Royalties - practice

So far the paper has focused on the principles for a royalty regime. This section discusses practical policy and implementation issues, with most of the discussion based on the official guidelines for cost recovery charges(Treasury, 2002).

Setting a royalty

Determining the size of a royalty can be done in various ways depending on the goals being sought and their relative importance, the information available and the risks faced.

Estimating a royalty in advance is information intensive.  Auction or tender approaches require a functioning market.

An obvious option is to attempt to estimate the appropriate rate to achieve the specific goals being sought. This could mean determining the level of economic rent available and fully capturing that from users, or calculating a royalty that will ensure a resource is depleted over an appropriate timeframe. The ability to follow such an approach will depend primarily on information availability.

The other primary option is an auction methodology where potential users bid (based on, for example, lump sums, time payments or profit shares) to use the resource. Auction approaches have the advantage of implicitly revealing information held by bidders, and over time can both evolve towards the optimal level and take into account changing circumstances. Risks here include collusion or asymmetric knowledge between bidders. Whether those risks matter, other than for initial distribution of economic rents, depends on circumstances.

Under either option there is the risk that the resulting royalty rate will not achieve some elements of the goals sought. For example, the royalty may be so high as to limit access by some parts of society, or so low that it encourages excessive use of the resource. On the former issue, any decision to reduce the rate will require decision-makers to determine whether greater intensity of use is acceptable, or consider an alternative or supplementary rationing system such as queuing.

Investment risk and resource damage are the main constraints on initial rate setting and later adjustments.

The importance of getting the royalty “right” first time will also depend on factors such as the nature of any associated investments. Would a resource user incur large fixed costs that would be jeopardised by a rate change? Could an initial rate that was set too low lead to irreversible damage?

Where there is scope for allowing the rate to evolve, there may be long-term advantages from doing so. Conversely where significant risks exist, such as of environmental damage, there is a case for setting a conservatively high royalty rate which can then be lowered as appropriate. The process for making such decisions should, however, be as clear and certain as possible.

Balancing multiple reasons for charging

Complications arise when there are multiple reasons for charging; e.g. example) to recover the costs of providing services, capture a share of the benefits received from private use of a public resource, fund general activity related to the resource (such as planning, conservation or education) or encourage or discourage an activity based on the externalities it creates.

These different purposes can call for a variety of responses which may vary in magnitude or even point in different directions.

Trying to deliver multiple goals with one instrument requires trade-offs that can compromise some or all of the goals.

One major risk is that the combined charge will be set at the wrong level. It is unlikely for example that the level of charge appropriate for encouraging efficient use will match the costs of managing a resource. This risk can be addressed by separating decisions on achieving a return from assets, recovering the costs of services, and reflecting any externalities of use.

Incentive problems can also arise where continued funding of desirable activities (such as marine education) depends on continued use which may not be sustainable (leading to collapse of a particular fishery), or may have undesirable external effects (such as loss of biodiversity through habitat damage).

In such cases there can be a perverse incentive to encourage resource use beyond the point of net national benefit. The best answer to such an incentive risk would probably be to separate the expenditure and revenue decisions. Whether any given divergence between purposes is sufficient to require such separation, will be a matter for judgement. Potentially conflicting purposes should, however, be evaluated and trade-offs explicitly made.

It is generally possible to identify cost recovery charges separately as they can be tracked and linked to specific activities, and doing so is central to their intended incentive effects on users and providers. This is consistent with the principle that “rentals for access to a resource are separate from charges for the management of the resource. To combine the two is to mix a return for the owner with a charge for a service. This would send confusing signals …”.[15]

Charges for other purposes (such as general revenue or royalties) should be separated out from cost recovery as far as is consistent with reasonable costs. This is to help ensure that each charge achieves its own intended purpose.