5. Royalties: Simple, but not neutral or progressive
Royalties are fees paid as compensation for the loss of a resource owned by the state. In most nations, legal ownership of mineral and petroleum resources belong to the state. They are solely an extractive-related revenue stream, typically based on either a percentage of the export price (ad valorem or added value) or a unit of production i.e. USD per tonne/barrel.
As royalties are applied to all production and are not directly related to the profitability of the project, they are a serious cost of doing business to investors.
The advantages for government stem from:
1. Their dependability as a revenue stream;
2. The timeliness of revenues since they commence immediately after production starts;
3. The administrative ease in calculating and collecting them.
However, because they increase the cost of doing business, royalties do not offer neutrality and can deter companies from investing. Additionally, they are not a particularly progressive fiscal instrument as by their nature they do not vary in direct connection with profits. That said, because they are based on production and prices, they are sensitive to the factors which can drive profits.
For the reasons above, royalties are a fiscal instrument used in almost all extractive projects, but rates are generally modest. Adjustments made to align royalties more with profits (i.e. enhance progressivity) include variable rate royalties whereby rates can be adjusted to reflect changes in prices or profitability according to an agreed formula.
Royalties can also be aligned to other characteristics, e.g. water depth for offshore oil or gas or mineral type. Governments do this to account for differences in the cost of doing business in more challenging physical environments or economic differences between different minerals. Complicating the fiscal regime often reduces administrative ease for both government and industry.