By Stephen E. Shay, Lecturer at Harvard Law School; Iain Steel, independent economics consultant; Gabrielle Beran, Governance and Program Manager, International Senior Lawyers Project-UK (ISLP-UK); Olumide Abimbola, Business Development Lead, CONNEX Support Unit.
Countries often collect royalties on the sale of their natural resources, but how can they be sure that the price is right when a mining company sells iron ore to its own steel mills? This was the problem faced by Liberia with its largest iron ore mine – and a common problem around the world in mining and many other sectors.
Sales between “related parties”, where the companies share a common owner and are therefore not independent of each other, use a “transfer price[i]” that is supposed to reflect fair market value – the price two independent firms would have agreed transacting at arm’s length. In this article, we describe how governments can make use of pricing agreements with companies to determine transfer prices by reference to international benchmarks, and the importance of reviewing these agreements to ensure they remain fit for purpose over time. We also draw lessons for revenue authorities, host governments and donor partners from the recent renegotiation of a pricing agreement in Liberia.
Royalties reflecting the state’s ownership of natural resources and right to revenues in advance of a mine’s profitability are often imposed as a percentage of the sales value – to take account of the cyclical nature of demand for the commodity. In this case, the ore price becomes a key determinant of government revenues from the royalties as well as the amount that mining companies must pay.
Contracts and legislation often require related-party resource transactions to be priced at fair market value, but do not specify in detail how fair market value is to be determined for the resource. This is where subsidiary agreements, such as pricing agreements, can play a valuable role by providing specific metrics appropriate to the facts. This will ensure that a reasonable measure of fair market value is achieved and provide certainty to both government and mining company.
In the case of the largest mine in Liberia, a royalty pricing agreement (RPA) was negotiated to determine the selling price for iron ore because the mine exported a large proportion of its output to steel mills in the same corporate group. The RPA was intended to ensure that royalties were collected on the fair market value of ore by determining the price using a formula based on public data that both parties could access. The RPA used a benchmark price for an ore with similar characteristics from Platts (a widely-accepted pricing benchmark for physical commodities) and made pre-determined adjustments for quality and impurities that affect furnace efficiency. A further adjustment, again based on a public index, removed market freight costs to ‘netback’ the selling price from the benchmark quoted delivery place, China, to the loading port in Liberia.
At the time the original RPA was negotiated, market practices in iron ore were evolving from fixed-price annual contracts to shorter-term agreements linked to spot prices. The original RPA also was entered into before the published price indices reported adjustments for impurities. In addition, the mining company shifted its production to a different site with iron ore of quite different characteristics than the original RPA formula was intended to price. As a result, the original RPA no longer reflected market pricing practice and was based on a reference for lower quality ore, resulting in lower revenues for the government.
From 2018-2020, the government of Liberia’s revenue authority (LRA) partnered with an economist, supported by the CONNEX Support Unit[ii], and a team of volunteer lawyers from International Senior Lawyers Project-UK (ISLP-UK). These advisors developed the economic modelling and advised LRA on legal strategy for a renegotiation of the RPA.
The shared objectives of the government and the mining company were to restore the royalty income negotiated for under the original RPA, to update the RPA to reflect new market practices, and to avoid future disputes by employing recognized international indices that would adjust to market changes.
The negotiations were completed in January 2020. The updated RPA method for calculating royalties is estimated to increase revenues for the government by between 14% and 24% over the period 2017 to 2026. The revised RPA relies on the Platts Iron Ore Index Fe 62% benchmark price with Platts adjustments for impurities that were not available when the original RPA was negotiated, freight, and actual transshipment outlays by the mining company.
What are lessons learned from this experience?
- Monitoring international benchmarks: Although many extractive industry contracts include ‘fiscal stability clauses’ that lock-in tax terms for many years, governments should routinely monitor the revenues they receive. Assessing mineral prices used in royalty payments against international benchmarks can identify valuation issues that can be addressed without triggering stability clauses, including through RPAs.
- Multidisciplinary negotiating teams: The multidisciplinary nature of transfer pricing underscores the importance of having the appropriate competences present in the government negotiating team. Complementary legal and economic expertise were required – to analyze both legal allocation of risks and modelling of potential outcomes from alternative strategies and compromises. The modelled outcomes played a significant role in determining red lines, targets and bids in the legal negotiating process. Governments should adopt this multidisciplinary approach, and donors as well as FDI promoters should encourage this approach when supporting governments.[iii]
- Use of technical experts: Where a government can afford it, it is advisable to draw on technical and market expertise to support the government before and during negotiations with the investor. For governments that do not have it internally and cannot afford external advisors, initiatives such as the CONNEX Support Unit and ISLP-UK might be able to assist.
- Ownership is key and trust is of the essence: The negotiation was particularly successful because the government of Liberia initiated the RPA review after their own price monitoring efforts, rather than at the prodding of an outside stakeholder. The LRA sought external support but kept full ownership of the process throughout, in the process building on their own technical skills that can be applied in the monitoring of revenues from other projects in the country. The fact that the government of Liberia had used technical assistance in past negotiations certainly aided the process – but so did the relationship of trust built over years between the CONNEX/ISLP-UK advisors and the LRA who have worked together in different iterations for nearly a decade[iv].
[i] For more on transfer pricing in the extractives sector, see the Tax and Development Program of the OECD Centre for Tax Policy and Administration (CTPA).
[ii] From 2016-2019, the OECD Policy Dialogue on Natural Resource-based Development (PD-NR) hosted the Negotiation Support Forum, which was initiated and supported by CONNEX, as part of the work stream “Getting Better Deals”.
[iii] The OECD Development Centre’s Guidance to Assemble and Manage Multidisciplinary Teams for Extractive Contract Negotiations is a resource to provide host governments with tools to assemble and manage a multidisciplinary team, and engage effectively in extractive contract negotiations.
[iv] The OECD Development Centre’s Guiding Principles for Durable Extractive Contracts cover many of the above-mentioned issues, setting out eight principles that governments and investors can use as a common reference for future negotiations of sustainable extractive contracts, that can reduce the drivers of renegotiation.