No 'gotcha' changes to the Petroleum Resource Rent Tax

As with every other policy debate, public discussion on the adequacy of the Petroleum Resource Rent Tax (PRRT) has become polarised. Critics argue it’s hopeless at gaining a fair share of the revenue from gas extraction for the community, while industry warns that any change whatsoever would frighten off future exploration and development. As usual, the truth lies somewhere between the extremes. The policy challenge is to find a middle path. More than three decades after the Hawke government’s introduction of the PRRT, some modifications to the tax are worthy of consideration.

But first to some guiding principles. As the resource owners, the community is entitled to a share of any resource rents from gas extraction; that is, the profits in excess of the returns needed to attract exploration for and development of gas reserves.

It follows that taxes that kick in before a project has achieved those returns can deter exploration and development, leaving the resource in the ground for the benefit of nobody other than opponents of all fossil fuels.

Next, chopping and changing the tax system at whim after huge investments have been sunk might seem clever, but can greatly add to sovereign risk, making investors wary about committing to future exploration in the country.  That said, where the potential profits are large, companies have consistently been willing to accommodate enormous investment risk in countries like Nigeria, Russia and some Latin American countries, where rule changes and resource nationalisation post-investment have been common.

Nevertheless, based on the principles of rent maximisation, rent sharing and stability of fiscal regimes, the PRRT allows exploration costs as a deduction that can be carried forward at an ‘uplift factor’ to be offset against future income. The uplift factor for exploration expenditure is the long-term bond rate plus 15 percentage points. This generous uplift factor is designed to compensate for the high risk of petroleum exploration.

Similarly, capital expenditures on a development project can be carried forward, but at a lesser uplift factor of the bond rate plus 5 percentage points. Cash operating costs are immediately deductible.

Since the PRRT applies to resource extraction, not to its further-stage processing, only expenditures associated with oil or gas extraction – not gas liquefaction or transportation to market – are claimable as costs.

Three changes to the PRRT could be contemplated. First, the 15 percentage-point compensation uplift factor for exploration expenditure was agreed as a compromise with industry in 1984 on the assumption that it was mainly searching for oil in frontier offshore territory, not gas. As much more offshore gas has been discovered over the last 30 years, it could be argued that 15 percentage points is now overly generous. For future exploration, it could be pared back to 5 percentage points to align it with the treatment of development expenditure.

Second, one of the legislated methods of setting a price for gas – called the Residual Price Method – might be open to exploitation by companies seeking to minimise PRRT liabilities. This method appears to deduct from the price some downstream costs, whereas the correct price is the one before any processing, transportation and marketing of gas occurs. It might be wise for the government to scrap this method in order to guard against transfer pricing.

Third, if Tax Office projections indicate offshore gas producers are unlikely to pay PRRT in the foreseeable future, a royalty could be contemplated, but one that recognises legitimate gas extraction costs. A 10 per cent royalty based on the gross value of gas production – as advocated by the Tax Justice Network – would result in higher-cost gas being left in the ground, generating no government revenue.

A royalty that allowed cash operating costs as a deduction would avoid this problem. If judged necessary, it could be offset against future PRRT payments, effectively bringing forward revenue. And, to enable investors to get their money back early, it could start, say, five years after the commencement of production.

While it is true that these suggested changes modify the 1984 PRRT, so did changes successfully sought by the industry in the mid-2000s that made the PRRT regime more generous to it.

Overall, the PRRT had been a successful revenue-sharing device for its first 30 years, collecting more than $33 billion for the community. Major disruptions to it after the industry has invested more than $250 billion, in a gotcha-style manoeuvre, would jeopardise future exploration and development. But just as the world has changed over the last three decades, sensible amendments to the tax regime for gas extraction could generate a reasonable share of rents for the community while supporting future exploration and development.