Some thoughts relating to the proposed fiscal framework and its impact on future investment

Dear MineWatchers,

First of all, many thanks to Alastair and MineWatchZambia for giving us this comprehensive one-stop-shop for news on the current ongoings in the Zambian mining sector. You are doing a fantastic job, and I for one appreciate it very much. I wanted to add some reflections on the current situation in Zambia and the question of whether the new tax regime, if imposed in its current form, will deter further investment and development of Zambia’s copper mining sector. The tone of this blog entry will strike a more cautious note compared to what we have seen recently, and in some sense I’m playing the devils advocate here. But personally I do think the current situation may well impact is on future investment, the question is only to what extent? This is hard to predict, but I wanted to stress a couple of points that are worth bearing in mind when discussing this issue.

First, the increase in taxes per se constitutes the first reason to expect a reduction in investment. The key point here is that compared to the tax regime previously in place, the new taxes do not represent a conservative tax increase. Granted, the new taxes may not be extremely high compared to other countries, but the tax burden increases significantly, in particular because of the reduction in capital allowances from 100% to 25%. The financial viability of all projects will be affected. Although incumbents with sunk costs are likely to continue with announced projects, I think many of the over hundred prospecting companies in Zambia are likely to pull out. At prospecting stage companies have not yet developed the ‘bankable documents’ which use proven reserves to raise financing necessary develop mining operations. They have yet to go to the capital markets and raise long-term financing, and some previously viable project will no longer be viable. Thus, although incumbent are in a sense ‘locked in’, prospecting companies are not. One effect over the medium term may be a relative increase in Chinese mining investment! The access to financing on subsidised terms provided by the Chinese government to many of its mining firms (e.g. through ExIm Bank) means that these firms require a lower ‘minimum’ returns to be profitable.

Secondly, there is the issue of regulatory stability in Zambia. A key concern for any investor is predictability, the ability to forecast cash flows. Indeed, from interviews with managers at the mines, it seems that the stability afforded by the DAs by far outweigh the importance of tax concessions per se. Stability is not so much about never changing regulations, but rather about firms having an element of predictability in their dealings with government. This can be seen in the development of new environmental regulations (revisions to the Environmental Prevention and Pollution Control Act), which in some cases may impose higher costs on firms, but which firms nonetheless support because they are seen as necessary in adapting the framework to modern mining methods. However, consider how government has publicly represented the mining sector as partly to blame for its decision to impose, without negotiation, a new fiscal regime (because of an alleged unwillingness of mining companies to renegotiate). Now, it is true that mining companies were initially against this idea, but during 2007 they all agreed to renegotiate. A senior manager at one mining company I spoke to referred to a letter from mid-2007, signed by the President himself, stating clearly that the Zambian government would not impose unilaterally a new fiscal. Where this type of commitment (never mind the DAs) end up entirely losing their value in promoting predictably, this clearly means investors are subject to greater risk. This sends a signal to future investors, who will require even greater forecast returns next time they come to invest in Zambia, to compensate for the evidence that the government does not attach much value to its commitments. As an executive director at Macquarie Bank, one of the world’s largest arrangers of financing for mining companies, put it “the Zambian government currently has the bargaining advantage given the high copper prices, but investors will remember this how government handled this situation once copper prices fall again and the bargaining pendulum swings back”.

This brings me to my third point. When we say that the Zambian mining sector will remain profitable, let’s bear in mind that what investors are looking for is a risk-weighted rate of return. In other words, the mere fact that this or that level of copper prices enable investors to earn a positive return is not enough to ensure that this investment will take place. It is not a binary issue about either breaking even or not, but rather about achieving an adequate return that compensates investors for the political and economic risks they are taking. For mining investments in developing countries, this can be in the range of 15-20%. Higher returns are required where institutional arrangements are weak, where property rights and contracts are not reliable, and where there is much government intervention. If one consequence of a unilaterally imposed new tax framework means that Zambia is considered a less ‘stable’ destination of investment, then investment into Zambia’s mining sector might get a double squeeze: financial forecasts will fall because tax costs increase (reducing forecast returns), at the same time as the hurdle rates, i.e. the risk-weighted returns that financiers require to consider a project feasible may increase (increasing required returns). Of course, as long as copper prices remain high, the number of projects which become unprofitable (and thus don’t take place) in Zambia is probably small – however, the government is dangerously placing all its eggs in one basket here. With the prospect of global recession, with China recently reporting its highest inflation in 12 years, there is a growing risk of a global softening of demand which may take some air out of copper prices.

At this stage, we should, of course, also be asking ourselves: if future investment into the mining sector is reduced slightly, then so what? Indeed too rapid investment may not be in the interest of the Zambia's development! (if the regulatory and institutional structure is not in place to ensure environmental and social sustainability) There are already serious constraints in regulatory capacity in bodies charged with oversight of the mining sector (Env. Council of Zambia, Mines Safety Department, the labour inspectorate etc.), with regulatory agencies already have a difficult time keeping up with existing developments in the mining sector. The shortage of such skills among regulators in Zambia will not abate in the near term, and is driven by the growth in the mining sector: salaries at the ECZ and the MSD are not competitive compared to those offered by the mines, and skilled engineers working as inspectors quickly get poached by mining companies.

Coming back to renegotiations (or lack thereof), I personally hope that the GRZ does engage the mining companies in some form of dialogue and negotiation. Reaching a negotiated settlement would send a signal that this is a government that, although it prioritises the welfare of own citizens (as it should), also listens to economic stakeholders, to avoid the sudden surprises that may deter foreign (and local!) investment.

• On the one hand, I am concerned that the GRZ may find it politically unacceptable to sit down to negotiate following the rallying behind the government. The new fiscal regime may have been announced with the aim of catching the mines on the offensive, letting the government set the agenda, and letter the mines respond to government’s position rather than letting them dictate the agenda. Although this may have been the intention, the widespread support by civil society, donors, the media, and virtually everyone else means that going to the negotiating table may become politically unacceptable.

• On the other hand there are many details surrounding the new fiscal framework which appear unclear, which government may have kept secret to allow for behind-the-scenes negotiation with the mines. I admit to not yet having looked at the new bills on Cho’s website, but it is my understanding that things like whether or not withholding taxes are time limited, whether windfall taxes are tax deductible and so on, have not been made clear. Another thing to keep our eyes peeled on is to what extent these rules will apply to companies with smelters (KCM, Kansanshi, MCM, CCS), as the fiscal framework applies to operations carried out under ‘mining right’ referred to in section six of the Mines and Minerals Act. For instance, CCS will *not* fall under the new fiscal framework as it operates under a mineral processing license, not a mining license. If companies are allowed to restructure in order to take advantage of this, their effective tax burden may become less, and this is one way the government can reach a ‘negotiated’ settlement, without being seen politically to be negotiating.

To sum up, I believe government is doing the right thing reforming the fiscal framework, but it is also adopting a strategy which appears, on the face of it, somewhat risky. Finding a win-win situation which improves (significantly) the tax receipts from the mining sector whilst signaling that it does incorporate concerns of private investment. An amicable solution to all of this would also engender more open state-firm relationships, on the back of which greater long-term transparency of the mining sector can be sought, for instance through the Extractive Industries Transparency Initiative. Any comments or thoughts about this would be much appreciated!

Dan Haglund
PhD candidate
University of Bath