Ethics @ Work: Changing royalties after gas is found

Although Israel is in an oil-rich region, the topic of mineral royalties has until recently been mostly theoretical.

October 14, 2010 22:48
Illustrative photo

311_offshore oil well. (photo credit: Associated Press)

Although Israel is in an oil-rich region of the world, the topic of mineral royalties has until recently been mostly theoretical. The Heletz field in the Negev has been producing a small quantity of oil since the 1950s, and the Yam Thetis consortium found meaningful amounts of natural gas offshore a few years ago. Overall, the amount of mineral wealth developed by private companies has been small. But recent large offshore gas finds by a consortium including major foreign investors have ignited a broad public discussion and dispute over the appropriate policy.

Israeli law prescribes a comparatively low level of royalties on mineral finds. It was under this relatively generous regime that the private companies invested huge sums in far-from-guaranteed hopes of finding gas or oil. Now the country is considering raising the level of royalties demanded, and the topic is being discussed by the Sheshinski Committee.

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The proposal has generated strong, and strongly moralistic, sentiments on both sides. Some are outraged by the prospect of using state power to force conditions on foreign investors, while others are outraged by the comparative pittance for which the government is selling the country’s mineral wealth to wealthy investors.

Likud MK Carmel Shama expressed the dilemma in picturesque language: “Some would define us as a banana republic or a third-world country if we alter the royalties. But there is already third-world conduct in the clearance sale [prices given] to foreign investors.”

What are the economic and ethical considerations in this dilemma? There are really two distinct questions.

First we have to ask what is the fair and appropriate policy for managing Israel’s mineral wealth. And to the extent the current policy differs from the ideal, we have to ask if it is fair to change the policy after investments have already been made.

The answer to the first question is that the country should seek the maximum return on its assets, just as a private investor would. It is true that the government gets income tax from the profits of the companies, but that income would accrue even if the gas were privately owned. The appropriate level of royalties depends on many factors, including the probability originally given for finding gas and the expense involved in searching and drilling. The greater the risk and expense, the greater the return deserved by the investors.

Without a detailed understanding of the geological realities, it is obviously impossible to give a firm opinion, but the current statutory royalty rate of 12.5 percent of profits does sound rather low to me. If you had an oil gusher in your backyard, would you let someone develop it in return for such a small amount?

But for better or worse, that is the regulatory environment that was in place when the investment was made. Is it right to change it now? For this question we may distinguish three levels of commitment.

Making a retroactive charge should be considered out of the question. Government policy creates an agreement between the government and citizens; there is no place for retroactive changes except in the cases of the most egregious oversights. New taxes now on extractions that already took place would definitely be inappropriate.

The following level is contractual obligation. Using state power to unilaterally abrogate contracts is both unfair and also unwise, since it will make investors extremely reluctant to take risks in the future. What about breaking contracts “contractually,” that is, incurring whatever fines or penalties the contract itself imposes?

This is not as serious a problem, because to some extent these penalties are themselves part of the contract. But even this is generally justified only when there was some development unforeseen in the original contract. When the State of Israel gave licenses to the companies looking for gas, it obviously was taking into account the possibility that large amounts of gas would be found, so tampering with the contracts would also seem ill-advised.

The final level is the overall regulatory regime in which business activity takes place. There is certainly importance to having stable regulations and tax rates to encourage investment in human and physical capital that will bear fruit in the distant future. But every country makes changes in tax rates and regulations according to changing circumstances, and if the changes are not extreme, policy changes cannot be viewed as “changing the rules of the game.” One of the rules is that a sovereign state will mold its tax code to suit its changing circumstances.

Labor MK Shelly Yacimovich, who supports raising the royalties, said: “The government engages all the time in steps that have retroactive impacts: It raises and lowers taxes, it cuts child support payments after people already bore children... It can raise the corporate tax rate, and then someone who already built a factory may come to object.”

In other words, an explicitly retroactive policy is against the rules of the game, but making a forward-looking policy change that has retroactive effects is part of the game.

So it seems to me that making changes in the royalty policy in a way that is not retroactive, does not go against explicit contracts or treaties, and is not designed specifically to exploit the recent finds, is legitimate and quite possibly called for.

Israel will have to adjust to being a country with mineral wealth. This will obviously require some change in the regulatory environment, and some of these changes will have retroactive impacts. Of course, it will be necessary to take into account the desire to have the image and reality of stable policies, but making a change in the royalty policy that fulfills these conditions does not make Israel a banana republic.

Asher Meir is research director at the Business Ethics Center of Jerusalem, an independent institute in the Jerusalem College of Technology (Machon Lev).

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