to the people who know what they talk about and hope they’ll humour me again in a timely manner.
– ds
And now I see I could have just said: “What Andrew said, more succinctly.”
– ds
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