Raising Alberta’s Royalties

Last week, the Royalty Review Panel recommended that Alberta raise its oil and gas royalties. Its 100-page final report, Our Fair Share, has generated healthy debate on a critically important subject. The basic message follows:

Albertans do not receive their fair share from energy development and they have not, in fact, been receiving their fair share for quite some time. Royalty rates and formulas have not kept pace with changes in the resource base, world energy markets and conditions in other energy-rich jurisdictions. Albertans own the resources. . . . The design of a royalty and tax system for energy resources therefore must justify every dollar that does not go to the owners.

The panel also expresses concern about “international competitiveness”, but quite correctly concludes that royalties are currently so low that increases would not remove “Alberta’s competitive edge”.

Of course, these strong arguments are not new. The Parkland Institute, Pembina Institute, and others have contended for years that Alberta’s royalties are too low. I put forward a similar analysis of Saskatchewan’s royalties five years ago.

The hugely significant news is that a government-appointed panel of businessmen and mainstream economists has come to the same conclusion. To quote a headline from the Edmonton Journal, “The pro-business panel put Albertans first.” The six members were a retired forestry executive, an economics professor and former civil servant, an economics professor and Fraser Institute fellow, a retired oil executive, a chartered accountant and businessman, and an energy-industry economist.

Although the recommendations go in the right direction, they arguably do not go far enough. The panel characterizes its recommendations as “a mitigating fiscal program that the government can undertake immediately” and questions “whether Albertans would be receiving their ‘fair share’ from oil sands royalties even if its policy recommendations are adopted in their entirety.”

The panel proposes to lower royalties on most conventional oil and gas wells, but to raise royalties on most of the output by concentrating on the most productive conventional wells and on the oil sands. These proposals are estimated to increase provincial revenues by $2 billion annually. An important caveat, included in a note below the table on page 17, is that this figure does not take account of the cost of a proposed tax credit for upgrading bitumen in Alberta. While processing the resource in Alberta rather than in the US is a worthy objective, it is debatable how much revenue the province should give away to achieve it.

The panel proposes to retain the 1% gross royalty for oil sands projects that have not yet paid off their capital costs, but to increase the post-payoff net royalty from 25% to 33%. However, the problem so far has not been that the net royalty is too low (although it is), but that companies avoid paying it by characterizing every new investment as a continuation of an existing project so that capital costs are never fully paid off.

Since this ring-fencing issue has been widely discussed for more than a year, it seems odd that the report states, “it appeared very late in our work that oil sands remittances might be victims of a ‘broken ring fence’ mechanism,” without suggesting a specific solution.  However, the proposed severance tax could be useful in this regard.

Notwithstanding these quibbles, the report constitutes a clear step in the right direction and should be implemented. A particularly interesting recommendation is to establish a new entity with auditor-general-type powers to scrutinize Alberta’s royalty regime and regularly report to the provincial legislature on its performance compared to other jurisdictions.

Such an approach is needed because energy/resource departments have proven highly susceptible to regulatory capture, whereby they become industry advocates rather than public stewards. While the panel worries that this proposal “may be seen as a betrayal of the department”, it seems to me that the department may have betrayed the public.

The oil industry has predictably responded with over-the-top doom and gloom. Its best argument is that extraction costs have risen along with oil prices, minimizing economic rent. However, high costs are a direct result of excessively rapid development and dissipated rent driving up input prices. Raising royalties would itself help to lower costs.

More generally, many of us think that a somewhat smaller volume of oil extraction would be desirable for the sake of conservation, reducing greenhouse-gas emissions and moderating the Canada-US exchange rate. The panel objects to the view “that royalties can be used as a throttle to speed or slow economic development” but concedes that “higher royalties and taxes will slow the pace of oil sands investment.”

The traditional tradeoff in setting royalties is between revenue and development. If one accepts that slower development is desirable, then higher royalties are a “win-win” proposition.

National Post columnists have been reduced to arguing that government is a fundamentally bad institution that should not be given more money. They overlook the fact that higher royalty revenues could be used to finance other tax cuts (although that is not what I would advocate).

Former Premier Ralph Klein has come out against the report on the basis that his friends in the industry do not like it. This approach to policy analysis helps explain how Alberta’s royalties fell so low. Hopefully, Premier Ed Stelmach will stand up to industry and reverse this trend.