Review of Australia`s Offshore Petroleum Exploration Policy Area

ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Area-‐Release, Tenement Conditions, Permit Allocation, Taxation, and Information Provision Prepared for Commonwealth Department of Resources,
Energy and Tourism
3 January 2012
ACIL Tasman Pty Ltd ABN 68 102 652 148 Internet www.aciltasman.com.au Melbourne (Head Office)
Level 4, 114 William Street Melbourne VIC 3000 Telephone (+61 3) 9604 4400 Facsimile (+61 3) 9604 4455 Email [email protected] Brisbane
Level 15, 127 Creek Street Brisbane QLD 4000 GPO Box 32 Brisbane QLD 4001 Telephone (+61 7) 3009 8700 Facsimile (+61 7) 3009 8799 Email [email protected] Canberra
Level 2, 33 Ainslie Place Canberra City ACT 2600 GPO Box 1322 Canberra ACT 2601 Telephone (+61 2) 6103 8200 Facsimile (+61 2) 6103 8233 Email [email protected] Perth
Centa Building C2, 118 Railway Street West Perth WA 6005 Telephone (+61 8) 9449 9600 Facsimile (+61 8) 9322 3955 Email [email protected] Sydney
Darwin
GPO Box 908 Darwin NT 0801 Email [email protected] PO Box 1554 Double Bay NSW 1360 Telephone (+61 2) 9389 7842 Facsimile (+61 2) 8080 8142 Email [email protected] For information on this report Please contact: Ken Willett Telephone (07) 30098702 Mobile 0412045455 Email [email protected] Contributing team members: Paul Balfe Alan Smart ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Contents Executive Summary viii 1 Introduction 1 2 Policy Design and Assessment Principles 5 2.1 Widely Accepted Public Policy Criteria 2.2 Re-‐statement of Criteria in Context of Exploration Licensing Policy 2.3 Principles of Equity 2.3.1 Ability to Pay Principle 2.3.2 Benefit Principle 2.3.3 Inter-‐Generational Equity 2.4 Economic Efficiency 2.4.1 Market Failure 2.4.2 Policy Failure 2.4.3 Ecǲ-‐ǳ 2.4.4 Matching Policy Instruments to Targets 2.4.5 Effectiveness Versus Efficiency 2.4.6 Economic Efficiency, Sustainability, and Economic Growth 2.5 Administrative Efficiency/Simplicity 3 Reality, Relevance and Role of Resource Rent 3.1 3.2 3.3 3.4 3.5 3.6 Concept of Resource Rent Risk, Uncertainty and Resource Rent Other Rents and Quasi Rents Economic Functions of Resource Rent Eliciting Supply -‐ Reality of Resource Rent Difficult Task of Designing Efficient Policy to Preserve and Capture Resource Rent 4 Elements and Structures of Petroleum Exploration Policies 4.1 Categories of Systems for Management of State-‐Owned Petroleum Resources 4.2 Elements of Policies for Petroleum Exploration and Extraction 4.3 Australian Offshore Petroleum Exploration Policy 4.3.1 Overview 4.3.2 Tenure 4.3.3 Transfer 4.3.4 Timing of Area Releases for Bidding 4.3.5 Transmission of Information 4.3.6 Taxation 4.4 Offshore Petroleum Exploration Policy -‐ Selected Other Countries 5 7 8 8 9 10 11 12 15 16 19 22 23 23 25 25 28 30 32 34 36 39 39 40 42 42 44 48 56 56 58 59 iii ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 5 Exploration Information Policy 5.1 External Benefits and the Public Good of Information 5.2 Asymmetric Information 5.3 Findings and Recommendations 5.3.1 Findings 5.3.2 Recommendations 6 Work-‐Bid Exploration Permit Regime 6.1 Overview of Previous Economic Assessments of Work Program Bidding 6.2 Model of Efficiency of Exploration Timing and Quantity 6.2.1 Analytical Benchmark: Unconditional Tenure and Transfer/Allocation Regime 6.2.2 Work-‐Bid Exploration Permit Regime 6.3 Implications of Risk and Uncertainty for Efficiency of Exploration Timing and Quantity 6.4 Dissipation of Resource Rent: Ex Ante Versus Ex Post 6.5 Norway's Inadvertent Amelioration of Resource Rent Dissipation 6.6 External Benefits of Exploration under Work-‐Bid Exploration Permit Regime 6.7 APPEA's Assessment of the Work-‐Bid System 6.8 Work-‐Bid Regime's Implications for Government Funding of Early-‐Stage, Broad-‐Area Exploration 6.9 Implications of Work-‐Bid Exploration Permit Regime for Development 6.10 Credibility and Administration Issues with Work-‐Bid Exploration Permit Regime 6.11 Equity Issues with Work-‐Bid Exploration Permit Regime 6.12 Reducing Resource Misallocation under Work-‐Bid Regime 6.13 Findings and Recommendations 6.13.1 Findings 6.13.2 Recommendations 7 Cash-‐Bid Exploration Permit Regime 7.1 Cash Bidding without Distorting Tenement Conditions 7.1.1 Operation of Cash Bidding as a Transfer/Allocation Mechanism 7.1.2 Arguments for Cash-‐Bidding 7.1.3 Issues with Cash Bidding 7.1.4 Auction Design 7.2 Cash Bidding with Highly Conditional Tenure 7.3 Cash Bidding as an Ex Ante Royalty 7.3.1 Assessment in the Absence of Policy and Market Failure 7.3.2 Interacting Policy and Market Failures 7.4 Cash Bidding with Petroleum Resource Rent Tax 7.5 Scope of Application of Cash Bidding 7.6 Cash Bidding Versus Royalty/Tax Rate Bidding 7.7 Findings and Recommendations 7.7.1 Findings 62 62 72 73 73 74 76 77 88 89 92 96 97 99 100 102 108 108 110 111 112 114 114 116 117 119 119 120 123 146 149 152 152 153 158 160 162 163 163 iv ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 7.7.2 Recommendations 166 8 Hybrid Work Program/Cash Bidding Regime 8.1 8.2 8.3 8.4 168 Existing Arrangements Assessment Potential Modifications Findings and Recommendations 8.4.1 Findings 8.4.2 Recommendations 168 169 171 173 173 173 9 Retention Lease Regime 174 9.1 Rationale and Arrangements 9.2 Assessment 9.3 Findings and Recommendations 9.3.1 Findings 9.3.2 Recommendations 174 174 178 178 178 10 Royalty/Taxation 180 10.1 Tenement Rentals 10.2 Petroleum Resource Rent Tax 10.2.1 Origins of Petroleum Resource Rent Tax 10.2.2 Extension of Application of PRRT 10.2.3 Assessment of PRRT 10.2.4 Treatment of Crude Oil Excise and Ad Valorem Royalty under Extended PRRT 10.2.5 Transitional Arrangements 10.2.6 Improving PRRT 10.3 Company Income Tax 10.4 Interaction of Royalty/Tax Regime and Tenement Arrangements 10.5 Findings and Recommendations 10.5.1 Findings 10.5.2 Recommendations 11 Recommended Reform Package 180 181 181 184 185 191 192 192 199 204 205 205 207 208 A Offshore Petroleum Exploration Policy Regimes -‐ Selected Countries A-‐216 B Offshore Petroleum Exploration: Quantitative Analysis B-‐230 C APPEA Responses to ACIL Tasman Questions on Offshore Petroleum Tenement and Information Policy C-‐249 D Terms of Reference: Review of Australia's Offshore Petroleum Exploration Policy D-‐269 E References E-‐270 v ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ List of boxes Box 1 Gaffney on Maximising Rent and Capturing a High Proportion of It 7 Box 2 Henry Tax Review on Charging for Petroleum and Other Mineable Resources 10 Box 3 Intervention Justified if Gains Exceed Losses 12 Box 4 Market Power Not an Issue in Domestic Gas Market 15 Box 5 Tinbergen on Interdependence of Instruments and Incompatibility of Targets 20 Box 6 ǲǳ 26 Box 7 ǯ 30 Box 8 Quasi-‐Rents from Exploration Investments 31 Box 9 Economically Efficient Timing of Exploration 33 Box 10 Alternative Case for Government Funding of B asic, Early-‐Stage, Broad-‐Area Exploration 65 Box 11 ǯ-‐Tax Scheme for Petroleum Exploration 67 Box 12 Mason Gaffney on Exploring Too Much Too Soon 79 Box 13 Herfindahl and Kneese on Exploration Subsidies or Equivalent Measures 79 Box 14 Typical Australian Conditional First-‐Come-‐First-‐Served Exploration Tenement Regime 80 Box 15 Henry Tax Review on Exploration Tenement Allocation Systems 88 Box 16 Work Program Bidding Crude Device for Addressing Information "Spillovers" Box 17 Ministerial Statement, 1985: Cash Bidding Preferred to Work Program Bidding for Highly Prospective Areas 117 Box 18 Efficiency Versus Waiting Ability 126 Box 19 How Should Reserve Prices Be Used? 129 Box 20 "Warehousing" and "Speculative" Activity Not Antisocial 140 Box 21 Sovereign Risk: Cash Bidding and Work Program Bidding 145 Box 22 Selection of Auction Systems to Suit Circumstances 148 Box 23 Fane and Smith on Rent Dissipation by Short Tenure even with Cash Bidding 150 Box 24 ǲǳon Value of Drilling Versus Waiting 152 Box 25 Fane and Smith on Retention Leases 175 Box 26 Productivity Commission on Retention Lease Policy 177 Box 27 Carry-‐Forward Rate Dilemma with Resource Rent Tax 187 Box 28 Potential Inefficiency of Borrowing from Petroleum Extraction Enterprises 197 Box 29 Reasons for Deferment of Economic Profits-‐Based Company Tax Regime 202 101 List of charts Chart 1 Analytical Framework Chart 2 Exploration Tenement and Early-‐Stage Exploration Policy Matrix 2 211 vi ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐOffshore Petroleum Exploration Policy List of figures Figure 1 Australian Policy Framework Arrangements for Offshore Petroleum Exploration and Development 43 Figure 2 Timing and Amount of Exploration with Perfect and Imperfect Tenement Arrangements 89 Figure 3 Timing and Amount of Exploration with Perfect and Imperfect Tenement Arrangements 121 Figure 4 Offshore Exploration Permits, 1985 to September 2009 B-‐231 Figure 5 Number of Exploration Companies with Equity in Offshore Exploration Permits B-‐231 Figure 6 Indicative Work Program Expenditure Committed in Offshore Exploration Permits B-‐232 Figure 7 Offshore Exploration Areas Offered and Bids Received B-‐233 Figure 8 Numbers of Offshore Exploration Permits Awarded and Take-‐up Rates B-‐234 Figure 9 Primary Bid Value Vs Tract Size, Areas of Varying Maturity, 2005 to Mid-‐2009 B-‐235 Figure 10 Primary Bid Value per km2 Vs Tract Size, Areas of Varying Maturity, 2005 to Mid-‐2009 B-‐236 Figure 11 Number of Exploration Wells Drilled B-‐237 Figure 12 Indicative Work Program Expenditure Commitments by Year of Acreage Release B-‐238 Figure 13 Offshore Petroleum Exploration Expenditure B-‐238 Figure 14 Comparison of Offshore Petroleum Exploration Expenditure with Work Program Commitments B-‐239 Figure 15 Work Programme Costs Vs Ex Post Value of Discoveries, Base Assumptions B-‐244 Figure 16 Work Programme Costs Vs Ex Post Value of Discoveries, Low Oil Price B-‐245 Figure 17 Work Programme Costs Vs Ex Post Value of Discoveries, Development Delay Sensitivity B-‐246 Figure 18 Work Programme Costs Vs Ex Ante Value of Discoveries, Base Assumptions Figure 19 Work Programme Costs Vs Ex Ante Value of Discoveries, Development Delay Sensitivity B-‐248 B-‐247 List of tables Table 1 Release of Basic, Disclosable Information 57 Table 2 ǯ B-‐241 Table 3 Australia's Offshore Petroleum Production B-‐241 Table 4 Gross Reserves Changes before Depletion B-‐241 Table 5 Estimated Gross Reserves Additions B-‐242 vii RĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǆĞĐƵƚŝǀĞ^ƵŵŵĂƌǇ Background In May 2011, the Commonwealth Government released a Strategic Review of Geoscience Australia prepared by the Department of Finance and Deregulation. Three of the Strategic Review's recommendations prompted the Department of Resources, Energy and Tourism (DRET) to engage ACIL Tasman to undertake an independent assessment of Australian offshore petroleum exploration policy. Terms of reference for the task are at Appendix D. Elements of Policy Reviewed The review focussed on five interrelated, interacting elements of offshore petroleum exploration policy:
transmission of information Ȃ addressing socially deficient availability of geological information resulting from external benefits of information "spillovers" and the public good nature of information

timing Ȃ when to release areas for exploration permit applications tenure Ȃ conditions applying to tenements or contracts in respect of the period (term) of the arrangement, amount and timing of relinquishment of territory, and exploration program timing, composition, and expenditure transfer Ȃ selection of entities to which government is to transfer (or allocate) rights to explore for, and (apply to) extract petroleum

taxation Ȃ pricing resources or capturing a share of resource rent for government. Current settings of these elements of the Australian offshore petroleum exploration policy regime are summarised in chapter 4. Corresponding settings applying in selected other countries are discussed very briefly in chapter 4 and are summarised in Appendix A. Policy Design and Assessment Principles DRET and ACIL Tasman agreed that policy instruments relating to offshore petroleum exploration should be analysed by reference to three widely accepted policy design and assessment principles. These principles are equity, minimisation departures from an efficient allocation of resources in the economy (economic efficiency) and administrative efficiency. They are explained in chapter 2. The analysis of policy instruments was undertaken having regard to:

the importance of matching policy instruments to objectives and targets the desirability of not attempting to achieve multiple targets with insufficient instruments Executive Summary viii ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ

the effects of each policy instrument on all objectives and targets, not just the one to which an instrument has been assigned the economic implications of addressing some market and policy failures without addressing others the economic implications of changing some policy settings without adjusting others the existence of constraints on use of some policy instruments for the appropriateness of deployment and settings of others. A well-‐founded premise underlying the assessment was that petroleum exploration serves an important economic function. Therefore, the review focussed on how to optimise this function with respect to the three policy assessment principles and other important considerations summarised above. Assessment Approach ACIL Tasman undertook an extensive review of the Australian and international literature relevant to the assessment of aspects of offshore exploration policy within the scope of this report. The surveyed literature is listed in Appendix E. In addition, ACIL Tasman scrutinised legislation and other government documents relating to Australia's offshore petroleum exploration policy, and consulted material on corresponding policies adopted by governments of other countries. A summary of relevant Australian policy arrangements, and a brief commentary on corresponding policy arrangements applying in selected other countries is provided in chapter 4. Appendix A expands on policy arrangements adopted by those other countries. ACIL Tasman qualitatively assessed existing Australian policy instruments by reference to the agreed policy design assessment principles, and compared Australian instruments with their counterparts in selected other countries (chapters 5-‐10). Quantitative techniques were also applied to test the validity of the qualitative assessment of the Australian work-‐bid exploration permit regime, which has been the only mechanism used to allocate/transfer Australian offshore exploration permits since 1992 (Appendix B). Potential reforms were derived by extension of the qualitative analysis of policy instruments applied in Australia and selected other countries, and from inferences drawn from consultation of the international literature. This analysis has been presented in chapters 5-‐11. This analytical derivation of reforms was based on the policy design and assessment principles described in chapter 2. Extensive consultation with members and staff of the Australian Petroleum Production and Exploration Association (APPEA) was an important aspect of the analytical process. This included verbal discussion of preliminary findings from ACIL Tasman's early analysis and responses to ACIL Tasman questions regarding key policy issues. ACIL Tasman's questions and APPEA's written responses are at Appendix C. Executive Summary ix ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Important Concept of Resource Rent The concept of resource rent is central to the economic analysis of offshore petroleum exploration policy. Since 1776, it has been a key concept in discussions of the economics of extractable, exhaustible resources and taxation thereof. Its importance for the economic analysis of tenement policy has been recognised for about 45 years. Resource rent refers to the imputed nett value of resources in situ. Typically, it is described as a residual derived by deducting from revenue all costs of exploration, assessment, development and extraction, including minimum required rates of return on capital invested in those activities. More precisely, resource rent is the maximum residual achievable in present value terms having regard to alternative technical and timing options in respect of exploration, development and extraction. If resource rent is estimated in advance of exploration and development -‐ on an ex ante basis -‐ allowance needs to be made for the risk and uncertainty (variability) associated with potential outcomes in exploration, development and extraction phases of projects. If nett value is imputed to resources in situ on the basis of realised outcomes -‐ on an ex post basis -‐ it is important to take into account the occurrence of poor as well as good realised outcomes. The concept of resource rent is discussed in some depth in chapter 3. Resource rent is the primary focus of exploration and extraction activity for petroleum and other mineable resources. It is also a major focus of government policy in respect of such activity. Enterprises seek access to prospects through licensing or contractual arrangements with governments so that they can capture resource rents. Governments, through licensing, contractual, and fiscal arrangements seek to capture the same resource rents to fund government expenditure programs and/or to divert some of the resource rents to subsidise more and earlier exploration and downstream activities. Poorly designed resource-‐access and fiscal arrangements tend to dissipate resource rent, impeding its capture by government or explorers. Policy arrangements that maximise (do not dissipate) resource rent are consistent with minimisation of departures from an efficient allocation of resources in the economy. Policy arrangements that capture a high proportion of resource rent are consistent with the benefit principle of equity and reconcilable with the ability to pay principle equity. Exploration Information Policy "Market failure" in the form of under-‐provision of the public good of information from early-‐
stage exploration and external benefits of information "spillovers" from subsequent exploration could mean exploration is undertaken too little, too late from a social perspective. Such market failure and various policy responses are discussed in chapter 5. There is a strong economic case for government funding of early-‐stage exploration and dissemination of the data, because of the public good nature of the information. This case holds in the context of cash bidding in conjunction with relatively unconditional tenure or Executive Summary x ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ with economically astute area release arrangements that withhold areas until they are "prime targets" for exploration. In the context of cash bidding, economically astute timing of area-‐releases, and eased tenure conditions, the case for government funding of early-‐stage exploration is strengthened by its capacity to improve competition and bids for exploration permits and to facilitate management of the cash bidding system by guiding timing of release of areas for bidding, setting of reserve prices, and decisions on acceptance or rejection of bids. In these circumstances, it would be appropriate to reorientate and expand the information-‐generation and interpretation roles of Geoscience Australia. In contrast, substantial reform of work-‐bid exploration permit and area-‐release regime would be required before government funding of early stage exploration and dissemination of the data could be economically justified. In the absence of major reform of that regime, continuation of government funding of early-‐stage, broad-‐area exploration should be re-‐
considered. Opinion is divided on the appropriateness of government intervention to increase the "spillover" of information from private sector exploration. One source of contention is the economic significance of exploration information "spillovers". Another issue relates to the relative merits of three alternative mechanisms for increasing information "spillovers":

work programme bidding and highly conditional tenure exploration subsidies government collection and early release of data generated by private sector explorers. Work program bidding is likely to offer the smallest stimulus to exploration where it is most justifiable economically because uncertainty is greatest and information "spillovers" are most valuable. In contrast, work program bidding provides the greatest stimulus in circumstances in which uncertainty and the value of information "spillovers" are least, and therefore the case for stimulus is weakest. Highly conditional tenure in the form of a short initial permit period and the 50 per cent relinquishment requirement on renewal would be most likely to bring-‐forward exploration in areas involving the greatest uncertainty, in which information "spillovers" would be most valuable. However, they may also be the areas in which exploration is most likely to be commercially premature, and the proportion of resource rent dissipated by high conditionality could be highest. In areas and timeframes in which exploration would be particularly premature, highly conditional tenure could discourage very early take-‐up of exploration permits, with the result that there would be no informational "spillovers". Work program bidding and highly conditional tenure can be dismissed as suitable measures for addressing information "spillovers". Moreover, the economic case for government intervention in any other form to increase information "spillovers" is undermined by highly conditional tenure and work program bidding. Positive information would increase or bring Executive Summary xi ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂtion Policy forward promised activity in relevant areas. This would tend to dissipate the value added by the information "spillovers", as well as the pre-‐existing ex ante resource rent. The analysis in this review favours government collection and early release of data generated by private sector explorers, rather than exploration subsidies. In particular, government collection and early dissemination of data provides more and better quality information than direct subsidies, avoids the economic efficiency costs of funding subsidies, and addresses asymmetric information market failure. Government funding of, and dissemination of data from early-‐stage exploration would complement government collection and early release of data generated by private sector explorers in addressing asymmetric information market failure. Arguably, a cash bidding regime would also help address this market failure. Work-‐Bid Exploration Permit Regime The work-‐bid exploration permit system and associated area-‐release arrangements applying in Australian offshore areas appear to have been designed and administered to bring-‐forward and increase exploration activity relative to outcomes based on rational commercial decision-‐
making. This has been the only exploration permit regime used in Australian offshore areas since 1992, and has been the dominant regime from enactment of the Petroleum (Submerged Lands) Act 1967 until its replacement by the Offshore Petroleum and Greenhouse Gas Storage Act 2006 and beyond. As explained in chapter 6, the work program bidding system for transfer/allocation of permits and the highly conditional tenure arrangements, in combination with premature area-‐
releases, tend to bring-‐forward exploration. The work program bidding system also tends to increase exploration outlays. This package of policy instruments acts like a subsidy to exploration activity that is marginal or sub-‐marginal because of time and location. These mechanisms misallocate resources, tending to dissipate ex ante resource rent. Therefore, they perform poorly with regard to the economic efficiency principle. They also perform poorly in terms of the administrative efficiency principle, because of the substantial administrative discretion and review of performance that characterise them. The distributional winners from work program bidding and highly conditional exploration tenure are providers of exploration and tenement administration services. The losers are shareholders of exploration enterprises and the rest of the community. Work program bidding is plagued by an inherent conflict between economic efficiency and credibility. If initial exploration downgrades an area, the program should be downgraded in the interests of efficient allocation of resources. However, relieving explorers of work-‐bid commitments would undermine the credibility of the work program bidding system. Attempting to protect the credibility of the system while reducing economic waste by careful evaluation of bids to distinguish realistic from unrealistic programs, followed by rejection of Executive Summary xii ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ unrealistic bids would increase the amount of administrative discretion and subjectivity in the bid evaluation process. In addition, it does not seem to be a viable option so long as it is administered so as to increase and bring-‐forward exploration activity from commercially preferred settings. "Good standing" arrangements have been applied in Australian offshore areas in an attempt to resolve the conflict between efficiency and credibility. However, they could reduce resource misallocation caused by work program bidding only marginally. The economic case against work program bidding and highly conditional tenure is strong in highly and weakly prospective and higher and lower risk/uncertainty areas. The analysis contradicts suggestions that it is important to replace the work-‐bid exploration permit regime only in highly prospective areas. Early release, work program bidding, and highly conditional exploration tenure arrangements designed to force the pace of exploration do not induce earlier development of resources discovered. So long as companies' flexibility is not constrained by regulation, they will develop resources when it is commercially optimal to do so, regardless of the timing of discovery. The time differences between discovery and development of petroleum resources in Australian offshore areas are consistent with the analysis of the tendency of work program bidding system, highly conditional tenure arrangements, and early area-‐releases to induce premature exploration. Data compiled by Geoscience Australia show that out of 385 offshore petroleum discoveries made between 1965 and 2009, only 83 had been brought into production. For the discoveries brought into production, the average time lag between discovery and development was 9.7 years for oil, 12.3 years for oil and gas, and 12.5 years for gas. The longest time lags between discovery and development for fields that have been brought into production were 43 years for an oil field (Legendre), 40 years for an oil and gas field (Rankin), and 29 years for a gas field (Patricia/Baleen). Moreover, there are numerous examples of discoveries made in the 1960s and 1970s that still have not been brought into production. Reform of the work-‐bid exploration permit and area-‐release regime is warranted. Minimum required reforms would involve:
re-‐prioritisation of the release program to target release of less attractive areas when they are judged to be "prime targets" for exploration
reduced conditionality of tenure to cover inadvertent premature releases because of uncertainty regarding optimal release times close scrutiny of work program bids for delayed area-‐releases to eliminate "gold plating".
These minimum reforms would increase the amount of administrative discretion and subjectivity in the bid evaluation process. Administration costs would rise because of greater Executive Summary xiii ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ required scrutiny of the size and content of work programs, as well as greater effort in determining timing of releases of areas for bidding. Another issue is that the competitive element of the transfer/allocation mechanism would be substantially reduced. Distributionally, these reforms would favour petroleum exploration and production companies to a greater extent than government, and therefore, the community. An alternative, preferred approach to reform would be to replace the current regime with cash bidding, delayed area-‐releases and/or relatively unconditional tenure. This regime would provide superior outcomes in respect of economic efficiency, administrative efficiency, and equity. An intermediate reform would substitute a hybrid allocation scheme for cash bidding. This would allocate permits on the basis of cash bids, subject to the highest bidder committing to a minimum program that is undemanding and tailored to the specific circumstances of each tenement. Cash-‐Bid Exploration Permit Regime A cash-‐bid exploration permit regime for Australian offshore areas was established in 1985 by an enabling amendment to the Petroleum (Submerged Lands) Act 1967. It was used for just a few exploration permits in the period 1985 to 1992, and has not been applied since. This regime continues to be available for deployment under the Offshore Petroleum and Greenhouse Gas Storage Act 2006. Cash bidding performs dual functions as a transfer/allocation mechanism for tenements and as an ex ante royalty/tax. Its performance of both functions rates highly in respect of economic efficiency, administrative efficiency and equity principles, as explained in chapter 7. The strong economic efficiency and equity attributes of cash bidding can be substantially offset by tenure conditions designed to advance the timing of exploration activity, combined with sub-‐optimal timing of release of areas for bids, as occurs in Australian and United States offshore areas. An explanation of this phenomenon is provided in chapter 7. While cash bidding preserves and captures ex ante resource rent, tenure conditions designed to advance the timing of exploration tend to dissipate resource rent, with the extent increasing as timing of release of areas for bidding is brought forward. This is a major flaw in the design of the cash-‐bid petroleum exploration permit regime available for deployment in Australian offshore areas and applying exclusively in United States offshore areas. Concerns that cash bidding for tenure with relatively few conditions would result in "warehousing" or "speculative" holding of tenements without activity, and that such behaviour is economically undesirable or antisocial are not supported by economic analysis. It is commercially rational and economically desirable that companies commence exploration Executive Summary xiv ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ as close as they can to the time when the immediate exploitation value of an area stops rising faster than the risk-‐adjusted opportunity cost of capital. The primary cause of a preference to hold a tenement without activity is release of areas before they are "ripe" for exploration. Premature release extinguishes the real option value of waiting otherwise available to the community through government. That real option value would be captured by explorers. The appropriate policy response is to release areas for bidding only when they are "ripe" for exploration. The cost of the extra analysis required to make releases at the "right" time from an economic perspective should be much less than the economic waste of resource misallocation and associated dissipation of ex ante resource rent caused by the combination of premature releases, work program bidding, and highly conditional tenure. In the context of cash bidding for relatively unconditional tenure, "market failure" in the form of under-‐provision of the public good of information from early-‐stage exploration and external benefits of information "spillovers" from subsequent exploration could mean exploration is undertaken too little, too late from a social perspective. The best methods of addressing these market failures are government funding of generation and dissemination of data from early-‐stage exploration, and government collection of exploration data from explorers and early release of that data to interested parties. Such exploration information policies are important complements to cash bidding. They facilitate sound decision-‐making regarding timing of releases of areas for bidding, which would limit "warehousing" of permits without activity. They also provide a b asis for setting of reserve prices, and rejection of bids, which are important devices for improving competition and reducing collusion. Effectively, the combination of these mechanisms and government information generation and collection activities inject the government into the auction process as a more informed back-‐stop bidder, which increases competition. In addition, these information policies reduce uncertainty for bidders and reduce information asymmetries, encouraging more bidding overall. The increase in competition and bids for areas offering more promise is likely to more than offset results of reduced interest in areas offering less promise. A common assertion by individuals in administering authorities and petroleum exploration and extraction enterprises is that exploration activity would fall under a cash bidding regime. The most commonly asserted reason is that payment of cash bids would leave less funding available for exploration. These assertions relate to changes relative to activity, the timing, quantity and location of which is effectively heavily subsidised. They ignore the important point that most of the change would be deferment, not reduction of exploration activity, and they reason on the basis of implausible assumptions of irrational corporate budgeting and adverse effects on capital accumulation. They also ignore the positive effects on exploration of reforms to exploration information policy and the ex post royalty/tax regime that logically would accompany tenement policy reform. Executive Summary xv ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Claims that cash bidding would erect a participation-‐deterring barrier to smaller firms and a consequent impediment to competition, not present in the case of work program bidding, are not supported by economic analysis. Reasons include the greater magnitude of work program bids than cash bids, joint bidding opportunities, experience in United States offshore areas, variability of bids with prospectivity or attractiveness of areas, and the proposed greater length and security of tenure of cash-‐bid permits, which would provide a better foundation for capital raising, than under work program bidding. In any event, perceived adverse effects of cash bidding on participation by small companies, and competition for permits, could be addressed by deferment of payments. One option would be to allow payment of cash-‐bid amounts over time with interest at a rate consistent with the risk-‐adjusted opportunity cost of large, diversified companies. This is not the preferred option. Another option would be to substitute petroleum resource rent tax rate bidding for cash bidding. Intermediate options would include adjusting royalty/tax arrangements applying to realised outcomes to change the up-‐front and outcome-‐related proportions of government revenue from petroleum exploitation. Cash bidding and a royalty/tax on realised resource rent, such as the petroleum resource rent tax, would complement each other in other ways. The presence of the petroleum resource rent tax would ameliorate "sovereign risk" concerns that might arise if cash bidding was the primary mechanism for government capture of resource rent. In addition, the tax system applying to realised resource rent could be adjusted to change the up-‐front and outcome-‐
related proportions of government revenue from petroleum exploitation to deal with concerns about disadvantage to smaller companies under cash bidding and consequent effects on competition. Cash bidding allows government capture of more resource rent without having to increase the tax rate or broaden the tax base, which would add to deadweight loss or adverse effects on resource allocation. While resource rent tax rate bidding would avoid a possible participation-‐deterring barrier to smaller firms associated with cash bidding, it would raise the ex post royalty/tax compared to a combination of cash bidding and petroleum resource rent tax. The ex post tax increase would increase the asymmetry of treatment of gains and losses under the petroleum resource rent tax, with a consequent increase in deadweight loss. In addition, differing tax rates for different projects would create difficulties in administration of the tax, because of a tax avoidance loophole in the context of transferability of exploration expenditures between projects within a company. Hybrid Work Program/Cash Bidding Regime Various parties have suggested that a hybrid work program/cash bidding system could be used to transfer/allocate offshore Australian petroleum exploration permits, instead of work program bidding or cash bidding. Some have perceived a hybrid system as a compromise between economists' strong advocacy for cash bidding, and exploration managers' and government technical advisers' strong preference for work program bidding. Others, such as Executive Summary xvi ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞtroleum Exploration Policy the Commonwealth Department of Finance and Deregulation in its Strategic Review of Geoscience Australia, have taken the view that neither work program bidding nor cash bidding is suitable in all circumstances, providing scope for a hybrid system. The Offshore Petroleum and Greenhouse Gas Storage Act 2006 (the Act) provides that a hybrid work program/cash bidding regime may be used to transfer/allocate a special petroleum exploration permit or a petroleum production licence over blocks from a surrendered, cancelled, or terminated petroleum production licence, retention lease or exploration permit, in which the administering authority considers there is petroleum. This mechanism has never been used to allocate a petroleum production licence in Australian offshore areas. It has been used only once to allocate a special petroleum exploration permit, over an area off the Victorian coast in 1986. This review assessed the hybrid concept not just in the particular circumstances described in the Act, but as a more general allocation mechanism that might be used instead of work program bidding and cash bidding. There is a very wide range of hybrid possibilities between the extremes of cash bidding and work program bidding. Indicative variations of the concept were considered. Under the hybrid system specified in the Act, the administering authority has discretion regarding relative weighting of cash bidding and work program bidding elements of the hybrid mechanism. The Act does not provide guidance on this matter. An administrative decision could be taken to adopt a transfer/allocation mechanism anywhere on the cash-‐bid to work-‐bid spectrum, including one end or the other. An intermediate arrangement would involve rejecting bids offering a work program judged to be inferior to some selected benchmark and then choosing the successful application from those above the benchmark on the basis of cash bids. The discretion in respect of relative weighting of work program and cash bidding in the hybrid system specified in the Act would allow variations in relative weightings from case to case. This provides the administering authority with considerable flexibility in tailoring the system to particular circumstances. However, this flexibility means sacrifice of transparency. The work program element of the hybrid regime also is inconsistent with transparency. A hybrid work program/cash bidding system is inferior to cash bidding in respect of economic efficiency, administrative efficiency and equity principles. The work program bidding element of the hybrid system would detract from the performance of the system in respect of these principles. While a hybrid system would result in less resource rent dissipation than a pure work program bidding system, this would occur only because the capture of some of the ex ante resource rent by the cash bidding element of the hybrid system would leave less for the work program element to dissipate. The performance issues of the hybrid system would be exacerbated by the high degree of conditionality of exploration permits subject to allocation/transfer. Executive Summary xvii ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ While the hybrid system broadly outlined in the Act involves more discretion and even less transparency than work program bidding, it could be modified administratively to be less subjective and discretionary, and more transparent than work program bidding. This would require that a minimum work program be specified for each area in advance of its release for offers. Such a system would be superior to work program bidding on the basis of economic efficiency, administrative efficiency and equity principles. The smaller is the minimum work program, the closer its performance would be to cash bidding with respect to these criteria. The only defensible reason for adopting a hybrid system as a general transfer/allocation mechanism would be policy pragmatism. A hybrid system involving specification of minimum work programs could be useful in gaining acceptance for a transition from work program bidding to cash bidding as the main device for allocating exploration permits. This could reduce concern in some parts of government and the petroleum exploration and extraction sector to departure from tradition and protection of vested interests of system administrators and providers of services to exploration. Retention Lease Regime Creation of petroleum retention leases in 1985 by an amendment to the Petroleum (Submerged Lands) Act 1967 provided discoverers of sub-‐commercial resources with a form of post-‐discovery tenure over those resources. As explained in chapter 9, this strengthened the capacity of work program bidding and highly conditional exploration tenure to induce too much exploration, too soon and in the process, dissipate ex ante resource rent. In the absence of retention leases, this capacity would be diminished as it would be much more difficult to retain tenure over sub-‐commercial resources. The retention lease system could also dissipate resource rent directly by requiring additional premature exploration and assessment activity and creating pressure to advance development. This is discussed in chapter 9. Proposals that retention lease conditions be tightened to force earlier development would counteract the tendency of work program bidding and highly conditional exploration tenure to cause too much exploration, too soon. However, such changes would cause resource rent dissipation in the case of already discovered resources, and discourage future exploration for other resources, which would reduce future investment. In the context of cash bidding with relatively unconditional tenure, a retention lease system that is not conditioned to force premature development and/or increase and bring forward exploration activity would perform an important economic function providing secure tenure over discoveries inadvertently discovered prematurely. However, in the context of work program bidding and highly conditional tenure, such a retention lease system would yield perverse outcomes. Executive Summary xviii ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Royalty/Taxation The Australian Government has used multiple policy instruments to charge a price for access to offshore petroleum resources:

ex ante royalties through cash bids for exploration permits (not used for 20 years) de facto royalties in the form of the petroleum resource rent tax (implemented in 1985 and extended to cover North West Shelf petroleum from July 2012)
ad valorem well-‐head value royalties on North West Shelf petroleum (credited against petroleum resource rent tax liability from July 2012)
crude oil excise, a de facto royalty on North West Shelf petroleum liquids (credited against petroleum resource rent tax liability from July 2012)
company income tax applying to companies in all economic sectors (46 per cent in the early 1980s and to be cut from 30 per cent to 29 per cent from 2013-‐14). These instruments comprise the pricing element of a petroleum resources "sale" package. The item for "sale" is framed by tenure arrangements defining exploration and extraction rights, including conditions attaching to those rights. The "sale" process is conducted via a transfer or allocation mechanism. The charging or pricing mechanisms should not be considered separately from other elements of the "sale" package, because there are important interactions between the charging or pricing arrangements and transfer/allocation and tenure arrangements. Reform of any element should take into account the implications of the change for the performance of other elements. Gains from reform of each element would be greatest in the context of simultaneous reform of the other. The recent extension of coverage of the petroleum resource rent tax is a step in the right direction from the perspective of the principles of economic efficiency and equity. The petroleum resource rent tax system exempts returns to all inputs from the tax base, unlike the valorem well head value royalty and the crude oil excise which tax returns to all inputs upstream from the taxing point, and the company income tax regime which does not exempt returns to equity (an important cost) from the tax base. This means the petroleum resource rent tax can capture more of the resource rent for the community with less economic damage or deadweight loss. Nevertheless, the performance of the petroleum resource rent tax in terms of economic efficiency and equity could be improved, as discussed in chapter 10. However, the benefits of these reforms could be undone by the work-‐bid exploration permit regime comprising work program bidding and highly conditional tenure, as explained in chapters 6 and 10. The petroleum resource rent tax could be made more efficient by provision of better loss offset arrangements. One option would be provision of same-‐period rebates at the tax rate for exploration expenditure prior to issue of a production licence. More ambitious options would be provision of effective full loss offsets through a Fane-‐Smith resource rent tax or an Allowance for Corporate Capital (ACC) tax. The most radical option would be to move to a Executive Summary xix ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ "real" cash flow or Brown tax system providing same period rebates for all negative cash flows at the tax rate. These tax systems are described in chapter 10. All of these reforms would reduce tax-‐created disincentives to explore and consequent resource rent dissipation. They would also reduce administration and compliance costs by simplifying arrangements for carrying-‐forward negative cash flows with interest. However, the asymmetric treatment of exploration gains and losses under the existing petroleum resource rent tax (reflecting limited loss offsets) helps to limit resource rent dissipation by work program bidding and highly conditional tenure. Undertaking tax reform to reduce disincentives to explore and consequent rent dissipation would facilitate greater rent dissipation by the work-‐bid exploration permit regime. Of course, it would make no sense to eschew improvements to the petroleum resource rent to reduce efficiency and revenue losses from the work-‐bid exploration permit regime. That would sacrifice potential efficiency and revenue gains. The best option by far would be simultaneous reform of both the petroleum resource rent tax system and the tenement regime. Indeed, this simultaneous reform should include reform of the company income tax system, involving improved loss offset arrangements, particularly in respect of exploration expenditures, and lower or zero taxation of "normal" returns to equity capital. Again, it would make no sense to eschew company tax improvements, with consequent efficiency, revenue and distributional gains, just to constrain efficiency and revenue losses caused by the tenement regime. The petroleum resource rent tax, company income tax, and improved versions of these taxes complement cash bidding, as discussed in chapters 7 and 10. The presence of taxes capturing shares of realised resource rent-‐would ameliorate "sovereign risk" concerns that might arise if cash bidding was the primary mechanism for government capture of resource rent. Meanwhile, cash bidding would allow government capture of more resource rent without having to increase the rate of tax on resource rent or broaden the tax base, which would add to the deadweight loss of adverse effects on resource allocation. There are two problems with transition arrangements for extension of the petroleum resource rent tax to North West Shelf petroleum. Crediting arrangements for the ad valorem royalty and crude oil excise mean that the adverse effects of those systems on marginal activity would remain. Deductibility of the market value of assets as at 1 May 2010 would confine the petroleum resource rent tax base to growth in nett value of resources between 1 May 2010 and the time of extraction. Executive Summary xx ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Recommended Reform Package Exploration Tenement Reform The preferred (first-‐best) exploration tenement reform would be to replace the current work-‐
bid and area-‐release regime with:
cash bidding

eased tenure conditions timing of release of areas based on greater analysis of the interaction and combined effects of geoscience considerations, anticipated access to infrastructure, current technologies and anticipated advances, the petroleum price outlook and underlying economic circumstances. The extent of the reduction in conditionality of tenure could be traded-‐off against deferment of release of areas for bidding. The more that release of less attractive areas is delayed, the less important would be the reduction in conditionality of tenure. A third-‐best exploration tenement reform would depart from the preferred reform package by allocation of permits on the basis of a particular hybrid system, rather than cash bidding. This particular hybrid system would determine which entity is granted a permit on the basis of cash bids, subject to the highest bidder committing to an undemanding, tailored minimum work program. Other elements of the third-‐best exploration tenement reform would be the same as the preferred reform. The minimum (fourth-‐best) set of exploration tenement reforms would involve:
delay of release of less attractive areas until they are judged to be "prime targets" for exploration
reduced conditionality of tenure
close scrutiny of work program bids for delayed area-‐releases to eliminate overbidding. The only defensible reason for substituting the third-‐best reform for the preferred (first-‐best) would be policy pragmatism. A hybrid system involving specification of minimum work programs could be useful in gaining acceptance for a transition from work program bidding to cash bidding as the main device for allocating exploration permits. This could reduce concern in some parts of government and the petroleum exploration and extraction sector to departure from tradition and protection of vested interests of system administrators and providers of services to exploration. Similarly, the only defensible justification for adopting the fourth-‐best reform would be to improve acceptance of the reforms by introducing an extra transition step between the current work-‐bid exploration permit regime and the preferred exploration tenement reform. This step would be taken prior to replacement of work program bidding with the particular hybrid system forming part of the third-‐best exploration tenement reform. Executive Summary xxi Review of AustrĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Each of these exploration tenement reform options would require legislative and administrative changes. These vary between options, as discussed in chapter 11. Variations on these options could be derived by applying different permit transfer/allocation systems in different circumstances. The location and timing of early-‐stage exploration activities of Geoscience Australia would also be determined by these circumstances. An illustration of such a reform option is provided by the two-‐dimensional matrix in Chart ES 1. The vertical axis labelled "Prospectivity" could represent the composite effect of geology, potential deposit size, water depth, available technologies, infrastructure availability, access to markets, other geographical considerations, and petroleum price expectations. The horizontal axis labelled "Current Knowledge Level" could represent what is known about an area. Obviously the factors represented by the two axes are partly interrelated. Therefore, "low" knowledge should be interpreted as little information beyond basic, relevant information that would facilitate a judgment on "prospectivity". Chart ES 1 Exploration Tenement and Early-‐Stage Exploration Policy Matrix High
Hybrid Bid
Prospectivity
Cash Bid
Cash Bid
GA Pre-‐
Cash or Hybrid Bid
competitive/ NERL
Cash Bid
Deferred GA Pre-‐
GA Pre-‐
competitive/ NERL competitive/ NERL
Hybrid Bid
Low
Low
High
Current Knowledge Level
* NERL = Non Exclusive Reconnaissance License
Source: ACIL Tasman. Executive Summary xxii ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The exploration tenement and information policy package depicted by Chart ES1 includes an exploration tenement policy that falls between the preferred (first-‐best) and third-‐best exploration tenement options. The second-‐best reform option depicted in Chart ES1 also includes pre-‐competitive or early-‐stage exploration by Geoscience Australia. Other defensible versions of the second-‐best reform option could be formulated. In the second-‐best reform, the package of cash bidding, delayed release of less attractive areas, and eased tenure conditions (first-‐best exploration tenement policy) would be applied only in areas displaying favourable combinations of prospectivity and current knowledge. A hybrid allocation system in which cash bids would determine which entity is granted a permit, subject to the highest bidder committing to an undemanding, tailored minimum program, would be substituted for cash bidding in the package in areas displaying high prospectivity and low knowledge or high knowledge and low prospectivity. In the case of moderate prospectivity and moderate knowledge, either the package including cash bidding or the package including a specific hybrid allocation system could be deployed. In areas characterised by moderate prospectivity and low knowledge, moderate knowledge and low prospectivity, or low prospectivity and low knowledge, neither the cash bidding nor hybrid packages would be used. In the first and second of these less favourable cases, Geoscience Australia could undertake early-‐stage exploration. In the meantime, these areas would not be released for bidding, but petroleum special prospecting authorities (non-‐
exclusive reconnaissance licences) could be made available to interested parties, perhaps for a longer term than the current maximum of 180 days. In areas characterised by low prospectivity and low knowledge, it would be very difficult to formulate an economic case for Geoscience Australia to undertake early-‐stage exploration. Such activity should be deferred pending a change in circumstances. However, petroleum special prospecting authorities might be issued to interested parties. In contrast, under the preferred (first-‐best) exploration tenement policy, cash bidding would be deployed in all cases depicted by shaded boxes (not just the dark shaded boxes). Under the third-‐best exploration tenement policy, the proposed hybrid system would be deployed exclusively in all cases depicted by shaded boxes. Retention Lease Reform It is recommended that the retention lease system be modified to eliminate requirements and pressures to undertake premature exploration, assessment, and development activities. This should be undertaken simultaneously with reform of exploration permit allocation, tenure, and area-‐release arrangements. Retention lease reform should include revision of the commercial viability test so that it could ascertain whether or not the immediate exploitation value of the discovered resource has stopped rising faster than the relevant risk-‐adjusted opportunity cost of capital, not just whether or not that value is positive. Executive Summary xxiii ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Impediments to voluntary, mutually beneficial transfers of exploration permits and retention leases should be identified and removed, because they impede transfer of title over a discovery to a party more interested in early development. This should include removal of registration fees for transfers of, and dealings in tenements. Exploration Information Policy Reform Exploration information programs are potentially important complements to first, second, third, and fourth-‐best exploration tenement and area-‐release systems. Both the early-‐stage exploration work undertaken by Geoscience Australia, and the private exploration data collection, repository and release functions defined by the Act and managed by Geoscience Australia are potentially highly desirable functions from an economic perspective. They are particularly valuable in the context of the preferred (first-‐best) tenement and area-‐release regime involving cash bidding. If a decision is taken to adopt cash bidding as the primary transfer/allocation system for Australia offshore petroleum exploration permits, and to eliminate or substantially ease tenure conditions that force the pace of exploration, or if a decision is taken to transition to such a regime by adopting the second-‐best exploration tenement policy, the exploration information-‐generation and interpretation roles of Geoscience Australia should be expanded. In addition, provision should be made for more and re-‐oriented analytical effort by Geoscience Australia and the Department's economic advisers to determine the timing and location of releases of areas for bidding. Analysis of appropriate settings for reserve prices for cash bids, and whether or not to reject any or all bids should replace assessments linked to the work-‐bid exploration permit regime. If a decision is taken to retain the current work program bidding and highly conditional tenure arrangements, the extent and focus of government funding of early-‐stage exploration should be re-‐assessed, because the potential benefits of the early-‐stage exploration program of Geoscience Australia tend to be dissipated by the current tenement regime. Exploration information generated by titleholders should be released earlier than allowed at present to improve the policy response to information "market failures", and to encourage more competition under a cash bidding regime. Data releases should be no later than one year from acquisition in the case of basic exclusive data, no later than two years from completion of an operation in the case of interpretative data, and no later than 10 years from completion of an operation in the case of non-‐exclusive data. Royalty/Taxation Reform While the current government plan to extend coverage of the petroleum resource rent tax and reduce the rate of company income tax are steps in the right direction, both tax regimes could be improved. Changes to the two tax systems should be focused on improving the extent of loss offsets and on other changes to reduce taxation on "normal" returns to capital, without Executive Summary xxiv ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ reducing the combined rate of tax on realised resource rent. These improvements should be made at the same time as the recommended changes to the tenement regime. The minimum recommended reform to the petroleum resource rent tax is provision of same-‐
period rebates at the tax rate for exploration expenditure prior to issue of a production licence. This would be an important step towards the economic ideal of a "real" cash flow tax, and a compromise between that system and the current petroleum resource rent tax. The minimum recommended reform to the company tax regime is provision of same-‐period rebates at the tax rate for exploration expenditure. If further steps are taken towards reducing the tax rate to the Henry Tax Review's recommended interim reform rate of 25 per cent (below the rate of 29 per cent already proposed by the Commonwealth government), these steps should be accompanied by increases in the petroleum resource rent tax rate to maintain the current combined tax rate at 58 per cent on realised resource rent. The petroleum resource rent tax rate would rise to 44 per cent when the company income tax rate drops to 25 per cent. Simultaneous Reform Each element of offshore petroleum exploration policy should not be considered separately from various other elements of the policy package, because there are important interactions between them. Reform of any element should take into account the implications of the change for the performance of other elements. Ad hoc reforms would be unwise. Cherry-‐picking of reform proposals in this review would be fraught with economic danger, because of the important interactions of policy instruments documented in the analysis presented. Piecemeal reforms undertaken without allowance for these interactions could lead to perverse outcomes. The various reforms proposed in this review should be undertaken simultaneously, as parts of a complementary package. Each reform has been designed in the context of the others. Gains from reform of each element would be greatest in the context of simultaneous, complementary reform of the others. Executive Summary xxv ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 1
/ŶƚƌŽĚƵĐƚŝŽŶ In May 2011, the Commonwealth Government released a Strategic Review of Geoscience Australia prepared by the Department of Finance and Deregulation. The Strategic Review included 11 recommendations regarding the future role of Geoscience Australia (GA) and offshore petroleum exploration policy. Three of the recommendations prompted the Department of Resources, Energy and Tourism (DRET) to commission an independent economic assessment of offshore petroleum exploration policy. Those recommendations were (Commonwealth Department of Finance and Deregulation, 2011, pp. xv, xvii, 44, 45, 110): "Recommendation 1: The (Strategic) Review (of Geoscience Australia) recommends that DRET review current policy and legislative arrangements for determining the selection, size and terms for release of offshore exploration acreage. The DRET review should examine whether the current policy represents the optimum strategy for facilitating exploration, as well as how alternative policies affect the business case for further government investment in pre-‐competitive information." "Recommendation 2 : Subject to any chan
ǯ
system for release of offshore exploration permits, the Review recommends that DRET and GA prepare for consideration in the 2012-‐13 budget context a submission to Government on funding continued investment in pre-‐competitive information, including ongoing management of data and data access." "Recommendation 11: As part of Recommendation 1, the Review recommends that DRET consider reintroducing cash bidding, or introducing hybrid cash/work program bidding arrangements for release of exploration acreage in offshore regions that already have demonstrated resource potential from commercial exploration or production." In July 2011, DRET engaged ACIL Tasman to undertake an independent review of Australian offshore petroleum exploration policy. Terms of reference for the review are at Appendix D. At the beginning of the review, it was agreed that existing and alternative policies relating to offshore petroleum exploration should be analysed by reference to three widely accepted policy assessment principles that have been applied in numerous policy reviews undertaken for the Commonwealth Government over the past 40 years. These principles are equity, economic efficiency and administrative efficiency. An underlying premise of the review was that petroleum exploration serves an important economic function. ACIL Tasman considers that this premise is well-‐founded.1 Therefore, the review was focussed on how this valuable economic function could be optimised by reference to the three policy assessment principles. 1 See ACIL Tasman (2010). Introduction 1 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞ Petroleum Exploration Policy Chart 1 Analytical Framework OVERARCHING POLICY ASSESSMENT CRITERIA
Intra-‐ and Inter-‐generational Equity
Frontier
Administrative Efficiency
Economic Efficiency
Immature
Mature
Submature
ATTRIBUTES and CONSIDERATIONS
TARGET AREAS
Geological Prospectivity
Non-‐exclusive reconnaissance license
Location/ water depth
Perceived Exploration Risk
Data Availability
Exploration Permit
Proximity to Infrastructure
Retention Lease
Production Licence
Transfer Rights
Relinquishment triggers
FORM OF TITLE
ATTRIBUTES and CONSIDERATIONS
Term, security
Conditions
Holding cost
First come, first served
Work Program Bid
Hybrid
Cash Bid
ATTRIBUTES and CONSIDERATIONS
ALLOCATION/ TRANSFER MECHANISM
DATA GENERATION AND MANAGEMENT
Triggers for release of areas
Level of Administrative Discretion
Government Pre-‐
competitive
Commercial multi-‐client studies
Impact on Investment Decisions
. Timing
. Quantum
. Composition
. Location
Flexibility to respond to new information
Titleholder generated
ATTRIBUTES and CONSIDERATIONS
Quantity
Quality
Ownership/ exclusivity
Availability
Release timing
Holding Costs
Acquisition Costs
RESOURCE VALUE SHARING
. Rental fees
. Work program commitments
Tax/Royalty Payments
ATTRIBUTES and CONSIDERATIONS
Intra-‐ and Inter-‐
generational Equity
Economic Efficiency
Administrative Efficiency
Source: ACIL Tasman. Introduction 2 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ACIL Tasman's review team commenced the analytical process with an extensive review of relevant Australian and international literature (see Appendix E), a detailed review of legislation and other documents relating to Australia's policy, and consideration of corresponding policies adopted by governments of other countries (summary at Appendix A). After analysing the available material and identification of key issues and concepts, by reference to the assessment principles, an analytical framework was formulated. It is depicted in Chart 1. Key issues, concepts and policy alternatives were identified and analysed qualitatively by reference to the agreed assessment principles. This analysis is presented in chapters 5-‐10. In addition, quantitative tools were used to analyse the resource allocation effects of the work-‐
bid petroleum exploration permit regime applying in Australian offshore areas. This analysis appears in Appendix B. Potential reforms were derived by extension of the qualitative analysis and from the reviews of the international literature and the offshore policy regimes of selected other countries, having, regard to the assessment principles (chapters 5-‐11). An important part of the analytical process was extensive consultation with members and staff of the Australian Petroleum Production and Exploration Association (APPEA). This included several hours of discussion with staff and representatives of member companies. Much of this discussion was conducted in two group sessions. Representatives of DRET also attended. The first session focussed on initial observations by ACIL Tasman drawn from the literature review and preliminary policy analysis. The second session focussed on questions formulated by ACIL Tasman to elicit input from APPEA member companies on key policy issues. Subsequently, APPEA provided written responses to the questions. APPEA also provided other pertinent comments (see Appendix C). APPEA's points are discussed in the body of this report. The review focussed on five interrelated, interacting elements of offshore petroleum exploration policy:

improving the distribution of income and wealth (intra-‐ and inter-‐generational equity) improving the efficiency of allocation of resources in the economy (economic efficiency) keeping administration costs to government and economic entities as low as possible consistent with equity and economic efficiency objectives (administrative efficiency, sometimes referred to as simplicity). These criteria have become widely accepted by economists, political analysts and governments around the world as broad policy objectives and/or principles to guide design and assessment of policy proposals and instruments (Musgrave, 1959; Stiglitz, 2000). The origins of these principles can be traced back at least 235 years to Adam Smith (1776). In Australia, since the early 1970s, equity, economic efficiency, and administrative efficiency/simplicity have been used as core policy design and assessment principles in reviews or analyses of a range of important policy issues. These reviews have been undertaken by federal and state governments, the Productivity Commission (including its predecessors), independent committees of inquiry, and economic analysts. A pertinent example is that, in the early 1980s, the Commonwealth Government applied equity, economic efficiency, and administrative efficiency/simplicity criteria in a comparative assessment of work program bidding and cash bidding prior to a decision to provide for cash ǲǳȋǡͳͻͺͷȌǤ
ȋ Ȍ ǯ
criteria to assess alternative tenement allocation and management systems and alternative taxation and royalty arrangements in a review of mining and minerals processing policy in Australia in 1991 (Industry Commission, 1991). In recent years, equity, economic efficiency, and administrative efficiency/simplicity principles have provided a foundation for several major policy reviews. For example, these ǯȋʹͲͲͻȌǡ

ǯȋʹͲͲͺȌ Carbon Pollution Reduction Scheme White Paper, and a Productivity Commission (2009) review of the regulatory burden on the petroleum extraction Ǥ ǯ
regulatory best practice (Office of Best Practice Regulation, 2007) and very similar guidelines agreed by COAG (2007). Policy Design and Assessment Principles 5 ReviĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The terms of reference for the Henry Tax Review, which included analysis of exploration and mining (including petroleum extraction) tenement regimes, specified (Henry, others, 2009, Part 1, p. vii): ǲ ǡ
(horizontal, vertical and intergenerational), and minimise complexity for taxpayers and the Ǥǳ ǯe petroleum strategy, published in April 1999 (Commonwealth Department of Industry, Science and Resources, 1999), specified the following objective: ǲ
ǳǤ This objective is consistent with principles of equity, economic efficiency, and administrative efficiency. The current statement of purpose of the Department of Resources, Energy and Tourism ȋȌǲǯǳǤ
consistent with principles of equity, economic efficiency, and administrative efficiency/simplicity. ǯ ǡ ǲǳǡ
ǡ ǲ is committed to creating a policy framework to expand Australia's resource base, increase the international competitiveness of our resources sector and improve the regulatory regime, consistent with the principles of environmental responsibility and susta Ǥǳ ǲ ǯ
ǳ ould ǲ ǯ ǳ
improved the efficiency of allocation of resources, thereby avoiding dissipation of resource rent (imputed nett value of resources in situ), and captured a high proportion of resource rent, particularly resource rent that would otherwise flow overseas. It is noted that the Commonwealth Department of Finance and Deregulation (2011) relied on improving the efficiency of resource allocation as its primary assessment criterion in its Strategic Review of Geoscience Australia. Some analysts have supplemented the core principles of equity, economic efficiency, and administrative efficiency with others. For example, the Henry Tax Review added fiscal sustainability, comprising revenue adequacy, durability, and flexibility, as a multi-‐faceted principle for tax reform (Henry et al, 2009). Stiglitz (2000) added flexibility as a criterion for assessing tax systems. The Commonwealth Office of Best Practice Regulation (2007) also added flexibility as a criterion for assessing regulatory policy instruments. Generally, however, criteria such as revenue adequacy, and flexibility are perceived to be aspects of other criteria. Policy Design and Assessment Principles 6 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 2.2
Re-‐statement of Criteria in Context of Exploration Licensing Policy Economic analyses of licensing, royalty and taxation policy for exploration and mining (including petroleum extraction) have often proposed an aspect or version of the principles of equity, economic efficiency, and administrative efficiency that is specific to exploration and mining (including petroleum extraction). This version is along the lines of: maximise resource rent and capture a high proportion of it. Examples of such a specification have been provided in:
a thought-‐provoking analysis of objectives of government policy for exploration licensing (brief excerpts in Box 1) by Mason Gaffney (1977a), an eminent specialist in the economics of land and mineable resources exploration and extraction
a detailed analysis of petroleum and coal exploration licensing policy for areas containing resources owned by the United States that was undertaken by petroleum economics and policy specialist Stephen McDonald (1979) an analytical overview of natural resource disposition systems by petroleum resource economics specialist Arlon Tussing (1984)

a substantial report on mining and minerals processing policy in Australia by the Industry Commission (1991)
a review of alternative tenement allocation systems by Walter Mead (1994), a prominent cash bidding proponent a World Bank review of petroleum tenement policies undertaken by Silvana Tordo and David and Daniel Johnston (2010).
The concept of resource rent has been briefly outlined in Box 1. It has been discussed in some depth in chapter 3. Box 1 Gaffney on Maximising Rent and Capturing a High Proportion of It ǲǤǤǤȋȌǡollect it. Rent is by definition a surplus above the return required to motivate production. It is equally well-‐defined as the return imputed to land. In either concept it is essentially the fat without the lean. The less of the lean one cuts into by clumsiness, the more of the fat he can secure without Ǥǳ ǲǮǯǤǡǡctive is to maximise the present value of nett land income over time, not the rent of any one year. With minerals (including petroleum) especially, timing is of the essence Ȃ not just when to produce, but also when to explore, when to begin, how fast to produce, and when to stop. Second, there must be a rent base, which presupposes public investment in infrastructure and private and/or public ǤǤǤǤǤǤǤǤǤǤǡǤǳ Source: Gaffney (1977a), pp. 5, 4. ǲǳ
to exploration for and extraction of mineable resources (including petroleum). Government Policy Design and Assessment Principles 7 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǲ ǳ cation of the benefit principle of equity to the government issue of rights to explore for and extract resources. The principle of improving the allocation of resources has been discussed in section 2.4. The benefit principle has been explained in sub-‐section 2.3.2. 2.3
Principles of Equity The literature relating to the economics of taxation and public expenditure, including various reviews of the Australian taxation system, has typically focused on two widely accepted concepts of intra-‐generational equiǤ ǲǳ
ǲǳǤ ǯȋͳ͹͹͸Ȍ
of taxation, and to earlier political and social philosophers. Richard Musgrave (1959) explained that the ability to pay approach had its origins in the sixteenth century and the benefit principle originated in the seventeenth century. Historically, the economics literature has focused mainly on intra-‐generational equity. Inter-‐
generational equity issues received comparatively little attention until the past 20 years. During this period, the concept of sustainable development or sustainability was popularised and climate change attracted increasing interest and concern. These occurrences resulted in greatly increased interest in inter-‐generational equity issues. 2.3.1
Ability to Pay Principle The ability to pay principle indicates that individuals should contribute to the cost of ǲǳǤ This principle has two dimensions:
horizontal equity Ȃ equal contributions from individuals having the same ability to pay
vertical equity Ȃ higher contributions from individuals having higher capacities to pay. The ability to pay principle is widely ǯ -‐distributive function, and as a guide for distributing the burden of funding the high proportion of government facilities and services for which application of user-‐charges is considered inappropriate. However, interpretations of ability to pay and views on how it should be applied differ greatly. In addition, measurement problems are formidable. The ability to pay concept is meant to relate to equity between people, not business entities. In addition, it is intended to apply to taxation, welfare and government expenditure policy as a whole, rather than to particular imposts and expenditure items. Consistent with this view, it is normal for governments to use income tax, transfers and expenditure policies to compensate for perceived inequities arising from the incidence of indirect taxes (such as GST and fuel tax) and user charges. Policy Design and Assessment Principles 8 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ If, despite these principles, government desired to consider transfers of exploration and extraction rights in an ability to pay frǡ ǲ ǳ
economic surplus above all costs, including finding and assessment costs and the cost of capital. Then, the ability to pay approach would indicate that enterprises with different economic surpluses from extraction activities should pay different amounts of royalty or tax-‐
price (vertical equity) and those with the same surplus should pay the same amount (horizontal equity). Unless there are unpaid returns to ability included in economic surpluses, such an appǲǳ-‐price regime as the benefit principle discussed in the next sub-‐section. That regime would target resource rent or the imputed nett value of the resource in situ. 2.3.2
Benefit Principle The benefit principle of equity is that people should contribute to the cost of government activities in accordance with the benefits they receive. The benefit principle is underpinned by the concept of allocation of supply through prices, rather than reliance on inefficient mechanisms, such as administrative allocation or rationing by queuing. Therefore, it tends to be consistent with economic efficiency. This is an important advantage of the benefit principle over the ability to pay approach. A disadvantage of the benefit principle is that, in general, it is not useful as a guide for the re-‐
distributive role of government. This function is the strength of the ability to pay principle. General benefit taxation is of interest mainly from a theoretical perspective. In contrast, specific benefit taxes are potentially applicable in practice in cases in which benefits of goods and services can be imputed to, and internalised by specific users, and there is rivalry for those benefits. In those circumstances, the benefit principle can be applied through a system of user-‐charges. Typical examples include charges for services and commodities provided by government owned entities, such as electricity, water and transport. The benefit principle is applicable to tenement policy for exploration and mining (including petroleum extraction), and associated royalty and taxation policy. When a government provides a right to extract petroleum, in return for a royalty or tax, it is selling petroleum in the ground to a sole beneficiary, the holder of the right to extract. The benefit principle suggests that the government, on behalf of the community, should charge a price for the resource in situ that reflects the benefit conferred on the holder of the right to extract. If the benefit differs, the price should differ. If the benefit is the same, the price should remain the same. The benefit is the value of the extractable resource in the ground, after deducting all costs, including the cost of capital and finding and assessment costs (including those relating to unsuccessful ventures). This benefit is resource rent or imputed nett value in situ. The benefit principle is consistent with the concept of obtaining an adequate return as owner of the resource. This concept has been specified as an objective from time to time by various state and federal governments in Australia. Such an objective was endorsed by, and implicitly linked to the benefit principle by the Henry Tax Review, as shown in Box 2. Policy Design and Assessment Principles 9 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Box 2 Henry Tax Review on Charging for Petroleum and Other Mineable Resources ǲ ǡ
appropriate return from resource exploitation under public or private production. In Australia, governments have traditionally allowed private firms to exploit non-‐renewable resources in return for a charge. Where governments allow private businesses to exploit non-‐renewable resources, governments can charge for the resources ȋǮǯȌǡǤith the ǯ -‐renewable resources is akin to selling a public asset. Resource taxes and auctions of exploration permits are therefore different from most other sources of tax revenue in that they charge for the sale of a publǤǳ Source: Henry, others (2009), p. 219. The benefit principle is also applicable when, on behalf of the community, governments allow access to the natural environment for disposal of pollutants not wanted by the rest of the community. The benefit principle would require that those who degrade the natural environment be charged a tax-‐price equivalent to marginal costs imposed on others (requiring them to internalise those costs). Such an application of the benefit principle would ǲǳǤ The ultimate incidence of a tax-‐price or royalty for extraction of a mineable resource, such as petroleum, could differ from its initial incidence. This would depend on the design of the system. The initial and ultimate burden would reside with whoever gains title to it, provided the royalty or tax base had been designed to coincide precisely with resource rent. Otherwise, the tax would be partly shifted back to providers of capital, labour/skills and other inputs. It would not be shifted forwards to customers provided that the extracting entity is a price-‐taker for its product. 2.3.3
Inter-‐Generational Equity The principle of inter-‐generational equity is closely linked to the concept of sustainable development or sustainability. Accumulation of capital and research by the current generation involves sacrifice of consumption and consequent bequeathing of capital stock and advances in technology to the next generation. On the other hand, extraction of natural resources and degradation of the natural environment deprive future generations of natural capital. Inter-‐generational equity involves even greater complexities and controversy than the difficult concept of intra-‐generational equity. One obvious issue is that there is much more information available to guide decisions regarding distribution between individuals within a generation than between present and future generations. Of course, it could be argued that concerns regarding inter-‐generational equity should be tempered by the expectation that continuing economic growth will make future generations wealthier than the current generation. However, that expectation must be Policy Design and Assessment Principles 10 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ adjusted to allow for the effects of environmental degradation, particularly climate change, on future growth (Helm, 2009). Another issue is that redistributive action is asymmetrical in the inter-‐generational case. The current generation could adjust the quantity and quality of the capital stock, including natural capital, bequeathed to future generations, but later generations could not improve the circumstances of previous generations. The literature on sustainable development has ballooned over the past 20 years. However, until recently, it has not been accompanied by a proportionate increase in serious analysis of principles to guide action in respect of inter-‐generational equity. Dasgupta (2004) and Heal (2005) have provided useful reviews of pertinent issues. Interest in inter-‐generational equity has increased greatly following publication of The Economics of Climate Change: The Stern Review at the end of 2007. The Stern Review presented controversial ethical arguments to justify selection of a very low discount rate for use in comparing time-‐separated costs and benefits of climate change inaction and abatement. A heated debate regarding an appropriate discount rate or rates in the context of climate change continues to rage. The general approach in the economics literature on sustainable development and natural ǯ is entitled to use natural and other capital as long as that generation invests sufficiently to maintain the quantity and quality of the aggregate stock of capital so that capacity to provide future flows of benefits to society is maintained.2 It is important to note that government appropriation of all or part of the nett imputed value of mineable resources in situ would not imply that it would be recycled to increase the stock of capital in the Australian economy. The government might decide to consume its take. 2.4
Economic Efficiency Economic efficiency refers to allocation of the various resources available in the economy to uses that yield the highest valued patterns of production and consumption. These resources include capital, labour, intellectual capital, land, water, mineable resources, and the natural environment. The principle of economic efficiency underpins the widely used assessment tool of benefit-‐
cost analysis. This tool is directed towards ascertaining whether or not a policy proposal (regulation, taxation, charging, or expenditure) could improve the efficiency of resource allocation in the sense that total benefits of the proposal exceed total costs, indicating a potential increase in community welfare, because gains to winners would be large enough to compensate losers. However, changes in the distribution of income and/or wealth could mean that a positive outcome from benefit-‐cost analysis would not necessarily lead to an unambiguous improvement in community welfare, unless losers were actually compensated. 2 See Solow (1974, 1993). Policy Design and Assessment Principles 11 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Therefore, benefit-‐cost analysis and other analyses focused on improving the efficiency of resource allocation/use is normally accompanied by distributional analysis so that government can decide if equity considerations outweigh the estimated potential change in community welfare, and if compensatory arrangements should be initiated on equity grounds. 2.4.1
Market Failure Concept and Types of Market Failure Markets generally allocate resources reasonably efficiently. But, there are various Ǥǲǳ
the economics literature. "Market failures" result in misallocation of resources available to the community or society. There are several sources of market failure, which include:

external costs external benefits under-‐provision of goods and services with public good characteristics (a high proportion of benefits are external)

information deficiencies Ȃ inadequate and asymmetrically available information incomplete markets excessive market power. Governments have established legal and protective frameworks to establish and enforce property rights, facilitate and enforce contracts, and protect people from criminal behaviour. This is a pre-‐condition of efficient operation of markets. So, such action by governments is not usually categorised as a response to market failure. However, the absence of such frameworks could reasonably be categorised as a form of market failure involving under-‐
provision of public goods, in this case, legal and protective arrangements. Government intervention to correct market failure would be justified, provided that social benefits of action would exceed the social costs. The proviso has long been accepted. For example, more than 50 years ago, Nobel Laureate for Economics, Ronald Coase stressed the latter point in a famous article on policy to address external costs (see Box 3). Box 3 Intervention Justified if Gains Exceed Losses ǲ ȋ Ȍ those harmful effects against the gains that accrue from allowing them to continue........ The problem which we face in dealing with actions which have harmful effects is not simply one of restraining those responsible for them. What has to be decided is whether the gain from preventing the harm is greater than the loss which would be suffered elsewhere as a result of stopǤǳ Source: Coase (1960), pp. 26, 27. Policy Design and Assessment Principles 12 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽlicy Government intervention to correct market failure could take different forms. The policy instrument or combination of instruments providing the greatest excess of social benefits over social costs should be selected. Several potential sources of "market failure" have been identified in petroleum exploration and development. These have been discussed briefly below. Market Failure in Exploration External Benefits and the Public Good of Information Information "spillovers" from the exploration activities of one party provide benefits to other parties without compensation. These are known as external benefits in the economics literature. The initial explorer's exploration effort could be less than if it captured all of the benefits. Moreover, enterprises might defer exploration, hoping to gain free information from exploration by others in similar circumstances. While such behaviours would be commercially rational, exploration and inadvertent dissemination of resulting information would occur to a lesser extent, and at a later time than socially desirable (Stiglitz, 1975; Peterson, 1975; Porter, 1995; Smith, 1997). In the case of very early-‐stage exploration in frontier areas, most of the benefits of exploration information could be external. Each party's use of it would not interfere with its use by others. Therefore, this information would take on the character of a public good. Such exploration might be particularly deterred not only by characteristically high uncertainty, but also by potential inability of the explorer to capture most of the benefits. To the extent that this exploration is substantially diminished or not undertaken at all, external benefits from ǲǳǤ External benefits of exploration may justify government intervention to increase exploration activity or otherwise increase the "spillover" of exploration information beyond the level that would result from commercially justifiable activity. The public good of early stage exploration information could justify government funding of generation and dissemination of that information. These concepts have been discussed in more detail in chapter 5. In addition, their implications for petroleum exploration policy in Australia's offshore areas have been investigated in that chapter and chapter 6. Asymmetric Information Exploration information has been asymmetrically provided, not just under-‐provided. The generator of the exploration information has better information available to it than Policy Design and Assessment Principles 13 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ competitors for adjacent or comparable areas. Asymmetric availability of information creates an external cost Ȃ a cost imposed on others without compensation. Entities with inferior ǡ ǲǳ
(Leitzinger, Stiglitz, 1984). Government intervention could be justified to address asymmetric information market failure. This market failure, intervention policy issues, and the implications of these matters for petroleum exploration policy in Australia's offshore areas have been analysed in chapters 5 and 7. External Costs of Environmental Damage Petroleum exploration involves risk of environmental damage and even loss of life. High profile oil spills in Australian and United States waters in recent years have demonstrated the significance of the risk and damage that might result. Such events have social consequences beyond any private costs borne by the perpetrator. These external costs are borne by:

people who value the natural environment individuals whose livelihood or quality of life depends on the quality of the environment those suffering loss of asset value because of property damage individuals who suffer other personal loss others who pay higher taxes or lose benefits from cuts to government programs to fund clean-‐up activities. Typically, governments have sought to avoid and otherwise deal with these events through regulation of activities and responsibility for remediation. Market Failure in Development Concern has often been expressed within administrative branches of Australian federal and state governments involved in management of offshore petroleum resources and activities that petroleum exploration and extraction enterprises may defer development of resources deemed commercially viable. It has been suggested that such behaviour is not in the public interest, and that government intervention is required to ensure that it does not occur. These matters were central to an options paper on offshore petroleum retention lease policy prepared by the Commonwealth Department of Resources, Energy and Tourism (2009). A recurring message in this document was that the Commonwealth Government sought commercial development of resources as early as possible.3 The prevalence of such views was noted by the Productivity Commission (2009) in its Review of Regulatory Burden on the Upstream Petroleum (Oil and Gas) Sector. The Productivity 3 See Commonwealth Department of Resources, Energy and Tourism (2009), pp. 4, 9, 14, 16, 22, 32, 33. Policy Design and Assessment Principles 14 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞPetroleum Exploration Policy Commission (2009) was not able to find any market failure that would support the view that a commercial decision to defer development would be contrary to the public interest. Indeed, it could not conceive any plausible economic argument that could justify requiring petroleum enterprises to bring-‐forward development of a resource or forfeit tenure over the resource. One market failure possibility is that an enterprise might have significant market power, which it seeks to exploit by withholding supply from a resource to increase the price for supply from its other resources. It is inconceivable that this could apply in the case of crude oil either internationally or domestically. Any Australian producer would surely be a price taker in both markets. For the same reason, it is also inconceivable in the international LNG market. It is difficult to conceive circumstances in which the exercise of market power could result in withholding of gas supply from a resource in the Australian market. Pertinent observations of the Productivity Commission (2009) regarding the absence of significant market power in the domestic gas market have been presented in Box 4. Box 4 Market Power Not an Issue in Domestic Gas Market ǲ ǤǤǤǤǤǤǤǤǤǮ
ǯǤǤǤǤǤǤǤǤǤǤǤǤǡes do not have an incentive to hoard reserves in order to influence prices. Thus, it could be expected that profit-‐maximising companies will develop or on-‐ǡǤǳ Source: Productivity Commission (2009), p. 94. An important point seems to have been overlooked by those suggesting that deferring forward development of an apparently commercial resource is contrary to the public interest. As Gaffney (1967a) pointed out, it is economically as well as commercially inappropriate to develop and commence extraction of an exhaustible resource, even if its nett present value from immediate development is positive, if that value is expected to rise at a faster rate than the relevant rate of return on capital. Development is economically and commercially desirable when nett present value from immediate development stops rising faster than the relevant rate of return on capital, as well as being positive. This point has been discussed and illustrated in chapter 6. A broader and more detailed discussion of retention lease policy, which includes the issues above, has been provided in chapter 9. 2.4.2
Policy Failure Costs of government intervention are not confined to costs of administering the action. To the extent that policy instruments distort otherwise preferred economic decisions, they cause ǡ ǲ ǳǤ
intervention depends on the nature of the intervention and the design of the policy Policy Design and Assessment Principles 15 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ instruments applied. Well-‐designed policy instruments would minimise the extent of any deadweight loss. Poorly-‐designed measures could cause substantial deadweight loss. Government intervention in economic affairs is pervasive. Market failure is just one of several reasons why governments intervene. Sometimes, they act to address circumstances wrongly perceived to be market failure. Governments typically modify the distribution of income and wealth for equity reasons. They act to stabilise the economy. At times, governments have intervened for protectionist or other political reasons. ǲǳǲǳ
interventions by government that cause larger deadweight losses than necessary, because of:

misdiagnosis of a problem poor policy selection flawed instrument design misguided action. A pertinent example of "policy failure" would be government establishment of a tenement or property rights regime for petroleum exploration and extraction that leads to departures from an efficient allocation of resources (deadweight loss), instead of facilitating such an allocation. It has been shown in chapters 6 to 9, that the Australian offshore petroleum tenement regime causes deadweight loss. Policy failure warrants corrective action by governments in the interests of economic efficiency, just as market failure does.4 The same conditions for intervention should apply. The social benefits of reform should exceed social costs, and the chosen approach to reform should be the one that yields the largest increase in social benefits relative to social costs. 2.4.3
ĐŽŶŽŵŝĐƐŽĨƚŚĞ͞^ĞĐŽŶĚ-‐ĞƐƚ͟ In a perfect world, all inefficiencies in the economy that arise from market failure would be corrected, and there would be no policy failures. Then, everyone could be made better-‐off. In reality, constraints on the form and extent of government intervention are common, with distributional considerations prominent determinants of such constraints. In addition, imperfect knowledge and deficient analyses often lead to poor selection and design of policy instruments. Consequently, elimination of all inefficiencies or achievement of economic efficiency is not a practical objective. A more realistic objective than an efficient allocation of resources or economic efficiency is improvement of the efficiency of resource allocation. Another way stating this objective is minimisation of aggregate inefficiencies or deadweight losses, subject to various extant constraints. Economic analysis of policy issues with this focus has become known as the 4 See Stiglitz (2000) and Winston (2006) for further discussion of both market failure and government (policy) failure. Policy Design and Assessment Principles 16 Review ŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǲ-‐ǳǲ-‐ǳǤ5 The branch of the economics ǲ-‐ǳ ǲ
ǳǤ6 ǡǲ-‐ǳppropriate label. ǲ-‐ǳ
highly technical. Some major results of this work and key insights particularly relevant to offshore petroleum exploration policy have been summarised briefly below. It is important to recognise that, in the context of numerous inefficiencies in the economy, as in Australia, government intervention to deal with a single problem or to undertake other piecemeal reform may result in an overall reduction in economic welfare rather than an increase. One source of inefficiency may partly offset the adverse consequences of another, and therefore, removing the first would exacerbate the nett adverse effects of the second. There may also be circumstances in which a reform to address one inefficiency may fall short of its potential because its effect is undermined by another inefficiency left uncorrected. The application of the petroleum resource rent tax in the mid-‐1980s to replace ad valorem well head royalties and an excise tax on crude oil for new projects, without any significant move away from work program bidding and highly conditional tenure, provided such an example.7 Over the past 30 years, several economic analysts have argued that work program bidding can dissipate resource rent and therefore reduce the revenue yield of the petroleum resource rent tax. 8 Ironically, the replaced royalty and tax systems would tend to offset the resource rent and revenue dissipation effects of work program bidding and highly conditional tenure. Moreover, the most criticised elements of the petroleum resource rent tax -‐-‐ the asymmetric treatment of exploration gains and losses (lack of full loss offsets) and the low carry-‐forward rate for early exploration outlays -‐-‐ also tend to offset resource rent and revenue dissipation effects of the tenement regime. However, these fiscal systems dissipate resource rent in a different way, by discouraging activity. Keeping rates low to contain the discouragement of activity sacrifices government capture of resource rent. These matters have been discussed in chapters 6 and 10. Obviously, any decision to undertake piecemeal policy action should be based on a thorough, broadly-‐based assessment of the benefits and costs of that action to ensure that policy changes do not do more harm than good in the context of other inefficiencies that remain. This would include analytical design or modification of instruments of partial reform to take account of interactions with remaining inefficiencies. 5 Pioneering work in this field can be found in Corlett, Hague (1953-‐54) and Lipsey, Lancaster (1956-‐57) and traced back to Ramsay (1927). 6 For seminal work in this field see Ramsay (1927), Baumol, Bradford (1970), and Diamond, Mirrless (1971a,b). 7 Work program bidding was displaced by cash bidding only in a relatively small number of cases from 1985 to 1992. Cash bidding has not been applied offshore subsequently. The areas offered for cash bids apparently were considered to be particularly prospective, and were very small relative to those offered for work bids. 8 For example, see Willett (1985, 2002), Fane, Smith (1986), Henry, others (2009). Policy Design and Assessment Principles 17 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǲ-‐ǳ
distorting otherwise efficient production decisions was more economically damaging than distorting consumption decisions and decisions linking production and consumption activities.9 They demonstrated that if economic rents could be fully captured by government taxes and user charges directly and precisely targeting those economic rents, and all factors of production and final consumption of produced goods and services were taxable, aggregate deadweight losses would be minimised if government fully captured economic rents and ensured that other taxes required to meet revenue requirements were set to ensure production efficiency.10 Achievement of production efficiency requires that all producers face the same prices. This condition is violated if:

intermediate inputs are taxed11 returns to inputs including factors of production (other than economic rents) are taxed differently in some uses than in others. Ad valorem well-‐head royalties and quantity-‐based imposts like the crude oil excise effectively tax intermediate inputs at the margins of extraction, investment and exploration, by disallowing deduction of upstream costs. For the same reason, they result in differential taxation of factors of production and other inputs at those margins, compared to taxes applied in other business sectors. Because the petroleum resource rent tax does not provide full loss offsets, it tends to tax marginal returns to investment in petroleum exploration and development more heavily than marginal returns to capital elsewhere. These levies interfere with production efficiency. If it is not possible for government to capture all economic rents directly and precisely through taxes or charges, because of political or practical constraints, it would still be important to capture as ǲ-‐ǳ
minimise reliance on distortionary taxes. It follows that it is also important to avoid policy measures that destroy these economic rents, preventing their capture by government. If direct and precise capture of some economic rents is not possible for political or practical reasons, it may be appropriate to tax more heavily the particular activities yielding those rents. This would be the case if the resulting production inefficiency is less than the deadweight losses caused by raising the same revenue by other means. This is possible ǯ
9 This point was highlighted by Auerbach (2010) ǯ
the Henry Tax Review panel. 10 For foundational work on this matter see Diamond, Mirrlees (1971a); Stiglitz, Dasgupta (1971); Mirrlees (1972); Dasgupta, Stiglitz (1972). 11 Intermediate inputs are produced goods and services that are used in production of other goods and services. They are distinguishable from primary inputs such as labour, intellect, natural resources and capital, which are referred to as factors of production. Policy Design and Assessment Principles 18 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ obtained from capturing economic rents, the smaller would be inefficiencies caused by the tax wedge between producer and consumer prices. Realisation of nett efficiency gains in this way would be dependent on a range of circumstances. Careful analysis would be required to formulate a framework of heavier taxation or charges on some activities than others that would result in a reduction of aggregate deadweight losses. 12 Formulation of a framework for direct and precise capture of economic rents could be a less intellectually challenging option as well as a more efficient one. The existence of resource rents and land rents (incorporating other associated genuine ǲ-‐ǳ Ȍǡ
capture those economic surpluses with small adverse effects on the efficiency of resource allocation/use provide an opportunity to at least partly displace inefficient government imposts, particularly those causing production inefficiencies. This would allow a reduction in ǲ ǳ age of taxes and government charges. This was ǯ
more efficient and heavier taxes on mineable resources and land, with lower, and perhaps ultimately, zero taxation of normal returns to equity capital under the company taxation regime. The ideal approach to correction of multiple inefficiencies is comprehensive reform. This does not require that all inefficiencies in the economy be addressed simultaneously. That would be impractical. It does mean simultaneous targeting of major sources of related, interacting inefficiencies that are not inevitable or not untouchable, and it does require thorough broadly-‐based analysis of the package of policy measures. For example, the ideal approach to reform of petroleum tenement conditions, tenement allocation arrangements, and fiscal systems would be to analyse their interactions and refine their settings as a package, rather than in isolation. 2.4.4
Matching Policy Instruments to Targets An important aspect of the policy task of improving the efficiency of allocation/use of ǡǲ-‐ǳǡ
means to policy ends or objectives, and to specific elements of objectives, which could be referred to as targets. The matching process is also important for effective policy. The distinction between efficiency and effectiveness has been discussed in the next sub-‐section. Seminal work on principles for matching policy instruments to targets was undertaken by Nobel Laureate for Economics, Jan Tinbergen (1952), and independently by Bent Hansen (1955). They formulated several important principles. Pertinent principles and implications have been briefly discussed below. These principles are consistent with the economics of the ǲ-‐ǳǤ 12 For a discussion of relevant issues in the context of petroleum exploration and extraction sector, see Stiglitz (1975), pp. 73-‐78. Policy Design and Assessment Principles 19 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The critical initial step is to ensure that targets, which are stepping stones to objectives, are logically linked to basic objectives like equity and economic efficiency. Sensibly determining the hierarchy of objectives and targets will facilitate the task of selecting and designing policy instruments to achieve objectives. If particular targets are not logically linked to objectives, instruments designed to pursue those targets could be incorrectly specified and achievement of some or all objectives impeded. For example, maximising resource rent, internalisation of external benefits and costs, and elimination of policy failures would be sensible stepping-‐stone objectives or targets of petroleum exploration and extraction policy linked to improvement of the efficiency of resource allocation/use (see section 2.2 and sub-‐section2.4.1 above). In contrast, government intervention to pursue a target such as maximisation of offshore exploration, as has been specified by the UK Government offshore areas for about 47 years, would be detrimental to pursuit of the objective of improving the efficiency of resource allocation/use. Taken to its logical conclusion, it would require all of the resources of the UK economy to be allocated to offshore petroleum exploration, supporting that activity, supporting exploration support activities, and so on. Clearly, such a target is economically absurd. A policy instrument may influence outcomes in respect of multiple targets or objectives, not just the primary one for which the instrument was adopted. Consequently, it would be sensible to engage in simultaneous consideration of the implications of multiple targets for instrument choice and the implications of instrument choice for multiple targets, rather than focus on the relationship between a single target and single instrument (see Box 5). Box 5 Tinbergen on Interdependence of Instruments and Incompatibility of Targets ǲcoherent entity. In most textbooks on economics or economic policy, separate components are ....... considered without much attention to their interdependence, and the targets and instruments of each of these components are often considered in isolation, this general coherence being neglected. Yet this interdependence is a reality and therefore the (economic policy) unit to be considered is the totality of all measures in execution Ǥǳ ǲincrease in the number of instruments, In particular, it will often be useful to analyse carefully why certain targets are, at first sight at least, contradictory, and this analysis will lead us sometimes to detect new Ǥǳ Source: Tinbergen (1952), pp. 68, 40-‐41. For example, work program bidding is a device for eliciting offers of larger and earlier exploration programs, as well as a means of allocating tenements on a competitive basis. However, this combination has tended to misallocate resources, involving dissipation of resource rent (see chapter 6). As a result, revenue from the petroleum resource rent tax and income tax have been reduced. So, in the process of pursuing two targets, work program bidding works against achievement of two primary objectives, economic efficiency and equity. Policy Design and Assessment Principles 20 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ If an instrument is an effective and efficient means of achieving one target, but has a detrimental effect on achievement of another target, rejection of that instrument or modification of it to trade-‐off between degrees of achievement of targets would not be the only options. It may be preferable to address the undesirable aspect of an instrument by changing the setting of another instrument or by adding a new instrument to the policy package (see Box 5). For example, cash bidding is widely regarded as an efficient and effective tenement allocation device, and while it captures uncertainty-‐adjusted anticipated resource rent (on an ex ante basis), it may be prone to a sovereign risk or time inconsistency problem. Governments receiving low cash bids for exploration prospects that turn out to be much better than originally anticipated having regard to uncertainty, might be tempted later to impose high royalties or taxes on realised outcomes. This could increase uncertainty associated with future investments in exploration and extraction, discouraging those investments. This problem could be avoided by establishing, prior to cash bidding, a royalty or tax regime designed to capture a substantial share of resource rent on a realised (ex post) basis. This issue has been discussed in chapter 7. A complementary example is that a tax or royalty designed to capture a high proportion of realised resource rent may encourage inefficient and avoidance practices that undermine realisation of the resource rent. This problem might be avoided, while still capturing a high proportion of resource rent, by lowering the tax or royalty rate and using cash bidding to allocate exploration tenements and collect some uncertainty-‐adjusted anticipated resource rent. Each policy instrument would improve the efficiency of the other, and together, they would deliver a high degree of compliance with the benefit principle of equity. This option has been discussed in chapter 7. Achievement of multiple targets often requires availability and application of at least as many policy instruments. If the number of available efficient and effective instruments is less than the number of targets, trade-‐offs between targets (compromises) are inevitable. A corollary of this is that trying to modify a single instrument to achieve multiple targets typically would result in trade-‐offs or compromises between targets. For example, at least three policy instruments would be required to achieve a substantial improvement in the efficiency of resource allocation with respect to exploration and extraction (maximising resource rent), and to capture a high proportion of resource rent. These policy instruments would be relatively unconditional tenure for exploration, development and extraction activities, an efficient tenement allocation mechanism, and ex ante and ex post charging regimes precisely targeting resource rent. One or two instruments could not achieve the two targets. These matters have been discussed in chapters 6, 7 and 10. Trade-‐offs between targets may be avoided by the addition of policy instruments to the policy package, by replacement of some instruments by others, or by adoption of a different set of instruments better suited to achievement of specific targets. Some targets may require Policy Design and Assessment Principles 21 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ multiple policy instruments. This can be illustrated by reference to Australian offshore petroleum exploration permit arrangements. Work program bidding was designed to allocate tenements and to elicit offers of greater and earlier exploration expenditure. Highly conditional tenure was designed to reinforce pressure to undertake more exploration earlier. The size of work program bids would be directly related to the magnitude of the anticipated resource rent, adjusted for uncertainty. In effect, work program bidding offers the nett value of the resource in situ as a subsidy to increase the size of the exploration effort and to bring forward its timing. However, the case for exploration subsidies is related to external benefits of information "spillovers" from exploration activity. These external benefits are likely to be larger (smaller) the less (more) is known about an area, because extra information is likely to be more useful when the body of available pre-‐existing information is small. Therefore, work program bidding is likely to offer the largest subsidy where it is least justified in economic terms, and little if any subsidy where a subsidy is most justifiable economically because oǲ" (see chapter 6). The work-‐bid exploration permit regime is an example of a case in which a different set of policy instruments, involving at least three capabilities, is required Ȃ one specifying security or conditionality of tenements, another to allocate tenements, and a third to increase the public availability of information generated by exploration. In performing the tenement allocation function, work program bidding (in conjunction with highly conditional pre-‐
development tenure), produces perverse outcomes in respect of the exploration information dissemination function. 2.4.5
Effectiveness Versus Efficiency ǲǳǲǳǤ
However, these principles certainly are not the same. It is important to distinguish between them. The effectiveness of an instrument would be indicated by the extent to which it could achieve a policy objective or target to which it was directed. In contrast, the performance of a policy instrument with respect to economic efficiency relates to its capacity to generate nett social benefits (social benefits in excess of social costs) through improvements to the allocation of resources. While it is useful to be able to determine whether or not policy regimes are effective, other criteria would often still be required to choose between effective policies. A function or target would need to be defined to provide a benchmark for effectiveness. Sometimes, potential government targets would depend on the policy instruments selected. Another issue is that a particular target may be achievable by different policy instruments that have substantially different equity and efficiency implications. Then, a choice between instruments would have to be made using equity, economic efficiency and administrative efficiency criteria. Policy Design and Assessment Principles 22 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Sometimes, a more effective policy would also be a more efficient policy. This certainly would not apply generally. However, it could apply if effectiveness was defined in terms of economic efficiency. 2.4.6
Economic Efficiency, Sustainability, and Economic Growth The concepts of economic efficiency and sustainable development or sustainability are compatible. There are two aspects of this. First, achievement of an efficient allocation of resources, including the natural environment and other natural resources, means that those imposing costs on others without compensation (external costs) must be required to take those costs into account (internalise them) when making decisions regarding their activities. Consequent behavioural adjustments as part of the internalisation process will improve the efficiency of resource allocation. Second, economic efficiency involves efficient allocation of resources over time, as well as a t a particular point in time. It is not just a static concept. It has a dynamic dimension, linked to economic development/growth. 2.5
Administrative Efficiency/Simplicity The administrative efficiency/simplicity criterion is concerned with avoiding unnecessarily high implementation, enforcement and compliance costs. Typically, the focus is on managing a policy regime in a way that facilitates achievement of economic efficiency and equity objectives at lowest practical cost to government and participants in the economy. Because reducing complexity is generally regarded as a key element of this task, administrative ǲǳǤ Policy administration costs are losses to the economy from government action. These costs are akin to deadweight losses. In effect, administrative efficiency is an aspect of economic efficiency, because its focus is minimisation of economic waste. However, administrative efficiency/simplicity is typically expressed as a separate principle. This approach has been followed here because it is helpful for analytical purposes, and because administration costs are important considerations when analysing the work program bidding system, and the petroleum resource rent tax regime applying in offshore areas under the jurisdiction of the Commonwealth Government. Complex, inconsistent, and uncertain legislation and regulations and arbitrary administration of those laws impose high compliance costs on individuals and business entities, and high enforcement costs on government. These costs translate into reduced availability of resource rents for capture by government and private sector participants in the extraction process. Discriminatory application of policy instruments, including exemptions, invariably adds to complexity, inconsistency and uncertainty regarding applicability. This, in turn, adds to Policy Design and Assessment Principles 23 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽn Policy economic waste in the form of inflated administration and legal costs for private sector entities and government. Policy Design and Assessment Principles 24 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 3
ZĞĂůŝƚǇ͕ZĞůĞǀĂŶĐĞĂŶĚZŽůĞŽĨZĞƐŽƵƌĐĞZĞŶƚ Resource rent is the primary focus of exploration and extraction activity for petroleum and other mineable resources. Resource rent is also central to government policy in respect of such activity. Enterprises seek access to prospects through licensing or contractual arrangements with governments so that they can capture resource rents. Governments, through licensing, contractual, and fiscal arrangements seek to capture the same resource rents to fund government expenditure programs and/or to divert some of it to subsidise more and earlier exploration and downstream activities. Poorly designed resource-‐access and fiscal arrangements tend to destroy resource rent, impeding its capture by government or explorers. Morris Adelman (1970) explained that enterprises do not simply search to replace depleting petroleum or to find more petroleum. They explore to find petroleum with combined finding and extraction costs lower than current marginal costs of extraction from existing known resources. So, their target is resource rent. The case for requiring mining (including petroleum extraction) enterprises to pay charges for access to mineable resources in the form of royalties or de facto royalties depends critically on the existence of resource rent. Royalties and de facto royalties typically are ex post charges calculated on the basis of realised outcomes, such as charges based on production, gross value of production, accounting profits or resource rent. In Australia, the crude oil excise, Petroleum Resource Rent Tax and Mineral Resource Rent Tax are examples of ex post de facto royalties. In some countries, ex post de facto royalties take the form of higher rates of corporate taxation for mining enterprises. However, royalties may take the form of ex ante charges based on anticipated outcomes. Cash bids for exploration licences are ex ante ǯ -‐adjusted estimates of resource rent. 3.1
Concept of Resource Rent The concept of resource rent can be traced back to David Ricardo (1821) and Adam Smith (1776). They saw sub-‐surface resources as forms of land. Because the return to land was known as rent, they regarded the return to mineable resources in situ as a form of rent. Smith observed that mines could yield rent. Ricardo ǲǳȋsee Box 6). Ross Garnaut and Anthony Clunies-‐ȋͳͻ͹ͷȌǲǳ
mines, including petroleum extraction activities. This term is now widely used in the economics literature, government and industry. Since Smith and Ricardo, land rents and resource rents have been regarded as amounts in excess of all payments required to elicit supply of all inputs to exploration, development and extraction activities. Therefore, in principle, rents could be subjected to a proportional tax or Reality, Relevance and Role of Resource Rent 25 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ charge by government without adverse effects on the allocation of resources. The logic is that a charge or tax that precisely targets land rent or resource rent would not fall on minimum returns to, or prices of inputs applied to exploit the land or extractable resource, with the result that exploitation activity would not be adversely affected. Box 6 ĂǀŝĚZŝĐĂƌĚŽŽŶ͞ZĞŶƚŽĨDŝŶĞƐ͟ Mines as well as land, generally pay a rent to their owner; and this rent, as well as the rent of land, is the effect and never the cause of the high value of their produce. If there were abundance of equally fertile mines, which any one might appropriate, they could yield no rent; the value of their produce would depend on the quantity of labour necessary to extract the metal from the mine and bring it to market. But there a re mines of various qualities affording very different results with equal quantities of labour. The metal produced from the poorest mine that is worked must at least have an exchangeable value, not only sufficient to procure all the clothes, food and other necessaries consumed by those employed in working it, and bringing the produce to market, but also to afford the common and ordinary profits to him who advances the (capital) stock necessary to carry on the undertaking. The return for capital from the poorest mine paying no rent would regulate the rent of all the other more productive mines. This mine is supposed to yield the usual profits of stock. All that the other mines produce more than this will necessarily paid to the owners for rent. Source: Ricardo (1821), p. 46. The rent of land is a perpetual return, although it will vary with circumstances, including the way it is maintained. The uncertainty-‐adjusted present value of the anticipated stream of future returns is the value of the land. Resource rent is much more complicated. There are four matters that make it so. First, resource rent is a price for the right to extract material. Extraction depletes resource deposits. The consequence is diminution of the asset. Resource rent is not a perpetual return to an asset. Second, deposits typically are not exhausted in a physical sense through extraction. Instead, they are exhausted in an economic sense when all economically recoverable material has been extracted. Third, reserves, as distinct from naturally occurring material, might be augmented by exploration, technological advances, cost-‐lowering activities by governments and other private sector entities, and higher real prices of the product of the resource. Fourth, exploration, development, commencement of extraction and the scheduling of extraction thereafter are non-‐repeatable opportunities. Therefore, timing of these events affects the outcome of nett present value calculations and is important for determining the maximum nett present value of resources. Timing matters have been discussed in sub-‐section 3.4. The concept of resource rent is central to the analysis of offshore petroleum exploration policy. Resource rent refers to the imputed nett value of resources in situ. Reality, Relevance and Role of Resource Rent 26 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Typically, resource rent is defined as a residual derived by deducting from revenue all costs of exploration, assessment, development and extraction, including minimum required rates of return on capital invested in those activities. More precisely, resource rent is the maximum residual achievable in present value terms having regard to alternative technical and timing options in respect of exploration, development and extraction. At any particular point of time, the maximum nett present value that can be realised by discovering, assessing and exploiting each deposit with appropriate starting dates and activity periods is the value that should be imputed to the mineable commodity in situ at that point time. In this report, resource rent or imputed nett value of resources in situ refers to that maximum value. Resource rent derives from both demand for products involving mineable resources and supply characteristics of those resources. The key supply characteristics are scarcity, exhaustibility (and associated timing issues), and heterogeneity within and across deposits. There are multiple sources of heterogeneity across deposits of mineable commodities and within individual deposits. Deposits possessing a commercially favourable combination of characteristics are relatively scarce. The more attractive is the combination of relevant ȋǲǳȌǡreater is its relative scarcity. Exploitation of relatively scarce deposits yields positive nett present value after covering the full costs of discovery, assessment, development, mining, processing and transportation, including the relevant cost(s) of capital (discount rate(s)). Because minimum required returns to all inputs are deducted in this calculation, the nett present value is largely imputable to the mineable commodity in situ. However, other immobileǡ ǲ-‐ǳ
rents, mobileǡǲ-‐speǳǲ-‐ǳ
value calculation and be entangled with resource rent. Relevant issues have been discussed in sub-‐section 3.3. Of course, different nett values could be imputed to different units of a resource within a deposit. Units with a negative unit nett value would be left behind or discarded as waste because extracting and/or processing them would cost more than they return and reduce the overall surplus. At any particular point of time, incremental supplies from known deposits will be available only at increasing incremental costs, and therefore, increasing product supply prices. However, technological advances that lower costs of exploration and exploitation, and discoveries of additional low-‐cost reserves from time to time could cause each quantity to be offered at a lower price or larger quantities offered at each price. Small cost-‐reducing technical advances are being made continuously and major technical breakthroughs are made from time to time. Historically, technological progress and consequent discoveries of low-‐cost deposits have more than offset the short-‐term tendency towards higher incremental costs and real market prices as production has expanded to meet increased demand. Reality, Relevance and Role of Resource Rent 27 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ This phenomenon does not imply that mineable commodities in situ would not have an imputed nett value. At any particular point of time, there would still be only a limited number of deposits that could be exploited economically. The relative scarcity of these deposits and the nett present values they could generate (the maximum in each case being the resource rent or imputed net value in situȌǲǳǤ Resource rents, as well as land rents, persist in the long term, because relative scarcity is sustained. In contrast, when higher than normal rates of return accrue to capital (not land and natural resources) deployed in particular activities or when particular types of profession attract unusually high payments, new entrants are attracted unless prevented by some artificial constraint, with the result that abnormally high returns are competed away in the medium-‐term or long-‐term. 3.2
Risk, Uncertainty and Resource Rent When imputing nett value to mineable resources in situ, allowance must be made for risk and uncertainty. This applies regardless of whether an estimate is made before or after outcomes are known. Consideration needs to be given to attitudes to risk as well as the degree of risk and uncertainty after taking account of the wide range of available mechanisms for ameliorating risk and uncertainty. It is notable that even royalty arrangements based on realised outcomes could operate as risk/uncertainty-‐sharing mechanisms between governments and mining enterprises, with the distribution of risk depending on the type of royalty and the rate. If resource rent is estimated in advance of exploration and development -‐ on an ex ante basis -‐ allowance needs to be made for the variability of potential outcomes in exploration, development and extraction phases of projects. If nett value is imputed to resources on the basis of realised outcomes -‐ on an ex post basis -‐ it is important to take into account poor as well as good realised outcomes. It is obvious that an ex post estimate of resource rent would be too high if it did not take into account the occurrence of unsuccessful exploration and extraction activities. An ex ante estimate of resource rent will be inversely related to the perceived extent of risk and uncertainty. If the probability distribution of possible outcomes is known, the variability of outcomes may be referred to as pure risk. The degree of pure risk will depend on the shape of the probability distribution of possible outcomes. The degree of uncertainty increases as knowledge of the probability distribution of outcomes declines. When knowledge of the probability distribution is completely unknown, pure uncertainty prevails. 13 Exploration and mining enterprises have to operate in the context of a mixture of risk and uncertainty. Attitudes to risk/uncertainty will affect ex ante e Ǥ ǲ-‐ǳ
investor will be indifferent between a safe outcome and risky/uncertain (variable) outcome 13 This distinction between risk and uncertainty was originally made by Frank Knight (1921). Reality, Relevance and Role of Resource Rent 28 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨshore Petroleum Exploration Policy ȋȌǤǲ-‐ǳ
reject a certain outcome in favour of a risky/uncertain opportunity with a lower expected Ǥ ǲ-‐ǳ
outcome to a risky/uncertain (variable) outcome having an expected value equal to the certain outǤǲ-‐ǳȀ
of a safe outcome only if the expected value of the former exceeded the certain value of the latter by a sufficiently large margin, with the margin increasing with the degree ǲ
ǳǤ ǲ-‐ǳ
mining enterprises. However, the degree of risk-‐aversion would vary between enterprises. ǲ-‐ǳ the exploration and mining sector. Ex ante estimates of resource rent would be affected by devices available for ameliorating risk and uncertainty. The better and more comprehensive are the available risk management mechanisms, the smaller would be the adverse impact of risk and uncertainty on an ex ante estimate of resource. Of course, costs associated with these mechanisms must also be considered when estimating resource rent. Commonly applied devices for ameliorating risk and uncertainty include:

exploration and production joint ventures large, diverse portfolios of exploration ventures thorough investigation and analysis of potential projects corporate entities with numerous shareholders long term sales contracts and other commodity price hedging arrangements insurance instruments. Unfortunately, these mechanisms fall short of the ideal of a complete set of perfect ȋ Ȍ Ǥ ǲ ǳǡ
investment in exploration and mining may be deferred and fall short of the quantum associated with an efficient allocation of resources. This result would be some loss of imputed nett value of minerals in situ. These considerations would obviously affect bids under work program and cash bidding regimes for transfer/allocation of exploration tenements, and subsequent exploration activity. The first of these regimes may have countervailing effects on timing and size of exploration effort arising from deficiencies in risk/uncertainty management devices. This would have to be weighed against their tendency to destroy resource rent. The issues have been discussed in chapter 6. Of course, governments must allow for risk and uncertainty faced by enterprises on an ex ante basis when trying to target resource rent via royalties or taxes on an ex post basis. To the Reality, Relevance and Role of Resource Rent 29 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ extent that they fail to do so, resources would be misallocated through distortion of incentives, with resulting destruction of resource rent and sacrifice of royalty/tax revenue. In addition, various ex post and ex ante pricing/taxation regimes may have significantly different effects on the distribution of risk and uncertainty between government resource owners and exploration and mining enterprises. This means estimates of resource rent would vary between individual regimes and combinations thereof. Indeed, ex ante and ex post estimates of resource rent are meaningful only in the context of the pertinent risk/uncertainty sharing or shifting arrangements between governments and enterprises that are reflected in tenement, royalty and taxation regimes. Further analysis of these issues has been undertaken in chapter 7. 3.3
Other Rents and Quasi Rents The term economic rent has been applied to economic surpluses deriving from various sources, including, but not restricted to land and mineable resources. The broader concept of economic rent has typically been defined as the difference between the return to a factor of production (land, extractable resources, labour and intellect, and capital) in its current use and what it would be paid in its next best use. The Henry Tax Review provided such a definition, supported by a simple example as shown in Box 7. Box 7 ,ĞŶƌǇdĂǆZĞǀŝĞǁ͛ƐĞĨŝŶŝƚŝŽŶŽĨĐŽŶŽŵŝĐZĞŶƚ ǲexcess of the return to a factor of production above the amount that is required to sustain the current use of the factor (or to entice the use of the factor). For example, if a worker is paid $100,000 but would still be willing to work at the same job if ȋȌ̈́͹ͷǡͲͲͲǡȋȌ̈́ʹͷǡͲͲͲǤǳ Source: Henry, others, Part 1, p. 171. ǡǲ-‐ǳǲ-‐
ǳǯǤ-‐specific rents are tied to specific geographical locations. Their sources are immobile. Firm-‐specific rents are not tied to specific geographical locations. Their sources are mobile (Osmundsen, 2005; Sørensen, 2007; Sørensen, Johnson, 2010). ǲ-‐ǳǡ
they may not be the only relevant sources of such rents. "Location-‐specific" rents may also derive from good infrastructure, high quality institutional arrangements, workforce skills and flexibility, agglomeration effects, barriers to entry to the Australian market, and government Ǥ ǲ-‐ǳ second group would be entangled with resource rents and land rents, and difficult to separate. They will cause resource rents to appear larger. The entangling or coalescing of these rents does not matter from a policy perspective, if they are all genuine economic rents. Reality, Relevance and Role of Resource Rent 30 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǲ-‐ǳ ǡ es, and expertise, including the synergistic efforts of skilled technical and management teams, which earn returns in excess of payments to individual components of or inputs to the package of capabilities. The sources of these implicit returns, and companies to which they accrue are mobile. ǡ ǲ-‐ǳ ǲ-‐
ǳ
accounting profits. If the royalty or tax ǡǲ-‐ǳǡ
sources of these rents and associated investment could be deployed elsewhere (Osmundsen, 2005; Sørensen, 2007; Deveraux, 2008; Sørensen, Johnson, 2010). ǡ ǲ-‐ǳ s would not be an issue for tenement allocation policy. When firms formulate bids under a cash-‐bidding or work-‐program bidding regime, they would not rationally include rents to mobile resources in the amount of their bids, because those resources have an opportunity cost Ȃ their value in another location to which they could alternatively be deployed. Similarly, firms applying for or negotiating acquisition of tenements under a conditional-‐first-‐come-‐first served system would have regard to opportunities ǲ-‐ǳ
work program commitments. In the short-‐run, some factors of production may earn unusually high returns apparently exhibiting attributes of an economic rent, because the supply cannot be quickly altered in response to a change in price. However, if increases in the supply of the factor can be achieved with the elapse of time, the high returns would not persist. The temporary high returns reflect earlier sunk costs and short-‐ or medium-‐term factor supply constraints. These rent-‐ǲ-‐ǳǤ Box 8 Quasi-‐Rents from Exploration Investments ǲȋȌȋȌǡs are sunk and uncertainty about the size of the deposit is substantially resolved. The present value of the subsequent expected revenues less development and extraction costs is Ǯ-‐ǯǤǤǤǤǤǤǤǤǤǤǤǤǤǤǤm that aims to be efficient should tax full (economic) rents, not Ǯ-‐ǯǤ ǡ
discoveries will be pursued. The full cost of resource exploitation includes the cost of unsuccessful exploration expenditures as well, ǡǤǳ Source: Boadway, Keen (2010), pp. 16, 17. Genuine economic rents persist in the long-‐ǡǲ-‐ǳ-‐
term or perhaps the medium-‐term futureǤǲ-‐ǳ-‐term through activity such as new investments, replication of skill sets, and development of new technologies, which expand supply of temporarily scarce resources, lowering their returns. ǲ-‐ǳǤ
Reality, Relevance and Role of Resource Rent 31 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝcy formulation of taxation policy is that although genuine economic ǲ-‐ǳ
readily distinguishable in the long-‐term, they may be difficult to distinguish in the short-‐term. An example relevant to exploration policy provided by prominent taxation economics specialists, Robin Boadway and Michael Keen, appears in Box 8. ǡǲ-‐ǳǲ-‐ǳǡǤ
There are doubts that mobile, firm-‐specific rents could persist in the long-‐term. It could be expected that high rewards for supply of the scarce inputs (including expertise in building a diversified extraction company), would elicit additional supply, at least in the medium-‐term, unless entry has been blocked as a result of a competitive imperfection or government intervention (Bjerkedal, Johnson, 2005, p. 172; Boadway, Keen, 2010, p. 60). ǲ-‐ǳǡǲ-‐ǳ
target only ȋ ǲ-‐ǳ
rent), so that deadweight loss can be avoided. In contrast, ǲ-‐ǳ
resource rents, would not be an issue for tenement allocation policy, for the same reasons it is ǲ-‐ǳ (see above). 3.4
Economic Functions of Resource Rent Prices perform three important economic functions:

eliciting or inducing supply rationing supply allocating supply. Returns to factors of production are prices for the use of those factors, even if returns are imputed (implicit), rather than actually paid (explicit). Certainly, returns to capital and labour, including intellect and skills, perform all three of the functions listed above. Returns to land Ȃ land rents Ȃ are not required to elicit supply of land as land already exists naturally and the amount available is fixed, but land rents do perform rationing and allocation functions. The case of returns to mineable resources Ȃ resource rents Ȃ presents some difficulties. Most economists have argued that, resource rents do not have to be captured by explorers/extractors to elicit supply mineable resources. They have explained that while exploration and extraction effort is required to locate and assess resources and convert them to reserves, and to produce a flow of products from reserves, the material in situ already exists naturally and its quantity is fixed. Others have claimed that all or nearly all of the revenues from extraction of mineable resources must be available to enterprises involved in exploration and extraction to ensure that these activities take place. This means resource rents do not exist or are trivial. This controversy has been discussed in sub-‐section 3.5. It is widely accepted among economists that returns to mineable resources perform the important functions of rationing supply and allocating supply between competing uses and users, just as returns to land do. In addition, there is a significant volume of literature dating Reality, Relevance and Role of Resource Rent 32 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ back to Lewis Gray (1914) and Harold Hotelling (1931) explaining the role of differences between the commodity price and marginal cost or nett price in guiding allocation of the exhaustible supply within a deposit over time from the chosen extraction commencement ǯǤ It is not as widely understood that differences between prices and costs over time have an important role in determining the optimal time to undertake exploration and development activity and to commence extraction. These are non-‐repeatable events, just as actual extraction over time cannot be repeated. The timing of all of these events affects the realised nett present value of mineable resources. The importance of timing of exploration was emphasised by Mason Gaffney (1967a) in seminal work on exploration economics and policies. A pertinent excerpt from this work has been re-‐produced in Box 9. Box 9 Economically Efficient Timing of Exploration "Everyone recognises that mineral extraction is non-‐repeating, so that timing is the essential economising choice. We often forget, however, that discovery14 is equally non-‐repeating and the timing is equally critical. The opportunity to discover is, as (Nobel Laureate William) Vickrey has said, a species of exhaustible economic opportunity. The optimal time to discover may very well be only a short period before liquidation (development and extraction) begins, even though that entails letting resources rise above the marginal condition before they are explored. When resources are marginal it means the present value of costs just equals the present value of revenues, so that any decision lowering costs or raising value of revenues by a small percentage has great leverage on nett rent and raises this by a large percentage ........... The nett present value of undiscovered marginal or slightly supramarginal minerals may therefore easily be rising faster than the interest rate, due to a much slower percentage rise of demand or drop of costs, warranting deferral of discovery and use. Discovery is not timely until the nett present value, nett of both development and discovery costs too, stops rising faster than the interest rate." Source: Gaffney (1967a), pp 386-‐387. Neglect of the economic importance of timing in exploration has led to highly asymmetric analytical scrutiny of government tenement policies that distort decisions regarding the composition and/or timing of exploration programs and the timing of development. Policies that might defer or reduce exploration programs have been roundly condemned. Few have contemplated that such policies might offset other distortions or that common tenement ǲǳ ǲ , ǳ. Mason Gaffney (1967a, 1977b) explained that recognition of this important point has been impeded by a strong "cultural subconscious" bias towards the view that more and earlier exploration is necessarily good from an economic or community (social) perspective. 14 Gaffney (1976a, p. 375) explained, "'Discovery' is not usually a single dramatic revelation, but a slow accretion of evidence." Reality, Relevance and Role of Resource Rent 33 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ There is analytical evidence that tenement policies in Australia have slanted exploration ǲ, ǳchapters 6, 7 and 9. This has occurred because of the design of tenure conditions and tenement transfer/allocation systems. Resulting policy-‐induced departures from the optimal size, composition and timing of exploration programs have reduced the realised nett present value of mineable resources, effectively destroying resource rent. 3.5
Eliciting Supply -‐ Reality of Resource Rent Arguments Rǯ It has sometimes been argued that resource rent or the imputed nett value of mineable resources in situ does not exist or is only a trivial amount. The reasoning has three elements. A typical line of reasoning is that all or nearly all of the revenues from mining must be available to exploration and mining enterprises to ensure that exploration and mining are not discouraged in the long term. The chance of capturing bonanza returns, despite a low probability of such returns, is perceived to be a necessary incentive for exploration and research to identify more effective exploration and exploitation techniques, respectively. This means all or nearly all revenue from extraction activity is required to elicit supply of, and is imputable to inputs other than extractable resources in situ. In other words, the argument is that resource rent does not exist or is only trivial. Other elements of the argument that resource rents do not exist or are trivial follow two divergent strands. One strand is that superior returns would be temporary, and competed away in the long-‐term. The rationale is that resources would continue to be attracted into exploration and research until returns in excess of normal uncertainty-‐adjusted rates of return on capital have been eliminated by falling product prices and increasing costs as output increases.15 The other strand concedes that superior deposits would yield superior returns in the long-‐
run, but to the extent that exploration and mining enterprises are not permitted to appropriate those above-‐normal returns, the possibility of a substantial reward to offset risk and uncertainty would be removed. Consequently, exploration would decline in areas that are not highly prospective or are considered to provide only a very remote chance of a bonanza discovery. Both strands of the second level of reasoning have referred to reports on profitability of Australian companies. These analyses have indicated that average and median rates of return on capital in the mining (including petroleum extraction) sector over the long-‐term have tended to be no better than rates of return in all sectors of the economy combined. However, some other results in these reports have not supported the first strand, but might be 15 For a recent articulation of this view, see Nakhle (2008), p. 21. Reality, Relevance and Role of Resource Rent 34 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ consistent with the second. These results indicated that the top 5 per cent of mining companies have earned substantially higher rates of return in the long-‐term than the top 5 per cent of all companies in the economy. The assumptions and analysis underlying the view that resource rent is non-‐existent or trivial have been strongly criticised in the economics literature. Several counter-‐arguments have been briefly discussed below. Relative Scarcity The argument against the existence of resource rent ignores the logic of analysis indicating that at any particular time, the variability of deposits means that superior deposits and lower cost or higher quality material in all deposits would be relatively scarce. Exhaustibility exacerbates scarcity because mining reduces the capacity of a deposit to generate future returns. The ability of superior deposits and units of resource to yield larger returns than required to compensate providers of inputs, other than extractable resources in situ, means that they have imputed value and that the imputed value would increase with positive characteristics of the material in situ. Naturally Occurring Concentrations Mineable resources in situ are available in their natural state and location prior to discovery and exploitation, regardless of the activities of prospectors and mining enterprises. While those activities add value to mineral deposits, they do not add more than the opportunity cost of those services. Positive Prices for Resources Around the world, enterprises have purchased exploration and mining properties from governments and other entities for prices in the form of lump sum payments, royalties, special taxes or a combination of these. Rates of return to capital have been calculated after deduction of these payments. Vigorous Pursuit of Worthless Assets The view that resource rent does not exist or is trivial effectively suggests that all activity to discover, assess and extract resources is targeting zero or trivial inherent value. This begs the question as to why enterprises have continued to engage in such supposedly futile activity in the long term, and to pursue vigorously rights to explore and extract. Destruction of Resource Rent The existence of resource rent is partly masked by the tendency of poorly designed exploration tenement systems to dissipate it. Arguments that all returns from extraction should accrue to contributors to exploration and extraction activity implicitly assume, incorrectly, that the pattern of exploration activity associated with existing tenement regimes Reality, Relevance and Role of Resource Rent 35 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ is consistent with economic efficiency. The main exploration tenement regimes applying in Australia Ȃ work program bidding and conditional first-‐come-‐first served systems Ȃ tend to undermine realisation of resource rent by distorting the timing and other aspects of exploration programs. This phenomenon has been explained in chapter 6.16 Resource rent is also partly hidden because some of it is dissipated by royalty and tax regimes meant to capture a portion of it. Poorly designed regimes dissipate resource rent by discouraging activity at or near the margins of exploration, investment and extraction. Profitability analyses indicating that median and average rates of return after company income tax in the mining sector are lower or no better than in the economy do not necessarily support the contention that resource rent is non-‐existent because outcomes are nett of:
royalty and de facto royalty payments to public and private sector entities, which appropriate part of resource rent
effects of government policies, such as imperfect tenement, royalty and tax regimes that tend to dissipate resource rent. Overall Assessment A balanced assessment of the various arguments leads to the conclusion that it is not reasonable to argue that resource rent is universally trivial or non-‐existent. All revenues do not have to be paid out to suppliers of capital, expertise and other inputs to elicit an economically efficient supply of exploration and mining effort. Resource rent is a differential economic surplus. It is trivial or zero in the case of marginal deposits and marginal resources within superior deposits, but increases with the quality of deposits and parts thereof. It is important from equity and economic efficiency perspectives to eschew policy instruments that destroy resource rent. This means tenement systems that distort exploration behaviour and royalty and tax regimes that do not target resource rent precisely should be avoided. Then, if resource rent is zero, either for deposits or individual units of resource, royalty or de facto royalty payments in respect of those deposits or units would correctly be zero. 3.6
Difficult Task of Designing Efficient Policy to Preserve and Capture Resource Rent The controversy regarding existence of resource rent has highlighted an extremely important point. Policy instruments used by governments to appropriate a portion of the imputed nett value of resources in situ must be designed to discriminate between returns required to elicit supply and surpluses above those returns and to allow for risk and uncertainty. To the extent 16 This phenomenon has previously been identified and explained by Willett (1985, 2002), Fane and Smith (1986), the Industry Commission (1991), and Smith (1997). Reality, Relevance and Role of Resource Rent 36 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨshore Petroleum Exploration Policy that such instruments fail to do so, they would tax returns required to elicit supply of inputs to exploration and mining activity. This would interfere with an otherwise efficient supply of exploration and mining effort and fail to comply with the economic efficiency objective. A proportional government impost that has been carefully and competently designed to fall only on imputed net value of mineable resources in situ would not distort exploration, investment and operating decisions. Therefore, it would not interfere with an otherwise efficient allocation of resources.17 In principle, such a regime could appropriate 100 per cent of resource rent. In practice, there are four major obstacles. First, an impost on ex post or realised, properly defined resource rent at a rate of 100 per cent would destroy the incentive to realise this economic surplus. The same problem would apply at lower but still very high rates. ǡ ǲ-‐ǳ mobile, ǲ-‐ǳ
immobile, ǲ-‐ǳǤǡ
source ǡǤǲ-‐ǳǲ-‐ǳ
rents were appropriated, inbound direct investment would be discouraged (see section 3.3 above). Third, the task of designing a practical royalty or tax system that would fall only on resource rent and not on returns to other inputs to exploration and mining involves significant challenges. Fourth, the task of designing a royalty or tax system to capture resource rent should be handled simultaneously with design of the tenement system, involving conditions attaching to tenements and the allocation mechanism. Because some tenement conditions and allocation systems destroy resource rent by distorting the timing and composition of exploration programs, they undermine royalty or tax systems designed to precisely target rent. While royalty and tax systems that do not closely target resource rent tend to partly counteract resource rent destruction by such tenement regimes, they destroy rent by falling on inputs other than the resource at the margin of exploration, investment and extraction. Therefore, joint reform of royalty/tax and tenement regimes is desirable. A cash bidding system could avoid the resource rent destruction problem and capture ex ante resource rent. However, this would be undone if the tenements auctioned were subject to short licence periods, demanding relinquishment requirements, and strict conditions regarding composition and timing of work programs. Even if such conditions were not 17 This understanding is well established in the economics literature. It dates back 235 years. See for example, Smith (1776), Article 1 of Part 2 of Chapter 2 of Book 5 in Volume 2; Ricardo (1821), chapters 3, 10; Gray (1914), pp. 443-‐444; Hotelling (1931), p. 164; Gaffney (1967), pp. 335, 364-‐365; Vickrey (1967), p. 322; Scott (1978), pp. 11-‐12; Dasgupta, Heal, Stiglitz (1980), pp. 160-‐161; Heaps, Helliwell (1985), p. 422; Smith (1997), pp. 207-‐208; Boadway, Keen (2010), pp. 15-‐17, 31-‐37. Reality, Relevance and Role of Resource Rent 37 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ applied to licences, cash bids based on ex ante assessments of tenements could be small relative to realised outcomes when prospects turn out much better than was expected ex ante. If governments act to increase their take, ignoring the ex ante risk and uncertainty that led to ǡǲǳǲǳǤ
The result could be even lower bids or no bids in future, meaning destruction of resource rent and lower revenues. Complementary reform of tenement regimes and royalty/tax regimes is required. A royalty/tax regime closely targeting ex post ǲ
ǳ Ǥ ex ante resource rent would address the revenue losses from having to keep ex post royalty/tax rates down. At the same time, eschewing highly conditional tenure arrangements would avoid resource rent destruction and consequent undermining of ex ante and ex post revenue. Details of such comprehensive, complementary reform have been discussed in detail in chapter 7. Reality, Relevance and Role of Resource Rent 38 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 4
ůĞŵĞŶƚƐĂŶĚ^ƚƌƵĐƚƵƌĞƐŽĨWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐŝĞƐ 4.1
Categories of Systems for Management of State-‐Owned Petroleum Resources In most countries, including Australia, ownership of petroleum resources in situ (in the ground) is vested in the nation state or a sub-‐national state or province. In these countries, private sector involvement in exploration for resources, and extraction of discovered resources is typically managed by an agency or agencies of the relevant government within a framework established by government legislation. Legal frameworks for private sector involvement tend to fall into three broad categories: concession regimes, production sharing contracts, and service contracts. Concession, production sharing, and service systems differ in various respects. Ownership of products of resource exploitation and exploitation facilities are two distinguishing characteristics (Tordo, 2007; Nakhle, 2008). In addition, each of these categories of legal framework could be divided into sub-‐categories on the basis of other specific, important distinguishing features. In the case of concession systems, a private sector entity is granted an exclusive right to explore for resources and (to apply to) develop and extract resources for sale within a specified area and period of time, with the concessionaire being responsible for all costs. In some cases, non-‐exclusive rights to undertake limited exploration activities may be issued prior to grant of exclusive rights to explore. Under concession systems, ownership of petroleum typically passes to the private sector holder of the relevant concession instrument (a production licence or lease) at the well head, subject to payment of royalty and/or de facto royalty (cash bids, special taxes). In some cases, such as in the United States, ownership rights to resources in situ are assigned to the concessionaire discovering them (Nakhle, 2008). The private sector concessionaire retains ownership of production facilities during currency of the licence, and typically is responsible for costs of shut-‐down, prescribed removal of facilities, and rehabilitation. Remaining fixtures usually become the property of the state (Tordo, 2007). Concession systems for petroleum exploration and extraction currently operate in 55 countries (Nakhle, 2008). Australian state and federal governments have adopted concession systems for petroleum and other mineable resources. With production sharing contracts, the private sector producing entity gains title to its contractual share (specified in legislation or negotiated) of petroleum production at the point of sale of the output, subject to satisfaction of royalty, de facto royalty and production cost Ǥ ǯ
Ǥ ǯ
Elements and Structures of Petroleum Exploration Policies 39 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ responsibility for all costs of exploration, development, extraction and sometimes abandonment. Ownership of exploration and production fixtures provided by the contractor typically passes to the state upon installation. The state or a government-‐owned petroleum company is typically responsible for costs associated with cessation of production, although in some cases this responsibility may reside with the contractor (Tordo, 2007). Production sharing contract systems for petroleum exploration and extraction currently operate in 64 countries. This type of system was first applied in Indonesia. This occurred in the early 1960s (Nakhle, 2008). Service contracts do not entitle the contractor to any share of the extracted petroleum resource. The contractor is paid fees for services provided to exploit the resource. Fees may be subject to taxation. The contractor may be paid in cash or kind. Fees may be specifically linked to the services provided (pure service contracts) or related to defined profit (risk service contracts). Service contracts of the latter type may be similar to production sharing contracts in respects other than non-‐entitlement and entitlement to a share of the resource following extraction. Only 12 countries have adopted service contract systems for petroleum exploration and extraction (Nakhle, 2008). 4.2
Elements of Policies for Petroleum Exploration and Extraction Regardless of the category of legal framework adopted for management of state-‐owned petroleum resources, economic outcomes are strongly influenced by six important elements (six ts) of petroleum exploration and extraction policy. These elements, which have been addressed in a variety of ways in petroleum producing countries, relate to:

timing Ȃ when to release areas for permit applications tenure Ȃ conditions applying to tenements or contracts in respect of the period (term) of the arrangement, amount and timing of relinquishment of territory, and exploration program timing, composition, and expenditure
transfer Ȃ selection of entities to which government is to transfer (or allocate) rights to explore for, and (apply to) extract petroleum
taxation Ȃ pricing resources or capturing a share of resource rent for government, including fees (licence/lease rentals, etc), royalties, cash bids (ex ante, de facto royalties), special taxes (ex post, de facto royalties), production sharing arrangements (ex post, de facto royalties), and company income tax
transmission of information Ȃ addressing socially deficient availability of geological information because of external benefits of information "spillovers" and the public good nature of information
trouble-‐amelioration Ȃ responding to socially deficient environmental and safety protection because of external costs of environmental and safety consequences of exploration, development and extraction activities. Elements and Structures of Petroleum Exploration Policies 40 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKffshore Petroleum Exploration Policy The policy settings in respect of each element will affect the efficiency of resource allocation, the extent to which resource rent is preserved or destroyed, and the extent to which resource rent is collected by government. Policy settings for one element may interact with policy instruments for another element. It is inappropriate to focus on policy settings for one element without regard to their implications for other elements. Transfer mechanisms, such as conditional first-‐come-‐first-‐served (over the counter), work program bidding, cash bidding, royalty bidding, and profit or production share bidding, should be considered in the context of prevailing ex post royalty and taxation arrangements because transfer mechanisms adjust the effective pricing of the transfer through taxation and royalty arrangements. Transfer mechanisms affect the extent to which resource rent is preserved or destroyed and therefore, the amount potentially available to government over project lives. Tenure conditions also affect the extent to which resource rent is preserved or destroyed and therefore, the amount potentially available for capture by government. This occurs because conditional tenure, rather than secure tenure, may distort decisions regarding the amount, composition, and timing of activity. Timing of release of areas for bidding interacts with transfer mechanisms and tenure conditions to influence the pace of exploration and the extent to which transfer/allocation and tenure arrangements could dissipate resource rent. Ex post royalty and taxation regimes may preserve or partly offset economic inefficiencies caused by the transfer or allocation system, depending on the extent to which they precisely target resource rent or are poorly targeted and discourage activities that lead to realisation of resource rent. However, such discouragement is a source of economic efficiencies that are likely to outweigh the partial offsetting of inefficiencies caused by the transfer system. Schemes to increase the public good or external benefits of early-‐stage exploration information (transmission of information arrangements) could be expected to increase, bring-‐
forward, and improve targeting of exploration activity. The efficiency of resource allocation would be improved by correction of information-‐related market failures. More information would also lead to greater competition and bids in cash bidding and work program transfer (allocation) schemes, and an increase in pre-‐emptive activity under conditional first-‐come-‐
first-‐served for areas revealed to be more prospective by the extra information. However, in the case of work program bidding and conditional first-‐come-‐first-‐served systems, economic gains from correction of information-‐related market failures are likely to be overwhelmed by economic inefficiencies or deadweight losses created by distortion of exploration activity by these transfer schemes (policy failures). The latter influence could be reinforced by tenure conditions that distort exploration activity. Resource rent, correctly conceived, is nett of external costs of exploration and extraction. If an estimate of resource rent did not allow for these social costs, it would overstate the social surplus that resource rent is meant to represent. If government intervention (trouble-‐
Elements and Structures of Petroleum Exploration Policies 41 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ amelioration) to internalise external costs of exploration, development and extraction is well-‐
designed, resource rent from private and social perspectives would coincide. The last of the five elements of petroleum exploration and extraction policy discussed above, trouble-‐amelioration, is outside the scope of the terms of reference. While the terms of reference have made transfer policy central to the assignment, they also require investigation of the case for transmission of information policies in the context of different transfer systems, and comparative information and analysis on taxation policies. It is also appropriate to consider tenure conditions at the same time, because they define the rights being transferred, and interact with transfer and taxation policy. 4.3
Australian Offshore Petroleum Exploration Policy 4.3.1
Overview The Australian offshore petroleum regime is a concession system. The Australian states and territories apply concession systems onshore for petroleum and other mineable resources. Broad distinctions been concession and contract systems have been outlined in section 4.1 above. Concession systems vary between countries. They also vary in some respects between provinces/states and between provincial and national jurisdictions in countries with federal systems of government. Concessions systems applying to petroleum resources may also differ from those applicable to other mineable resources. Such differences apply in Australia. ǯ
entities to hold petroleum titles appropriate to their activities. These include exploration permits, retention leases, production licences, petroleum special prospecting authorities, and petroleum access authorities. The arrangements impose various obligations on title holders, including data reporting, and gaining approval of field development plans, recovery rates, and well operations. In subsequent sub-‐ ǡ ǯ
regime has been outlined, using the categorisation of elements of policy formulated in section 4.2, apart from trouble-‐amelioration, which is outside the scope of the terms of reference. The other policy elements are:

tenure transfer timing

taxation transmission of information. Tenure aspects of the regime have been specified in Chapter 2 of the Offshore Petroleum and Greenhouse Gas Storage Act 2006 and in various Parts of the Offshore Petroleum and Elements and Structures of Petroleum Exploration Policies 42 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Greenhouse Gas Storage (Resource Management and Administration) Regulations 2011. These elements have been outlined in sub-‐section 4.3.1 below. Figure 1 provides a diagrammatic ǯ
extraction policy regime. It has been reproduced from a review of petroleum extraction and policy arrangements in Australia by the Productivity Commission (2009). Transfer/allocation aspects of the regime have been specified in Chapter 2 of the Offshore Petroleum and Greenhouse Gas Storage Act 2006. They have been outlined in sub-‐section 4.3.2, below. Timing and other aspects of releases of offshore areas for bidding have been set out in guidelines provided on the website of the Department of Resources, Energy and Tourism. Part 8 of the Offshore Petroleum and Greenhouse Gas Storage (Resource Management and Administration) Regulations 2011 covers release of information regarding petroleum exploration and extraction activities on various forms of petroleum title. Geoscience Australia undertakes early-‐stage exploration in frontier areas and publishes the results. The programming and funding of this work is handled through the budget process. Information ǯ
outlined in sub-‐section 4.3.4 below. Royalty/taxation policies have outlined in sub-‐section 4.3.5 below. Figure 1 Australian Policy Framework Arrangements for Offshore Petroleum Exploration and Development Data source: Productivity Commission (2009) Elements and Structures of Petroleum Exploration Policies 43 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ In chapters 5 to 10ǡǯ
assessment principles outlined in chapter 2. This policy regime has been compared with concession systems and contract systems in other countries in chapter 11. 4.3.2
Tenure Tenure conditions, along with transfer (allocation) mechanisms have been specified in Chapter 2 of the Offshore Petroleum and Greenhouse Gas Storage Act 2006. Tenure conditions relate to and vary with the following forms of title or tenement:
work-‐bid petroleum exploration permit cash bid petroleum exploration permit special petroleum exploration permit (granted over blocks in surrendered, cancelled or terminated permit, lease or licence) petroleum retention lease

petroleum production licence petroleum special prospecting authority petroleum access authority

infrastructure licence pipeline licence.

The role of infrastructure and pipeline licences is outside the scope of the terms of reference for this report. Therefore, these titles have not been discussed. Petroleum Exploration Permits The Offshore Petroleum and Greenhouse Gas Storage Act 2006 (the Act) provides for three types of petroleum exploration permit: work-‐bid exploration permits, special exploration permits, and cash-‐bid exploration permits. Each of these permit-‐types is associated with a different transfer or allocation system (discussed in a subsequent sub-‐ǲǳȌǤ
The first and second permit-‐types are subject to work and expenditure conditions, but the third is not. Work-‐bid and special exploration permits pre-‐dated cash-‐bid permits, which were introduced in 1985 by amendments to the Petroleum (Submerged Lands) Act 1967, the predecessor to the current Act. A petroleum exploration permit may be granted subject to whatever conditions the administering authority thinks appropriate, except where there would be conflict with conditions specified in the Act. A petroleum exploration permit authorises exploration and recovery of petroleum for appraisal purposes in the permit area. A work-‐bid exploration permit and a special petroleum exploration permit may specify conditions requiring work, timing thereof, and expenditure. A cash-‐bid petroleum exploration permit must not be granted subject to work and expenditure conditions. Elements and Structures of Petroleum Exploration Policies 44 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The duration of the original issue of a petroleum exploration permit is 6 years. For a petroleum exploration permit issued by way of renewal, the duration is 5 years. A work-‐bid petroleum exploration permit originally granted on or after 1 January 2003 in response to an application invitation issued on or after 1 January 2003 may be renewed no more than twice. A special petroleum exploration permit may be renewed no more than twice if it was originally granted on or after 1 January 2003. Other work-‐bid and special petroleum exploration permits may be renewed more than twice unless prevented by permit halving rules. An application for renewal of a cash-‐bid petroleum exploration permit may not be lodged if the permit had already been renewed once or the original notice inviting cash-‐bid applications specified that renewal was not allowed. Clearly, less generous renewal opportunities apply to cash-‐bid permits than to work-‐bid and special petroleum exploration permits. ǲǳ
permit each time it is renewed. The number of blocks to be halved excludes petroleum pool location blocks. The latter blocks may be added to the blocks in renewal application that survive the halving procedure. ǲ ǳ
compliance with permit conditions, and relevant provisions of the Act and the regulations. However, a renewal may be granted if the administering authority is satisfied that there are sufficient grounds to warrant a renewal. In other respects, a renewal may be granted on whatever conditions the administering authority thinks appropriate, with notable exceptions in relation to the number of renewals and their duration (outlined above) and the prohibition on work and expenditure conditions for renewals of cash-‐bid permits. Guidelines issued by the Department of Resources, Energy and Tourism state that a renewal application in respect of a work-‐bid exploration permit would be regarded as a work bid. Therefore, the renewal would be subject to the administering authority being satisfied with proposed expenditure and the magnitude and content of work programs. Petroleum Retention Leases In 1985, petroleum retention leases were created through amendments to the Petroleum (Submerged Lands) Act 1967. The amending bill described its purpose as follows: ǲ -‐commercial discoveries. Retention leases will allow explorers to retain tenure over discoveries until they become commercial and should provide an additional measure of encouragement for companies exploring in deep water or gas prone Ǥǳ A petroleum retention lease may be granted to the holder of a petroleum exploration permit or a life-‐of-‐field petroleum production licence, over a block or blocks in that permit or licence containing petroleum, recovery of which is not currently commercially viable, but considered Elements and Structures of Petroleum Exploration Policies 45 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ likely to become commercially viable within 15 years. A petroleum retention lease authorises petroleum exploration and recovery of petroleum for appraisal purposes in the lease area. A petroleum retention lease may be granted subject to whatever conditions the administering authority thinks appropriate, except where there would be conflict with conditions specified in the Act. The Act provides that an application for a petroleum retention lease must be accompanied by proposals regarding work and expenditure in respect of the area, and details of current and future commercial viability of petroleum recovery. It also provides that work and expenditure conditions may be specified in a petroleum retention lease in respect of the lease area. The Act stipulates that the lessee must comply with a request to re-‐evaluate the commercial viability of production from the lease area (otherwise than by drilling wells) within a period 90 days. However, a longer period may be allowed. No more than one re-‐evaluation can be required in a lease period. The duration of a petroleum retention lease is 5 years. Such a lease may be renewed for further periods of 5 years on application. The Act provides that an application for renewal of a petroleum retention lease must be accompanied by proposals regarding work and expenditure in respect of the area, and details of current and future commercial viability of petroleum recovery. Renewal is dependent on previous compliance with conditions of the lease, relevant provisions of the Act and the regulations. Renewal is also subject to recovery of petroleum continuing not to be commercially viable, but being considered likely to become commercially viable within 15 years. If the temporary commercial non-‐viability requirements are satisfied, but various conditions specified by government have not been complied with in the past, a renewal may be granted if the administering authority is satisfied that sufficient grounds exist to warrant renewal. Work and expenditure conditions may be specified in respect of the area of a petroleum retention lease when it is renewed. A petroleum retention lease may be revoked if the results of a re-‐evaluation of commercial viability requested of the lessee by the administering authority lead the latter to form an opinion that recovery of petroleum from the lease area is commercially viable and the lessees response does not change that opinion. If the lessee applies for a petroleum production licence, in relation to one or more of the blocks comprising the lease, within 12 months of the revocation notice, the revocation takes effect following the earliest of the grant, refusal or lapse of the application. If an application for a petroleum production licence is not made within the period allowed, the revocation of the lease takes effect at the end of 12 months from the date of the revocation notice. Elements and Structures of Petroleum Exploration Policies 46 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞPetroleum Exploration Policy Petroleum Production Licence A petroleum production licence authorises petroleum extraction and exploration activities in the licence area. A petroleum production licence may be granted in three types of circumstances:
pursuant to an application by the holder of a petroleum exploration permit or petroleum retention lease in respect of blocks covering a petroleum pool in the permit or licence area

in exchange for another licence that applied to the same block in response to hybrid work program and cash-‐bid applications in respect of blocks from a surrendered, cancelled or terminated petroleum production licence, retention lease or exploration permit in which the administering authority considers there is petroleum. A petroleum production licence may be granted subject to whatever conditions the administering authority thinks appropriate, except where there would be conflict with conditions specified in the Act. A general condition specified in the Act requires the licensee to explore in the licence area to determine whether or not it contains any additional recoverable petroleum and recover it if commercially viable. However, the Act provides that a licence must not be granted subject to specific requirements to drill a well, undertake a seismic survey or another survey, or spend particular amounts in respect of the licence area. Despite this, an application for a licence must be accompanied by proposals for work and expenditure in respect of the area that is the subject of the application. The duration of a petroleum production licence granted on or after 30 July 1998 is indefinite. In the case of a licence granted before 30 July 1998, the licence period is 21 years. The duration of the first renewal of 8 specific licences originally granted before 30 July 1998 is indefinite. The duration of the first renewal of other licences originally granted before 30 July 1998 is 21 years and the duration of a second renewal is indefinite. The Act refers to a licence with an indefinite duration as a life of field petroleum production licence. If no petroleum recovery operations have been undertaken for a continuous period of at least 5 years in a life of field petroleum production licence, the licence may be terminated following consideration of submissions in response to a notice of a proposed termination. Petroleum Special Prospecting Authority A petroleum special prospecting authority authorises the registered holder to carry on petroleum exploration operations in the authority area, subject to whatever conditions the administering authority thinks appropriate, except where there would be conflict with the Act. Drilling a well is excluded by the Act. Elements and Structures of Petroleum Exploration Policies 47 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ A special prospecting authority cannot be applied for over an area so long as a permit, lease or licence remains in force under the Act in respect of the area. However, more than one petroleum special prospecting authority may exist in respect of an area at the same time. The duration of a petroleum special prospecting authority must not exceed 180 days. It remains in force for the time period specified in the authority. A petroleum special prospecting authority cannot be transferred. Petroleum Access Authority The registered holder of a petroleum exploration permit, retention lease, production licence or special prospecting authority may apply for and be granted a petroleum access authority over blocks in an offshore area outside the permit, lease, licence or authority to undertake activities to more effectively exercise the applicantǯs rights or properly perform its duties in respect of the permit, lease, licence or special prospecting authority. The holder of a petroleum access authority may undertake operations authorised in the authority. Particular exploration activities could be authorised in a petroleum access authority. Operations related to recover ǯ ǡ
ȋ ǯ Ȍ
authorised. Activities in both categories could be authorised. Drilling a well could not be authorised. A petroleum access authority may be granted over an area that is the subject of a petroleum exploration permit, retention lease, production licence or special prospecting authority not held by the applicant for the petroleum access authority. A decision to grant an authority must take into account submissions received in relation to the matter. A petroleum access authority remains in force for the period of time specified in the authority. This period may be extended. The registered holder of a petroleum access authority must provide monthly reports to the holder of a coincident permit, lease or licence on operations and results in the area of overlap. 4.3.3
Transfer Mechanisms for the Commonwealth Government to transfer (allocate) exploration and extraction rights to enterprises, along with tenure conditions, have been specified in Chapter 2 of the Offshore Petroleum and Greenhouse Gas Storage Act 2006. Transfers of rights may be made on five different bases:

work program bidding cash bidding hybrid cash and work program bidding pre-‐emptive conditional allocation Elements and Structures of Petroleum Exploration Policies 48 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
conditional over-‐the-‐counter transfer of rights. Petroleum exploration permits may be granted on the basis of either work program bidding or cash bidding or hybrid cash-‐work program allocation/transfer mechanisms. However, work program bidding has been the dominant mechanism historically. Work program bidding was displaced by cash bidding only in a relatively small number of cases from 1985 to 1992. Cash bidding has not been used offshore after 1992. The areas offered for cash bids apparently were considered to be particularly prospective, and were very small relative to those offered for work bids. Cash bidding has not been mentioned as a transfer (allocation) mechanism for petroleum exploration permits in current published guidelines for release of areas for applications, although it has been specified as an allocation option in the Offshore Petroleum and Greenhouse Gas Storage Act 2006 and its predecessor Act since the mid-‐1980s. While cash bidding and work program bidding were equally prominent in the, Commonwealth ǯͳͻͻͲOffshore Strategy: Promoting Petroleum Exploration, cash bidding was not mentioned in the 1999 Australian Offshore Petroleum Strategy. Pre-‐emptive conditional allocation is the only transfer mechanism provided by the Act for petroleum retention leases. Such a lease may be granted only to the holder of a petroleum exploration permit or a life-‐of-‐field petroleum production licence over a block or blocks in that permit or licence containing petroleum considered to be uncommercial at that time, but likely to become commercially viable within 15 years. In most circumstances, the pre-‐emptive conditional mechanism is the only one available under the Act for granting petroleum production licences. Then, a licence could be issued only to the holder of a petroleum exploration permit or petroleum retention lease in respect of blocks covering a petroleum pool in the permit or licence area or to the holder of a licence in exchange for another licence that applied to the same block. However, in the special case of release of blocks from a surrendered, cancelled or terminated petroleum production licence, retention lease or exploration permit, in which the administering authority considers there is petroleum, a hybrid work program and cash-‐
bidding mechanism may be used to determine the recipient of a petroleum production licence. This mechanism has never been used to allocate a petroleum production licence in Australian offshore areas. Petroleum special prospecting authorities are allocated on a conditional over-‐the-‐counter basis. Petroleum access authorities may be transferred using an allocation mechanism involving elements of pre-‐emptive and over-‐the-‐counter mechanisms. More detail has been provided below in respect of the work program bidding, cash bidding, pre-‐emptive, and over-‐
the-‐counter mechanisms defined in the Act for transferring offshore exploration and extraction rights to enterprises. Elements and Structures of Petroleum Exploration Policies 49 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Work Program Bidding for Petroleum Exploration Permits Work program bidding has been the only mechanism used to allocate petroleum exploration permits after 1992. Nevertheless, the Offshore Petroleum and Greenhouse Gas Storage Act 2006 and its predecessor Act have provided the option of using either work program bidding or cash bidding to allocate a petroleum exploration permit over specific blocks since the mid-‐
1980s. The Act does not permit specific blocks to be offered for bids under both systems during the same application period. The Act does not specify the frequency of releases of offshore areas for work program bids. The current practice is to make annual releases. The well-‐established release process commences 12 months before a release with invitations to industry participants to nominate areas for consideration for inclusion in an annual release. Nominations are assessed and short-‐listed. Selection criteria may include previous interest in and exploration of the nominated area, availability of a new geoscientific scenario, new market developments, and availability of geoscientific data from studies by Geoscience Australia. The Act provides that applications for petroleum exploration permits over areas included in a release be invited by notice in the Commonwealth of Australia Gazette. The Act requires that ǯ
proposals, available technical expertise, and financial resources. Current guidelines issued by the Department of Resources, Energy and Tourism require applicants to submit minimum guaranteed work programs for years 1, 2, and 3, which should include significant amounts of new seismic surveying and/or exploration drilling. Secondary work programs for years 4, 5, and 6 are also required to be submitted. The guidelines state that they should include substantial operational activities that will significantly advance exploration of the area, and satisfy normal expectations of at least one exploration in the six-‐year period of any permit granted. ǲ
ǳ Ǥ so provides that if two or more applicants are considered to be ǲ ǳǡ they may be asked to provide proposals for additional work and expenditure of the kinds considered relevant by the administering authority. Current guidelines issued by the Department of Resources, Energy and Tourism stated that ǲ
petroleum potential within the permit area in the minimum guaranteed (program) period of Ǥǳ18 The guidelines listed the following bid assessment criteria: 18 This aim is potentially inconsistent with the economic efficiency objective discussed in chapter 2. This matter has been investigated in chapter 6. Elements and Structures of Petroleum Exploration Policies 50 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ

the number and timing of exploration wells to be drilled the amount, type and timing of seismic work to be undertaken other surveys, data acquisition, and data reprocessing to be performed or purchased the significance of appraisal work proposed in respect of previous discoveries in the area the type, scope and objectives of proposed geotechnical studies
ǯ
proposed work
financial and technical resources available to the applicant to undertake the proposed work program and meet commitments in respect of other permits
past performance in petroleum exploration in Australia and overseas. ǲ ǳ be selected on the basis of minimum guaranteed work programs, the amount and timing of work proposed under secondary work programs will be assessed having regard to the criteria above. Current guidelines issued by the Department of Resources, Energy and Tourism have stipulated that the minimum guaranteed work program (applying to years 1-‐3) cannot be reduced after an exploration permit has been awarded. Moreover, permit holders must undertake each component of the guaranteed program in respect of the permit area in the specified year, except that components may be brought forward and credited towards the program in the specified year. According to the guidelines, secondary work program ǲ
Ǥǳ The guidelines have specified that work programs may be varied only if:

an activity is replaced by work deemed similar or superior by the administering authority, or substantial and compelling technical evidence is provided, in which case the entire secondary program may be renegotiated before year 4 or on an annual basis before each year in the secondary program period. The guidelines have stated that additional time to carry out work obligations in respect of any year may be allowed only in the event of an occurrence that cannot reasonably be anticipated or controlled, or if seismic work additional to the original program is undertaken to meet a drilling commitment. ǲ ǳ
compliance with permit conditions, and relevant provisions of the Act and the regulations, although a renewal may be granted if the administering authority is satisfied that there are sufficient grounds to warrant a renewal. In other respects, a renewal may be granted on whatever conditions the administering authority thinks appropriate. Guidelines issued by the Department of Resources, Energy and Tourism state that a renewal application is regarded as Elements and Structures of Petroleum Exploration Policies 51 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǲǳ ǡ minimum guaranteed and secondary work programs and these are expected to meet the same criteria as apply to assessment of work program bids. Work program bidding for petroleum exploration permits is characterised by substantial administrative discretion. This characteristic, in combination with tenure conditions outlined above, means tenure is subject to significant uncertainty or lack of security. Cash Bidding for Exploration Permits The Offshore Petroleum and Greenhouse Gas Storage Act 2006 and its predecessor, the Petroleum (Submerged Lands) Act 1967, have provided the option of using cash bidding instead of work program bidding to allocate a petroleum exploration permit over specific blocks since 1985. When the Petroleum (Submerged Lands) Act 1967 was amended to provide for cash bidding, the Commonwealth Government envisaged that cash bidding would apply only to highly prospective areas, and argued that it was superior to work program bidding in such areas on economic efficiency, administrative efficiency and equity grounds and would complement the decision to apply the petroleum resource rent tax in ensuring the community collects and adequate share of resource rent in offshore areas (Evans, 1985). Although the declared intention in 1985 was to apply cash bidding only to highly prospective areas, the Act does not confine application of cash bidding to areas assessed as highly prospective. It is silent on application criteria. The Act provides that applications may be invited for cash-‐bid petroleum exploration permits by notice in the Commonwealth of Australia Gazette. It stipulates that specific blocks are not to be offered for bids under both systems during the same application period. The notice must summarise conditions to which the permit would be subject, including renewal, and specify matters to be taken into account in deciding whether or not to reject an application. The Act requires that an application for a permit must be accompanied by details of the ǯ ise, financial resources, and the amount the applicant would be prepared to pay to acquire the permit. The Act stipulates that a cash-‐bid petroleum exploration permit must not be granted subject to work and expenditure conditions. The Act provides that any or all cash-‐bid applications may be rejected. If two or more applications are not rejected, the permit is awarded to the applicant offering the highest cash bid. If two or more applications offered the equally highest cash payment, and they are not rejected, a permit may be granted to one of the applicants. It is clear that the Act allows rejection of cash-‐bid applications for reasons other than the amount of the cash bid. Indeed, the highest bidder may be rejected for reasons other than the size of the bid. Renewals of cash-‐bid petroleum exploration permits must not be granted subject to work and expenditure conditions, just as initial grants are not. Less generous renewal opportunities Elements and Structures of Petroleum Exploration Policies 52 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞum Exploration Policy apply to cash-‐bid permits than to work-‐bid and special petroleum exploration permits. A cash-‐bid permit may be renewed no more than once, and if specified in the original notice inviting cash-‐bid applications may not be renewable at all. In contrast, work-‐bid permits originally granted in response to an application invitation issued on or after 1 January 2003 may be renewed twice. Hybrid Cash and Work Program Bidding for Exploration Permits A hybrid cash and work program bidding system may be used to allocate a special petroleum exploration permit over blocks from a surrendered, cancelled or terminated petroleum production licence, retention lease or exploration permit, in which the administering authority considers there is petroleum. This system was used for one area off the Victorian coast in Release 1 for 1986. The allocation regime is the same as for cash-‐bid exploration permits, except that:

a notice calling for applications does not have to specify conditions of the grant and matters to be taken into account in deciding whether or not to reject an application an ǯ
expenditure in respect of the area available (as well as the cash amount the applicant is prepared to pay for the grant of the production licence and ǯ
available technical expertise and financial resources) a deposit of 10 per cent of the cash amount offered is payable with the application. The Act provides the administering authority with substantial discretion to reject applications for special petroleum exploration licences without reference to cash bids. The administering authority may choose to reject an application on the basis of its accompanying proposed work program or technical and financial resources available to an applicant. Indeed, a special petroleum exploration permit may specify conditions requiring work, timing thereof, and expenditure, as in the case of a work-‐bid exploration permit. In contrast, a cash-‐
bid petroleum exploration permit must not be granted subject to work and expenditure conditions. The Act does not provide guidance on relative weighting of cash bidding and work program mechanisms. This has been left to administrative discretion. Hybrid transfer/allocation system applying to special petroleum exploration permits is also characterised by substantial administrative discretion, like work program bidding. As a result discretion applying to relative weighting and allocation and conditions applying to tenure, there is substantial uncertainty in respect of tenure. Hybrid Cash and Work Program Bidding for Production Licences A hybrid cash and work program bidding system may be used to allocate a petroleum production licence over blocks from a surrendered, cancelled or terminated petroleum production licence, retention lease or exploration permit, in which the administering Elements and Structures of Petroleum Exploration Policies 53 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ authority considers there is petroleum. This mechanism has never been used to allocate a petroleum production licence in Australian offshore areas. Headings in the Act refer to a production licence granted in this way as a cash-‐bid petroleum production licence. However, it would be more appropriate to refer to such a licence as a hybrid cash-‐work-‐bid production licence. The allocation regime is the same as for cash-‐bid exploration permits, except that:
a notice calling for applications does not have to specify conditions of the grant and matters to be taken into account in deciding whether or not to reject an application
ǯ
expenditure in respect of the area available, as well as the cash amount the applicant is prepared to pay for the grant of the production licence
an application does not have to provide ǯ
expertise and financial resources
a deposit of 10 per cent of the cash amount offered is payable with the application. The Act provides the administering authority with substantial discretion to reject applications for a production licence under this regime without reference to cash bids. The administering authority may choose to reject an application on the basis of the work program proposed in the application. As for special petroleum exploration permits, the Act does not provide guidance on relative weighting of cash bidding and work program transfer/allocation mechanisms. This has been left to administrative discretion. Similarly, the allocation mechanism is subject to substantial administrative discretion. Therefore, this hybrid arrangement is characterised by similar uncertainty issues to those identified in respect of hybrid cash and work program bidding for special petroleum prospecting permits. Pre-‐emptive Conditional System for Petroleum Retention Leases The Offshore Petroleum and Greenhouse Gas Storage Act 2006 provides that a petroleum retention lease may be granted to the holder of a petroleum exploration permit or a life-‐of-‐
field petroleum production licence, over a block or blocks in that permit or licence containing petroleum. An important proviso is that recovery of the petroleum is not currently commercially viable, but considered likely to become commercially viable within 15 years. Moreover, the lessee must comply with a request to re-‐evaluate the commercial viability of production from the lease area (otherwise than by drilling wells) within a period 90 days. However, a longer period may be allowed. No more than one re-‐evaluation can be required in a lease period. An application for a petroleum retention lease must be accompanied by proposals regarding work and expenditure in respect of the area, and details of current and future commercial viability of petroleum recovery. Work and expenditure conditions may be specified in a petroleum retention lease in respect of the lease area. Elements and Structures of Petroleum Exploration Policies 54 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The transfer system for petroleum retention leases is pre-‐emptive because the holder of the right to apply is based on two pre-‐emptive actions:
occupation of the relevant area through possession of a petroleum exploration permit or life-‐of-‐field production licence that includes the area
discovery of petroleum in the relevant area. The transfer system is conditional for two reasons. First, grant of a lease is subject to commitment to work and expenditure conditions specified by the administering authority. Second, it is subject to a conditional non-‐viability test. Renewal of a petroleum retention lease is also pre-‐emptive and conditional. However, the pre-‐emptive actions are a little different. In the case of renewal, the applicant already holds a lease and the initial discovery was made prior to the initial grant of the lease. Pre-‐emptive Conditional System for Petroleum Production Licences Under the Offshore Petroleum and Greenhouse Gas Storage Act 2006, the main mechanism for transferring petroleum production licences is a pre-‐emptive system. An alternative mechanism, hybrid work program and cash bidding, is available in quite specific circumstances, as outlined above, but has not been used to transfer petroleum production licences. The primary transfer system for petroleum production licences is pre-‐emptive because the holder of the right to apply is based on two pre-‐emptive actions:
occupation of the relevant area through possession of a petroleum exploration permit or petroleum retention lease or another licence that includes the area
discovery of petroleum in the relevant area. The transfer system could be regarded as conditional because of a general requirement in the Act for the licensee to explore in the licence area to determine whether or not it contains any additional recoverable petroleum and recover it if commercially viable. While an application for a licence must be accompanied by proposals for work and expenditure in respect of the area that is the subject of the application, the Act provides that a licence must not be granted subject to specific requirements to drill a well, undertake a seismic survey or another survey, or spend particular amounts in respect of the licence area. It is obvious that the conditionality of the transfer system is much less than for petroleum retention leases. Conditional Over-‐the-‐Counter System for Petroleum Special Prospecting Authorities An over the counter system is used to transfer petroleum special prospecting authorities. The recipient of an authority is not determined by a bidding or pre-‐emptive mechanism. The transfer/allocation mechanism for special prospecting authority is conditional. It cannot be applied for over an area, so long as a permit, lease or licence remains in force under the Act in respect of the area. An authority authorises the registered holder to carry on petroleum Elements and Structures of Petroleum Exploration Policies 55 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ exploration operations, excluding drilling, in the authority area, subject to whatever conditions the administering authority thinks appropriate. However, grant of an authority does not provide exclusive rights to explore the area. More than one petroleum special prospecting authority may be granted in respect of an area at the same time. A petroleum special prospecting authority cannot be transferred from the initial holder of the authority to another party. This mechanism differs in important respects from the over-‐the-‐
counter mechanism that is the dominant transfer scheme used by Australian state and territory governments to transfer (allocate) on shore exploration rights in respect of petroleum and other mineable resources to enterprises. The latter scheme is a conditional-‐
first-‐come-‐first-‐served mechanism. Pre-‐emptive Conditional Over-‐the-‐Counter System for Petroleum Access Authorities The transfer/allocation mechanism for petroleum access authorities involves elements of pre-‐
emptive and over-‐the-‐counter mechanisms. The pre-‐emptive element derives from the applicant having rights to explore for or extract petroleum in a pre-‐existing permit, lease, licence or special prospecting authority that require access via an authority in respect of another area. The over-‐the-‐counter element relates to the application being in respect of an area not already held under title by the applicant and not subject to a form of competitive bidding. The transfer is subject to various conditions, including non-‐exclusivity and not being allowed to drill a well. 4.3.4
Timing of Area Releases for Bidding The Commonwealth Government conducts annual releases of specific offshore areas for bidding. Exploration entities may place bids for areas included in a release within a specified time frame, usually 6 to 12 months. Areas included in a release are selected following an extensive period of stakeholder consultation. This includes an invitation to nominate vacant areas for inclusion in the release. Selection is based on analysis of a range of relevant factors, such as availability of information from early-‐stage exploration by Geoscience Australia, changes in the geoscientific "story", changes in market or infrastructure circumstances, previous interest and activity in an area, and nominations. Geological and geophysical data and analyses and other relevant information are included in a release support package. 4.3.5
Transmission of Information Release of Exploration Information from Petroleum Titles The Offshore Petroleum and Greenhouse Gas Storage (Resource Management and Administration) Regulations 2011 include provisions relating to transmission of geoscientific and exploration information arising from survey and drilling activities undertaken under Elements and Structures of Petroleum Exploration Policies 56 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ various forms of petroleum title. These provisions vary according to the type of title and the nature of the information. The administering authority may make open information about a well or survey publicly known at any time. Open information refers to general information such as the name of the survey or well, the petroleum title, the basin or sub-‐basin, the titleholder, the type and size of survey, timing of the activity, and the location, purpose, depth and status of wells. Other disclosable, documentary information regarding exploration may be made publicly known or released to an entity with time lags varying with the type of information and title. 19 For basic disclosable information, the confidentiality period ranges from 1 to 3 years for exclusive data. Non-‐exclusive data Ȃ data collected for sale or licence Ȃ generally remains confidential for 15 years. More detail is provided in Table 1. Table 1 Release of Basic, Disclosable Information
Data Source Release Date Seismic survey that collected exclusive data conducted under a petroleum production licence that is still in force 2 years after acquisition Seismic survey that collected exclusive data conducted under a petroleum title other than a production licence including an exploration licence and retention lease 3 years after acquisition Seismic survey that collected exclusive data under a petroleum title that has expired or otherwise been surrendered Day of expiry or surrender A survey that collected 2D seismic as non-‐exclusive data 15 years after acquisition A survey that collected 3D seismic as non-‐exclusive data required to be produced as a condition of grant of a petroleum title 15 years after acquisition for 3D seismic 5 years after acquisition for 2D seismic extracted from 3D data Other geophysical and geological surveys conducted under a petroleum production licence 2 years after acquisition Other geophysical and geological surveys conducted under a petroleum exploration permit, retention lease or scientific investigation consent 3 years after acquisition Other geophysical and geological surveys conducted under a petroleum exploration permit, retention lease, production licence or scientific investigation that has expired Day of expiry Other geophysical survey conducted under a petroleum prospecting authority as exclusive data if the title has expired Day of expiry Well information conducted under a petroleum production licence that is still in force 1 year after the end of the operation Well information conducted under a petroleum title other than a production licence that is still in force 2 years after the end of the operation Well information collected under a petroleum title that has expired 33Day of expiry, surrender or termination Petroleum mining samples conducted under a production licence 1 year after the end of the operation Petroleum mining samples conducted under a petroleum title other than a production licence 2 years after the end of the operation Petroleum mining samples conducted under a petroleum title that has been cancelled Day of expiry, surrender, cancellation, revocation or termination Data source: Offshore Petroleum and Greenhouse Gas Storage (Resource Management and Administration) Regulations 2011. 19 This excludes information regarding technical and financial resources available to titleholders and contents of applications for titles. Elements and Structures of Petroleum Exploration Policies 57 ReǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ In the case of interpretative, disclosable information relating to the sea-‐bed, sub-‐soil or petroleum in a title area, the prescribed release date is more than 5 years after the end of the operation to which the information relates. Documentary information may be released at any time, if the titleholder has made the information publicly known or if the titleholder has provided written consent. In the event of such consent, exclusions and timing restrictions outlined above would be overridden. Pre-‐competitive Information Compiled and Released by Geoscience Australia Geoscience Australia undertakes early-‐stage petroleum exploration programs in frontier areas and publishes the results. They focus on areas where data availability is very limited and uncertainty is considered too high for companies to be interested in early-‐stage exploration activity. 4.3.6
Taxation Tenement Rentals Offshore petroleum tenement rental rates are:

՜ $55 per block (0.70/km2) petroleum retention lease ՜ $6,820 per block ($87/km2) petroleum product՜ $20,460 per block (262/km2) Petroleum Resource Rent Tax The petroleum resource rent tax regime has been in place for offshore petroleum extraction since the mid-‐1980s. Current arrangements include:
a tax rate of 40 per cent on positive "real" cash flows, which exclude financial items such as interest and dividend payments and receipts, and capital raisings and repayments
carry-‐forward of un-‐recouped expenditures at various rates of return (threshold or carry-‐forward rates) î the long-‐term Commonwealth Government bond rate plus 15 percentage points for exploration expenditure incurred within 5 years of the date of lodgement of data required for the grant of a production licence î the GDP deflator for earlier exploration expenditure î 5 percentage points above the long-‐term bond rate for development and other non-‐
exploration expenditures
exclusion of North West Shelf petroleum, to which an ad valorem royalty of 10-‐12.5 per cent of well head value and a de facto royalty in the form of an excise duty regime for crude oil involving marginal rates of tax that increased with production rates, reaching a top marginal rate of excise duty was 87 per cent of the import parity price of crude oil. Elements and Structures of Petroleum Exploration Policies 58 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽration Policy On 2 July 2010, the Commonwealth Government announced extension of coverage of the petroleum resource rent tax arrangements from 1 July 2012. This tax regime would cover extraction of North West Shelf and onshore petroleum, and coal seam methane. Transition arrangements would apply to existing projects. These included provision of credits ǲ
ǳ for extraction activities in areas previously excluded from the petroleum resource rent tax. Under the transition arrangements, the tax payer could elect to use as a starting value for deductible expenditures at 1 May 2010 either the market value of past investments, including the value of the resource or the written down book value of past investments, excluding the value of the resource or actual expenditure over the 8-‐year period from 1 July 2002 to 1 May 2010. The starting asset value as at 1 May 2010 and subsequent eligible expenditure could be uplifted at the carry-‐forward rate applicable to general project expenditure in the case of market value and book value estimates, and at rates relevant to the type of expense in the case of the look-‐back method of estimation. The carried forward starting value and subsequent eligible expenditure would be deductible in full at 1 July 2012 for producing tenements and on commencement of production for other tenements. Company Income Tax
ǯ͵Ͳ
per cent to defined company accounting profits that in general are sourced in Australia. A dividend imputation system avoids double taxation of returns to domestic shareholders. The company income tax system allows deduction of operating costs, interest, and allowances for depreciation. Exploration expenditures are deductible for year in which they are incurred. the tax falls on the full return to corporate equity. As a result, the tax falls on ǲǳ
surplus returns or economic rents. However, it exempts the "normal" return component of returns to exploration investment from tax. On 2 July 2010, the Government announced that company income tax rate would fall from 30 per cent to 29 per cent starting in 2013-‐14. This would lag by one year the extension of coverage of the petroleum resource rent tax and application of a mineral resource rent tax to coal and iron ore mining. 4.4
Offshore Petroleum Exploration Policy -‐ Selected Other Countries In this section and in Appendix A, offshore petroleum exploration policy in several selected countries has been briefly outlined. This sample includes policy regimes based on concession systems and others based on production sharing contract systems. The selected countries include five advanced countries with concession systems (Norway, UK, Canada, USA and New Zealand) one developing country with a concession system (Thailand), another developing country with a hybrid concession/production sharing contract regime Elements and Structures of Petroleum Exploration Policies 59 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ (India), and a two developing countries using production sharing contracts (Indonesia and Malaysia). More concession systems than production sharing systems were included in the sample, because the former are more directly comparable with Australia's offshore petroleum exploration policy, and advanced countries typically have concession systems. The three developing countries included in the sample were selected because they are located in southern and south-‐eastern Asia, in relative proximity to Australia. The offshore petroleum exploration policy regimes in the nine selected countries have been summarised in tabular format in Appendix A. The summary for each country has been segmented under the headings: exploration licensing, allocation system, tenure/relinquishment, permit fees, and royalties and taxes. The governments of most of the selected countries use work program bidding as a mechanism for transfer/allocation of exclusive exploration rights. The government of the United States, by far the largest producer of both oil and gas within the group, relies exclusively on cash bidding as a transfer/allocation mechanism for offshore petroleum exploration licences. Cash bidding may be used to allocate petroleum exploration rights in parts of offshore Newfoundland/Labrador (Canada) and New Zealand that are deemed to be highly prospective, with work program bidding being the allocation mechanism otherwise deployed. Cash bidding is not an option for the other Canadian offshore area available for petroleum exploration, offshore Nova Scotia. Offshore petroleum exploration tenure arrangements vary substantially internationally. Some governments authorise exploration on a non-‐exclusive basis prior to competitive bidding for exclusive exploration rights. Examples include the United States, Norway, the UK and New Zealand. Others grant only exclusive exploration rights. Examples include Canada-‐
Nova Scotia, Canada-‐Newfoundland/Labarador and Thailand. Authorisations to explore on a non-‐exclusive basis are typically much shorter than licences to explore on an exclusive basis. Initial periods of exploration titles granted on an exclusive basis typically fall in the range of 4 years (for example, the UK) to 10 years (for example, Norway). The shorter exploration titles typically can be renewed, but only if work commitments are met and sometimes subject to partial relinquishment requirements too. Some titles may be extended on a long-‐term basis to allow production (for example, Norway, the UK and the US), while in other cases a separate production licence must be applied for to allow production (for example, New Zealand and Canada). United States offers a relatively short title period in shallow water areas (5 years) and one of the longest title periods (up to 10 years) for deepwater areas and other areas considered to involve difficult conditions. Work commitments do not apply, because leases are allocated on the basis of cash bidding. Extension for further exploration or production is dependent on making a discovery and lasts as long as commercial production or exploration continues. There are no partial relinquishment requirements, just total relinquishment if a discovery is not made. Elements and Structures of Petroleum Exploration Policies 60 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Exploration licence fees or rentals vary widely between countries. In some cases (for example, offshore UK, and in some areas offshore US), fees/rentals escalate over time to encourage surrender of areas that are no longer of significant interest. During the period from the early 1970s to the mid-‐1980s, there was a strong international trend away from ad valorem royalties based on well head value or some other concept of gross value towards:

royalty systems or special petroleum tax systems based on some concept of profit, or production sharing contract systems, which are effectively profit sharing regimes and therefore, forms of profit-‐based tax. Typically, standard company income tax regimes also apply. In some cases, payments in respect of the special profit-‐based tax are deductible from the company income tax base, as is the case with Australia's petroleum resource rent tax. In other cases, payments in respect of the special profit-‐based tax applying to petroleum are not deductible for determination of company income tax liability and company income tax payments are not deductible from the base of the special petroleum tax. Norway provides an example of such an arrangement. The United States Government's offshore regime is a notable exception to the trend to profit-‐
based royalty or special petroleum tax regimes. The United States has persisted with ad valorem royalties in combination with cash bidding (an ex ante royalty). Elements and Structures of Petroleum Exploration Policies 61 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 5
ǆƉůŽƌĂƚŝŽŶ/ŶĨŽƌŵĂƚŝŽŶWŽůŝĐǇ Australian offshore petroleum exploration information policy targets three sources of market failure:

external benefits of exploration information "spillovers" the public good of information from early-‐stage exploration
exploration information asymmetries. This chapter discusses these information market failures. It also analyses the suitability of existing Australian exploration information policy. This chapter highlights the important point that formulation of exploration policy should have regard to the implications of the accompanying tenement regime for the social benefits of information provided through government action. This matter has been neglected in previous analyses of the offshore petroleum exploration permit regime and exploration policy. 5.1
External Benefits and the Public Good of Information When exploration is undertaken by one entity, significant information benefits could inadvertently spill-‐over without compensation to other intending explorers. These external benefits of exploration would particularly help explorers interested in adjacent areas, comparable geological structures and environments, and similar exploration concepts. Bǲǳ
activity. Because the initial explorer would not gain all of the benefits of its own exploration, as a result of information spilling-‐over to others, its exploration effort could be less than if it captured all Ǥ ǡ ǡ ǲ-‐ǳ
gaining free information from exploration by others in similar circumstances. While such behaviours would be commercially rational, exploration and inadvertent dissemination of resulting information would occur to a lesser extent, and at a later time than socially desirable (Stiglitz, 1975; Peterson, 1975; Porter, 1995; Smith, 1997). The significance of external benefits of exploration tends to be inversely related to the amount of existing knowledge about the area being explored or directly related to the extent of pre-‐
Ǥǲǳ to be more valuable to other parties than from areas already known to be highly prospective. ǲ-‐ǳ
would be greater in frontier areas. Even if each explorer in an area considered that expected private returns from exploration would be positive, each might hold back because others have not commenced exploration, causing each to re-‐consider, thinking it may have been overoptimistic initially (Hendricks, Kovenock, 1989). Exploration Information Policy 62 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǲǳǡ-‐stage exploration in frontier areas are more likely to occur (as well as being more valuable) because:

early exploration typically involves large-‐area screening activities tenure may not be available on a sufficiently large scale to undertake such activities efficiently20
any subsequent focus of exploration is readily observed and interpreted by others. ǡǲǳ
inadequate. Then, each explorer may choose to drill quickly on the basis of private information, when information pooling might lead to a more economically efficient outcome involving sequential activity or drilling in some cases but not others. In this case, socially inadequate information could lead to some premature, duplicative exploration activity, in contrast to exploration being too little, too late in frontier areas. While this problem might be offset by trade in information and tenements or privately initiated coordination activities, data on petroleum drilling patterns in United States offshore areas suggests that this generally has not occurred (Hendricks, Kovenock, 1989). Very early-‐stage, exploration in frontier areas, particularly broad-‐area exploration, ǲ
ǳ. In such cases, most of the benefits are external. Explorers' inability to capture most of the benefits would particularly deter exploration, adding to the effects of characteristically high uncertainty in frontier areas. To the extent that this exploration is substantially diminished or not undertaken at all, external benefits from information ǲǳǤ The public good character of a good or service increases with the proportion of benefits from the good, service or activity that represents external benefits. When the external benefits component of benefits from a good, service or activity is particularly large, the good, service ǲǳǤ"pure public good" is an extreme case of external benefits. The benefits from provision of a pure public good are almost entirely external benefits. Pure private goods are at the opposite end of the spectrum. Benefits of pure private goods are almost entirely internal in nature. Public goods and private goods are usually discussed by reference to the extent of rivalry in ǡǡǤǯ
good or service means another party cannot use it, it is a private good. If its use by each party ǯipt of benefits from it, and the incremental cost of making it available to additional users would approximate to zero, it is a public good. If some or all entities except one could be excluded from use of such a good, doing so would not be economically efficient because social benefits of providing wide-‐ranging access would exceed 20 Commonwealth Department of Finance and Deregulation (2011, p. 39) pointed out in its Strategic Review of Geoscience Australia that current exploration tenement regimes in Australia generally do not assign exploration rights on a scale at which strategic regional framework exploration studies would be viable for private investors. Exploration Information Policy 63 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨfshore Petroleum Exploration Policy Ǥǯ
by others Ȃ meaning it is a private good Ȃ exclusion would be economically efficient. If provision of public goods was left to the private sector, public goods would be underprovided or not provided at all, because of free-‐riding or inefficient exclusion. This would be inconsistent with an efficient allocation of resources. The standard economic prescription for under-‐provision of public goods is government provision (funding) of public goods. This is effectively a government subsidy of 100 per cent. In the case of underperformance of activities yielding significant external benefits that represent a much smaller percentage of total benefits from such activities than 100 per cent, the standard economic prescription is provision of government subsidies at a correspondingly lower rate than 100 per cent. It has been suggested in the literature on the economics of exploration that these prescriptions can be extended to public good and external benefits of exploration information. The public good argument has also been more widely supported. The exploration information public good argument suggests full government funding of compilation of basic, early-‐stage, broad-‐scale geological and geophysical information to provide a foundation for private sector exploration. This information would be made available to explorers at the marginal cost of supply (the incremental cost of supplying one extra user), which is close to zero. Such an approach is consistent with existing practice in Australia. It has been accepted as economically legitimate, with minimal discussion, by the Industry Commission (1991), its successor the Productivity Commission (2009) and the Henry Tax Review (Henry, others, 2009). The Commonwealth Department of Finance and Deregulation (2011) supported the public good argument for government funding of basic, early-‐stage, broad-‐scale exploration to provide a foundation for private sector exploration. It also advanced an alternative supporting argument, pointing out that it was in the interests of government as owner of resources and recipient of royalty and tax revenue from resource development to fund such exploration and apply the resulting information to maximise resource rent and increase its revenue. This information could be used to guide releases of territory for private exploration, and to attract investment by private sector explorers. The Department of Finance and Deregulation explained that efficient provision of available information to potential investors ǯ
community. This was described as analogous to release of a prospectus. Box 10 provides excerpts from relevant parts of the Strategic Review of Geoscience Australia. The public good and prospectus arguments are simply different ways of explaining that a case can be made for government funding of basic, early-‐stage, broad-‐scale exploration and dissemination of the resulting data on grounds that it would improve the efficiency of ǤǲǳǤ
This correction improves the efficiency of resource allocation. It also facilitates maximisation Exploration Information Policy 64 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ of resource rent by addressing information impediments. These impediments are forms of ǲ ǳǤ ocation of resources. Maximising resource rent is an aspect of improving the efficiency of resource allocation, as explained in section 2.2 above. Box 10 Alternative Case for Government Funding of Basic, Early-‐Stage, Broad-‐Area Exploration ǲǡ-‐competitive information is in informing decisions on which specific areas within a region or basin are viable for release for private exploration. For offshore petroleum, this decision process is managed by DRET on behalf of the Australian Government. At this stage the Government itself is the main beneficiary of the information in terms of identifying the ǤǥǥǥǤ A closely associated second stage in use of pre-‐competitive information is in promoting the exploration potential of Australian territory either in general terms or for specific areas being offered for exploration permits with a view to attracting investment from private explorers. Pre-‐
ǯ
ǤǥǥǥǤ The two stages described above represent the primary application of pre-‐competitive data and have strong analogies to the costs and processes involved in developing a prospectus for the sale of an asset. While the process involves providing information to potential investors, the underlying objective is not to benefit those investors but to elicit a positive investment respǤ
ǯ
interest in gaining the most favourable return for the community is served by ensuring the efficient provision of available information on that opportunity to potential investors. This holds regardless of how the Government seeks to capture a return for allocation of exploration rights. Ǯǯ
provision of pre-‐competitive information. While public good attributes certainly apply to pre-‐competitive information, under this
ǯǡdary tax revenues from resource development, that forms the core business c ase for the Government to generate and provide pre-‐competitive information as described above. This business case is heavily dependent on the current system for allocating exploration acreage which generally does not assign exploration rights at a scale where strategic regional framework studies become viable for private investors. ........... For offshore exploration, the available evidence weighs heavily against any expectation that a private sector interest or consortium would invest in regional studies of frontier areas under the current regime for assigning exploration and production permits. The fact that such areas have not been surveyed, taken together with clear statements from industry that such studies would not be a commercially viable investment, argue for a government role in information provision as ultimate owner and controller of any Ǥǳ Source: Commonwealth Department of Finance and Deregulation (2011), pp. 38-‐40. Members of the Australian Petroleum Production and Exploration Association (APPEA) supported the role of Geoscience Australia in generating and releasing early-‐stage exploration information. APPEA said that this role is:21 ".... very important in frontier basins, as most areas do not have much data coverage. These areas are too high risk for individual corporations to justify the preliminary investment needed to ascertain even the most basic petroleum related information. The pre-‐competitive data acquired by Geoscience 21 See Appendix C, under "Information Policy", response to ACIL Tasman's question 26. Exploration Information Policy 65 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Australia helps 'polarise' these areas; either highlighting their potential or pointing out why no further investigation is required." APPEA also observed:22 "Geoscience Australia currently restricts its pre-‐competitive work programs to frontier acreage that they deem to be poorly understood to attract reasonable bids. Their pre-‐competitive work has been successful in generating bids in the southern ocean of Australia, including BP's bid of over $500 million in (a) primary term work program in the Great Australian Bight." APPEA was asked whether or it considered the role of Geoscience Australia in generating and releasing early-‐stage exploration information should be extended or contracted. APPEA did not express a firm view one way or the other in response to this question.23 The economic case for government funding of, and release of data from early-‐stage, broad-‐
area exploration depends critically on a policy context involving non-‐distorting tenement transfer/allocation system and relatively unconditional tenure arrangements. Such a policy context is not apparent in Australian offshore areas. As explained in section 6.6, the benefits of government funded exploration information tend to be dissipated by work program bidding and highly conditional tenure arrangements. These exploration tenement arrangements do not have other compensating features. Dissipation of the benefits of exploration information would not occur under a cash bidding system with relatively unconditional tenure. Indeed, early-‐stage exploration information would improve competition and bids under such a cash bidding system, and facilitate its management by guiding timing of release of areas for bidding, setting of reserve prices, and decisions on acceptance or rejection of bids. However, the Australian offshore cash bidding system is underpinned by highly conditional tenure, which tends to dissipate resource rent. As argued in chapter 7, highly conditional tenure arrangements should not accompany cash bidding. Consistent extension of the information public good argument suggests provision of exploration subsidies to explorers undertaking pioneering work in terms of time, location, geological environment, exploration technique, and time. The appropriate subsidy would equal the sum of the amounts other interested tenement holders would be prepared to pay for ǲǳǤǡ
proposed by some analysts that most exploration expenditures could be subsidised, with the rate of subsidy varying according to perceived riskiness of the exploration activity, which could be influenced by factors such as timing, location, geological context, exploration phase, and exploration method (Stiglitz, 1975, p. 94; Fane, Smith, 1986, p. 228; Smith, 1997, p. 204). 22 See Apendix C, "Information Policy", APPEA's response to ACIL Tasman's question 29. 23 See Appendix C, "Information Policy", APPEA's response to ACIL Tasman's question 27. Exploration Information Policy 66 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Nobel Laureate in Economics Joseph Stiglitz suggested that the subsidy range could include negative subsidies, which are taxes (see Box 5). This would ensure internalisation or ǲǳ ǲǳ
provided to others. The tax or negative part of the subsidy range would also provide a source of funds for payment of subsidies. Box 11 ^ƚŝŐůŝƚǌ͛Ɛ^ƵďƐŝĚǇ-‐Tax Scheme for Petroleum Exploration ǲǡǡrnality of information. Thus, to induce the appropriate amount of exploratory activity, the government needs to impose a tax subsidy that is a function of the distance from other wells. If the well is very far from any other well, there should be a drilling subsidy. If the well is very close to neighbouring wells, there should be a drilling tax. The comparative advantages of such a tax subsidy scheme, compared to other methods of attempting to resolve the informational Ǥǳ Source: Stiglitz (1975), p. 94. Subsidising exploration, other than provision of a subsidy of 100 per cent for compilation of basic, early-‐stage, broad-‐scale exploration information (government provision), is not consistent with existing practice in Australia. Governments in Australia have not subsidised exploration for petroleum since 30 June 1974, when the Commonwealth Government terminated the Petroleum Search Subsidy Scheme. This scheme had been established in 1957 and revised from time to time (Williams, 1974). The government of the day explained that it had decided to abandon the subsidy scheme because it considered that public funds could be used better for other purposes (Crean, 1973, p. 1750). This implies that the government had estimated or perceived that the social opportunity cost of funds involved in the scheme exceeded the social benefits. While the Henry Tax Review supported government funding of early-‐stage exploration, it argued against ǲǳǤ
asserted that there is no evidence of significant market failures beyond early-‐stage exploration, citing the Industry Commission (1991) in support of its view. Subsidising exploration involves four problems. First, it requires government funding, which means higher taxes or government charges and/or reductions in other government programs ȋ ǯ Box 5). Second, the additional information ǲǳ ould ǡ ǲǳǤ ǡ
determining appropriate, differential subsidy rates for various stages and locations of exploration activity would involve challenging practical issues. Fourth, there is some doubt ǲǳ ǡ as outlined below. Exploration Information Policy 67 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Controversy regarding the significance of exploration "spillovers" has not been resolved by the results of quantitative analysis. An econometric study by Ken Hendricks and Robert Porter (1996) was undertaken with a large data set (2404 tracts) for the Gulf of Mexico. Th ǲ
ǳǡ
previously, and information externalities are most likely to be important in those regions. They found evidence of influence of ǲǳ Ǥ
However, the results were not strong. They suggested that this reflected the uncertainty that firms encounter in making exploration decisions. Using the same data set, Cynthia Lin (2009) applied econometric techniques to investigate the significance of economic inefficiencies arising from external benefits of petroleum exploration ǲǳǤ not indicate economic inefficiencies as a result of ǲǳin the next 12 months. Lin (2009, p. 593) concluded: ǲ ǯ
neighbours. This is true even on small tracts, where stǤǤǤǤǤǤǤǤǯ
exploration decision instead depends on exogenous factors such as the estimated pre-‐sale value of the tract, the tract's winning bid in the lease sale, whether or not it is the last year of the lease term, and Ǥǳ However, Lin explained that she had found that external benefits from information ǲǳ ǡ
been successful or unsuccessful. She offered the following intuitive explanation (Lin, 2009, p. 593): ǲǤǤǤǤǤǤǤǤǤǤǡ
ǯǡe the drilling may or may not be successful. As a consequence, the information externality may be Ǥǳ James Smith and Rex Thompson (2009) investigated the importance of information "spillovers" in "wildcat" areas by drawing on data from five United States outer continental shelf lease sales in which a total of 582 tracts attracted cash bids. For each of these lease sales (but not others), the United States Geological Survey identified groups of tracts associated with common geological structures and shared risk factors, allowing distinction between holdings that are geologically concentrated and those that are geologically diversified. Smith and Thompson (2009) found that information "spillovers" were of material importance in the exploration process. They explained that the option value of information "spillovers" provided an incentive for companies to assemble highly geologically concentrated portfolios of exploration prospects to internalise external benefits of information. While internalisation of information "spillovers" through geological concentration reduced uncertainty, greater geological concentration increased the correlation of elements in exploration portfolios, Exploration Information Policy 68 Review of AustraůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ resulting in a higher variance in outcomes. Therefore, exploration entities have to make trade-‐offs between concentration and diversification. Smith and Thompson (2009) found that the nett effect was a significant tendency of all companies to assemble concentrated holdings. They found that this tendency was stronger for private companies than public companies, despite their presumption that private companies were more risk averse. However, they revealed that the portfolios of small public companies were not more concentrated than the portfolios of large public companies. An alternative to subsidising exploration to increase information "spillovers" (as distinct from government provision of basic, early stage exploration data) would be government collection, and public dissemination at marginal cost of supply of exploration data generated by private sector explorers. Mason Gaffney (1977b, p. 112) advocated such an approach in a major report to the Alaskan Government on oil and gas leasing policy: "All information generated on State-‐owned lands should be reserved to the State and made public immediately." The Henry Tax Review gave subdued endorsement to government collection and dissemination of information from private sector exploration, as well as government funding of earlier-‐stage exploration information. The authors of the Review observed (Henry, others, Part 2, Volume 1, p. 220): ǲ Ǯ ǯ -‐
competitive geological data, in collecting and providing public access to geological data from exploration, and in publishing the results of geological research (Industry Commission, 1991). Such information assists efficient private exploration and provides input into resource planning and land managǤǳ The Henry Tax Review did not elaborate on its support for government collection and dissemination of data from private sector exploration. It certainly did not address the important issues of timing of release of data and potential exclusions of some information. Government collection of exploration data from private sector explorers and provision of that data to other interested parties is justifiable on "public good" grounds. All of the exploration information has public good properties, not just the portion that inadvertently spills over to others during and after exploration activity. This information collection and dissemination mechanism has three advantages over government subsidies to exploration. First, it provides better quality information than ǡ ǲǳǤ Second, it is likely to provide more information than ǲǳǤ Third, it relieves taxpayers and beneficiaries of government programs of the funding burden associated with funding subsidies. An issue with any scheme to increase information "spillovers" from private sector exploration is that, in the context of highly conditional tenure and work program bidding, which bring-‐
forward exploration, positive information would increase exploration work-‐bids in relevant Exploration Information Policy 69 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ areas. This would tend to dissipate the value added by the information "spillovers", as well as the pre-‐existing ex ante resource rent, as explained in chapter 6. It would particularly weaken the case for an exploration subsidy scheme. Of course, an information collection and dissemination program would not address the ǲǳ
advantage of all benefits of their activities and therefore exploration may be too little, too late from a social perspective, ǲǳ
decisions. However, this may be more than offset by the uncertainty-‐reducing effect of the increase in quantity and quality of information provided by collection of exploration information from private sector activity and dissemination of that information by government. On the other hand, the Industry Commission (1991, vol. 3, p. 39) said it ǲǳ
that government collection and dissemination of exploration data was justified. It gave three reasons for this view. First, the Commission ǣ ǲǤǤǤ
which is most likely to yield information of wider interest ..... is already undertaken by Ǥǳ Second, it suggested that other information of interest could be exchanged through market transactions. Third, the Commission asserted that compulsory acquisition and dissemination of private sector exploration results by government arguably may discourage exploration by entities producing that information. ǯǡǡ
ǲǳ as knowledge about the prospectivity of an area Ǥ ǡ ǲǳ not important for exploration later than basic, early-‐stage, broad-‐scale exploration. It did not provide evidence to support this view. Also, this view is either weakly or strongly contradicted by empirical evidence cited above. ǯ (regarding market transactions in information) again was not supported by analysis and appears to conflict with the Commission's first point. It is also inconsistent with the finding of Hendricks and Kovenock (1989), gained through a theoretical bargaining game model, that even with verifiable disclosure of private information and well-‐defined property rights, bargaining to coordinate activities or transfer tenements would not eliminate all of the economic inefficiencies resulting from decentralisation of exploration decisions. Hendricks and Kovenock explained that this result was supported by data in respect of United States offshore petroleum leases and activity. The third point made by the Industry Commission is consistent with the argument that exploration would be socially deficient if explorers are not able capture all of the benefits of their activities. However, the significance of this point is reduced to the extent that "much of the exploration activity which is most likely to yield information of wider interest ..... is ǳ (the Commission's first point). Moreover, it is relevant that government intervention to collect and disseminate exploration information from each explorer would encourage exploration by others. Each explorer whose data is Exploration Information Policy 70 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ collected and disseminated by government may benefit from disclosure of information generated by other explorers. The Commonwealth Government collects information generated by exploration in petroleum tenements,24 and, releases basic exclusive data 2-‐3 years after acquisition by the explorer, and interpretative data 5 years after the end of the operation to which the data relates. Non-‐
exclusive data (data collected for sale or licence) typically is not released until 15 years after acquisition by the explorer. Restrictions on release of information may be by-‐passed, provided written prior consent has been provided by the titleholder. More detail on these arrangements has been provided in sub-‐section 4.3.5. APPEA has advised that its members support the current exploration information release regime.25 APPEA argued that the length of information release delays provided a good balance between maintenance of a competitive advantage by the generator of the information for a fixed period and access of information by other explorers. ACIL Tasman is not persuaded that the generator of information in respect of an offshore area under the control of the Australian Government should be given a competitive advantage that reduces gains from the public good nature of the information. APPEA supported the complementary data repository function of Geoscience Australia.26 During the workshop, APPEA members explained that they placed high value on the data repository function of Geoscience Australia. APPEA members stated that if cash bidding replaced work program bidding, exploration information should not be released for the life of the permit. APPEA did not explain this view, other than to observe that the tenement holder pays for the tenement through its cash bid. ACIL Tasman considers that this does not provide adequate support for treating exploration information differently under work program bidding than under a cash bidding regime. Indeed, as explained above and in chapters 6 and 7, dissemination of exploration information is much more likely to lead to socially beneficial outcomes under a cash bidding regime than under a work program bidding regime, because of the tendency of the latter to dissipate the value added by general availability of the information. On balance, the preceding analysis supports early release of information generated by private sector exploration in petroleum tenements and the complementary data repository and dissemination functions of Geoscience Australia. There do not appear to be valid economic reasons for delaying release of basic exclusive data beyond one year from acquisition, 24 Petroleum tenements include petroleum exploration permits, petroleum retention leases, petroleum production licences, petroleum special prospecting authorities, petroleum access authorities or scientific investigation consents. 25 See Appendix C, response to question 25 under heading "Information Policy". 26 See Appendix C, response to question 26 under heading "Information Policy". Exploration Information Policy 71 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ interpretative data beyond 2 years from completion of an operation, and non-‐exclusive data beyond 10 years. It has been suggested by some parties that tenement conditions and tenement allocation systems designed to force the pace and increase the amount of exploration activity could be ǲ ǳ external benefits of ǲǳ and the "public good" of exploration information. For example, APPEA members cited exploration information generation is an important argument for work program bidding.27 The value of such systems as devices to address information "spillovers" has been investigated in depth in chapters 6 and 7. There it has been concluded that such arrangements could not a ǲǳ and are likely to do much ǡ ǲ ǳ, a concept discussed in sub-‐section 2.4.2. 5.2
Asymmetric Information Information market failures may result from asymmetric availability of information, not just information under-‐provision. Exploration information has been asymmetrically provided. A private sector explorer has better information available to it than competitors for adjacent or comparable areas. Asymmetric availability of information creates an external cost Ȃ a cost imposed on others without compensation. Entities with inferior information are ǡǲǳȋǡǡͳͻͺͶȌǤ Subsidising exploration would increase exploration activity and thereby increase inadvertent ǲǳ consequent external benefits, but it would involve considerable practical difficulties and could not resolve the problem of asymmetric availability of exploration information. Government collection and release of exploration data would address asymmetric availability of information and the resulting external cost. The earlier exploration data is made publicly available following exploration activity, the greater the reduction of exploration information asymmetry. Greater public dissemination of exploration information also would increase external benefits, as explained above. Asymmetric information market failure might be addressed automatically under a cash bidding regime. Walter Mead, Asbjorn Moseidjord, and Philip Sorensen (1984) argued that the first auction in an area, in which no bidder has superior information, might attract bids reflecting not only the right to explore and exploit, but also the opportunity to obtain information that could be useful in later auctions in the area. The winning bidder would be paying for the right to have a later informational advantage. This would tend to internalise 27 See Appendix C, "Some general comments", comments on the segments of the Henry Tax Review, and responses to ACIL Tasman questions 1, 2, 9, 13, and 19. Exploration Information Policy 72 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ the external cost associated with an asymmetric information market failure. It would also compensate government for loss of cash bidding revenue from later auctions in which earlier explorers in relevant areas have informational advantages. Mead, Moseidjord and Sorensen explained that this argument was supported by the results of detailed analysis of bidding patterns and profitability outcomes in respect of the large number of oil and gas tenements issued in the Gulf of Mexico by the United States Government from 1959 to 1969. The implications of asymmetric information for cash bidding have been discussed in more detail in sub-‐section 7.1.3 under the sub-‐heading "Asymmetric Information". 5.3
Findings and Recommendations 5.3.1
Findings There is widespread acceptance that a strong economic case exists for government funding of early-‐stage exploration and dissemination of the data, because of the public good nature of the information. However, the economic case depends critically on the prevailing tenement regime. Retention of current work program bidding and highly conditional tenure arrangements would undermine the case for government funding of early-‐stage, broad-‐area exploration. These tenement arrangements tend to dissipate the value added to prospects by the exploration information, as well as dissipating ex ante resource rent. However, the case for the early-‐stage exploration program could be restored to the extent that the work-‐bid exploration regime is reformed along lines proposed in section 6.13 below. The minimum (third best) reform would involve:
delay of release of less attractive areas until they are judged to be "prime targets" for exploration

reduced conditionality of tenure close scrutiny of work program bids for delayed area-‐releases to eliminate overbidding. A second best reform would modify the preferred reform package by making allocation of permits on the basis of cash bids subject to the highest bidder committing to an undemanding, tailored minimum program. The preferred reform option is to replace the current release and work-‐bid regime with cash bidding, delayed area-‐releases for less attractive areas, and eased tenure conditions. In these circumstances, the case for a government funded early-‐stage exploration program would remain strong. Indeed, early-‐stage exploration information would improve competition and bids under such a cash bidding system, and facilitate its management by guiding timing of Exploration Information Policy 73 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ release of areas for bidding, setting of reserve prices, and decisions on acceptance or rejection of bids. In these circumstances, it would be appropriate to expand the information-‐generation and interpretation roles of Geoscience Australia. More analysis by Geoscience Australia and the administering authority's economic advisers would also be required to determine the timing and location of area releases for cash bidding. Meanwhile, analysis of appropriate settings for reserve prices for cash bidding, and whether or not any or all bids should be rejected would replace current assessment arrangements in respect of work programs under the work program bidding system, and for determination of programs to be included in conditions of initial and renewal exploration permits. If all of the tenement and area release reform options are rejected, continuation of government funding of early-‐stage, broad-‐area exploration should be re-‐assessed. Opinion is divided on the appropriateness of government intervention to increase the "spillover" of information from private sector exploration. The main source of contention is the significance of exploration information "spillovers". A secondary issue relates to the relative merits of exploration subsidies, and government collection and early release of data generated by private sector explorers. On balance, the analysis in this chapter indicates that government collection and early release of data generated by private sector explorers would be a better policy option for a variety of reasons. In particular, it provides more and better quality information, avoids the economic efficiency costs of funding subsidies, and addresses the problem of asymmetric information. An issue with any scheme to increase information "spillovers" from private sector exploration is that, in the context of highly conditional tenure and work program bidding, which bring-‐
forward exploration, positive information would increase exploration work-‐bids in relevant areas. This would tend to dissipate the value added by the information "spillovers", as well as the pre-‐existing ex ante resource rent. It would particularly weaken the case for an exploration subsidy scheme. Asymmetric information market failure could be addressed by government funding of, and dissemination of data from early-‐stage exploration, and by government collection and early release of data generated by private sector explorers. Arguably, a cash bidding regime would also deal with this problem. 5.3.2
Recommendations If a decision is taken to adopt cash bidding as the primary transfer/allocation system for Australia offshore petroleum exploration permits, and to eliminate or substantially ease tenure conditions that force the pace of exploration, as recommended in chapter 7, the exploration information-‐generation and interpretation roles of Geoscience Australia should be expanded. In addition, provision should be made for more analytical effort by Geoscience Australia and the Department's economic advisers to determine the timing and location of Exploration Information Policy 74 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ releases of areas for bidding. Meanwhile, analysis of appropriate settings for reserve prices for cash bids, and whether or not to reject any or all bids should replace assessments linked to the work-‐bid exploration permit regime. If a decision is taken to retain the current work program bidding and highly conditional tenure arrangements, the extent and focus of government funding of early-‐stage exploration should be re-‐assessed. Exploration information generated by titleholders should be released earlier than allowed at present to improve the policy response to information "market failures", and to encourage more competition under a cash bidding regime. Data releases should be no later than one year from acquisition in the case of basic exclusive data, no later than two years from completion of an operation in the case of interpretative data, and no later than 10 years from completion of an operation in the case of non-‐exclusive data. Exploration Information Policy 75 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚore Petroleum Exploration Policy 6
tŽƌŬ-‐ŝĚǆƉůŽƌĂƚŝŽŶWĞƌŵŝƚZĞŐŝŵĞ This chapter provides an assessment of the work-‐bid exploration permit regime applying to Australian offshore petroleum exploration. This regime involves periodic area-‐releases for applications, a work program bidding transfer/allocation mechanism and highly conditional tenure. The implications of any significant differences between the Australian regime and other selected countries' versions of this type of regime have been assessed. The implications of interactions between these and other aspects of policy have been analysed where appropriate. Other important elements of offshore petroleum exploration policy have been analysed in chapters 5, 7, 8, 9, and 10. The assessment in this chapter (and in chapters 5, 7-‐10) has been based on policy design and assessment principles discussed in chapter 2. These principles are equity, economic efficiency, and administrative efficiency. The concept of resource rent discussed in chapter 3, the extent to which it is preserved or dissipated by offshore policies, and the distribution of resource rent are central to the analysis in this chapter for reasons explained in section 2.2 of chapter 2, and in chapter 3. Relevant parts of Australia's work-‐bid exploration permit regime have been outlined in sub-‐
sections 4.3.2 and 4.3.3 of chapter 4. Elements of other selected countries' versions of this regime have been summarised in section 4.4 and Appendix A. The Australian regime and other countries' versions of this regime have four basic elements:
periodic area-‐releases for exploration permits (annual for offshore Australia), supported by detailed exploration data packages and other relevant information

highly conditional tenure allocation of tenements on the basis of an assessment of work program commitments offered by competing enterprises considerable discretion available to the administering authority in setting tenure conditions and selection of recipients of permits.
The similarity of work-‐bid schemes internationally is not surprising, because it appears that the Norwegian system (established in 1965) and the Australian regime (established in 1967) were based on elements of the system established in 1964 by the United Kingdom (UK) Government for offshore petroleum exploration. Subsequently, basic elements of this type of scheme were adopted by governments of other countries.28 The Australian work-‐bid exploration permit regime, and other selected countries' variants, have been designed and administered to increase and bring-‐forward exploration activity 28 For an historical and critical analysis of the early years of the UK and Norwegian work program systems, see Dam (1976). Work-‐Bid Exploration Permit Regime 76 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ relative to outcomes based on rational commercial decision-‐making. This approach has been based on the presumption that more exploration and earlier activity are necessarily advantageous from an economic or social (community) perspective. While exploration is a very important economic activity, this presumption is accurate only to the extent that increasing and bringing forward exploration relative to patterns based on rational commercial decision making would correct (but not over-‐correct) deferment or reduction of exploration activity caused by market and policy failures. Although the Petroleum (Submerged Lands) Act 1967 was amended in 1985 to establish cash bidding as an alternative to work program bidding for transfer/allocation of exploration permits, work program bidding has remained the dominant allocation system since 1985. Cash bidding was used only in a relatively small number of cases from 1985 to 1992 and has not been used offshore since 1992. To provide context for the policy analysis in this chapter, a detailed statistical review of offshore petroleum exploration activity since 1985 was undertaken. The results have been documented in Appendix B. The assessment of the Australian work-‐bid exploration regime in this chapter demonstrates that it performs poorly with respect to economic efficiency, administrative efficiency and equity criteria. Because of its severe resource allocation deficiencies, it represents a clear example of the concept of policy failure described in sub-‐section 2.4.2. 6.1
Overview of Previous Economic Assessments of Work Program Bidding Kenneth Dam (1965) analysed the offshore oil and gas licensing arrangements established by the United Kingdom (UK) Government under the Continental Shelf Act 1964. He described this system as a "form of competitive bidding in work programs". It involved elements of competitive bidding and government-‐company negotiations in respect of work programs. The UK Minister of Power announced assessment criteria for allocation of licences in 1964. One criterion was to "encourage the most rapid and thorough exploration and economical exploitation of petroleum resources on the continental shelf". Others included "the program of work" and "ability and resources to implement it". Dam observed that the Ministry of Power had substantial administrative discretion in selecting licensees. Dam (1965) explained that the scheme provided a subsidy to induce earlier and more exploration activity than the interests of explorers would dictate in the absence of the subsidy. Resource rent was effectively deployed as an exploration subsidy. The scheme sacrificed resource-‐access payments to government. Dam (1965, p. 65; 1976, p. 36) elaborated: "The subsidy was not only undisclosed and hence shielded from criticism, but also has the politically attractive quality of not coming out of tax revenues, but rather of being merely a reduction of monies that would otherwise flow from the oil companies to the Treasury." Dam (1965) explained that a requirement to relinquish not less than 50 per cent of a licence area after the initial licence period of 6 years tended to induce earlier, additional exploration, Work-‐Bid Exploration Permit Regime 77 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆploration Policy like the work program system did. Dam (1976) observed that there was a question whether relinquishment requirements would increase the speed of exploration above the rate set by the work commitment. Dam explained that the work program system and relinquishment arrangements adversely affected the efficiency of resource allocation and denied resource rent to the Treasury and therefore the community. He argued that allocation of petroleum exploration licences by means of a competitive cash bidding system would be superior on grounds of efficiency of resource allocation, administrative efficiency, and returns to the community or equity. Nobel Laureate Ronald Coase (1970) endorsed Dam's analysis. He commented that use of work program bidding, rather than competitive cash bidding to award North Sea oil and gas licences adversely affected the efficiency of allocation of resources. Later, Kenneth Dam (1974, 1976) undertook further analysis of the UK work program system and an experiment with cash bidding in 1971. As a result, he challenged two assumptions underlying the work program system: the desirability of forcing more rapid exploration than market forces would call forth, and the effectiveness of the work program regime in speeding up of exploration. Dam concluded that the UK work program system provided a "most expensive" subsidy to exploration. Mason Gaffney (1967a) provided a seminal exposition of the importance of timing of exploration and development for an efficient allocation of resources. He explained that the design of tenement policies could misallocate resources by motivating too much exploration, too soon. He used a diagrammatic model to facilitate his exposition. An extended version of this model has been used in section 6.2 to explain Gaffney's insights and apply them in the context of Australia's offshore work-‐bid exploration permit system. Gaffney (1967a) explained, with the aid of his model that if pre-‐discovery tenure is imperfect and discovery establishes secure tenure, exploration would be undertaken prematurely and pre-‐emptively to obtain secure tenure. This would result in dissipation of resource rent by interest on premature exploration expenditures. Gaffney (1967a, p. 391-‐392) observed: "It is widely understood that the rule of capture motivates premature use of fugacious petroleum. It is not so widely understood, but more forcefully true, that open access for prospectors followed by closed access after discovery overmotivates prospecting by a large factor. The oil pumper only gets what he pumps; the discoverer gets the whole resource. The entire discovery value of resources becomes the motive to explore. It calls forth outlays roughly equal to itself, dissipating the entire (resource) rent by interest cost on early (exploration) investments." Gaffney explained that an extreme case was the system of open access to public lands in the United States to explore for "hard rock" mineable commodities, followed by granting of secure tenure after discovery of an eligible resource. However, he stressed that it was not necessary for there to be completely open access before discovery for premature, pre-‐emptive exploration to occur. The problem could be created by "imperfection in the tenure of undiscovered resources" or the "absence of good tenure" before discovery. Work-‐Bid Exploration Permit Regime 78 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Gaffney explained that the tendency of tenement policies to motivate exploration too much, too soon was based on long-‐exposure to a mistaken perception that more and sooner exploration are necessarily positive from a social perspective. An excerpt from Gaffney's seminal work has been reproduced in Box 12. Box 12 Mason Gaffney on Exploring Too Much Too Soon ǲ ǣ ǡ ǫ
enough, but not too soon? I have been writing as though the motive to explore were an unqualified good. Yet it is entirely possible to motivate too much, and too soon, and it may well be that we are doing so. If that sounds like desecrating church, mother and flag, beware! It only betrays ǯ-‐exploration bias that suffuses our traditions so thoroughly we are scarcely aware of it. Men who on most issues seek an optimal moderate target as a norm will find that that they can conceive of having too little mineral reserve but hardly of having too much. It is as though one could be too thin but never too fat. But it is possible to explore too much Ȃ and equally wasteful Ȃ Ǥǳ Source: Gaffney (1967a), p. 381. Orris Herfindahl and Allen Kneese (1974, pp. 135-‐136) investigated the consequences of the institutional arrangements for, exploration of, and acquisition of secure tenure on public lands in the United States. Unlike Gaffney, they did not investigate the implications of imperfect rather than open pre-‐discovery access. They were not aware of Gaffney's seminal analysis. Herfindahl and Kneese used a much simpler model than Gaffney, but arrived at the same conclusion. When access to secure tenure is conditional on discovery, the "social nett return" from resources (resource rent) is "entirely dissipated" by compound interest on "premature exploration outlays". Herfindahl and Kneese (1974) strongly criticised subsidies or their equivalent that have been designed to stimulate and bring forward exploration activity, because they would cause misallocation of resources. Box 13 reproduces an excerpt from their critique of such policies. Box 13 Herfindahl and Kneese on Exploration Subsidies or Equivalent Measures "......... exploration activity is not to be encouraged, per se, any more than one would want to encourage expenditure on the function of milling ores or shelling peanuts. It would seem a little odd to imagine the seller of Planters Peanuts arguing that incentives should be provided to encourage more peanut shelling, yet it is often argued that exploration for minerals ought to be encouraged and stimulated by subsidies or their equivalent. As a general matter, the one is an uneconomic as the other. Outlays on exploration are like any others. The object is to spend as little and as late as possible, making appropriate adjustments at the margins where inputs can be substituted. These adjustments refer to the composition and timing of different types of expenditures on exploration ........ Given the composition of expenditures on exploration, however, it still remains true that they should be as little and as late as possible" Source: Herfindahl, Kneese (1974), pp. 132-‐133. Work-‐Bid Exploration Permit Regime 79 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Gregg Erickson (1977) analysed work program bidding, which he referred to as work commitment bidding. Erickson explained that each prospective bidder would consider the maximum amount it could promise to spend on a work program on the tenement offered for bidding and still expect to break even. He pointed out that a bidder under a work program bidding system could promise to spend more than the same bidder would offer under a cash bidding regime to the extent that the promised exploration expenditure could be expected to add value to the tenement. Erickson acknowledged Kenneth Dam's analysis, but did not appear to be aware of the work of Gaffney or Herfindahl and Kneese. He agreed with Dam (1965) that the work commitment bidding system provided a subsidy for exploration. Erickson (1977, p. 76) commented: "As such, the criteria for its evaluation should be no less stringent than those applied to a direct appropriation of public funds or a tax concession adopted for the same purpose." He pointed out that the subsidy would be difficult to determine. Moreover, if a "right" level of subsidy existed, it would be largely a matter of luck if the foregone government revenue happened to equal that amount. Erickson used numerical examples to suggest that the contribution of potential resources to economic welfare, resource rent, could be dissipated by work program bidding. Box 14 Typical Australian Conditional First-‐Come-‐First-‐Served Exploration Tenement Regime Under a conditional first-‐come-‐first-‐served exploration tenement regime, an enterprise wanting to secure suspected petroleum bearing lands that might provide the basis for an extraction operation would need to apply for, and be granted an exploration tenement on an over-‐the-‐counter (distinct from competitive bidding) basis. A successful application would prevent the area from falling into the hands of competitors, at least temporarily. The tenement would be granted for a limited period of a few years, and subject to performance of a minimum work program with timing and specifications that would be determined by, negotiated with, or deemed satisfactory by government. A grant would also be subject to the administering authority being satisfied that the applicant had adequate expertise and financial resources available to it. In the event of conflicting applications, typically, the tenement would be granted to the applicant offering the program considered "best" by the administering authority, subject to expertise and financial resources available to the applicant being deemed adequate. Then, the conditional first-‐come first-‐served system would take on some of the character of work program bidding. Relinquishment of part of the area would be required from time to time during the period of the tenement and/or before renewal. Renewal would typically be subject to performance of a minimum work program. The probability of secure tenure would be greatly increased by exploration activity leading to discovery of a resource, which would generate an exclusive right to apply for an extraction or retention tenement. Clearly, secure tenure would depend on applying for and being granted an exploration tenement before another party, meeting minimum requirements regarding the quantum and timing of work within the limited period provided, satisfying relinquishment requirements, and ultimately discovering a resource. Source: ACIL Tasman research. Work-‐Bid Exploration Permit Regime 80 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Athol Fitzgibbons (1978) briefly discussed the Australian conditional first-‐come-‐first served system (see Box 14), which is the main transfer/allocation system for exploration tenements used onshore by state and territory governments. He did not discuss work program bidding. Fitzgibbons pointed out that under this system, each explorer must advance its claim to avoid loss of tenure to another. The timing of application for exploration tenements and exploration activity would depend not only on technical matters, but also on gaining secure tenure. Exploration would be undertaken earlier and faster than indicated by efficient resource allocation. He asserted that this would result in dissipation of resource rent. The first detailed analysis of transfer/allocation systems in Australia was undertaken by Ken Willett in the Green Paper on Mining Royalty Policy for the Northern Territory (Northern Territory of Australia, 1981). He adapted Gaffney's analytical framework and insights to analyse a typical Australian conditional first-‐come-‐first-‐served regime, an outline of which appears in Box 14. The analysis did not cover work program bidding, but Willett (1985, 2002) later extended the analytical framework to assess that transfer/allocation regime for exploration tenements. Willett found that a conditional first-‐come-‐first served system could partly or completely dissipate ex ante resource rent through the opportunity cost of capital applied to premature exploration outlays. He pointed out that the rent dissipation would be reduced by royalty or tax liabilities based on future extraction outcomes, to the extent that those fiscal regimes did not exclude interest on exploration outlays from the royalty or tax base. However, this exclusion tends to destroy rent in another way, by discouraging investment at the margins of exploration and investment (Northern Territory of Australia, 1981). Willett explained that resource rent taxes/royalties (and other economic profits-‐based royalty/tax regimes) exclude interest on exploration outlays in respect of discovered resources through carry-‐forward of those expenditures at a high rate of return until cash flows are adequate to cover the accumulated outlays. Therefore, they tend to institutionalise dissipation of ex ante resource rent by not penalising premature outlays through tax on interest foregone and excessive outlays. However, they do not do so completely because of asymmetric treatment of successful and unsuccessful exploration. This asymmetric treatment discourages exploration, but reduces the dissipation of rent through premature exploration induced by a conditional first-‐come-‐first-‐served exploration tenement system (Northern Territory of Australia, 1981). It was explained that the dissipation of resource rent by premature exploration expenditures could be eliminated if the conditional first-‐come-‐first-‐served system was replaced by allocation of unconditional, long-‐term tenure through a cash bidding regime. The former would dissipate resource rent by misallocating resources to exploration. The latter would not distort exploration decisions, thereby preserving ex ante resource rent, as well as capturing it (Northern Territory of Australia, 1981). Work-‐Bid Exploration Permit Regime 81 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ This analysis triggered Australian academic interest in the effects of work program bidding, as well as the consequences of the conditional first-‐come-‐first-‐served system. Several studies over the following decade analysed conditional first-‐come-‐first-‐served systems or work program bidding systems or both. In a review of Willett's analysis for the Northern Territory, David Nellor, Richard Clarke and Michael Porter (1981) of Monash University's Centre of Policy Studies agreed that a conditional first-‐come-‐first-‐served system caused economic inefficiency. The review attached an earlier paper by David Nellor (1981) written subsequent to the analysis by Willett in the Green Paper. Nellor (1981, pp. 10-‐11) argued that under a system of "bidding for permits or leases by means of offering work programs .......... the work program will be extended to the point where the present value of losses incurred from the work program offset the present value of the expected nett profit from gaining the mineral lease." It appears that Nellor was referring to both conditional first-‐come-‐first-‐served and work program bidding regimes, but this was not made clear in the paper. Nellor (1981) pointed out that if a royalty or tax regime based on realised outcomes was in place prior to exploration tenement allocation, overextension of the work program would not occur if the costs of any over extension (excessive expenditure and interest on premature outlays) were included in the royalty/tax base. However, if the costs of overextension were excluded from the tax base, as is the case for a resource rent tax, overextension would occur and the costs would be borne by government through loss of revenue. Nellor should have said partly borne by government, because he did not envisage a resource rent tax would be applied at a rate of 100 per cent. Nellor's point on the influence of the design of taxation of realised outcomes on the extent of overextension of exploration programs supported Willett's analysis in the Green Paper. Peter Swan (1981) of the Australian National University, in a review of the Green Paper, endorsed the validity of the arguments that a conditional first-‐come-‐first-‐served would tend to dissipate ex ante resource rent and that realised economic profits-‐based royalty/tax regimes such as a resource rent tax, tend to institutionalise dissipation of ex ante resource rent by not penalising premature outlays through tax on interest foregone and excessive outlays. Swan stressed that it was not this type of tax regime that was the source of the problem, but the lack of secure, pre-‐discovery tenure. Swan's solution was to combine cash-‐
bidding for secure tenure over promising areas with an economic profits-‐based royalty/tax. Ben Smith and Alistair Ulph (1982) of the Australian National University argued that a conditional first-‐come-‐first-‐served system created a bias towards an "excessively rapid rate of exploration" from a social perspective. Later, Ben Smith (1984) argued that the premature conduct of exploration resulting from this system would dissipate resource rent to an unspecified degree. He also suggested that work program bidding would have a similar effect, but he did not clearly distinguish between the two systems and therefore, the implications of the analysis for work program bidding were not clear. Smith (1984) advocated replacing such allocation systems with cash bidding. He argued that this was a pre-‐requisite for implementation of a resource rent tax or other realised economic profits-‐based system. Work-‐Bid Exploration Permit Regime 82 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Nellor and Clarke (1983) analysed work program bidding, but included discussion of conditional first-‐come-‐first-‐served systems under the label "work program bidding", without adequately distinguishing between the two regimes. As a result, they stated that work program bidding is the mechanism generally used in Australia to determine the allocation of exploration tenements among potential explorers. In reality, the conditional first-‐come-‐first-‐
served regime was the dominant system applied by state and territory governments onshore, and work program bidding was the dominant regime applied offshore under Commonwealth Government legislation. Nellor and Clarke argued that "work program bidding" leads to over-‐expansion of exploration with associated economic waste manifested in dissipation of ex ante resource rent. They suggested ex ante resource rent could be totally dissipated. Nellor and Clarke pointed out that "work program bidding" has relatively high administration costs. In addition, they commented on the distributional implications of the regime. They explained that providers of exploration services and system administration services would benefit, while loss of government revenue resulting from resource rent dissipation meant potential beneficiaries of some government expenditure programs would miss out. Theodore Bergstrom (1984) of University of Michigan, and visiting professorial fellow at Monash University's Centre of Policy Studies, followed Nellor and Clarke in failing to distinguish between work program bidding and conditional first-‐come-‐first-‐served regimes, referring to both types of transfer/allocation system for exploration tenements as "work program bidding". Bergstrom (1984, p. 179) endorsed Nellor and Clarke's finding regarding economic inefficiencies caused by "work program bidding" in the following terms: "........ if work program bidding proceeds to the point where the winning bidder's rate of return after engaging in the work program is no higher than can be found elsewhere, then the works program must result in a waste of resources whose value equals the amount of (resource) rent that would have resulted from efficient development." Peter Swan (1984) (who was at the University of New South Wales at the time) recognised the distinction between work program bidding and conditional first-‐come-‐first-‐served systems, but did not articulate the differences. However, he argued that both mechanisms could be expected to lead to a dissipation of resource rent. Swan reiterated his earlier proposal to combine cash-‐bidding with a realised economic profits-‐based system. In response to suggestions that there are no resource rents in the Australian mining, including petroleum extraction, sector, Swan (1984, p. 8) observed: "The (resource) rents are there all right for the taking, but the way we have managed the mad scramble for resource wealth has encouraged its being frittered away. ........... The absence of riches may itself be due to defective methods of lease allocation which unfortunately are still in use." Ken Willett (1985) articulated the differences between work-‐bid and conditional first-‐come-‐
first-‐served exploration tenement regimes. He analysed each system in some depth. This contribution adapted the analytical framework and insights of Mason Gaffney (1967) to assess Work-‐Bid Exploration Permit Regime 83 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ work program bidding, and extended Willett's earlier work (see Northern Territory of Australia, 1981) on typical Australian conditional first-‐come-‐first-‐served systems. This analysis did not use Gaffney's diagrammatic model to illustrate results of the analysis. Willett (1985) explained that both work-‐bid and conditional first-‐come-‐first-‐served systems of allocating exploration tenements misallocated resources, tending to dissipate ex ante resource rent. Work-‐bid and conditional first-‐come-‐first served systems subsidised exploration, but were found to be poor mechanisms for offsetting inefficiencies caused by information "spillovers" and consequent external benefits of exploration. It was also pointed out that they involved relatively high administration costs. Willett explained that the rent-‐dissipating tendency of these exploration tenement regimes undermined revenue from royalty/tax systems based on resource rent or economic profits, such as resource rent taxes, to the extent that they exempted excessive exploration expenditures and interest on premature exploration from the tax base. Ironically, conventional royalty systems based on gross value or quantity of production tended to offset the resource rent dissipation problem arising from tenement systems encouraging too much exploration, too soon. They did so by capturing a portion of resource rent without exempting from the royalty base those costs of exploration activity that were incurred too much, too soon. However, these levies could not be set to capture a high proportion of resource rent without destroying resource through adverse effects on incentives to explore, invest and extract. As a result of the revenue losses and effective subsidies associated with work-‐bid and conditional first-‐come-‐first served regimes, they were found to perform poorly on equity grounds. Willett (1985) favoured a combination of cash bidding and a realised economics profit-‐ or rent-‐based royalty/tax regime. He argued it was particularly important to replace work program bidding and conditional first-‐come-‐first-‐served exploration tenement regimes in "attractive" areas. Later, Ken Willett (2002) elaborated on and extended his previous analysis and results using a modified, more elaborate version of his earlier model (in Northern Territory of Australia, 1981), which in turn was based on Gaffney's model (in Gaffney, 1967a). An important advance was the application of Gaffney's model to improve the explanation of the inefficiency of inducing exploration too soon. Another important extension was a strong emphasis on the desirability of ensuring that tenure conditions, as well as the transfer/allocation mechanism, did not cause misallocation of resources, a point emphasised earlier by George Fane and Ben Smith (1986). More detail regarding the analysis and results in respect of the work-‐bid regime has been provided in sections 6.2, 6.3, 6.5, 6.8 and 6.9 below. George Fane and Ben Smith (1986) focused on work program bidding, but unlike Willett (1985), they did not also analyse the conditional first-‐come-‐first-‐served regime. Moroever, the analytical approach was different. In general, Fane and Smith arrived at very similar conclusions to those of Willett (1985). One exception was that the former focussed on the amount of exploration effort, while the latter discussed timing too. Later, Willett (2002) Work-‐Bid Exploration Permit Regime 84 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ further emphasised timing, noting that resources were misallocated because of pressure to explore too much, too soon, not just too much. Another difference between the analysis of Fane and Smith (1986) and Willett (1985) was that the former stressed that, to avoid misallocation of resources, it was important to address tenure conditions that applied pressure to explore, and not just focus on the work program bidding tenement allocation mechanism. This point was subsequently endorsed by the Industry Commission (1991) and Willett (2002). The Industry Commission (1991) analysed conditional first-‐come-‐first-‐served and work program bidding exploration tenement regimes in detail. Its conclusions were similar to those of Willett (1985) and Fane and Smith (1986). However, the Commission did not address the effects of these systems on government royalty or tax revenue. The Commission recommended replacement of work program and conditional first-‐come-‐
first-‐served exploration tenement regimes with cash bidding for long-‐term, relatively unconditional, tradeable rights to explore for and extract resources. Conditions would be confined to matters such as treatment of the environment and payment of royalty, and would certainly exclude work requirements. The Commission considered that work program bidding was the least desirable system. Ben Smith (1997) analysed both work-‐bid and conditional first-‐come-‐first-‐served exploration tenement regimes. Smith arrived at similar conclusions to Willett (1985) regarding the tendency of these regimes to dissipate ex ante resource rent, and the economic efficiency and revenue implications of their interaction with various types of royalty and taxation systems. Like Willett (1985), Smith (1997) highlighted the point that resources were misallocated by distortion of the timing as well as the amount of exploration activity. Smith (1997) commented that the "main case for a regime which encourages greater levels of exploration than private resource owners would be likely to choose" is provided by information "spillovers", because to the extent they are important, they lead to less exploration than is socially desirable (see chapter 5). However, Smith suggested two reasons why work-‐bid and conditional first-‐come-‐first-‐served systems are "extremely blunt" instruments for correcting resource misallocation arising from information "spillovers". First, the subsidy provided by these regimes is unrelated to the significance of the "spillover". Second, the incentives they provide may dissipate the value of the information generated. Smith (1997) advocated combining cash bidding with a royalty/tax on realised cash flows with full loss offsets (refund of negative cash flows including costs of unsuccessful exploration at the tax rate) or an equivalent regime. Alternatively, the royalty/tax could be replaced by a free carried interest for government at the exploration stage, with a contributing interest thereafter. Ursula Kretzer (1993) analysed work program bidding from an economic efficiency perspective. Her analysis was based on a mathematical model. She discussed the implications of the results for the UK offshore exploration licensing regime. Work-‐Bid Exploration Permit Regime 85 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Kretzer explained that work program bidding is a less effective mechanism than cash bidding for allocating tenements to those who value them highest. Also, while work program bidding distorts exploration activity, cash bidding does not cause departure from optimal exploration programs. Kretzer's analysis indicated that under a system of work program bidding for exploration tenements, competitive pressures would result in work bids in excess of the profit maximising level. They would trade-‐off the increased probability of winning the tenement with a program bid in excess of the optimal program against the loss of profit resulting from overextension of exploration. Kretzer did not mention or discuss the distinction between overextension through exploring too much and exploring too soon. Kretzer argued that the overextension of exploration programs was similar to the overcapitalisation effect observed in industries subject to rate of return regulation. Averch and Johnson (1962) explained that such regulation induced overinvestment relative to the optimal level for a chosen output. Similarly, setting the size of exploration programs as a performance indicator encouraged expansion of work programs above the optimal level. 29 Kretzer explained that the greater the number of competing entities in a work program bidding situation, the higher work bids would be. At the limit, they would reduce expected economic profits or resource rents to zero. Kretzer also found that the degree of overextension of exploration programs is inversely related to the anticipated ratio of cost to price. The overextension at low cost-‐price ratios is higher than at low cost-‐price ratios in absolute terms and relative to undistorted programs. Kretzer (1993) pointed out that in the case of a work program bidding system, the "winner's curse" worsens resource allocation, while adjustments to avoid the "winner's curse" reduce that adverse effect. However, she pointed out that the extent of these effects was likely to be muted to some extent because work program bids do not depend solely on ex ante resource rent, being influenced also by exploration cost and program considerations. In any event, she pointed out that there had been debate in the literature on bidding for offshore petroleum exploration tenements as to whether companies actually adjusted at all for the "winners curse". Ursula Kretzer (1993) observed that the UK Government had continually argued that it was appropriate to award offshore petroleum exploration licences on the basis of work programs, because it advanced the government's desire for "rapid and thorough exploration and exploitation of North Sea oil resources". Kretzer pointed out that not only did work program bidding result in the inefficient allocation of resources and consequent economic waste, but also it was arguably inconsistent with the desire for rapid and through exploration. She 29 Mason Gaffney (1977b, p. 64) made a similar point: "Overinvestment in exploration is just as much padding and gold plating as any other kind of overinvestment. It is insidious and seductive because it is invisible and hard to evaluate, and because there is in the 'cultural subconscious' a pro-‐exploratory bias." Work-‐Bid Exploration Permit Regime 86 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ suggested that scarce capital unnecessarily tied up in overextended programs by work program bidding was not available to explore other areas. In a subsequent paper, Ursula Kretzer (1994) explained that forcing companies to maintain exploration work programs following reductions of uncertainty from information accumulation removed the potential to improve the productivity of exploration investment. She did not comment on the implications for credibility of the system if changes to programs were allowed in the light of accumulation of information. Walter Mead (1994), a well-‐known specialist in the economics of natural resource leasing at University of California Santa Barbara, undertook a comparative analysis of alternative allocation systems for petroleum exploration tenements. Mead argued that work program bidding:
provides an expensive subsidy to exploration that is not subject to benefit-‐cost analysis
would avoid economic inefficiencies only if decision-‐makers correctly rejected all work program offers not supported by benefit-‐cost analysis "...... appears to sacrifice nearly all of the economic rent, substituting work programs for cash rent collection"

would not deliver the activity on which a tenement grant was based, and would lack credibility and integrity if work programs could be renegotiated to remove uneconomic commitments. Mead advocated cash bidding for tenements. He stressed that under cash bidding, tenements should not be subject to short tenure periods, because short tenure interfered with efficient allocation of resources over time, which meant rent dissipation. An analysis of the Australian offshore work program bidding regime by the Australian Bureau of Agricultural and Resource Economics (ABARE) explained that winning program bids may be "much larger than optimal" and "competitive pressures tend to push bids toward the point where the expected supernormal profit (economic rent) of the project to the winning bidder is zero" (Maritz, 2003). In other words, work program bidding tends to dissipate resource rent. The Henry Tax Review was critical of conditional first-‐come-‐first-‐served and work program bidding systems as mechanisms for transfer/allocation of exploration tenements. The authors of the Review ranked work program bidding last, behind a conditional first-‐come-‐first-‐served system, and their preferred allocation system, cash bidding (Henry, others, 2009, Part 2, Volume1, pp. 229, 231). A relevant excerpt from the report of the Henry Tax Review is shown in Box 15. The Henry Tax Review was also critical of limited periods of tenure applicable to exploration and retention tenements, and relinquishment conditions requiring the periodic reduction of the area held under exploration tenements. The authors (Henry, others, 2009, Part 2, Volume 1, p. 230) argued that these arrangements: Work-‐Bid Exploration Permit Regime 87 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ "...... may create an incentive for firms to inefficiently bring forward exploration and production, but may also serve to restrict the incentive for firms to delay exploration and production in order to gain from the 'spillover' benefit of information generated by activity in neighbouring fields." Box 15 Henry Tax Review on Exploration Tenement Allocation Systems "The States typically assess a prospective investor on a first-‐come-‐first-‐served basis, with a nominal application processing fee. The first-‐come-‐first-‐served basis of allocation creates an incentive for firms to undertake exploration sooner than they would have if property rights had been clearly defined. The Australian Government allocates offshore exploration permits under a work program bidding system. Exploration permits are allocated to the firm with the preferred exploration work program. Work program bidding creates an incentive for exploration expenditure above a commercially sensible level. To win exploration permits, firms may commit to a work program that spends the expected resource rents on over-‐exploration. Work program bidding can dissipate all the expected rents if bidding is competitive and the tax system is efficient (Fane, Smith, 1986)." Source: Henry, others (2009), p. 229. The Commonwealth Department of Finance and Deregulation (2011, pp. 41-‐42) suggested in its Strategic Review of Geoscience Australia that George Fane and Ben Smith (1986) had argued that work program bidding would completely dissipate resource rent and eliminate any return to government from the petroleum resource rent tax. The Department observed that experience showed that work program bidding did not come close to extinguishing expected future resource rents. However, the Department must have overlooked the explanation by Fane and Smith (1986) as to why the design of the tax meant that resource rent would be only partly dissipated. Willett (1985, 2002) also provided reasons why resource rent would be only partly dissipated. This matter has been analysed in section 6.4. The Commonwealth Department of Finance and Deregulation (2011) considered that work program bidding caused resource misallocation. Moreover, the Department provided effective counter arguments to suggestions that work program bidding could have a redeeming feature as a means of increasing information "spillovers" and resulting external benefits of exploration. This matter has been discussed in section 6.5 below. 6.2
Model of Efficiency of Exploration Timing and Quantity The implications of the work program bidding transfer/allocation mechanism and associated, highly conditional tenure arrangements for the quantity and timing of exploration activity can be analysed and illustrated with the aid of a diagrammatic model shown in Figure 2. The model is based on one formulated by Mason Gaffney (1967a) and applies insights presented in Gaffney's seminal work on economically efficient timing of exploration under perfect tenure, and the adverse efficiency effects of highly conditional pre-‐discovery tenure. Mason Gaffney's model was used by Ken Willett in modified form in the Green Paper on Mining Royalty Policy for the Northern Territory (Northern Territory of Australia, 1981) to analyse the Work-‐Bid Exploration Permit Regime 88 RevŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ resource allocation effects of conditional-‐first-‐come-‐first-‐served transfer systems and associated tenure arrangements. Subsequently, Ken Willett (1985, 1991, 2002) extended this analytical approach and applied it to assess work program bidding transfer systems and underlying tenure arrangements. The model also is useful for analysing cash bidding with and without secure tenure. 6.2.1
Analytical Benchmark: Unconditional Tenure and Transfer/Allocation Regime To analyse the effects of the work-‐bid exploration permit regime on the efficiency of resource allocation, it is necessary to have a benchmark for determining how exploration activity would be affected by work program bidding and the associated tenure arrangements. Therefore, we consider the case of completely unconditional tenure and a transfer/allocation system that does not award exploration permits based on the magnitude, composition and timing of exploration and development commitments. Outcomes in this case provide a basis for assessing outcomes under the work-‐bid exploration permit regime. Figure 2 Timing and Amount of Exploration with Perfect and Imperfect Tenement Arrangements Source: Willett (2002), p. 157. There are two key concepts in the analytical framework underlying Figure 2:

"immediate exploitation value" at any point of time the "value of the right to exploit" at any point of time. ǲIǳany point of time refers to the nett present value of future cash flows expected to be realised if the exploration-‐assessment-‐planning-‐development-‐
Work-‐Bid Exploration Permit Regime 89 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ extraction sequence of activities (the exploitation sequence) commences and is expeditiously pursued as from that point of time. The trajectory of this value over time is depicted by the solid curve labelled "immediate exploitation value" in Figure 2. "Immediate exploitation value" is nett of exploration, other assessment, design/planning, development and operating costs. Because "immediate exploitation value" at any point of time is the result of a nett present value calculation, it is also nett of the risk-‐adjusted, opportunity cost(s) of capital, represented by the discount rate(s) used in the calculation. ǲIǳght increase at a higher rate than the cost of capital (before time B in Figure 2) if the relevant product price is expected to rise and/or exploitation costs are expected to fall sufficiently quickly in real terms. While real prices of crude oil and other mined commodities have exhibited downward trends for long periods over the past 130 years, they have also experienced medium-‐term up-‐turns in response to demand surges and/or short-‐ to medium-‐term capacity constraints. One striking example was the dramatic surge in oil prices in the decade from the early-‐1970s, associated with the first and second "oil crises". Another was the strong performance of real oil prices from the early 2000s to the third quarter of 2008, and the oil price resurgence from early 2010, which have been underpinned by strong economic growth in China, India and other developing countries. These long-‐ and medium-‐term trends have been overlain by substantial shorter-‐term price volatility. During the early years of the rise of oil prices from the historical low of early-‐1999, around US$10 per barrel in 2011 dollars, subsequent strong price increases would not have been anticipated, as indicated by the very limited response of explorers which were apparently conditioned to a long-‐term downward trend in crude oil prices from the early-‐1980s to early-‐
1999. More recently, behaviour of explorers has indicated that, in general, they expect a continuation of current relatively high prices, and many expect prices to continue to rise in real terms in the foreseeable future. The International Energy Agency's medium-‐term outlook is for increasing real oil prices as higher cost and non-‐conventional oil resources are brought on-‐stream. This is based on the perception that demand growth will outstrip growth of supply from new discoveries and technological improvements. In contrast, the trend of exploitation costs has generally been downwards in real terms on a long-‐term basis (with periodic spikes in "boom" conditions). The causes of this trend have been: x continuous, small, and occasional large advances in technology and techniques applicable to exploration, extraction and transportation x improved access to infrastructure and other goods and services as economic activity expands in quantitative and geographical terms. ǲ ǳ negative (before time A in Figure 2), it would not make commercial or economic sense to commence the exploitation sequence. ǲ
Work-‐Bid Exploration Permit Regime 90 Review of Australia͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǳ positive (after time A), and increasing at a rate higher than the opportunity cost of capital (before time B), it would be economically appropriate to defer commencement of the exploitation sequence. It would also be commercially appropriate, provided that exploration tenure is not short and/or conditional on undertaking earlier activities on the tenement. Then, the exploration/mining enterprise could earn more by waiting than by beginning the exploitation sequence, realising periodic surpluses, and reinvesting them at the opportunity cost of capital adjusted for differential risk. In principle, the ideal time to commence exploration activities in a particular area is when ǲ ǳ -‐adjusted opportunity cost of capital. This is depicted in Figure 2 by point M (time B) where the ǲ ǳ "compound interest at cost of capital curve".30 Then, the nett present value in the base year that can be realised by exploring for, and exploiting a resource in a future time period will be maximised. That maximum is represented by present value amount LB = X0, which is the maximum of the curve ("base year NPV") showing "immediate exploration value" at each time discounted to the base year. It is also the "immediate exploitation value", MB, discounted from time B to the base year, as shown by the intersection of the ǲǳwith the vertical present value axis in Figure 2. This maximum is the value referred to in this report as imputed nett value of a deposit or resource rent. Any such reference is specific to a particular time. At time 0 (the base year) in Figure 2, it is X-‐0. At time A, it is NA. At time C, it is PC. At each time, it also represents the "value of the right to exploit" at a future time. The "value of the right to exploit" at any particular time is the value of the right to explore, otherwise assess, develop and extract from a tenement that provides the holder with secure property rights including the right to undertake activity as and when the tenement holder sees fit. The "value of the right to exploit" at times prior to the ideal time to commence the exploitation sequence is the "immediate exploitation value" at the ideal commencement time, discounted back to the prior times at the risk-‐adjusted opportunity cost of capital. Therefore, the "value of the right to exploit" increases over time at a rate equal to the risk-‐adjusted opportunity cost of capital, ǲǳ
below this cost of capital. In Figure 2, the "value of the right to exploit" is depicted by the rising "compound interest at cost of capital" curve between time C and time B (between point P and point M on that curve). ǡǲ
ǳȋͳȌǡ
30 After time B, it will be advantageous to commence the exploitation sequence as soon as possible. The reason is that the expected periodic surpluses, can be realised and invested to yield a better rate of return, the opportunity cost of capital adjusted for differential risk. Work-‐Bid Exploration Permit Regime 91 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ right to exploit can no longer rise as fast as the cost of capital or faster ǲ
ǳǤBeyond time B, the "value of the right to exploit" would be the "immediate exploitation value". Also, the base year value of the "right to exploit" would decline if such a deferment occurs. This is depicted by the declining portion of the "base year NPV" curve showing "immediate exploitation value" at each time discounted to the base year. ǲǳȋ
in Figure 2), it does not mean that the "value of the right to exploit" is negative at that particular time. If it is expected that exploitation would ǲ
ǳ ȋȌǡ ȋ ʹȌǡ
deferred until then, the right to exploit would have a positive value in each prior year. This is depicted by the positive value of points on the ǲ ǳ curve until time B (point M) and the "immediate exploitation value" curve after time B (point M). It is also depicted by the positive segment of the "base year NPV" ("immediate exploitation value" discounted to base year) curve after time A in Figure 2. 6.2.2
Work-‐Bid Exploration Permit Regime The Australian work-‐bid exploration permit regime distorts decisions regarding the timing of commencement of the exploration-‐assessment-‐planning-‐development-‐extraction sequence of exploitation activities (the exploitation sequence) outlined in the model above, unless each permit area released is "ripe" or a "prime target" for exploration. This regime also distorts decisions regarding the quantity and composition of exploration programs. Two elements of the work-‐bid exploration permit regime tend to distort exploration decisions, causing resource misallocation. One element is the work program bidding system -‐ the tenement transfer/allocation mechanism. The other element is the high degree of conditionality of tenure. For expository purposes, these elements have been analysed separately below. In reality, each reinforces the tendency of the other to force the pace of exploration. They combine to cause exploration activity that from a social or community perspective is too much, too soon. The following analysis of work program bidding and highly conditional tenure also applies to systems similar to Australian arrangements applying in other countries. Such systems have been summarised briefly in Appendix A. Work Program Bidding To capture title to a potential resource in the context of work program bidding, an explorer could commit to spend up to the sum of the "value of the right to exploit" a prospect at a future time (shown by the curve MNXP in Figure 2) and "discounted efficient exploration cost" (shown by the curve KQVZ). The inducement to do so derives from the potential or ex ante nett value of a resource (ex ante resource rent), anticipated competition for title, the administering authority's preference for earlier, larger, and specific types of exploration Work-‐Bid Exploration Permit Regime 92 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌoleum Exploration Policy activities, and the substantial increase in longevity and decrease in conditionality of tenure that derives from a discovery. The greatly improved longevity and reduced conditionality of tenure that result from transition from an exploration permit to a retention lease or production licence reduce risk and uncertainty faced by the explorer and facilitate deferment of development until the sum ǲ ǳ Ȁ
than the relevant risk adjusted return on capital. In Figure 2, this is depicted as occurring well after time A and could take place after time B. If work program bids are requested at time 0, the explorer could promise an exploration program with a present value at time 0 equal to the sum of the "value of the right to exploit" and "discounted efficient exploration cost",31 which is X0 plus V0. If development commences at time B, the realised nett present value is MB plus KB. However, promised exploration outlays of X0 plus V0 at time 0, and compound interest on these amounts from time 0 to time B, total MB plus KB. Therefore, the present value of the realised surplus from exploration and exploitation is zero. The imputed nett value of the deposit in the base year has been destroyed by exploration costs in excess of the efficient level by XW plus V0, and foregone returns of YX plus WV (between times 0 and 0). This indicates that work program bidding misallocates resources, in the process tending to destroy imputed nett value through a combination of: x
exploration expenditure in excess of the most efficient quantum; and x
the opportunity cost of (foregone returns on) capital invested in early, pre-‐emptive exploration. The relative importance of these mechanisms of ex ante resource rent dissipation would depend on the timing of release of an area for work-‐bids. The earlier is the release, the more important is the relative contribution of foregone returns on pre-‐emptive exploration outlays. The closer is the release time to the optimal time to commence the exploitation sequence, the greater is the relative contribution of bid "gold-‐plating" to resource rent dissipation. If releases for work-‐bids are made at the optimal time to commence activity, "gold-‐plating" alone would be responsible for ex ante resource rent dissipation. Delay of releases beyond the optimal time to commence activity would progressively dissipate ex ante resource rent directly, as indicated by the declining "base year NPV" curve after time B 31 There is an important distinction between the "immediate exploration cost" and the "discounted efficient exploration cost". The "immediate exploration cost" at any particular time is the current exploration cost if exploration commences at that time. It declines over time in real terms as technology and knowledge improve. The change in the "immediate exploration cost" over time is depicted by the curve RK in Figure 2. The efficient exploration cost is the exploration cost current at the optimal time to commence the exploitation sequence. When that cost is discounted back to earlier times it is the "discounted efficient exploration cost" at those earlier times. The change in the "discounted efficient exploration cost" over time is depicted by the curve ZK in Figure 2. Work-‐Bid Exploration Permit Regime 93 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ in Figure 2. "Gold-‐plating" induced by work-‐programme bidding would tend to dissipate remaining ex ante resource rent. Highly Conditional Tenure Pressure to explore earlier than justified by commercial considerations is provided by explicit tenure conditions, not just the work program bidding transfer/allocation mechanism. In the Australian offshore petroleum regime, this pressure is provided by:

a relatively short initial tenure period (6 years) the segmentation of work programs during permit periods into minimum guaranteed programs in years 1-‐3 and secondary programs in years 4-‐6 compliance with work and expenditure commitments and requirements 50 per cent relinquishment prior to renewal work and expenditure requirements formulated by the administering authority for renewal permits. While work-‐bid exploration permits may be renewed twice (5 years each time), the 50 per cent relinquishment requirement prior to each renewal provides pressure to explore early. The minimum guaranteed program period of 3 years in each tenure period also creates pressure to explore early. Pressure is also provided by an important implicit condition, the influence of which should not be overlooked. It is the deadline for submission of applications for an area and the consequent timing of grant of an exploration permit. If a potential explorer does not comply with that deadline, another party obtains the exploration permit. Early release of an area results in pre-‐emptive applications. Then, short tenure and 50 per cent relinquishment requirements prior to renewal exert pressure to explore early. The pressure to explore early that is created by explicit and implicit tenure conditions is entangled with pressure in the same direction from work program bidding. The simultaneous activation of these forms of pressure to explore early, does not necessarily mean that the effects are additive. However, it is clear that in the absence of work program bidding, the explicit and implicit conditions attaching to exploration tenure would still tend to dissipate resource rent. Because work and expenditure commitments and conditions are closely integrated with the work program bidding allocation mechanism, the focus of the analysis in this sub-‐section is on timing and relinquishment conditions. These conditions alone would tend to dissipate resource rent. This outcome can be demonstrated with the aid of the diagrammatic model in Figure 2. If an exploration permit expires prior to time C so that long-‐term, relatively unconditional tenure is dependent on making a discovery before that date, a permit would not be sought or taken-‐up, even though the "value of right to exploit" is significantly positive at PC. This is because Work-‐Bid Exploration Permit Regime 94 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽn Policy "immediate exploration cost" would exceed the sum of "value of right to exploit" and "discounted efficient exploration cost". If a discovery had to be made no later than time 0 (base year) in Figure 2 to gain long-‐term tenure, with minimal conditions, an enterprise would be prepared to take-‐up an exploration permit. However, by spending "immediate exploration cost" before expiry of the permit, ex ante resource rent (X0) would be largely dissipated. The large portion dissipated is represented by the sum of "value of right to exploit" and "discounted efficient exploration cost" less the sum of "value of right to exploit" and "immediate exploration cost", which reduces to the difference between the "immediate exploration cost" and "discounted efficient exploration cost" at time 0. 32 If discovery was required before time A to obtain long-‐term tenure, ex ante resource rent (NA) would be partly dissipated (less than half), as indicated by the difference between the "immediate exploration cost" and "discounted efficient exploration cost" lines at time A. The remaining portion of ex ante resource rent available to be shared between the explorer and government would be the sum of the "value of right to exploit" and the "discounted efficient exploration cost" less the "immediate exploration cost". In this example, the ex ante resource rent not dissipated would be just over half the ex ante resource rent. If the timing of access to a permit or its attaching conditions meant discovery was required not long before time B for long-‐term tenure to be attainable, the amount of ex ante rent dissipated would be relatively small, as indicated by the difference between the "immediate exploration cost" and "discounted efficient exploration cost" lines at that time. Most of the ex ante resource rent, represented by the sum of the "value of right to exploit" and "discounted efficient exploration cost" less the "immediate exploration cost", would be available for sharing between government and the explorer. It is clear from the illustrations using Figure 2 that the potential for tenement conditions to dissipate ex ante resource rent depends on the timing of grant of an exploration permit, the length of pre-‐discovery tenure, and the size of the gap between the expiry date of the exploration permit and the optimal time to commence the exploration-‐assessment-‐planning-‐
development sequence (the exploitation sequence), represented by time B in Figure 2. Obviously, the consequences of highly conditional pre-‐discovery tenure are severe in areas made available prematurely for permit applications, and diminish in importance as timing of issue and expiry of permits approaches the optimal time to commence the exploitation sequence. The resource rent dissipation problem could be ameliorated by deferring access to less prospective areas until they become "prime targets" for exploration. This would render irrelevant common arguments that short tenure, relinquishment requirements, work program bidding, and/or work and expenditure conditions are justifiable to prevent inactivity by 32 For analytical convenience, taxes on realised outcomes have been ignored. Work-‐Bid Exploration Permit Regime 95 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ tenement holders. If the timing of release of an area is economically astute, exploration could be expected to be undertaken promptly. Deferment of access until an economically astute time would require greater analysis by government's geo-‐scientific and economic advisers. However, significant residual uncertainty could still mean that timing could be imperfect. To allow for inadvertent premature releases, tenure could also be lengthened. The more astute timing is, the smaller would be the economic gains from lengthening tenure and the less important it would be to lengthen tenure. If releases were delayed too long, until after the optimal time to commence activity, timing and relinquishment conditions set to force the pace of exploration would not dissipate ex ante resource rent because they would be redundant. However, the undue delay of releases would progressively dissipate ex ante resource rent directly, as indicated by the declining "base year NPV" curve after time B in Figure 2. 6.3
Implications of Risk and Uncertainty for Efficiency of Exploration Timing and Quantity For purposes of simplification and illustration, the preceding analysis did not adequately take into account the effects of risk and uncertainty on exploration decisions. In almost all cases, individual exploration ventures are characterised by a high degree of exploration risk and uncertainty. This means that the ideal timing of exploration can rarely be achieved in practice. However, this does not undermine the thrust of the analysis above. If pre-‐discovery tenure is unconditional (unlike under a work-‐bid exploration permit regime), risk and uncertainty would not interfere with the incentive to keep exploration outlays to a minimum and to incur them as late as possible without jeopardising the ideal time for commencement of development and extraction. Indeed, exploration risk and uncertainty would contribute to the incentive to delay the commencement of exploration. Risk-‐averse enterprises under no pressure to explore early may choose to wait for advances in exploration techniques, infrastructure improvements, and more favourable economic conditions. Also, they may tend to wait for others to undertake activity on nearby ground, thereby reducing uncertainty regarding their own ground. When enterprises undertake detailed exploration programs, announced results and subsequent behaviour provide valuable free information to nearby tenement-‐holders. When formulating their exploration programs, firms ignore the external benefits conferred on others. The consequences of risk and uncertainty and informational externalities associated with exploration may be too little exploration, too late.33 33 A broad discussion of exploration information "spillovers" has been provided in chapter 5. Specific issues relating to suggestions that the consequences of external benefits could be addressed by a work-‐bid exploration permit regime have been discussed in section 6.6 below. Work-‐Bid Exploration Permit Regime 96 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ In contrast, in the context of the work-‐bid exploration permit regime, exploration risk and uncertainty may exacerbate the tendency of this regime to induce too much exploration, too soon from an economic perspective. The explanation provided by Mason Gaffney (1967a, pp. 387-‐388) follows. The less information there is available about an area, the more difficult it is to distinguish between good and poor prospects in advance. If information is limited (uncertainty high), incremental exploration to gain secure title over potential resources is more likely to be motivated by the average outcome rather than the marginal product of exploration activity. In effect, the imputed nett value of good prospects encourages exploration activity on poor prospects, effectively subsidising them. This would strengthen the inducement to undertake premature, pre-‐emptive activity in areas not yet regarded as being highly prospective. If explorers exhibit "risk loving" or gambling behaviour, the relatively few cases of extremely high pay-‐offs from exploration could attract activity in excess of their aggregate value. Expressing this in terms of the diagrammatic analysis linked to Figure 2, bids may be higher than the sum of the "value of the right to exploit" a prospect (shown by the curve MNXP in Figure 2) and "discounted efficient exploration cost" (shown by the curve KQVZ). In other words, the extent of activity in areas for which information is sparse may result in negative economic value Ȃ economic waste in excess of destruction of ex ante resource rent. In circumstances in which uncertainty is not as high as in Gaffney's explanation, but still significant, and in which a prospect is perceived to be marginal or not much better than marginal ex ante, a prospect may be rendered sub-‐marginal ex ante. This could result from requirements to honour bid commitments regardless of exploration outcomes, to do so within a relatively short period, and/or the anticipation of demanding work conditions on renewal of a permit. This reinforces the argument that a work-‐bid exploration permit regime would be an economically inefficient policy instrument in less attractive areas. 6.4
Dissipation of Resource Rent: Ex Ante Versus Ex Post The Commonwealth Department of Finance and Deregulation (2011, pp. 41-‐42) stated in its Strategic Review of Geoscience Australia: "It has been proposed that a work program bidding system is incompatible with a Resource Rent Tax regime (Fane, Smith, 1986, p. 221). The central argument for this is that a competitive work program bidding system would encourage bidders to over-‐invest in exploration to the extent that their bids defray all the economic rent (super profits) expected from the downstream development. If those expectations were realised for the winning bidder, the practical outcome would be the elimination of any return to government (and the community) from a Resource Rent Tax. The over-‐investment in exploration would represent a nett loss of resources to the economy. Work program bidding has remained the main method used by the Australian Government for competitive allocation of offshore exploration permits since a Petroleum Resource Rent Tax was introduced. Experience over this period shows that the work program bidding system does not come close to extinguishing expected future economic rents."(italics added) Work-‐Bid Exploration Permit Regime 97 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ However, this statement overlooked the following important point made by George Fane and Ben Smith (1986, p. 224): "The denial of full loss offsets on unsuccessful exploration is now the factor that will prevent the dissipation of all the rents from offshore petroleum exploration, which work program bidding would otherwise induce ................. tax recipients would clearly be made better off by the project, since tax receipts would be positive if the project were successful (ie if it paid RRT) and would be zero, rather than negative if the project failed." There are several additional reasons why petroleum resource rent tax revenue could be collected, notwithstanding partial dissipation of ex ante resource rent.
Work program bidding and highly conditional exploration tenure dissipate ex ante (anticipated) resource rent. Ex post (realised) outcomes typically differ from anticipated (ex ante) outcomes.
If a prospect turns out to be better than anticipated realised nett cash flows would exceed anticipated cash flows.
Ex post nett cash flows would exceed ex ante resource rent if there is an unforeseen, substantial increase in petroleum prices after bidding for an exploration permit. This has occurred over the past 12 years, after oil prices had declined in real terms from the early 1980s until 1999. It is inconceivable that 6-‐10 years ago most explorers would have anticipated real prices would be 8-‐15 times those prevailing in 1999. The petroleum resource rent tax system was adjusted in 1990 to introduce a second threshold rate to carry-‐forward exploration expenditure. The original rate of the long-‐term bond plus 15 percentage points for exploration expenditure was restricted to expenditure incurred within 5 years of the date of lodgement of data required for the grant of a production licence. Other exploration expenditure could be carried forward only at the GDP deflator (maintained in real terms) for future deduction. This adjustment would have ensured that the real, risk-‐adjusted required rate of return on premature, or "gold plated" exploration programs was included in the tax base, helping to offset the tendency of work program bidding to dissipate resource rent and undermine the tax base. However, the extent to which the low carry-‐
forward rate for early exploration could reduce resource rent dissipation has been undermined the ability of companies to transfer exploration outlays between projects within the company. The petroleum resource rent tax treats exploration gains and losses asymmetrically. The very low carry-‐forward rate for early exploration expenditures is just one reason for this. Another reason is that companies without petroleum resource rent liabilities would not be able to get rebates at the tax rate for unsuccessful exploration expenditures.

The company income tax system also treats exploration gains and losses asymmetrically. Companies without income tax liabilities would not be able to get rebates at the tax rate for unsuccessful exploration expenditures. Even if exploration is successful, companies would have to carry-‐forward exploration without interest and would not even have the real value of their outlays protected from inflation. Work-‐Bid Exploration Permit Regime 98 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
These asymmetries would tend to offset to some extent the tendency of the work-‐bid exploration permit regime to induce too much exploration, too soon. In the case of the North West Shelf, the ad valorem royalty and crude oil excise capture a portion of resource rent for government without providing any deductions for expenditures upstream of the taxing point. These regimes effectively tax all inputs to exploration and extraction, including the opportunity cost of capital applicable to early exploration outlays, and therefore would tend to offset the tendency of work program bidding and highly conditional tenure to induce too much exploration, too soon. Some of these considerations mean work program bidding and highly conditional tenure would only partly dissipate ex ante resource rent. Others emphasise the important point that work program bidding and highly conditional tenure affect ex ante resource rent, and this may be masked by unanticipated changes in circumstances that raise ex post resource rent and more than compensate for partial dissipation of ex ante resource rent. In Appendix B, quantitative analysis covering the period 2000 to 2009 has been presented showing how ex post rent could be whittled down by bringing forward exploration activity. This analysis also illustrates how unforeseen events like the dramatic oil price surge of the 2000s can mask the dissipation of both ex ante and ex post resource rent. The quantitative analysis in Appendix B also supports the qualitative analysis indicating that work programme bidding and highly conditional tenure, in combination with premature release of some areas for private sector exploration, tend to dissipate ex ante resource rent. Aspects of the royalty/taxation regime that have ameliorated the tendency of the work-‐bid exploration regime to dissipate ex ante resource rent are not satisfactory counter-‐measures. These aspects destroy ex ante and ex post resource rent through discouragement of activity at the margins of extraction, investment and exploration. Unanticipated historically high oil prices have simply masked the severity of resource rent dissipation by the tenement regime and the royalty/tax system. Of course, if oil prices in future are as anticipated or less than anticipated by explorers, the dissipation of ex ante resource rent would translate into similar or exaggerated dissipation of ex post resource rent. It should not be assumed that the huge upward shift in oil prices that occurred between 1999 and either 2008 or 2011 will happen again in the next decade or so, and continue masking resource rent dissipation by the tenement regime and the royalty/taxation system. 6.5
Norway's Inadvertent Amelioration of Resource Rent Dissipation Norway adopted a work program system for offshore petroleum exploration in 1965, paralleling most aspects of the UK system established in 1964. However, following major discoveries in the early 1970s, and a huge increase in oil prices associated with the oil price shock of 1973, a Norwegian Government "go-‐slow" policy evolved to address structural adjustment and macroeconomic consequences of a substantial, booming oil and gas sector (Dam, 1976). Work-‐Bid Exploration Permit Regime 99 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Policy consistency would have required abolition of the work program bidding system and highly conditional tenure, because they encouraged faster exploration, but this step was not taken. Instead, Norway greatly slowed down and reduced the number of blocks released for bidding and eschewed releases of areas considered marginal. In addition, it required a substantial carried interest in each licence for a government-‐owned oil company until a discovery was deemed commercial, increased the ad valorem royalty rate on a sliding scale basis, and introduced an "excess profits" tax to be applied on top of company income tax (Dam, 1976). The "go-‐slow" policy reduced the tendency of the work program system to induce pre-‐
emptive, premature exploration outlays that would have caused economic waste in the form of foregone rates of return on such outlays. In addition, the fiscal measures reduced the motivation for premature or "gold plated" outlays. Put another way, this combination of policies reduced the effective subsidy to exploration of prospects when they are sub-‐marginal or marginal for locational or timing reasons. It appears that the counter to ex ante resource rent dissipation was inadvertent, rather than intentional. If it had been intentional, presumably the work program system would have been abandoned. Either way, countering ex ante resource rent dissipation was fortuitous. 6.6
External Benefits of Exploration under Work-‐Bid Exploration Permit Regime External benefits from information "spillovers" are much more important in areas for which available information is very limited. Therefore, exploration is more likely to be too little, too late from a social perspective in these areas. Because the work-‐bid exploration permit regime tends to induce exploration that is too soon, too much or both from a social perspective after a permit has been granted, and because there is less ex ante resource rent for this regime to dissipate in areas for which information is sparse, it has been suggested that work program bidding and highly conditional tenure could be appropriate, pragmatic policy instruments to correct the effects of socially deficient exploration information.34 However, this suggestion is not supported by economic analysis. The size of work program bids would be directly related to the magnitude of the anticipated nett value of the resource in situ (resource rent), adjusted for uncertainty. In effect, work program bidding offers the ex ante resource rent as a subsidy to increase the size of the exploration effort and to advance its timing. However, the case for exploration subsidies depends on the existence and magnitude of external benefits of information "spillovers" from exploration activity. These external benefits 34 The Australian Petroleum Production and Exploration Association has advanced an argument along these lines as a justification for Australia's work-‐bid petroleum exploration permit regime, as discussed in section 6.7. Work-‐Bid Exploration Permit Regime 100 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ are likely to be larger, the greater is the uncertainty regarding an area, because extra information is likely to be more useful in frontier areas. Therefore, work program bidding is likely to offer the largest subsidy in circumstances in which it is least justified economically, and offer little if any subsidy in cases in which a subsidy is most economically ǲǳǤ This point was recognised by the Commonwealth Department of Finance and Deregulation (2011) in its Strategic Review of Geoscience Australia. A pertinent excerpt is shown in Box 16. Box 16 Work Program Bidding Crude Device for Addressing Information "Spillovers" "There is some disagreement in the literature on the value of information externalities from private exploration. Available evidence does suggest that the recycling of private exploration data through Geoscience Australia has value, although ...... this is likely to vary from situation to situation and be diminished for established 'brownfields' areas. The work program bidding system as a universal mechanism for allocation of offshore acreage, is a crude device for addressing information externalities and would appear to have the greatest impact (through competitive pressure) in 'brownfields' areas of highest prospectivity. That is, the incentive to enhance exploration created by the work program bidding system appears to be strongest where it is both least needed and more likely to cause over-‐investment in information." Source: Commonwealth Department of Finance and Deregulation (2011), p. 42. Highly conditional tenure in the form of short initial tenure and the 50 per cent relinquishment requirement on renewal would tend to bring-‐forward exploration, providing an offset to exploration being too little, too late from a social perspective because of information "spillovers". Short tenure would be most likely to bring-‐forward exploration in areas not yet considered prime targets. These may be the areas in which information provided as "spillovers" would be most valuable, because of scarcity of information. However, they may also be the areas in which exploration is most likely to be commercially premature, and the proportion of resource rent dissipated by high conditionality could be highest. In areas in which exploration would be particularly premature in some timeframes, highly conditional tenure could discourage very early take-‐up of exploration permits, with the result that there would be no informational "spillovers" in those cases (see sub-‐section 6.2.2 under heading, "Highly Conditional Tenure"). It is unclear whether or not the resource rent dissipation effect of short tenure would outweigh or be outweighed by external benefits of additional information "spillovers". One important consideration would be the significance of information "spillovers" and external benefits from them. Their significance has been discussed in chapter 5. The existence or otherwise of significant external benefits of information "spillovers" has been subject to significant debate and remains unresolved. In any event, additional external benefits of extra information "spillovers" resulting from bringing forward exploration could add to the ex ante value of some areas not yet released for applications. Positive information would increase exploration work-‐bids in those areas, Work-‐Bid Exploration Permit Regime 101 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ tending to dissipate the value added by the information "spillovers", as well as the pre-‐
existing, more uncertain ex ante resource rent. 6.7
APPEA's Assessment of the Work-‐Bid System Extensive consultation between ACIL Tasman and APPEA members and staff elicited an assessment by APPEA of Australia's work-‐bid exploration permit system. The assessment was provided initially through interaction and verbal responses to written questions provided by ACIL Tasman, and subsequently by provision of consolidated written responses to the questions. In the same document, APPEA also commented on the Henry Tax Review's observations regarding tenement policy. The basic premise underlying APPEA's assessment was that more exploration and earlier exploration are necessarily economically desirable. This is evident from several statements in written comments provided to ACIL Tasman. APPEA's opening paragraph included the following statement (italics added): "It is in the nation's best interests to stimulate the efficient discovery of the nation's endowment of non-‐
renewable petroleum resources, particularly given the nation's declining oil production. Consequently, the regulatory framework should seek to stimulate the maximum level of effort towards the nation's hydrocarbon endowment." APPEA claimed:35 "Any system that loses the benefits of competitive work program bidding has a short term money focus and will be at the expense of national future prosperity." In response to the question, "Is it appropriate for government to have an exploration permit regime designed and administered to increase the amount and pace of exploration?", APPEA answered in the affirmative and elaborated as follows.36 "This bid system ensures knowledge is progressed, permits are not held in perpetuity, and others are given a chance to explore as acreage is turned over. Furthermore, if a non-‐commercial discovery is made that has the prospect of being commercial in the next 15 years, expenditure can be slowed and the asset can be retained via a Retention Lease. It is also assumed that governments want to see a reasonable pace of exploration, given the revenue that comes in from production and the need to replace our dwindling oil supplies." Among the perceived advantages of Australia's work-‐bid system, APPEA cited the following.37 "System of renewal and relinquishment also encourages pace of exploration requiring companies to ensure they don't give away prospective acreage." 35 See Appendix C, response to ACIL Tasman question 21. 36 See Appendix C, response to ACIL Tasman question 7. 37 See Appendix C, response to ACIL Tasman question 1. Work-‐Bid Exploration Permit Regime 102 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The premise that more exploration and earlier exploration are necessarily economically desirable in all circumstances is not supported by economic analysis. It is undermined by the analysis in sections 6.2 and 6.3 and the review of the relevant economic literature in section 6.1. Using the tenement allocation regime and tenure conditions in conjunction with early releases of areas for work-‐bids to increase the amount and timing of exploration has an economic cost in the form of misallocation of resources and an associated tendency towards dissipation of ex ante resource rent. The economic cost is potentially high relative to ex ante resource rent. Earlier exploration would be desirable if releases are delayed until after the optimal time to commence activity. However, the solution would be more-‐astute timing of releases, not work program bidding, short tenure and relinquishment conditions designed to force the pace of exploration. Work program bidding would dissipate ex ante resource rent through "gold-‐
plating", but could not bring forward exploration activity because of the unduly delayed release. Short tenure and relinquishment conditions could not bring forward exploration in areas not released. They would be redundant when releases are delayed, because explorers would commence activity promptly to avoid further dissipation of ex ante resource rent through undue delay. APPEA correctly pointed out that it was in the nation's best interests to ensure efficient exploration for petroleum. However, ACIL Tasman does not agree with the general statement that this required stimulation of maximum exploration effort. It is our view that APPEA did not intend that this statement should be taken literally, because it would require that all of the resources of the Australian economy be allocated to offshore petroleum exploration, supporting that activity, supporting activities that support exploration support activities, and so on. Clearly, this would be highly inefficient. The economic cost would be higher than complete dissipation of ex ante resource rent. More and earlier exploration would be in the nation's best interest when market and policy failures reduce and defer exploration inappropriately from an economic perspective. But, correction of these market and policy imperfections is very different to stimulation of maximum exploration effort. Corrective intervention would improve the efficiency of resource allocation. Pursuing maximum exploration efforts would badly misallocate resources. While APPEA considered that the work-‐bid exploration permit regime increased the amount and speed of exploration and that this was appropriate, it claimed that this regime did not effectively subsidise exploration and that an effective subsidy was not desirable. APPEA described this regime as "essentially neutral".38 ACIL Tasman does not agree with these claims, because as APPEA stated, the work-‐bid exploration permit regime increases exploration and advances its timing. As pointed out by several eminent economists and explained in preceding analysis in this chapter, the work program bidding and highly 38 See Appendix C, APPEA response to ACIL Tasman question 9. Work-‐Bid Exploration Permit Regime 103 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ conditional tenure arrangements tend to effectively deploy ex ante resource rent to subsidise exploration in areas that are marginal or sub-‐marginal for timing, technical and locational reasons. The substantial economic cost of the resource misallocation arising from the work-‐bid exploration permit regime, whether or not it is regarded as providing a subsidy, must be weighed against the economic benefits cited by APPEA. These nominated benefits are:

additional information increased security of supply spreading the bid cost over the life of the permit facilitates participation by small companies and improves exploration economics

greater likelihood of success in competition for funds in global budgets facilitation of contracting and scheduling of rigs and service vessels for operations in Australia, with resulting cost savings facilitation of management of exploration programs in joint ventures.
APPEA placed considerable emphasis on the perceived benefits of information generated by the work-‐bid exploration permit system. Four examples follow.39 "The work program bidding system places a greater value (than a cash bidding system) on the geoscientific data acquired and the knowledge derived from such data. Such data is then returned to the people of Australia, at a higher value than just cash as it provides information and understanding upon which to build the future growth of the industry." "There ... seems to be insufficient recognition that the collection and management of data collected from the work program bids become part of the larger precompetitive geoscientific knowledge from which future generations of industry and community derive benefit." "All expenditure contributes towards exploration and our understanding of the petroleum potential of the country." "In technical frontiers, work program (bidding) generates new data and understanding of prospectivity." "It provides an effective geoscience knowledge pool for the government to leverage ....." Suggestions that the work-‐bid exploration permit regime could be justified as a device for increasing external benefits of information "spillovers" or the public good of exploration information have been analysed in section 6.6. It was pointed out that work program bidding is likely to offer the smallest stimulus to exploration where it most justifiable economically because uncertainty is greatest and information "spillovers" are most valuable. In contrast, work program bidding provides the greatest stimulus in circumstances in which uncertainty and the value of information "spillovers" are least, and therefore the case for stimulus is weakest. 39 See Appendix C, "Some General" Comments", "Henry Tax Review on Resource Taxes and Auctions", and response to ACIL Tasman questions 1 and 2 under "Work-‐Bid Exploration Permit Regime". Work-‐Bid Exploration Permit Regime 104 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Highly conditional tenure in the form of short initial tenure and the 50 per cent relinquishment requirement on renewal would be most likely to bring-‐forward exploration in areas involving the greatest uncertainty, in which information "spillovers" would be most valuable. However, they may also be the areas in which exploration is most likely to be commercially premature, and the proportion of resource rent dissipated by high conditionality could be highest, as explained in sub-‐section 6.2.2 under the sub-‐heading "Highly Conditional Tenure". In areas and timeframes in which exploration would be particularly premature, highly conditional tenure could discourage very early take-‐up of exploration permits, with the result that there would be no informational "spillovers". APPEA argued that work program bidding allowed the cost of bids to be spread over the life of an exploration, in contrast to cash bidding under which the bid amount was payable up-‐front. APPEA pointed out that this facilitated participation by small companies and asserted that it improved exploration economics.40 The minimum guaranteed component of a work program bid has to be spent over three years. Under a cash bidding regime the amount of the bid regime would have to be paid up front. However, government could allow payment of cash bids over three years. Presumably, a small company would have to raise capital for its three year program up-‐front. Otherwise, it would not be able to demonstrate its financial capability to undertake the promised work. As Erickson (1977) pointed out, a bidder under a work program bidding system could promise to spend more than the same bidder would offer under cash bidding regime to the extent that the promised exploration could be expected to add value to the permit. It follows that the initial capital raising requirement under work program bidding could be higher than under cash bidding. It is not clear that the deferred outlay arrangement under work program bidding (or cash bidding) would help small companies in the event that exploration is unsuccessful. If initial results reveal that a permit does not warrant the minimum guaranteed component of the work commitment in years 1-‐3, the obligation to honour the commitment or enter into a good standing arrangement to spend the remainder of the commitment in a re-‐release area would handicap a small company if it tried to raise capital for another venture. ACIL Tasman does not agree with APPEA's claim that work program bidding improves exploration economics. As explained above, work program bidding tends to misallocate resources, which involves dissipation of ex ante resource rent. This is not beneficial for the community, government or exploration companies. APPEA suggested that the work-‐bid exploration permit regime would provide security of supply and balance of payment benefits.41 It is not clear how increasing the amount and 40 See Appendix C, responses to ACIL Tasman questions 1, 2, and 11. 41 See Appendix C, "Maximising the value of rents from non-‐renewable resources", "Addressing Exploration spillovers", and response to ACIL Tasman question 8. Work-‐Bid Exploration Permit Regime 105 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ advancing the timing of exploration would contribute to security of supply. Effectively subsidising exploration through the work-‐bid exploration permit regime extends exploration activity at locational and temporal margins, but does not improve the economics or advance the timing of development and exploitation, as explained in section 6.9 below. Markets have worked very well in rationing, re-‐allocating and calling forth additional supply on a global basis through price signals whenever supply-‐restricting or demand-‐increasing oil shocks have occurred over the past 40 years. Price rises have promptly eliminated potential shortages. Domestic supply of a greater proportion of domestic use of oil would not avoid price rises. In globally integrated crude oil and oil products markets, prices would rise in response to any internationally significant supply-‐restricting or demand-‐increasing oil shock, regardless of its location, reducing quantity demanded, re-‐allocating released supply and inducing additional supply. Suggestions that it would be appropriate to increase the amount and bring forward the timing of exploration on balance of payments grounds are misconceived. The appropriate targets of petroleum exploration policy should be efficient resource allocation, administrative efficiency, and equity, not the balance of payments. The latter should be regarded as a macroeconomic variable, not turned into a policy target. In any event, it is automatically managed by the floating exchange rate. An argument that exploration should be effectively subsidised in the hope of increasing domestic petroleum production to reduce demand for foreign currencies implies that the Australian dollar is worth less than signalled by its trade weighted average exchange rate. If the Australian dollar is too high because of protection of trade-‐exposed industries, the appropriate response is to remove the protection. If the Australian dollar is considered too high relative to its long-‐term value, because of a perception that the mined commodity price boom is only temporary, an appropriate response would be government capture of a higher proportion of resource rent and sterilisation of existing and additional windfall in overseas assets to hold down the exchange rate. Effectively subsidising petroleum exploration is not an efficient response to an exchange rate perceived to be overvalued. APPEA members have argued that the expenditure commitment aspect of the work-‐bid regime and associated retention of tenure considerations increase Australian exploration managers' success rate in competition for funds in global exploration budgets. To the extent that this occurs (and there is no reason to believe otherwise), it would mean more and sooner exploration in Australia. This would be good for Australia from an economic perspective if exploration activity undertaken under the work-‐bid regime was consistent with an efficient allocation of resources. However, the analysis in sections 6.1, 6.2 and 6.3 has shown that this regime tends to misallocate resources, and in the process, dissipates ex ante resource rent. APPEA members have argued that work program bidding provides cost-‐reducing benefits relative to cash bidding by facilitating:
contracting and scheduling of rigs and service vessels for operations in Australia Work-‐Bid Exploration Permit Regime 106 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
simplifying the task of management of divergent views of exploration programs in joint ventures. ACIL Tasman considers that these arguments are plausible, and would be open to consideration of supporting evidence. Of course, the benefits arising from simplification and co-‐ordination of program administration has to be weighed against the resource misallocation costs of the work-‐bid exploration permit regime. While APPEA strongly supported the work-‐bid exploration permit regime, it acknowledged that when competition for permits was strong, economic waste could occur. It argued that the "good standing" arrangements could resolve this problem in most cases, and that cash bidding was an appropriate response only in a very narrow range of cases:42 "In highly contested permits, there is a risk of being unable to meet bid levels without wasting funds, although the Good Standing process is a relatively effective mechanism to deal with this problem." "An identified shortcoming is where highly valuable discovered hydrocarbons are contained within a bid block. In this case, the exploration work program bid system is distorted by the assessed discovered value, as was the case at Cornea (42 well bid). These issues may have been avoided with a judicial use of cash-‐bonus bidding. This provision currently exists within the legislation, but is rarely used (eg., Golden Beach gas field in ~1986)." ACIL Tasman's analysis does not support the view that the "good standing" system is "a relatively effective mechanism" for dealing with resource misallocation and consequent economic waste caused by work program bidding. This system allows transfer of expenditure obligations from one permit in which they are not commercially justifiable to a re-‐release area in which the expenditure would not be commercially justifiable without the regulatory incentive to main "good standing" to qualify for future work program bidding rounds. Presumably, a company's decision to meet its expenditure obligations in a re-‐release area, rather than in the original permit or vice versa indicates that expenditure in the chosen location is perceived to be less wasteful than in the other. The problem of economic waste resulting from work program bidding remains, albeit in less severe form. APPEA has not explained why its members deem cash bidding suitable for a narrow range of areas, but not others. Areas considered suitable for cash bidding by APPEA would be those containing resources, which have not been commercially viable in the past and are considered so far from viability that they have not been retained in a retention lease. Inconsistently, APPEA wants to persist with work program bidding for areas considered attractive for other reasons, even though it acknowledges economic waste can occur. 42 See Appendix C, response to ACIL Tasman questions 1 and 3. Work-‐Bid Exploration Permit Regime 107 ReviĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 6.8
Work-‐Bid Regime's Implications for Government Funding of Early-‐Stage, Broad-‐Area Exploration It is widely accepted that there is a solid economic case for government funding and dissemination of early-‐stage, broad scale exploration information. The conventional information public good case and a compatible "portfolio" argument advanced by Commonwealth of Finance and Deregulation have been discussed in chapter 5. Consistent with these arguments, the Commonwealth Government has been funding generation and release of data from early-‐stage, broad-‐area petroleum exploration offshore. These arguments implicitly assumed the absence of other interacting sources of distortion of the efficiency of resource allocation. Clearly, there are other relevant sources of distortion, particularly work program bidding and highly conditional tenure. These policy instruments tend to undermine benefits from government exploration programs directed at correcting information public good market failure. The addition to the ex ante nett value of potential resources resulting from government provision of exploration information would attract higher exploration work-‐bids, tending to dissipate the value added by the information program, as well as the prior, more uncertain ex ante resource rent. Work program bidding and highly conditional tenure are incompatible with government funding and release of early-‐stage exploration information. Moreover, these tenement arrangements would not be suitable substitutes for government provision of information. Work program bidding subsidises exploration least where it is most economically justifiable, in frontier areas where information is sparse. Highly conditional tenure would not attract applications in circumstances in which exploration would be particularly premature. These matters have been explained in the section 6.6. If government decides to retain work program bidding, despite the severe deficiencies identified in this document, it should review its early-‐stage exploration program, because its potential benefits are lost in the context of the existing work-‐bid exploration regime. However, the case for the early-‐stage exploration program could be validated to the extent that the work-‐bid exploration regime is reformed along lines proposed in section 6.12. The case would remain strong in the context of a tenement transfer/allocation system, such as cash bidding, that does not dissipate resource rent and value added by additional information. An economically appropriate reform package would retain the exploration information program and replace work program bidding with cash bidding. 6.9
Implications of Work-‐Bid Exploration Permit Regime for Development Proponents of work program bidding systems have argued that inducement of earlier and additional exploration is a good thing because it will result in earlier development of resources. The argument is seriously flawed. To the extent that discovery on a work-‐bid exploration permit provides relatively secure tenure through the conditional, pre-‐emptive right to apply for a retention lease or production Work-‐Bid Exploration Permit Regime 108 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ licence, a rational enterprise will not seek to develop and exploit the deposit until the sum of ǲ ǳ efficient exploration/assessment cost is positive, and stops rising faster than the relevant risk-‐adjusted opportunity cost of capital. Before that time, the enterprise and the community in general could earn a higher return from appreciation of the value of the identified resource and the embodied exploration investment, than from exploitation of the deposit and investment of the surplus. Premature development is commercially and socially undesirable. If post-‐discovery tenure is lengthy and unconditional, development will occur after time B in Figure 2. If exploration is undertaken prematurely because of incentives created by the work-‐
bid exploration permit regime, development could be expected to commence a short time ʹǡ ǲ ǳ
exploration/assessment costs can be expected to ǲ
ǳǤ ǡ
extraction risk and uncertainty to induce deferment of commencement of development to undertake risk/uncertainty assessments and formulate and implement management strategies. The nett effect will vary from case to case. In any event, a rational enterprise would want to commence development around or not too long after time B in Figure 2. The ideal time to commence development from a social/economic perspective would be the same. A rational mining enterprise would favour that timing, whether or not pre-‐discovery tenure is highly conditional and exploration is pulled forward. Premature discovery certainly does not justify early development and cannot be expected to induce it. Indeed, it is widely recognised that prematurely discovered resources may remain undeveloped for years or even decades. Only if a newly discovered deposit is "ripe" for exploitation, would it be developed immediately after expeditious exploration and assessment. Various government policy requirements may cause deferment of development. For example, acquisition of development tenure may require unreasonably protracted environmental assessment and approvals processes. In such circumstances, development may be deferred ǲ ǳ
exploration/assessment costs stops rising faster than the relevant discount rate. Then, part of the imputed nett value of the deposit would be dissipated by foregone interest on capital invested in prior exploration, assessment and planning. That social loss adds to those arising from excessive costs of negotiating environmental approvals and land access, and any deadweight losses arising from the form of environmental and other land access conditions. Work-‐Bid Exploration Permit Regime 109 Review of AustraůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 6.10
Credibility and Administration Issues with Work-‐Bid Exploration Permit Regime If an exploration permit allocated by work program bidding turns out to be less attractive than anticipated at the time the program was formulated, the work commitment would not be commercially or economically appropriate. Attempts by the administering authority to enforce the original program would result in economic waste. Enterprises may be prepared to submit to such pressure to avoid being declared ineligible for future grants of tenements and write-‐off the losses against other ventures, but the aggregate imputed nett value of resources would still be reduced. If bids are not enforced, the credibility of the work program bidding system would be undermined. It would become a method of allocating tenements to those who can make unrealistic program promises most convincingly. Therefore, the integrity of the system would remain under constant threat. It follows that work program bidding is plagued by an inherent conflict between economic efficiency and credibility. Various responses have been suggested, other than the one preferred in the economics literature, to abandon work program bidding in favour of cash bidding. One potential response would be to attempt to protect the credibility of the system while reducing economic waste by careful evaluation of bids to distinguish realistic from unrealistic programs, followed by rejection of unrealistic bids. However, such an administrative arrangement would increase the amount of administrative discretion and subjectivity in the bid evaluation process. Also, it does not seem to be a viable option, so long as it is administered so as to increase and bring-‐forward exploration activity from commercially preferred settings. Under the Australian offshore regime, a "good standing" process has been applied to avoid wasteful expenditure and maintain the credibility of the work program bidding regime. This system allows transfer of expenditure obligations from a permit in which completion of a minimum guaranteed program is not justified, to a re-‐release area. However, expenditure in re-‐lease areas typically would not be commercially justifiable at the time without the regulatory incentive to main "good standing" to qualify for future work program bidding rounds. If a company chose to meet its expenditure obligations in a re-‐release area, rather than in the original permit or vice versa, it would presumably indicate that expenditure in the chosen location was perceived to be less wasteful than in the other. The problem of economic waste resulting from work program bidding remains, albeit in less severe form. Therefore, the "good standing" arrangements have not resolved the conflict between economic efficiency and credibility. It is not credible to suggest otherwise. The work-‐bid exploration permit system is characterised by relatively high administration costs. Such a system is expensive for government and enterprises to administer for four reasons: Work-‐Bid Exploration Permit Regime 110 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ x
the difficulty of avoiding recurring threats to the integrity of the system x
work program bid formulation x
substantial administrative discretion in selection of a successful bidder, assessment of renewal applications, and formulation of renewal conditions x
a requirement for substantial monitoring effort in respect of work programs, relinquishment and other requirements x
costs for enterprises in ensuring compliance with permit conditions and requirements of relevant legislation and regulations. Such unduly high administration costs represent economic waste. Effectively they reduce realised resource rent. 6.11
Equity Issues with Work-‐Bid Exploration Permit Regime The work-‐bid exploration permit regime has distributional or equity implications that need to be considered when assessing the policy. The issues relate to intra-‐generational and inter-‐
generational concepts of equity. As explained above, this regime tends to dissipate resource rent or imputed nett value of resources. This reduces returns to participants in the industry through payments for their inputs, and returns to the community through (de jure and de facto) royalty and tax systems based on economic and accounting profits, such as the petroleum resource rent tax and the company income tax. Yields from these taxes are reduced to the extent that they validate too much exploration, too soon, through immediate rebates at the tax rate. 43 Under both the petroleum resource rent tax and company income tax regimes immediate company-‐wide deductibility of exploration costs is permitted. The petroleum resource rent tax system also allows carry-‐forward of exploration expenditures at the long-‐term bond rate plus 15 percentage points if those expenditures are incurred within 5 years of the date of lodgement of data required for the grant of a production licence. Earlier exploration expenditure may be carried forward only at a rate equal to the GDP deflator. 43 Conventional ad valorem and specific royalties and de facto royalties tend to preserve resource rent, because they do not allow deductions for exploration expenditures. Indeed, they do not provide deductions for any expenditures upstream from the point of application of the royalty. However, because these levies do not recognise costs and losses (and specific levies also do not recognise changes in prices), they discourage activity at the margins of exploration, investment, and extraction. This destroys resource rent in another way. Therefore, these levies cannot be levied at high rates without causing considerable economic damage. This limitation on rates means that their capacity to offset the rent dissipating effects of the work-‐bid exploration permit regime is also limited. Work-‐Bid Exploration Permit Regime 111 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽre Petroleum Exploration Policy The government, on behalf of the community, is denied a fair market price for rights to explore and mine to the extent that companies have other income that allows immediate rebates for exploration expenditure at the tax rate. This is inconsistent with the benefit principle of equity explained in sub-‐section 2.3.2 of chapter 2. Dissipation or destruction of resource rent also means that it cannot be invested for the benefit of future generations. Therefore, the work-‐bid exploration permit regime is inconsistent with concepts of inter-‐generational equity (see sub-‐section 2.3.3). The distributional winners from the work-‐bid exploration permit regime are providers of exploration services and tenement administration services. This regime effectively applies resource rent as a subsidy to provision of exploration and tenement administration services. However, there is no indication that the community regards providers of these services as more worthy recipients of a portion of the resource rent than other existing or future members of the community who would benefit from increased investment, government services, or lower taxes. 6.12
Reducing Resource Misallocation under Work-‐Bid Regime In sections 6.2 and 6.3, it was shown that work program bidding misallocates resources, and in the process tends to dissipate ex ante resource rent through a combination of: x
exploration expenditure in excess of the most efficient quantum; and x
foregone returns on capital invested in early, pre-‐emptive exploration. The relative importance of these mechanisms of resource rent dissipation would depend on the timing of release of an area for work-‐bids. The earlier is the release, the more important is the relative contribution of foregone returns on pre-‐emptive exploration outlays. The more the release time is delayed to approach the optimal time to commence the exploitation sequence, the greater is the relative contribution of bid "gold-‐plating" to resource rent dissipation. It was also shown in sections 6.2 and 6.3 that highly conditional tenure potentially misallocates resources and thereby tends to dissipate ex ante resource rent. This depends on the timing of grant of an exploration permit, the length of pre-‐discovery tenure, and the size of the gap between the expiry date of the exploration permit and the optimal time to commence exploration. The consequences of highly conditional pre-‐discovery tenure are severe in areas made available prematurely for permit applications, and diminish in importance as timing of issue and expiry of permits approaches the optimal time to commence exploration. The resource misallocation and associated ex ante resource rent dissipation problem could be ameliorated by deferring access to less prospective areas until they become "prime targets" for exploration. This would eliminate economic waste from foregone returns on pre-‐emptive premature exploration outlays induced by work program bidding and highly conditional tenure. Work-‐Bid Exploration Permit Regime 112 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Such action would render irrelevant common arguments that short tenure, relinquishment requirements, work program bidding, and/or work and expenditure conditions are justifiable to prevent inactivity by tenement holders. If the timing of release of areas is economically astute, exploration could be expected to be undertaken promptly. Deferment of access until an economically astute time would require greater analysis by government's geo-‐scientific and economic advisers. However, significant residual uncertainty would still mean imperfect timing. To allow for this, tenure could also be lengthened. The more astute timing is, the smaller would be the economic gains from lengthening tenure and the less important it would be to lengthen tenure. Increased effort to achieve economically astute timing of area-‐releases for bidding would be an important step in the right direction, but is not sufficient to avoid resource misallocation and ex ante resource rent dissipation caused by the work-‐bid exploration permit regime. If releases are delayed, rather than premature, work program bidding would induce expenditure bids in excess of the efficient amount ("gold plating"), rather than pre-‐emptive, premature outlays. One potential response would be to carefully evaluate bids for delayed area-‐releases to distinguish realistic from unrealistic, "gold plated" programs, followed by rejection of unrealistic bids. This would mean eschewing administration of work program bidding for the purpose of increasing the amount of exploration at any time. If this was done economically astutely, the conflict between economic efficiency and credibility of the allocation system that is inherent in work program bidding would be resolved. Such an administrative arrangement would increase the amount of administrative discretion and subjectivity in the bid evaluation process. It would require that government officials make economically and technically astute judgements regarding the size, composition and timing of commercially and economically optimal programs. Obviously, the cost of administering the work-‐bid exploration permit regime would rise because of greater required scrutiny of the size and content of work programs, and greater effort in determining timing of releases of areas for bidding. Two particularly important additional issues must be kept in mind. First, the competitive element of the transfer/allocation mechanism would be substantially reduced. Second, there would be important distributional consequences. Ex ante resource rent preserved (dissipation avoided) would accrue to petroleum exploration and production companies, rather than to providers of services for exploration activities that are marginal or sub-‐
marginal in respect of location and time, or for "gold plating" of activities. Government and therefore, the community would have to bear the increase in administration costs, but would benefit later through higher petroleum resource rent tax and company income tax revenue. Of course, the deficiencies of the work-‐bid petroleum exploration permit regime could be addressed by replacing it with a regime involving cash bidding, more strategically-‐timed area-‐
releases and/or relatively unconditional tenure. As explained in chapter 7, this regime would Work-‐Bid Exploration Permit Regime 113 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵ Exploration Policy provide superior outcomes in respect of economic efficiency, administrative efficiency, and equity. 6.13
Findings and Recommendations 6.13.1
Findings The work-‐bid exploration permit regime and associated area-‐release arrangements applying in Australian offshore areas appear to have been designed and administered to bring-‐forward and increase exploration activity relative to outcomes based on rational commercial decision-‐
making. The work program bidding system for transfer/allocation of permits and the highly conditional tenure arrangements, in combination with premature area-‐releases, tend to bring-‐
forward exploration. The work program bidding system tends to increase outlays. The package of policy instruments act like a subsidy to exploration activity that is marginal or sub-‐
marginal because of time and location. These mechanisms misallocate resources, tending to dissipate ex ante resource rent. Therefore, they perform poorly with regard to the economic efficiency principle. They also perform poorly in terms of the administrative efficiency principle, because of the substantial administrative discretion and review of performance that characterise them. The distributional winners from work program bidding and highly conditional exploration tenure are providers of exploration and tenement administration services. The losers are shareholders of exploration enterprises and the rest of the community. Work program bidding is plagued by an inherent conflict between economic efficiency and credibility. If initial exploration downgrades an area, the program should be downgraded in the interests of efficient allocation of resources. However, relieving explorers of work-‐bid commitments would undermine the credibility of the work program bidding system. Attempting to protect the credibility of the system while reducing economic waste by careful evaluation of bids to distinguish realistic from unrealistic programs, followed by rejection of unrealistic bids would increase the amount of administrative discretion and subjectivity in the bid evaluation process. In addition, it does not seem to be a viable option so long as it is administered so as to increase and bring-‐forward exploration activity from commercially preferred settings. "Good standing" arrangements have been applied in Australian offshore areas in an attempt to resolve the conflict between efficiency and credibility. However, they could reduce resource misallocation caused by work program bidding only marginally. For more than 45 years, work program bidding has been criticised in the economics literature for its poor performance in respect of economic efficiency, administrative efficiency, and equity principles. Australia's offshore work-‐bid exploration permit regime has been criticised for the same reasons by several Australian and American economists over the past 30 years. The critics have included the authors of the Henry Tax Review. Work-‐Bid Exploration Permit Regime 114 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The economic case against work program bidding and highly conditional tenure is strong in highly and weakly prospective and higher and lower risk/uncertainty areas. The analysis contradicts suggestions that it is important to replace the work-‐bid exploration permit regime only in highly prospective areas. Early release, work program bidding, and highly conditional exploration tenure arrangements designed to force the pace of exploration do not induce earlier development of resources discovered. So long as companies' flexibility is not constrained by regulation, they will develop resources when it is commercially optimal, regardless of the timing of discovery. Reform of the work-‐bid exploration permit regime is warranted. Minimum required reforms would involve:

re-‐prioritisation of the release program to target release of less attractive areas when they are judged to be "prime targets" for exploration, rather than when release is inefficiently premature or unduly delayed reduced conditionality of tenure to cover inadvertent premature releases because of uncertainty regarding optimal release times close scrutiny of work program bids for delayed area-‐releases to eliminate "gold plating". These minimum reforms would increase the amount of administrative discretion and subjectivity in the bid evaluation process. Administration costs would rise because of greater required scrutiny of the size and content of work programs, as well as greater effort in determining timing of releases of areas for bidding. Another issue is that the competitive element of the transfer/allocation mechanism would be substantially reduced. Distributionally, these reforms would favour petroleum exploration and production companies to a greater extent than government, and therefore, the community. An alternative approach to reform would be to replace the current regime with cash bidding, delayed area-‐releases and/or relatively unconditional tenure. This regime would provide superior outcomes in respect of economic efficiency, administrative efficiency, and equity. An intermediate reform would substitute a hybrid allocation scheme for cash bidding. This would allocate permits on the basis of cash bids, subject to the highest bidder committing to a minimum program that is undemanding and tailored to the specific circumstances of each tenement, as discussed in chapter 8. If government decides to retain work program bidding, despite the severe deficiencies discussed in this report, it should review the focus and effectiveness of the early-‐stage exploration program, because its potential benefits tend to be lost in the context of the deficient tenement arrangements. However, the case for the early-‐stage exploration program could be validated to the extent that the work-‐bid exploration regime is reformed along lines Work-‐Bid Exploration Permit Regime 115 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶ Policy proposed above. The case would remain strong in the context of cash bidding, delayed area-‐
releases for less attractive areas, and eased tenure conditions. 6.13.2
Recommendations The preferred reform option is to replace the current release and work-‐bid regime with cash bidding, delayed area-‐releases for less attractive areas, and eased tenure conditions. The minimum (third best) reform would involve:
targeting release of less attractive areas when they are judged to be "prime targets" for exploration, rather than when release is inefficiently premature or unduly delayed

reduced conditionality of tenure close scrutiny of work program bids for delayed area-‐releases to eliminate overbidding. A second best reform would modify the preferred reform package by making allocation of permits on the basis of cash bids subject to the highest bidder committing to an undemanding, tailored minimum program. If all of these options are rejected, the focus, effectiveness and continuation of government funding of early-‐stage, broad-‐area exploration should be carefully re-‐considered. Work-‐Bid Exploration Permit Regime 116 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 7
ĂƐŚ-‐ŝĚǆƉůŽƌĂƚŝŽŶWĞƌŵŝƚZĞŐŝŵĞ The cash-‐bid exploration permit regime for Australian offshore areas was established in 1985 by an enabling amendment to the Petroleum (Submerged Lands) Act 1967, which two decades later became the Offshore Petroleum and Greenhouse Gas Storage Act 2006. The Commonwealth Government at the time advised that this regime would be used only in highly prospective areas, but the Act does not include such a restriction, and is silent on criteria for determining when and where this regime is to be applied. In 1985, the Commonwealth Government argued that cash bidding was superior to work program bidding in highly prospective areas on economic efficiency, administrative efficiency and equity grounds. The Government also saw cash bidding as a royalty/tax instrument that would complement the petroleum resource rent tax in capturing an "adequate" share of resource rent for the community. A pertinent excerpt from an announcement around that time by the Minister for Resources and Energy, Senator Gareth Evans, about release of areas in the Timor Sea for cash-‐bid exploration permits has been reproduced in Box 17. Box 17 Ministerial Statement, 1985: Cash Bidding Preferred to Work Program Bidding for Highly Prospective Areas ǲǤǤǤǤǤǤǤǤǤ applying to such highly prospective areas the existing work program bidding system, so as to simultaneously achieve economic efficiency in exploration decisions, equity, and even-‐handed administration. The proposed cash bidding system will greatly assist in improving efficiency of offshore exploration programs and in facilitating administration of exploration titles. Cash bidding for exploration permits complements the resource rent tax decision, and taken together the measures will ensure that the community recovers an adequate share of the economic rent on offshore resǤǳ Source: Evans (1985). In 1985, the Government sought to improve the efficiency of resource allocation and government revenue from petroleum extraction by replacing the crude oil excise and ad valorem royalties with the petroleum resource rent tax, and by substituting cash-‐bidding for work program bidding, at least in highly prospective areas. These taxation and tenement allocation reforms were not extended to include measures to address the adverse effects of tenure arrangements on the allocation of resources. In contrast to minor use of cash bidding in Australian offshore areas between 1985 and 1992 and no subsequent application in these areas, cash bidding has been used almost exclusively by the United States Government as the allocation mechanism for offshore petroleum exploration tenements. United States deployment of cash bidding has certainly been confined just to areas considered highly prospective. This system has been use in United States offshore areas for more than 55 years, has allocated thousands of leases, and collected billions of dollars of revenue for the United States Government. Cash-‐Bid Exploration Permit Regime 117 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ As the discussion in the preceding chapter has pointed out, the effects of an exploration tenement regime on the efficiency of resource allocation derive from the design of tenure arrangements, as well as from the nature of the permit transfer/allocation mechanism. Tenure conditions, such as short permit periods, 50 per cent relinquishment of permit area on renewal, and further work requirements on renewal reinforce the tendency of work program bidding (and a conditional first-‐come-‐first-‐served system) to induce too much exploration, too soon from a social perspective. Moreover, the extent of competition for cash-‐bid exploration permits and the magnitude of bids can be adversely affected by such conditions. Replacement of work program bidding by cash bidding does not alter the tendency of such underlying tenure conditions to misallocate resources. Cash bidding (auctioning of tenements) has been widely promoted in the economics literature as an economically efficient mechanism for allocation of exploration tenements. In this literature, cash bidding has been strongly preferred to work program bidding. This is obvious from the review of the literature on work program bidding in section 6.1. However, too often, analyses of cash-‐bid regimes have explicitly or implicitly assumed perfect tenure, neglecting the economic implications of conditions attaching to allocated tenements. In the economics literature, cash bidding has also been proposed as a device for collection of royalty/tax on an ex ante basis. Sometimes it has been suggested that it be applied as a standalone device for government capture of resource rent (for example, see Porter, 1985; Mead, 1994). Most often, it has been promoted as an ex ante revenue complement to other royalty/tax systems applying on an ex post basis. Some analysts have portrayed cash bidding as complementary to royalty/tax systems targeting realised economic or accounting profits for up to three other reasons.
Cash bidding with relatively unconditional, long-‐term tenure does not dissipate resource rent, and therefore does not undermine a realised profit base for royalties/taxes.
Cash bidding, in combination with tax/royalty systems based on realised or ex post resource rent, allows government capture of a larger share of resource rent while avoiding inefficiencies and rent dissipation that would result from sole reliance on high rates of tax/royalty on realised tax/royalty bases. Taxation/royalties linked to realised outcomes that capture an adequate share of ex post resource rent mean that low cash bids for areas that subsequently are revealed to contain highly attractive resources do not induce action by government to change the tax regime when exploration capital has been sunk, thereby creating a "sovereign risk" deterrent to future exploration and investment.
In contrast to widespread support for cash bidding (tenement auctions) in the economics literature, suggestions that cash bidding should be adopted as a major tenement allocation device in Australia have often been opposed by government tenement administrators, and by mining/petroleum sector representatives. Cash-‐Bid Exploration Permit Regime 118 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Various arguments for and against cash bidding without distorting conditions applying to underlying tenements have been assessed in section 7.1 below. In section 7.2, the consequences of auctioning highly conditional tenure have been analysed. The role of cash bidding as an ex ante royalty regime either alone or in combination with other royalty/tax systems has been discussed in sections 7.3 and 7.4. Cash bidding has been compared with royalty/tax bidding in section 7.5. In addition, in the following discussion, the implications of differences between the United States system and the Australian regime have been indicated. Lessons have also been drawn from analyses in the considerable economics literature on operation of the United States cash bidding regime. 7.1
Cash Bidding without Distorting Tenement Conditions The analysis in this section has been focused on cash bidding's role as mechanism for the transfer/allocation of exploration permits. To separate the effects of cash bidding from effects of conditions applying to the underlying tenure to be allocated, it has been assumed for analytical purposes that the tenements to be allocated are free of conditions that tend to increase the amount and/or pace of exploration. Specifically, it has been assumed that tenements are granted:

7.1.1
for long periods without periodic relinquishment requirements without conditions relating to the size, composition, and timing of exploration activity and expenditure with an attaching right to extract resources. Operation of Cash Bidding as a Transfer/Allocation Mechanism Under the Australian cash bidding (tenement auction) regime defined by the Offshore Petroleum and Greenhouse Gas Storage Act 2006, the relevant administering authority invites applicants to offer up-‐front cash payments for the right to explore for petroleum, and if a discovery is made, to apply on an exclusive basis for a production licence or retention lease. Tenements are allocated mainly on the basis of the magnitude of payments offered. Experts in petroleum exploration and extraction enterprises would attempt to estimate what a tenement is worth, having regard to all relevant geological, geophysical, geographical, environmental, infrastructural, and market factors, and any conditions attaching to the tenement or obligations imposed by legislation. They would also have regard to risk and uncertainty and available devices for managing them. After assessing all of these and other relevant matters, interested parties would determine their bids. The particular type of cash bidding system defined in the Act is a simultaneous, first-‐price (pay-‐as-‐bid), sealed bid auction. This is the most prominent type of auction system for Cash-‐Bid Exploration Permit Regime 119 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ petroleum tenements. It is the one used by the United States Government to allocate offshore petroleum exploration leases. Participants simultaneously bid dollar amounts for any tenement or tenements of interest. When all bids are in, any or all bids may be rejected. The tenement is then allocated to the remaining bidder offering the highest (first) price. The winning bidder pays what it has offered. Effectively, the legislation allows the administering authority to set a secret reserve price, just as the United States administering agency does. This feature is desirable for reasons outlined below. There is a very substantial economic literature on auctions and bidding in general. It is beyond the scope of this report to survey that literature here. For valuable, wide-‐ranging surveys, see McAfee and McMillan (1987), Klemperer (2004), Milgrom (1989; 2004) and Krishna (2010). There is also a large volume of economic literature on use of auctions for allocation of tenements for exploration for mineable resources, particularly petroleum. Much of this literature has focused on the economic performance of cash bidding for offshore petroleum exploration leases on the United States outer continental shelf. A recent brief introduction to the research and issues in relation to this regime has been provided by Philip Haile, Kenneth Hendricks and Robert Porter (2010). Valuable recent surveys taking a broader view of cash bidding for mineable resource exploration tenements have been provided by Peter Cramton (2007, 2010). Cash bidding for petroleum tenements has typically been associated with a simultaneous, first price, sealed bid arrangement, because this auction design is the one used by the United States Government to allocate offshore petroleum tenements. However, there are multiple auction systems to choose from. In some circumstances, other systems may be more appropriate than a simultaneous, first-‐price sealed bid system. Indeed, there is no system that is best in all circumstances. The best approach would depend on the setting. This is a key finding of the relevant economics literature (Klemperer, 2002, 2004; Cramton, 2007, 2010). Relevant issues have been discussed in sub-‐section 7.1.4. 7.1.2
Arguments for Cash-‐Bidding Several arguments have been advanced in support of cash bidding in the economics literature. Some relate to its role as a tenement transfer/allocation mechanism. Others relate to its role as a device for charging an ex ante, lump-‐sum royalty determined in the market for exploration and extraction rights. Indeed, it has been argued that one of its virtues is that it can serve dual purposes. Cash bidding has been justified on economic efficiency, administrative efficiency and equity grounds. Various arguments for cash bidding have been set out under those headings below. Cash-‐Bid Exploration Permit Regime 120 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Economic Efficiency Because a cash bid is determined and paid before transfer/allocation of a tenement, the cash bidding mechanism does not distort subsequent exploration, investment and operating decisions by the tenement-‐holder, because the cash payment is a sunk cost when those decisions are being made. The program that would be commercially and economically appropriate in the context of long-‐term, relatively unconditional tenure without any up-‐front cash bid, would still be commercially appropriate with cash bidding. The timing aspect of the non-‐distortionary nature of cash bidding can be illustrated by reference to the diagrammatic model presented in section 5.2. It has been reproduced below for convenience as Figure 3. When tenure is secure, the ideal time to commence the exploration-‐assessment-‐planning-‐
development-‐extraction sequence of activities (exploitation sequence) is when the present value of commencing the exploitation sequence immediately ("immediate exploitation value") stops rising faster than the relevant risk-‐adjusted opportunity cost of capital. It is depicted by time B in Figure 3. At that time, the nett present value of the right to exploit the prospect is amount MB (= YO). An enterprise would be prepared to make a cash bid up to that amount. At earlier times, the firm would be prepared to cash-‐bid discounted amounts derived by discounting the amount MB using the risk-‐adjusted opportunity cost of capital. These amounts are depicted by the curve PXNM in Figure 3. For example, the enterprise would cash-‐bid up to an amount NA in a tenement auction at time A, an amount X0 at time 0, and PC at time C. Figure 3 Timing and Amount of Exploration with Perfect and Imperfect Tenement Arrangements Source: Willett (2002), p. 157. Cash-‐Bid Exploration Permit Regime 121 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ These maximum cash-‐bids transfer ex ante resource rent to the government, but do not dissipate it. The ideal time to commence the exploitation sequence from a commercial perspective is not changed by cash-‐bidding for secure tenure. It remains at the time (depicted by time B in Figure 3) when "immediate exploitation value" stops rising faster than the relevant risk-‐adjusted opportunity cost of capital. Similarly, with relatively unconditional tenure, there is no reason why payment of a cash bid would alter the commercially desirable time to develop any resource. A rational enterprise would not aim ǲ
ǳ efficient exploration/assessment cost is positive, and stops rising faster than the relevant risk-‐adjusted opportunity cost of capital. That would be after time B in figure 3. Before that time, the firm and society in general could earn a higher return from appreciation of the value of the identified resource and the embodied exploration/information investment, than from exploitation of the deposit and investment of the surplus. The ideal time to commence development from a commercial perspective would remain the same as the appropriate time from a social viewpoint. The assumption of relatively unconditional tenure is critically important. If tenure is subject to conditions that distort the timing of activity, resources can be misallocated and resource rent dissipated, notwithstanding the neutrality of cash bidding with respect to resource allocation. This important issue has been addressed in section 7.2 below. Unlike royalty/tax systems based on realised outcomes, cash bidding does not tax mobile, firm-‐specific rents. The bidder has the discretion to exclude any mobile rents from its offer (see section 3.3 above). Cash bidding complements royalty/tax systems based on realised resource rent. It allows capture of resource rent by government with a lower royalty/tax rate, and therefore less economic damage or deadweight loss than would otherwise be the case. Royalty/tax systems based on realised resource rent help overcome concerns that "sovereign risk" might be created by government action to collect more royalty/tax if prospects or petroleum prices turn out much better than anticipated when bidding occurred. Administrative Efficiency Cash bidding is a transparent transfer/allocation mechanism involving a simple selection criterion that allows objection determination of the winning bidder. It does not involve administrative discretion and arbitrary decisions. Therefore, it involves much lower government administration costs than existing tenement regimes that are heavily reliant on administrative discretion. The transparency of the system and objectivity of the criterion mean that compliance costs are also low relative to other systems. As a royalty regime, cash bidding does not involve any administration and compliance costs additional to those required for its operation as a tenement allocation system. In other words, Cash-‐Bid Exploration Permit Regime 122 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ the incremental administration costs of cash bidding's role as a royalty mechanism would be zero. Equity Cash bidding is an equitable tenement allocation and royalty mechanism. It complies with the benefit principle of equity, which indicates that beneficiaries of goods and services provided by government should contribute in accordance with the benefits they receive (see section 2.3.2). Each bidder determines what it is prepared to pay in the differing circumstances of each prospect, having regard to all expected outcomes and revenues and costs, including risk and uncertainty. In the absence of anti-‐competitive behaviour, enterprises with superior combinations of knowledge, expertise, other resources, and capacity to manage risk and uncertainty would be able to submit higher bids and win access to the potential resource. The winning bid should approach the highest price an industry participant would be prepared to pay up-‐front at the time of the bidding for the right to explore for and extract petroleum in the permit area. Cash bidding is a flexible mechanism for capturing the highest ex ante price for each prospect in the circumstances prevailing at the time of the tenement auction. The ex ante, lump-‐sum royalty would be adjusted downwards by the bidder to allow for income tax obligations and any obligations to pay an additional royalty/tax, such as the petroleum resource rent tax, calculated on the basis of realised outcomes (ex post royalty/tax). The adjustment would take account of the deductibility or otherwise of the cash bid in calculating liabilities for ex post royalties and taxes. 7.1.3
Issues with Cash Bidding A number of issues have been raised regarding a cash bidding system. These have been briefly outlined and discussed below. Effect on Exploration Activity A common concern among administering authorities is that replacement of work program bidding by cash bidding for long-‐term exploration and extraction rights with minimal conditions would reduce exploration activity. APPEA's members have claimed that this would occur. In responses to ACIL Tasman's questions, APPEA members stated, inter alia:44 "Fewer discoveries will be made as a result of lower exploration levels within prospective acreage." "Nett effect of cash bids is a reduced level of exploration activity, with its long-‐term consequences of less development, production and PRRT revenue." "In most cases, cash bidding will slow down the pace of exploration and result in less exploration activity." 44 See Appendix C, responses to ACIL Tasman questions 13 and 16. Cash-‐Bid Exploration Permit Regime 123 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The benchmark for such concerns and claims has been the timing and amount of exploration under existing tenement regimes. This exploration benchmark is not consistent with an efficient allocation of resources. The timing and amount of activity comprising the benchmark have been influenced by an effective subsidy to exploration activity that is marginal or sub-‐
marginal in respect of time and location. The subsidy has been provided by regulated redeployment of resource rent through work program bidding and highly conditional tenure, as demonstrated in chapter 6. The economically appropriate benchmark would be the efficient timing, location, amount and composition of exploration. This benchmark would reflect the consequences of comprehensive rather than piecemeal reform, the importance of which was emphasised in sub-‐sections 2.4.3 and 2.4.4. This would include reform of existing royalty/tax regimes as proposed in chapter 10, increased funding of early-‐stage exploration activity by government, and earlier release of data from private sector exploration as proposed in chapter 5, as well as reform of tenement regimes. This reform of royalty/tax and information policies would stimulate exploration activity in Australia in a manner consistent with an efficient allocation of resources. The most common reason asserted for claims that exploration would be adversely affected is that cash bid payments would take away funds otherwise available for exploration. For example, APPEA members stated:45 "Cash-‐bid dollars (are) sterilised from advancing (the) state and maturity of exploration knowledge." "Exploration and production companies apply a 'capital constrained' approach to their global exploration budgets. All activities in cash-‐bid permits are discretionary, so (company branches required to cash-‐bid are) at a funding disadvantage globally against those jurisdictions where activities are committed through a work-‐bid system." "...... cash bidders may be limited by cash reserves available at hand to make such bids, whereas the chances of finding JV or farm-‐in partners (including institutional funding) is more plausible for a broader industry membership under a work program bidding system." This line of argument exaggerates effects of cash bidding. There are seven reasons why it does so. First, cash bids would not take funds away from commercially and economically appropriate activity. The exploration not funded at a particular time would be activity involving commercial and economic waste because of premature timing and "gold plating". Premature activity would be deferred until commercially and economically appropriate, rather than eliminated forever. Second, the argument is based on the assumption that funds available to and within each enterprise for exploration are fixed. ACIL Tasman does not consider that persistence of fixed quantities of funds for exploration beyond a single budget period is plausible. Petroleum 45 See Appendix C, "Some general comments" and responses to ACIL Tasman question 13. Cash-‐Bid Exploration Permit Regime 124 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ prices, the opportunities available, and the anticipated gains from exploration can be expected to influence the availability of funds for exploration to, and within enterprises. Third, if capital rationing is a common problem among bidders, it would be reflected by relatively high implicit costs of capital. Then, bids would be lower because of the effect of discounting at high rates. Lower bids would reduce the amount drawn from the pool of funds to be rationed. If a tenement is considered a high priority prospect by an enterprise with capital rationing, it would gain an allocation of capital. If it is not a high priority prospect, exploration could be deferred until it attained that status. Fourth, after a cash bid payment has been made, the payment becomes a sunk cost. Rationally, subsequent allocations of funds should be made on the basis of future prospects and returns. A high cash bid would indicate perceived high prospectivity, and that should mean the area receives priority funding. Fifth, capital accumulation in the petroleum sector should not be any less with a cash bidding system that preserves and redistributes the ex ante resource rent than with a regime that misallocates resources and thereby dissipates resource rent. Therefore, aggregate corporate capacity to fund exploration should not be diminished by tenement auctions. Sixth, in section 6.1, it was reported that Ursula Kretzer (1993) suggested that scarce capital unnecessarily tied up in overextended programs because of work program bidding was not available to explore other areas. Adoption of cash bidding would involve a move from work program bidding, involving such distortion of exploration activity, not a shift from the appropriate benchmark of an allocation system that does not distort the timing and quantity of exploration activity. Seventh, if a tenement involving secure tenure is worth paying-‐for, it would be explored by a rational enterprise when its immediate exploitation value stops appreciating faster than the relevant opportunity cost of capital, as explained in section 6.2. If the tenement-‐holder did not wish to fund exploration at that time, it could enter into a joint venture agreement with, or sell to another entity capable of funding exploration. Cost of Capital and Risk Management Asymmetries Mason Gaffney (1977b, 2009), argued that cash bidding would not necessarily allocate tenements to the most efficient operator, particularly if the government relies mainly on cash bids to capture resource rent. This would detract from the case for cash bidding on grounds of economic efficiency and compliance with the benefit principle of equity. Gaffney pointed out that very large enterprises have significantly lower costs of capital than other enterprises because of their large, diversified asset bases. This gives them a waiting advantage over other firms in bidding for tenements that could potentially yield support long-‐
lived projects and/or that may not be "ripe" for exploration and extraction for a long time. In such cases, cash bidding would screen enterprises by their financial strength and capacity to wait, rather than by their ability to find and extract petroleum. He explained that low costs of Cash-‐Bid Exploration Permit Regime 125 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ capital and therefore low discount rates did not imply superior present or future efficiency. Relevant excerpts from Gaffney's report to the Alaskan Government have been reproduced in Box 18. Box 18 Efficiency Versus Waiting Ability "We should not think that selling for top dollar will tend to screen out leaner firms. Lean, efficient firms can pay well for something they can sell quickly. It is long waiting periods that screen out lean firms: they work with impatient money. ........... To require bidders to pay in advance for an unknown possibility of acquiring a 20-‐ or 30-‐year supply is virtually to substitute wealth for productivity as the effective basis of allocation. The possession of great wealth suggests there may have been past productivity, although predation and privilege are also sources of wealth. It is no guarantee of present or future productivity." Source: Gaffney (1977b), pp. 98, 108. Gaffney also argued that the lottery element in cash bidding could exclude some potentially efficient enterprises. He pointed out that bids tended not to be closely correlated with exploration and extraction outcomes. Then, if most investors are risk-‐averse, as is generally believed, cash bidding could screen out possible entrants. Richard Norgaard (1977) of University of California, Berkeley, in a research paper for Mason Gaffney's report to the Alaskan Government on petroleum leasing policy pointed out that small firms were particularly disadvantaged in bidding relative to large firms with extensive exploration portfolios over which to spread risk and uncertainty. Small companies' disadvantage in spreading risk would contribute to cost of capital differentials highlighted by Gaffney (1977b, 2009). Gaffney favoured auctions, but argued that government should rely much more on deferred payments than on up-‐front payments to capture resource rent. He suggested various ways in which auctions could still be deployed, while payments are deferred. Gaffney suggested that if the bid variable is a cash payment, it could be spread over time with periodic payments adjusted to including interest at an appropriate rate. However, he did not favour this option. Kenneth Dam (1976) pointed out shortcomings of spreading payments of a cash bids over time to help small companies to compete. If the obligation to make payments plus interest over time is absolute, small companies would not be assisted if an exploration permit turns out to have no value, because the debt would be an impediment to private sector financing of other ventures. If the payment obligation is contingent on holding of the permit, the instalment arrangement would convert a sunk cost into an avoidable future cost. This could cause the permit holder to relinquish title and not develop a marginal project or to abandon a project that becomes marginal later, because deferred bid payments would be regarded as a project cost. Cash-‐Bid Exploration Permit Regime 126 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Gaffney (1977b, 2009) favoured deferred payments closely linked to what is disclosed by exploration and extraction, fully recognising the tenement holder's inputs to exploration and extraction. One option suggested was to make the bid variable a share of resource rent. This last option has been discussed in section 7.5. Payments in respect of tenements could be deferred in various other ways. For example, requirements to pay petroleum resource rent tax and income tax in Australia, and ad valorem royalty plus company income tax in the United States reduce the magnitude of cash bids and defer payments. Second, the magnitude of bids could be further reduced and payments further deferred by denying cash bid payments as deductions under the petroleum resource rent tax (currently not deductible) and company income tax (currently deductible in Australia and the United States). This last option has been discussed under the sub-‐heading "Competition and Small Companies" below" within this sub-‐section (7.1.3). Other reasons for carefully considering the appropriate balance between up-‐front and conditional payments have been discussed in sections 7.3 and 7.4. An issue with Gaffney's argument that cash bidding would not necessarily allocate tenements to the most efficient operator (at least when the government relies mainly on cash bids to capture resource rent) is that differences between companies' cost of capital and related capacity to manage and bear risk and uncertainty are just as important as differences in other costs of exploration and extraction for determining relative efficiency. The lower cost of capital of very large, diversified entities indicates both superior ability to raise capital and superior attributes in management of, and capacity to bear risk and uncertainty. The absence of a full set of risk and insurance markets to deal with risk and uncertainty is a source of "market failure". While there are various risk/uncertainty management devices available to small and large companies to reduce the extent of this market imperfection, large, diversified companies appear to have access to a wider range of options, including being large and diversified. These advantages are reflected by large, diversified companies' lower cost of capital. Deferment of liability for payment of a share of resource rent to government is one way of providing another risk/uncertainty management device to companies. Of course, it means government would take a larger share of the risk/uncertainty. It would be compulsory risk/uncertainty sharing for companies, which might displace other options (Smith, 1997). Therefore, it is unclear whether or not it would increase the likelihood of tenements being allocated to the most efficient operator, and improve the efficiency of resource allocation. Competition Concerns have been expressed by representatives of administering authorities that the market for tenements will not be competitive for various reasons (not including the one discussed immediately above). Specific concerns typically include the following. Cash-‐Bid Exploration Permit Regime 127 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ

The number of potential purchasers of exploration rights may be small, particularly in areas that are not considered highly prospective. Bidders might collude to restrain the size of bids. Small explorers could be squeezed-‐out because of inadequate financial resources to fund up-‐front cash payments. APPEA members have also expressed this concern. Competition -‐ US Offshore Experience Natural resource auction specialist Walter Mead and co-‐authors (1983, 1986) empirically analysed results of United States outer continental shelf petroleum lease auctions over nearly 30 years prior to 1983. Their analysis indicated that competition for tenements had been sufficiently strong to protect the public interest. In 1983, the United States changed from a nomination system to determine which tracts should be offered for bidding to an "Area Wide Leasing" (AWL) system, which offered most of the vacant offshore areas, including thousands of deep water tracts, for cash bids in each lease sale. In addition, tracts with water depth in excess of 200 metres were offered with lease periods of 8-‐10 years, instead of 5 years, and ad valorem royalty rates for tracts with water depths in excess of 400 metres were lowered from 16᪟ per cent to 12.5 per cent. These substantial changes to the United States offshore cash bidding regime, the huge spike in oil prices from 1973 to 1981, the oil price collapse in 1986, and low and declining oil prices in the 1990s have complicated the task of assessing changes in competition for leases under cash bidding. Omowumi Iledare, Allan Pulsipher, Williams Olatubi and Dimitry Mesyanzhinov (2004) undertook an empirical analysis of the extent of competition in United States outer continental shelf cash bidding, focusing on the period from 1983 to 1999. They did not find evidence of a decrease in, or deficiency of competition in this period. Iledare and his co-‐authors (2004) found that the market for leases was not concentrated (as measured by the Herfindahl index) and became less concentrated with time in the 1983-‐1999 period. In addition, they pointed out that the average number of bids per lease rose from 1.44 in the 1983-‐89 period to 1.48 in the 1990-‐99 period. The average number bids for leases attracting more than one bid rose from 2.66 in 1983-‐89 to 2.73 in .1990-‐99. The last statistic is marginally above the corresponding average in the 1954-‐66 period. Bids per lease attracting more than one bidder were more than 40 per cent higher during the oil shocks of 1973-‐1981 than in the pre-‐oil shock and 1990-‐99 periods, as would be expected. Iledare and his co-‐authors (2004) found that the larger firms, particularly the very large enterprises, tended to make larger winning bids. They did not find evidence of anti-‐
competitive effects of joint bidding on the size of high bids. Later, Iledare and Pulsipher (2007) found that a prohibition on joint bids between very large firms enacted in December 1975 had reduced competition for petroleum leases, particularly in the 1990s. Cash-‐Bid Exploration Permit Regime 128 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Competition Improvement Devices There are various ways in which concerns about lack of competition can be ameliorated. Some of these have been applied in the United States offshore regime and may have contributed to the reasonable degree of competition observed under that regime. These measures and others have been discussed below. Conducting tenement auctions on a sealed-‐bid basis tends to encourage more participation, inducing effective competition even if the number of bidders is small. In addition, the "winners curse" problem for weaker bidders is likely to be far less severe in a sealed bid auction than in an open auction. Therefore, weaker players could bid aggressively (Klemperer, 2002, 2004). Collusion is much harder in a sealed bid auction than in an open auction. However, collusion is still a potential issue (Klemperer, 2002; Cramton, 2010). The latter point was stressed by oil and gas cash bidding specialists, Philip, Kenneth Hendricks and Robert Porter (2010), who pointed out that more research was required to determine the significance of collusion in respect of cash bidding for United States offshore oil and gas leases. Declaration of the right to reject any or all bids, and setting of undisclosed reserve prices could be used to avoid granting of tenements, if there is concern competition might not be effective, because of suspected collusion or few bidders. These measures would effectively introduce an additional competitive bidder, the government. Of course, their effectiveness would depend on the information and expertise available to the government in setting reserve prices and deciding to accept or reject bids (Gaffney, 1977b). Peter Cramton of University of Maryland, who is a highly regarded specialist in the economics of auctions, has made some pertinent observations regarding the role of reserve prices. These have been shown in Box 19. Box 19 How Should Reserve Prices Be Used? "Reserve prices in natural resource auctions have two main purposes: 1) to guarantee substantial revenue in auctions where competition is weak but the reserve is met, and 2) to limit the incentive for -‐ and the impact of -‐ collusive bidding. Reserve prices mitigate collusive bidding by reducing the maximum gain of the collusive bidding. Setting reserve prices for natural resource auctions is difficult given the enormous uncertainty of values. The approach taken in the US is to have a low minimum bid that applies to all lots, and then accept or reject winning bids ex post. Thus the reserve price is secret and can depend on the observed bidding behaviour." Source: Cramton, (2010), pp. 298-‐299. Sealed bidding, declaration of the right to reject any or all bids, and setting of undisclosed reserve prices are features of the United States cash bidding regime for offshore petroleum tenements. Another feature of this regime designed to improve competition is that very large Cash-‐Bid Exploration Permit Regime 129 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ oil companies are prohibited from participating in joint bids with each other, but may bid jointly with smaller enterprises. Small explorers are permitted to bid jointly with anyone. Bids could and should be accepted from anyone, not just exploration and extraction enterprises. Investment funds and enterprises may be interested in holding natural assets in their portfolios. Bidding by conservation groups and other interested entities would help ensure that petroleum prospects are allocated to what is perceived to be their highest-‐valued use at the time. Participation in auctions by parties from outside the industry would enhance competition. Competition and Joint Bidding Natural resources auction specialist, Walter Mead and co-‐authors (1986) conducted empirical analysis that indicated that after allowing for quality differences between tenements, there was no significant difference between high bids submitted by joint bidders and solo bidders. Omowumi Iledare and Allan Pulsipher (2007) undertook an econometric analysis of the consequences of the policy (enacted December 1975) of prohibiting joint bids by the largest oil companies. They did not find evidence of lack of competition in respect of petroleum tenements in the Gulf of Mexico. They did find that this result could not be attributed to the prohibition. Their analysis indicated that overall, the joint bid restriction had "reduced bidding effectiveness, especially in the 1990s." The analysis suggested "a pattern of fewer bids and fewer bidders per lease for leases won by restricted bidders over the entire period (1983-‐1999) and became more pervasive in 1990-‐1999." Competition and Nominations Some analysts have argued that a nomination process would help increase competition for tenements. It has been suggested that areas should be released for bidding only following receipt of either at least two unsolicited expressions of interest or at least one unsolicited expression of an interest followed by a successful call for written expressions of interest. The results of this private sector input would not be made public. Under the United States offshore cash bidding arrangements prior to the introduction of AWL in 1983, a tract had to be nominated by one or firms before being offered for sale by auction. Tracts offered for cash bidding were selected on the basis of nominations. Often, the selected tracts were nominated by multiple firms. Haile, Hendricks and Porter (2010, p. 394) observed: "......... presumably firms nominated tracts they believed most likely to be productive. ........ The favourable selection of tracts that existed prior to AWL may also have played an important informational role. Under the nomination process, the mere fact that a tract was offered suggested that at least one other firm thought the tract was likely to be valuable. Thus the nomination process might have provided both a way of coordinating competition and a way of reducing the severity of the winner's curse." Cash-‐Bid Exploration Permit Regime 130 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ A problem with relying on nominations according to Mason Gaffney is that over-‐nomination of areas of interest was routine for many firms seeking to hide their real intentions (Gaffney, 1977b, p. 84). This could lead to premature release of areas for bidding and acquisition for pre-‐emptive purposes. In the case of offshore Australia, as part of the process of selecting areas for release for work program bidding, petroleum exploration and extraction stakeholders are invited to nominate vacant areas for release. All nominations are considered carefully before a decision is made regarding inclusion or exclusion. A comparison of nominations and subsequent bids undertaken by Department of Resources, Energy and Tourism revealed that from 2002 to the latest release, in most years, companies participated in bids in respect of less than 25 per cent of areas they had nominated themselves. In three of the past eight years, there were no bids by companies in respect of areas they had nominated themselves. Competition and Small Companies The previous sub-‐section outlined Mason Gaffney's argument that cash bidding tended to screen enterprises on the basis of their financial strength and consequent capacity to wait, and their attitudes to the lottery element of bidding for exploration tenements, rather than by the ability of enterprises to find and extract petroleum. Gaffney (1977b, 2009) explained that this adversely affected competition, as well as impeding allocation of tenements to the most efficient operator. Richard Norgaard (1977, p. 3) argued that small firms were particularly disadvantaged in bidding relative to large firms with extensive exploration portfolios over which to spread risk and uncertainty. He explained that this reduced competition for leases: "Unequal competition is less competition, which further reduces the likelihood that government will collect its fair share." APPEA members have claimed that small explorers could be prevented from participating in cash bidding for exploration permits because of inadequate financial resources to fund up-‐
front cash payments. They stated:46 "..... cash bidding will be a major barrier to small company participation on offshore petroleum exploration." "Small companies generally have limited access to cash, in advance of having an investment opportunity against which funds can be raised." "Small companies (are) unable to effectively compete, because of the need to focus limited resources through effective exploration, ie, cash in the ground." "Not only does [cash bidding] involve the direct transfer of funds from companies to the government (and the associated loss of exploration effort), it clearly discriminates against the interests of smaller companies that are less able to divert scarce funds from exploration to access payments. 46 See Appendix C, "current methods of allocating exploration permits may also erode resource rents", and responses to ACIL Tasman questions 10, 13 and 18. Cash-‐Bid Exploration Permit Regime 131 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Australia is best served by having its scarce exploration funds invested directly into work aimed at discovering petroleum resources. The knowledge gained and the benefits derived from successful exploration far outweigh an initial upfront payment to government. Not only does cash bidding restrict the amount of funds available for exploration activities, it also discriminates against small companies who rely predominantly on funds raised through share issues. In this latter case the use of cash bidding could be described as limiting competition." Similar claims were made by Australian petroleum industry representatives in the mid-‐1980s, when the Petroleum (Submerged Lands) Act 1967 was amended to enable allocation of exploration permits by cash bidding (Oil & Gas Australia, March 1985). These claims mirrored views expressed by various parties in the 1970s in the United States regarding disadvantage to small companies and detriment to competition from the requirement to make up-‐front cash payments under the offshore petroleum cash bidding regime that had been established in 1954. In response, legislation was changed to require experimentation with alternative bid variables over a five-‐year trial period from 1979. These alternatives had to be deployed for no less than 20 per cent of leases and no more than 60 per cent of all petroleum leases offered for sale (Mead, Moseidjord, Muraoka, 1984; Moody, 1994). The United States Government trialled cash bidding with:
ͳ͸᪟
per cent to 65 per cent

profit share rates to government of 30 to 50 per cent, instead of ad valorem royalty an ad valorem royalty at a rate of 33 per cent an ad valorem royalty at a rate of 12.5 per cent. All of these alternative schemes, except the last one, could have been expected to reduce cash bids ͳ͸᪟
per cent, because of increased, deferred payments to government. If up-‐front bids were an obstacle to small firms, there should have been an increase in the percentage of companies participating that can be categorised as "small" (outside the top 20). Instead, winning bids were not significantly reduced relative to the traditional cash bidding arrangements under any of the alternative arrangements. Meanwhile, the number of bidders rose in the case of cash bidding with a sliding scale ad valorem royalty scheme, did not change significantly in the case of cash bidding with a 12.5 per cent ad valorem rate, and fell significantly for cash bidding combined with profit share payments to government and the 33 per cent ad valorem royalty rate. The percentage of small companies among bidders fell significantly in the case of every alternative scheme trialled (Moody, 1994). Carlisle Moody (1994) suggested that the trialled alternatives to the traditional United States cash bidding regime might have failed to increase participation by small companies because a suitable mechanism already existed to deal with the requirement to make up-‐front payments. That mechanism, which is available to small and large companies, is to bid jointly with others. Moody pointed out that under the traditional United States cash bidding system, over 51 per Cash-‐Bid Exploration Permit Regime 132 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ cent of bidding companies were categorised as "small". In joint bids, around 59 per cent of companies were in the "small" category. Work program bidding is APPEA's benchmark for claims of disadvantage to small companies under cash bidding. APPEA's members asserted that participation by small companies and competition are not impeded under work program bidding:47 "Small companies need to use cash resources in the most effective manner possible. Work program bidding facilitates this as it puts cash into the ground." "Cash bidding detracts from the open competition for acreage that is possible through a work program bidding system Ȃmay be limited by cash reserves available at hand to make such bids, whereas the chances of finding JV or farm-‐in partners (including institutional funding) is more plausible for a broader industry membership under a work program bidding system." "A work program bidding system allows smaller players, who are perhaps prepared to explore in the overlooked corners of basins, to progress and promote exploration with a new perspective on the acreage (for example the efforts of Strike Oil in the Casino discovery in the Otway Basin). In a cash bid system, this would not be possible, as for the smaller player, the cash is spent up-‐front, and not targeted towards exploration, which means these players would simply be expensed out of the game." Logically, up-‐front cash bids could present an absolute barrier to entry for small firms only in the case of very highly prospective ground. In that case, they may encounter particular difficulties being accepted into joint ventures with large firms or bringing together a sufficiently large number of small firms to attain the required aggregate financial capacity and degree of risk-‐spreading. However, these difficulties would also apply in the case of work program bidding, bearing in mind that, although work-‐bids relate to outlays over three years (period for minimum guaranteed work program) instead of one, work-‐bids would be higher than cash bids to the extent that the promised program is expected to add to the value of the tenement (Erickson, 1977). In addition, companies have to demonstrate financial capacity to undertake their shares in programs. In the case of areas that are not considered particularly attractive, such as the "overlooked corners of basins" (see APPEA quote above), cash bids would be correspondingly lower than in attractive areas, and still less than work program bids. Therefore, barriers to entry from cash bidding to small firms would also be lower. ACIL Tasman does not consider that cash bidding would exclude small companies from such areas. Small explorers could encounter greater barriers to entry with cash bidding than under work program bidding only to the extent that increasing the length and reducing conditions of tenure, and inclusion of extraction rights increased the value of tenements. However, increasing the length and security of tenure would also provide a better foundation for capital raising, which would tend to reduce barriers to entry relative to those prevailing under a work program bidding regime. 47 See Appendix C, "Some general comments", and response to ACIL Tasman question 18. . Cash-‐Bid Exploration Permit Regime 133 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ In sub-‐section 7.1.3 under the sub-‐heading, "Efficiency of Winning Bidder", options were discussed for reducing size of up-‐front cash payments to avoid disadvantage to small companies, and thereby increase competition. These options included payment of cash-‐bid amounts over time, and not allowing cash bids as a deduction for the purposes of taxation on the basis of realised outcomes (In Australia, cash bids are deductible from the income tax base, but not the base for the petroleum resource rent tax). However, APPEA has opposed non-‐deductibility of cash-‐bids as indicated below. "To provide a balance between accepting exploration risk and reward, cash bids like other exploration expenditure should be tax deductible. Government and nations benefit from the development of hydrocarbon resources through taxes, petroleum resource rent tax and royalties. Any system that does not encourage exploration will jeopardise future revenue streams." ".... bids should definitely be deductible. However, bid levels would not necessarily increase if they were deductible. Exploration and production companies do take tax deductibility into account when assessing the economic value of opportunities, but at the same time they manage their global exploration budgets on a capital constrained, pre-‐tax basis." The first quote suggests that non-‐deductibility of cash-‐bids, meaning lower cash bids, would discourage exploration. This is correct because the company income tax system and petroleum resource rent tax regimes tend to discourage exploration, as explained in chapter 10, while cash bidding does not adversely affect the efficiency of resource allocation. This could be ameliorated by reforms to these taxes proposed in chapter 10. However, APPEA has also claimed that higher cash bids would discourage exploration, particularly in the case of small explorers. ACIL Tasman notes that APPEA's position regarding tax deductibility of cash-‐bids appears to be inconsistent with its view that cash bids disadvantage small companies. There are three reasons for this observation. First, deductibility should mean higher up-‐front payments and a compensating reduction in deferred payments, but APPEA has said that higher cash bids would disadvantage small companies. Second, deductibility of cash bids disadvantages small companies and newcomers to Australia without taxable company income, relative to large companies with taxable income. Large companies with taxable income would be able to make larger bids than small companies without taxable income, because of tax deductibility of cash bids. Third, the argument that tax deductibility of bids is desirable is contrary to the suggestion in the second quote immediately above that bids might not change with changes in deductibility of bids. To sum up, the choice between tax deductibility and non-‐tax deductibility of cash bids would not be a simple one. Points in favour of non-‐deductibility are that:

cash bids would be smaller, facilitating participation by small companies the extent to which cash bids are less than work program bids (with tax deductible exploration outlays) would be greater Cash-‐Bid Exploration Permit Regime 134 Review of AuƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
large companies with taxable income would not have a bidding advantage over small companies and newcomers without taxable income. Points in favour of deductibility of cash bids are that:
economic efficiency gains would derive from being able to collect the same share of resource rent in present value terms with lower tax rates
it is feasible for small companies to engage in joint bidding to help them cope with higher bids, noting that this occurs in United States offshore areas where deductibility of cash bids is available (Increased risk sharing with government through non-‐deductibility of cash bids may be superfluous to the extent that small companies can engage in joint bidding.). Competition and Information Richard Norgaard (1977) explained that lack of pre-‐auction information reduced bidding activity and competition in auctions. He argued for government funding of, or participation in exploration activity before tenement auctions to reduce uncertainty, and to guide formulation of area release schedules and reservation prices for each area. He argued that these advances would increase competition substantially, with consequent improvement of bids. Norgaard explained that intelligent formulation of reservation prices not only allowed the government to behave as an extra competitive bidder, but also could reduce the effectiveness of private sector bidders' game theoretical strategies. He claimed that disrupting such strategies would have a greater impact on competition than increasing the number of bidders. Competition and Supply of Tenements Representatives of petroleum exploration enterprises have expressed concern that the market for tenements would not be competitive, because governments might restrict supply of tenements to raise bids. Others have argued that it is in the interests of the community that government avoids flooding the market for tenements. Obviously, the Commonwealth Government competes with governments elsewhere in the world as a supplier of tenements. The effect on bids of restricting Australian supply would depend on the closeness of international substitutes for Australian tenements, the potential number of bidders, and degree of competition between bidders. It is not clear how much supply would need to be restricted before explorers became concerned and the government made significant gains. This matter requires further research. However, ACIL Tasman notes the importance of timing of release of areas for exploration permits for the efficiency of offshore petroleum exploration. Winner's Curse The "winner's curse" issue was highlighted by ARCO (Atlantic Richfield) personnel, Edward Capen, Robert Clapp, and William Campbell (1971) in the context of (first-‐price, sealed bid) cash bidding for United States outer continental shelf petroleum exploration and extraction Cash-‐Bid Exploration Permit Regime 135 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ leases. The concept of the "winner's curse" refers to the danger that the winning bid could exceed the value of the rights because it is the most optimistic bid. Over the past 40 years, the potential "winner's curse" has received considerable attention in the economics literature on auctions in general,48 the literature on petroleum tenement auctions,49 and in work focused specifically on the "winner's curse".50 The "winner's curse" phenomenon is not confined to cash bidding. It could also apply in the case of work program bidding, as Ursula Kretzer (1993) pointed out. While the ex post value of an area is common to all bidders or close to it, various bidders will have different ex ante perceptions of that (almost) common value, because of uncertainty, and the differing incomplete information possessed in relation to potential resources and extraction costs, and future petroleum prices. If each auction participant bids what it believes a permit is worth, having regard to the information available to it and residual uncertainty, the highest bidder would be the one with the most optimistic view of the value of the permit. The winning bid is the high-‐side outlier, not a representative or average bid. A bidder might revise its ex ante valuations if it had access to the basic and interpretative information in the possession of other parties at bidding time. Consistent with this, the winning bidder's valuation is likely to fall after it learns it has won, because the signal provided by the lower bids of others reveals that the information held by unsuccessful bidders indicated lower valuations. The negative information obtained by the winning bidder through the announcement that it is to be granted a tenement worsens with higher numbers of competing bidders. Knowing that 10 others have been out-‐bid is worse news than advice that five others have been beaten, and learning that 5 others have been out-‐bid provides a more negative perception of winning than knowledge that two other have been beaten. The "winner's curse" would occur only if the winning bidder overestimates the value of rights to explore and extract and bids that a price equal to that value estimate or another price higher than the actual value. This problem might be avoided because of good information, estimating skill, good luck, or cautionary strategic thinking in formulation of a bid. A rational bidder, recognising the danger of experiencing the "winner's curse", would respond by bidding conservatively or would learn by experience to do so. Therefore, the potential for widespread persistence of the "winner's curse" has been treated with some scepticism by many economists, who have argued that persistence of bidding behaviour leading to the "winners curse" is irrational and unsustainable in the long-‐term. 48 For example, see Milgrom and Weber (1982), Milgrom (2004), Klemperer (2004) and Krishna (2010). 49 For example, see Cramton (2007, 2010) and Kretzer (1993). 50 For example, see Thaler (1988), and Kagel and Levin (1986, 2002). Cash-‐Bid Exploration Permit Regime 136 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨfshore Petroleum Exploration Policy However, some "behavioural" economists have used psychological experiments involving university students and executives to test the likelihood of persistence of the "winners curse". They found that participants tended to learn only slowly and with difficulty. Moreover, the learning appears to be context-‐specific (Kagel, Levin, 1986, 2002; Thaler, 1988). If an auction participant "shades" its bid appropriately to avoid the "winner's curse", when other participants don't do so, it avoids paying too much, but may not be granted any permits. This is an unsatisfactory state of affairs. One alternative is to pursue permits elsewhere, but that could involve changing from participation in cash bidding in one country to work program bidding in another. A second option could be to try to farm-‐in to areas after permits have been awarded. A third alternative, favoured by prominent "behavioural" economist Richard Thaler (1988), is to warn competitors about the "winner's curse", so that they will "shade" their bids too. Then, the dilemma would disappear, except for the emergence of naive new entrants, which would have to be warned or left to learn by experience. The third alternative is the one that Capen, Clapp and Campbell (1971) or ARCO deliberately or inadvertently chose by publishing their analysis of the "winner's curse" under cash bidding for petroleum leases in the Journal of Petroleum Technology. Their work and the substantial amount of material published since 1971 on the dangers of "winner's curse" in petroleum tenement auctions should have alerted bidders and ameliorated the problem. Of course, if all participants are alert to the potential "winner's curse", they still have to "shade" their bids appropriately. Each bid should be determined to allow for the negative information that winning would convey to a bidder. Moreover, the greater is the number of bidders, the greater the downward adjustment should be. This is the case because greater competition tends to raise bids, and because a higher number of bidders tends to widen the distribution of value estimates (Krishna, 2010; Cramton, 2010). Determining the appropriate "shaded" bid would be a strategically difficult task. However, debate continues regarding the ongoing significance of the "winner's curse" in practice. It seems more likely to be a problem in early stages of the process of learning about and adjusting to the "winner's curse", and in cases when there is a relatively large number of participants. There are no obvious resource misallocation effects arising from the "winner's curse" and bidders' adjustments to avoid it under a cash bidding regime. If participants bid too high or adjust too much for the "winner's curse", future resource allocation, is not affected because the bid amount is a sunk cost. The "winner's curse" and adjustments to it do have distributional implications. Beneficiaries of government expenditure programmes and/or tax payers generally gain from bids in excess of ex ante resource rents and over-‐bidders lose. Adjustments by bidders to avoid the "winner's curse" would change the distributional balance. In contrast, in the context of the work-‐bid exploration permit regime involving work program bidding, relatively short tenure and relinquishment conditions, the "winner's curse" Cash-‐Bid Exploration Permit Regime 137 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ exacerbates resource misallocation allocation caused by that tenement regime. Adjustments to avoid the "winner's curse" reduce that adverse effect. If releases of areas for work-‐bids are premature, this occurs because work program bidding and tenure conditions designed to bring forward exploration induce too much exploration, too soon. Adjustments to work program bids to avoid the "winner's curse" reduce the extent of the distortion of the quantum and timing of exploration. If releases of areas for work-‐bids are unduly delayed, being later than the optimal time to commence activity, the "winner's curse" would exacerbate the tendency of work programme bidding to induce too much exploration or "gold-‐plating", and adjustments to bids to avoid the "winner's curse" would ameliorate this tendency. Premature exploration is obviously not an issue when releases of areas for bids are unduly delayed. However, Ursula Kretzer (1993) pointed out that the extent of the combined effects of work program bidding and the "winner's curse" were likely to be muted to some extent because work program bids do not depend solely on ex ante resource rent, being influenced also by exploration cost and program considerations. From a distributional perspective, the "winner's curse" increases gains to providers of exploration services (at the expense of exploration company shareholders and the community) under a work program bidding system, and adjustments to work bids to avoid the "winner's curse" reduce those gains. Asymmetric Information Asymmetric information refers to an uneven distribution of information among market participants resulting in significant informational advantages to some over others. As explained in chapter 5, government funding of early-‐stage, broad area exploration, and government collection and release of privately generated exploration information gathered in respect of petroleum tenements could be reasonably efficient mechanisms for addressing "market failures" arising from public good and external benefits aspects of exploration information and from asymmetric information issues. However, it has been argued that uncorrected information asymmetries could undermine the efficiency and revenue yield of cash bidding. The argument is along the following lines. Enterprises that have been exploring areas in the vicinity of the tenement to be auctioned should have an informational advantage, because of data generated by their previous activities. Other entities with inferior information may reason that, if they bid on the basis of the information available to them, they are unlikely to win, and if they do win, it is likely to mean they have overbid. A potential bidder with superior information may reason that those with inferior information would either not bother to bid or bid low on a precautionary basis, because of their inferior information. In this context, a bidder with superior information may lodge a lower bid than can be justified by the information available to that enterprise. Therefore, the result of asymmetric information may be less competition for tenements and Cash-‐Bid Exploration Permit Regime 138 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽleum Exploration Policy lower bids. This is supported by a detailed empirical study by Walter Mead, Asbjorn Moseidjord and Philip Sorensen (1984) covering the very large number of oil and gas tenements issued by the United States Government in the Gulf of Mexico from 1959 to 1969. This line of argument does not take into account how potential acquisition of informational advantages could affect cash bidding. Mead, Moseidjord, and Sorensen (1984) argued that in the first auction in an area, in which asymmetric information is not an issue, bids should take into account not only the potential value of the right to explore and exploit, but also the perceived value of the opportunity to obtain information that could be useful in later auctions in the area. In effect, the winning bidder would be paying for the right to have a subsequent informational advantage. Therefore, cash bids would tend to internalise the external cost associated with an asymmetric information market failure. Moreover, government would tend to be compensated for lower cash bids from later auctions, in which earlier explorers in relevant areas have informational advantages. Mead, Moseidjord and Sorensen explained that this reasoning was supported by the results of detailed analysis of bidding patterns and profitability outcomes in respect of the large number of oil and gas tenements issued in the Gulf of Mexico by the United States Government in the period 1959 to 1969. In such circumstances, cash bidding would automatically address asymmetric information market failure in respect of petroleum exploration. Instead of cash bidding's efficiency and revenue yield being undermined by asymmetric information issues, cash bidding would help to correct this source of market failure. "Warehousing" and Speculation It has often been asserted by opponents of cash bidding that the winning bidders for long-‐
term tenure without work requirements would be able to "warehouse" or sit on tenements, "speculating" or "real-‐estating", rather than actively exploring. They have also suggested that such behaviour would necessarily be economically undesirable. Their recommended response has been deployment of work program bidding and tenure conditions that force the pace of exploration. On this matter, APPEA said:51 "A cash bidding system gives the permit holder the "option" to explore rather than the obligation to conduct a nominated minimum level of activity. This would result in less activity due to cyclical changes in business conditions and company strategy. There are numerous anecdotal examples of discoveries resulting from well that were committed but reluctantly drilled (for example, Bayu-‐
Undan)." "Cash bidding may not provide adequate impetus to explore within the first 4 to 5 years of a permit term." "Development pace will be slowed unless government introduces a mechanism for forcing it." 51 See Appendix C, response to ACIL Tasman question 19. Cash-‐Bid Exploration Permit Regime 139 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ A notable aspect of these comments by APPEA members is that government regulation of programs based on work-‐bids seems to be preferred to rational commercial decisions of exploration enterprises. It seems highly unlikely that this could be in the best interests of shareholders. As explained in chapter 6, it is against Australia's national interest. The alleged undesirability of "warehousing" behaviour has been criticised in the economics literature. The critique has four aspects. First, the winning "speculator" would have to make the top bid to be awarded the tenement. Moreover, the administering authority typically could reject any or all bids considered unsatisfactory. This is the case in the Australian and United States offshore cash bidding systems. Second, if the winning bidder chose to defer commencement of the exploration-‐development-‐
extraction sequence, because it considered that immediate exploitation value of the permit rights was appreciating faster than the relevant opportunity cost of capital (before time B in Figure 3), both the enterprise and society would benefit as demonstrated in section 6.2. Such ǲǳ would be socially responsible, as the Industry Commission (1991, Volume 3, p. 39) observed: "........ the act of abstaining from actually exercising mineral rights because, for example, the real value of such rights is rising, is exactly what society should applaud, since it is in the interests of those with a stake in the outcome (eg, via royalties) to maximise the nett worth of any particular asset. Thus 'real-‐
estating' can be highly desirable in the right circumstances." Ted Bergstrom (1984) of University of Michigan argued that this "speculative" activity would facilitate an efficient allocation of resources over time. Indeed, "speculative" activity would implicitly recognise the anticipated demands of, and supply available to future generations. Comments by Bergstrom on the matter of "speculative" activity in tenements have been re-‐
produced in Box 20. Box 20 "Warehousing" and "Speculative" Activity Not Antisocial "Economic analysis of the intertemporal allocation of exhaustible resources suggests that this view ('speculation' is antisocial) is misguided. So long as mineral rights can be bought and sold, an individual will hold mineral rights without exploring or developing a property only so long as he believes that the market value of the random stream of income which would arise from postponement exceeds the market value he could obtain from immediate exploration or development. Efficient allocation of resources requires that the schedule for exploration and mining activities on a land parcel or for mining from a known mineral deposit be that schedule which maximises the market value of the resulting stream of random costs and r eturns. This means that where mineral rights can be privately bought and sold, competitive firms will have appropriate incentives to time their activities in a socially efficient way. In fact it is precisely through the 'speculative' activities of investors who believe that they will gain by waiting to exploit mineral potential that the anticipated demands of future generations are able to influence the rate at which earlier generations exhaust these resources. Perhaps those who believe that speculation is antisocial would do well to reflect on whether they would regard the same activities as socially meritorious if they were renamed 'conservation'" Source: Bergstrom (1984), p. 178. Cash-‐Bid Exploration Permit Regime 140 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂtion Policy Third, if a gain could be made by selling a tenement to another party wanting to explore it, rather than by holding it, a rational "speculator" would sell. Again, such "speculative" activity would be socially responsible, as well as being commercially sound. Fourth, for "warehousing" of tenements to be economically negative, it would have to be shown that it was caused or exacerbated by some "policy failure" or "market failure" resulting in resource misallocation. The main "policy failures" affecting timing of exploration are work program bidding and highly conditional tenure, but these tend to bring-‐forward exploration when areas have been released prematurely, dissipating ex ante rent in the process (see chapter 6), rather than delay activity. Two "market failures" have been identified that could affect the timing of exploration. Their implications have been discussed briefly below. "Market failure" in the form of under-‐provision of the public good of information from early-‐
stage exploration and external benefits of information "spillovers" from subsequent exploration could mean exploration is undertaken too little, too late from a social perspective , as explained in chapter 5. These "market failures" are best dealt with through government funding of early-‐stage exploration and dissemination of data, and government collection of exploration data from explorers followed by early release of that data to interested parties. Work program bidding and/or highly conditional tenure to advance the timing of exploration are not appropriate policy instruments for addressing those "market failures", as explained in section 6.6. Under the sub-‐headings, "Efficiency of Winning Bidder" and "Competition" in this sub-‐section (7.1.3), consideration was given to "market failure" associated with the gap between a full set of risk and insurance markets and the various devices available to petroleum extraction and extraction to manage risk and uncertainty. It was noted that large, diversified companies were better placed with regard to the latter, which meant that they had lower costs of capital, could make higher bids, had greater waiting capacity, and were more likely to defer activity. It also meant less competition for tenements, which would result in lower bids. There are various mechanisms available to reduce the size of upfront payments, thereby removing the bidding advantage of large, diversified companies. This could mean greater participation by small companies, greater competition for permits, and higher bids (Gaffney, 1977b). Because smaller companies have higher costs of capital than large, diversified firms, the former would be less likely to defer exploration. However, it should not be assumed that this would necessarily be a good thing from an economic perspective. It is important to recognise that "market failure" with respect to management of risk and uncertainty means the costs of capital of small companies should be regarded as too high, rather than costs of capital of large, diversified companies being seen as too low. In any event, if small companies are minority participants in joint ventures with large companies, the timing of exploration activities is likely to be determined by the large entities. Cash-‐Bid Exploration Permit Regime 141 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ An important point neglected by proponents and opponents of the argument that tenement "warehousing" is economically inappropriate is that the fundamental reasons for the "warehousing" phenomenon are the structure of tenure arrangements and timing of releases, which are within the control of government. Any release of areas for bidding pressures enterprises to act pre-‐emptively to acquire tenure. Delaying release allows government to "keep its options open" so that it can take advantage of benefits of waiting. Early release closes off those options for government.52 However, it opens those options for the entities granted tenements without conditions that increase the pace and quantity of exploration activity. Of course, if the benefits of waiting are not sufficient to cover the opportunity costs of waiting, delaying release would not be economically sensible. Economically astute selection of timing, sequencing and location of areas for permits would allow the government to maximise the present value of its share of the nation's potential natural resource endowment, having regard to any option value of waiting. Any option value of flexibility provided by government undertaking more pre-‐competitive exploration prior to release of areas should also be taken into account in determining how much work should be undertaken by government prior to release of areas, what areas should be release and when this should occur. For government, the timing option is available before title is granted to an enterprise. For an enterprise, the timing option is not realistically available until after title has been granted. Following release of an exploration permit for bids, an interested entity could choose to make an offer or decline to do so. If it declined to make an offer, it would not get a second chance in a later round unless no other party made a bid, or the government rejected all bids when the permit was first released, or the permit was relinquished by the winning bidder. Waiting would be a high risk option and probably a low value option. To have a reasonable chance of gaining title to an area in which it was interested, an entity would have to bid when the government decided to release the area for offers, and bid high enough at that time. If an area was released for offers long before it could be regarded as a prime exploration target (for example, time C in Figure3, compared to the optimal time to commence activity, time B), its value to a bidder at the time of release would reflect the anticipated value of the right to exploit at the ideal future time, after discounting over a long period at a risk-‐reflective opportunity cost of capital. A rational bidder could offer up to its perceived value at the time of release of the right to exploit, after adjusting for the potential "winner's curse". A rational winning bidder would then wait until the immediate exploitation value stops rising faster than opportunity cost of capital (time B in Figure 3) before exploring, provided it was permitted to do so. 52 Kjell Sunnevåg (1998) recognised the applicability of real options analysis to exploration permitting policy. Sunnevåg considered circumstances in which government had flexibility in timing area releases, but not cases in which an explorer could delay exploration after being granted title. For a detailed discussion of the real options approach to decision-‐making, see Dixit and Pindyck (1995). Cash-‐Bid Exploration Permit Regime 142 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The circumstances of government decision-‐making in respect of release of areas for bids closely match those in which real option values can arise. Experts in this field, Avinish Dixit and Robert Pindyck (1994), identified these circumstances as having three elements. They have been listed below, along with our comments, in brackets, regarding their applicability to area release decisions of government:

considerable uncertainty (exploration and investment outcomes) a high degree of irreversibility of an action (grant of a permit)
flexibility in timing of the action (timing of release of an area for bids and subsequent grant of a permit). Real option benefits to the community (through government) from delaying release of areas for bids could include the nett value of information it could generate by its own early-‐stage exploration activities, the value added by information regarding private sector exploration activities in comparable areas, the benefits of greater clarity regarding economic trends and their implications for petroleum prices, value added by better information regarding complementary activities, etc. These real option benefits would be reflected by higher bids (after discounting). Earlier release than justified by an ex ante assessment of economic value extinguishes the real option value of waiting that would otherwise available to the community through government. In this case, the real option value would be captured by explorers through waiting to explore. This value has been illustrated by the analysis in section 6.2. It is important to note that this involves a transfer of benefits from the community to petroleum exploration and extraction companies, not destruction of benefits or economic waste. Real option benefits may also arise from incremental acquisition of information, which provides a foundation for better informed decision-‐making regarding the appropriate type and timing of future activity. Such incremental information acquisition provides real option benefits of improved decision-‐making speed and flexibility. The release of an area allows explorers to capture these benefits. Deferment of release allows government to do so through its own incremental information acquisition program. It might be argued that cash bidding for areas released early, without conditions designed to bring forward exploration, would capture the real option value to government of waiting and/or undertaking incremental information acquisition. However, there are reasons why this might not happen. First, the cost of capital to government is less than for explorers, even large, diversified entities. Second, early release would deny the government the opportunity of capturing more of the addition to nett value from undertaking incremental exploration activities itself either independently of other events or in response to information yielded by other activities. Third, early release would mean bids could not capture increases in ex ante resource rent resulting from unforeseen or poorly perceived improvements in circumstances affecting the potential value of a prospect. Cash-‐Bid Exploration Permit Regime 143 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Trying to deal with potential inactivity following premature release of areas by mechanisms such as work program bidding and/or tenure conditions designed to force the pace of exploration focuses on the effect of premature release, not the cause. It would be unwise, because these policy instruments tend to dissipate ex ante resource rent as shown in chapter 6 above and in section 7.2 below. The appropriate policy response is more careful consideration of timing of release of particular areas, taking into account real option benefits to the community associated with different timing of release of various areas and various amount of pre-‐competitive, early-‐stage exploration. Of course, making releases of exploration permits at the "ideal" or "right" time would present difficulties. It would require careful analysis by the government's geo-‐science and economic advisers, having regard to a wide range of geological, engineering, infrastructure, and market considerations. However, the cost of such analysis should be much less than the deadweight loss of resource misallocation and associated dissipation of ex ante resource rent caused by work program bidding and/or tenure conditions designed to force the pace of exploration activity. It has sometimes been suggested that tenement "warehousing" could be addressed by "delay rentals", perhaps with rentals rising over time, to induce early exploration activity. Escalating rentals apply in offshore UK areas to encourage early relinquishment and thereby increase pressure to advance exploration and have been applied in some areas in recent US releases (see Appendix A). Typically, liability for delay rentals would cease on relinquishment, discovery of a resource, or commencement of production. For example, US offshore lease cease when a tract is surrendered or production commences. The suggested application of delay rentals has usually been based on the premise that earlier exploration and production are necessarily desirable from a social perspective. However, the analysis in chapter 6 and section 7.2 above has shown that this premise is false. In any event, liability for delay rental payments would result in compensatory reductions of cash bids. This would limit the ability of delay rentals to speed up exploration and development by successful bidders. The effect would be similar to payment of cash bids over time (see sub-‐section 7.1.3 under the heading, "Efficiency of Winning Bidder"). The reduction in cash bids would be greater for large, diversified companies than for smaller companies, because the former have lower costs of capital. The ability of smaller companies to compete for permits would be improved. However, earlier exploration would occur only to the extent that small companies became more successful in bidding and were not minority partners in joint ventures with large companies. Of course, if the estimated present value of delay rentals exceeded the value a company placed on a prospect, the company would not bid. Cash-‐Bid Exploration Permit Regime 144 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Risk and Uncertainty Some opponents of cash bidding have claimed that it would increase risk and uncertainty faced by explorers. ACIL Tasman does not accept this claim and offers several counter arguments. First, cash bids will be substituted for work program bids, rather than substituted for no obligations. Under cash bidding, the enterprise should bear no more risk and uncertainty. Indeed, cash bids would be smaller than work bids (see section 6.2). Second, while in the case of work program bidding, the explorer would be locked into performing its minimum guaranteed exploration program for years one to three, it would face uncertainty regarding renegotiation of its secondary program for years four to six, and then further uncertainty regarding renewal conditions. Third, if government decided to rely more on cash bids as an ex ante royalty and less on royalty/tax systems based on outcomes, it could allow cash bids as deductions from the base of the petroleum resource rent tax and income tax. The cash bid offered by an enterprise would rise, but not by as much as the expected present value of the conditional royalty would fall, because risk-‐averse enterprises would adjust cash bids to reflect increased nominal risk and uncertainty borne by the enterprise. Effectively, the increased nominal risk would be shifted back to the government via the bid. Fourth, it is incorrect to argue that cash bidding is more susceptible than work program bidding to ǲǳex post government intervention to capture a bigger portion of any ǲǳǤ
Kenneth Dam (1976) pointed out that work program bidding meant that government gave away resource rent. He argued that it could lead to measures to recapture the resource rent through ex post measures, as had occurred in the case of UK offshore petroleum. Indeed, Dam argued that work program bidding was at least as likely and perhaps more likely than cash bidding to be susceptible to "sovereign risk". Some pertinent observations by Dam (1976) have been shown in Box 21. Box 21 Sovereign Risk: Cash Bidding and Work Program Bidding ".... uncertainties created by these attempts to recapture the economic rent through retrospective measures will create a risk that parallels and sometimes exceed the risk of state repudiation under an auction (cash bidding) system. ......... As we have seen in the state participation 'negotiations' in Britain, the very existence of discretionary allocation encourages the authorities to use the implicit threat of withholding future licences as a weapon to induce companies to forgo whatever legal rights they might have against retrospective measures. The result is that the discretionary system may lead to greater risks of retrospective measures than would exist under an auction (cash bidding) system. Whatever the weakness of the auction system generated by the untrustworthiness of the state, it is this paralleled precisely by the weakness of a discretionary systems stemming from the same untrustworthiness." Source: Dam (1976), p. 179. Cash-‐Bid Exploration Permit Regime 145 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ In any event, there is a practical means of addressing this issue. This method has been adopted by the Commonwealth Government through establishment of the petroleum resource rent tax, which has been in place since the mid-‐1980s when the Petroleum (Submerged Lands) Act 1967 was amended to provide for cash bidding. Bids obviously would be adjusted down to reflect the existence of the tax. Fifth, cash bidding for permits with lengthy tenure, a right to extract, and minimal conditions would eliminate the substantial risk and uncertainty prevailing under existing regimes in respect of tenure. Sixth, with secure tenure, enterprises are able to choose to wait for additional information, improved techniques, and other changes in circumstances. This would reduce risk and uncertainty. While the risk and uncertainty borne by enterprises under cash bidding regime would not rise and may indeed fall relative to work program bidding, cash bidding would not counter any retarding effects on exploration of residual risk and uncertainty ultimately borne by investors. The work program bidding regime would tend to counter those retarding effects, but generate massive over-‐kill, and cause dissipation of ex ante resource rent. However, other sectors of the economy face risk and uncertainty. After allowing for the substantial range of devices available to exploration/extraction enterprises and those available to other business enterprises to manage and ameliorate risk experience, it is not at all clear that residual risk and uncertainty borne by the former would be significantly greater. Therefore, if risk-‐taking is considered to be deficient, general policy measures to deal with that perceived problem would be more appropriate than special measures for exploration/mining, other than those eliminating government impediments to efficient exploration and mining activity (Stiglitz, 1975). 7.1.4
Auction Design There is a substantial body of economic literature on auction design, providing comparative analysis of the advantages and disadvantages of the various systems in different circumstances. It is beyond the scope of this report to survey that literature here. For valuable, wide-‐ranging surveys, see McAfee and McMillan (1987), Klemperer (2002, 2004), Milgrom (1989; 2004) and Krishna (2010). Valuable recent overviews of design issues for cash bidding regimes for mineable resource (particularly petroleum) exploration tenements have been provided by Peter Cramton (2007, 2010). There are multiple auction systems to choose from to underpin a cash bidding system for petroleum allocation. A key lesson from the relevant economics literature is that there is no system that is best in all circumstances. The best approach would depend on the setting. There have been highly successful and particularly unsuccessful auctions in terms of price outcomes. Typically, the difference between the former and the latter has been astute Cash-‐Bid Exploration Permit Regime 146 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ matching of auction design to the circumstances in the former case (Klemperer, 2002, 2004; Cramton, 2007, 2010). The range of alternative auction formats includes:
a first-‐price, sealed bid auction -‐ used to sell United States offshore petroleum exploration licences, and effectively specified for Australia's offshore petroleum permit cash bidding system
a second price, sealed bid auction which awards the tenement to the highest bidder at a price equal to the bid of the second highest bidder -‐ sometimes referred to as a Vickrey auction after Nobel Laureate in Economics, William Vickrey, who undertook seminal work (Vickrey, 1961, 1962) on the economics of auctions an open, ascending price auction -‐ known as an English auction an open, descending bid auction -‐ known as a Dutch auction, and strategically equivalent to a first-‐price, sealed bid auction (Krishna, 2010)

a "clock auction" in which the auctioneer announces prices and bidders signal interest
an ascending price until a small number of bidders remain, followed by a final first-‐
price (pay-‐as-‐bid), sealed bid phase, in which each finalist must bid at least as much as much as its final bid in the first phase -‐ devised and described as an "Anglo-‐Dutch auction" by Klemperer (1998, 2002)
a variation of the Anglo-‐Dutch auction to facilitate packaging involving a clock auction instead of an ascending price auction for individual lots in the first stage, plus a revealed preference activity rule to prevent bidders from shifting to packages that are relatively more expensive, and a final stage consisting of a simultaneous, first-‐
price sealed bidding arrangement for individual lots -‐ proposed by Cramton (2007, 2010)
a "package clock auction" involving a clock stage in which bidders signal interest for lots followed by a supplementary first price, sealed bid stage for packages, with a revealed preference activity rule to prevent bidders from shifting to packages that are relatively more expensive -‐ proposed by Ausubel, Cramton and Milgrom (2006). Key issues to be taken into account in selecting a system include prospectivity, information asymmetries, tenement value interdependencies, the number of tenements to be offered at one time, sequencing, potential collusion, potential entry-‐deterring activity, predatory behaviour, and auction proceeds. A simultaneous, first-‐price sealed bid auction may be the most appropriate auction system in some circumstances, but not others. The simultaneous, first-‐price, sealed bid system in the United States and Australian cash-‐
bidding regimes for offshore petroleum exploration permits is likely to be the best option when competition is expected to be weak, lots tend to be marginal or have relatively low ex ante value, and permit values tend to be additive, rather than interdependent, thereby minimising packaging issues. In addition, this system is more likely to yield higher revenue in the context of ex ante heterogeneity among bidders and is less susceptible to collusion than open auctions. It is also relatively easy to implement (Cramton, 2007, 2010). Cash-‐Bid Exploration Permit Regime 147 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Other systems may be more suitable in other circumstances. When information asymmetries are important, competition for tenements is strong, or value interdependencies and therefore packaging issues are important, the combination systems outlined above should be most suitable. Peter Cramton's insights on selecting auction systems for different circumstances illustrate how the efficiency of an auction process could be improved by tailoring choice of a system to particular circumstances. Cramton (2007, 2010) has provided specific suggestions as to how selection of an auction system should vary according to prospectivity and available information. An excerpt from a recent contribution on tenement auctions has been re-‐
produced in Box 22. Box 22 Selection of Auction Systems to Suit Circumstances "For settings where there are sets of lots with substantially different value structures, it makes sense to use different formats with different sets of lots. For example, a country may have 12 wildcat tracts that are excellent prospects, 36 drainage tracts that are good to excellent prospects, and 200 tracts that are marginal prospects. The excellent prospects could be done as a standard package clock, the drainage lots as an Anglo-‐Dutch (Cramton variation), and the marginal prospects as a first-‐price sealed-‐bid. With this approach, the package clock auction is not complicated by the great number of drainage and marginal lots. Moreover, the drainage lots may have large (information) asymmetries among the bidders as a result of private drilling information from neighbouring lots. The Anglo-‐Dutch design handles these asymmetries well. Finally, 'additive values' is probably a good assumption on marginal prospects and in any event the economic loss from the less efficient first-‐price sealed-‐bid approach is not great when auctioning marginal lots. Alternatively, since implementing three different formats is probably too much, the country could split the lots into two sets: those with high prospects and those with low prospects. The first-‐price sealed-‐bid format could be used for the low-‐
prospect tracts and one of the dynamic formats could be used for the high-‐prospect tracts." Source: Cramton (2010), p. 312-‐313. Participation and collusion are key issues to be addressed in auction design. The first-‐price, sealed bid system helps to address these issues. There are other important mechanisms that could also be brought to bear on these issues. Common prescriptions are declaration of the right to reject any or all bids, and setting of undisclosed reserve prices. These prescriptions are applied in the United States Government's offshore petroleum cash bidding regime, and are available under the Australian cash bidding system. These measures effectively add government as an independent, competitive bidder. Of course, the effectiveness of these measures would depend on the information and expertise available to the government in setting reserve prices and deciding to accept or reject bids. In a widely cited article on auction design, auction specialist Paul Klemperer (2002, p. 187) of Oxford University concluded by emphasising the importance of tailoring design to address participation and collusion issues, and to cater for specific circumstances: "In conclusion, the most important features of an auction are its robustness against collusion and its attractiveness to potential bidders. Failure to attend to these issues can lead to disaster. Furthermore, Cash-‐Bid Exploration Permit Regime 148 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ anyone setting up an auction would be foolish to follow past successful designs blindly; auction design is not 'one size fits all'. ....... In the practical design of auctions, local circumstances matter, and the devil is in the details." 7.2
Cash Bidding with Highly Conditional Tenure The Offshore Petroleum and Greenhouse Gas Storage Act 2006 (previously Petroleum (Submerged Lands) Act 1967) provides for cash-‐bid exploration permit conditions that could be described as 'find quickly or relinquish' or 'use it or lose it' requirements. While the Act stipulates that a cash-‐bid petroleum exploration permit and any renewal of such a permit must not be granted subject to work and expenditure conditions, it provides for highly conditional tenure that applies pressure to bring-‐forward exploration activity from its commercially and economically optimal timing. The Act provides that a published notice calling for applications for cash-‐bid petroleum exploration permits must summarise permit conditions, including renewal arrangements, and specify matters to be taken into account in deciding whether or not to reject an application. The Act allows rejection of cash-‐bid applications for reasons other than the amount of the cash bid. As in the case of work-‐bid permits, initial tenure is only for 6 years and 50 per cent relinquishment requirements apply before renewal. Tenure is even more conditional or less secure than for work-‐bid exploration permits. A cash-‐
bid exploration permit may be renewed no more than once, for 5 years. A cash-‐bid exploration permit may not be renewed at all, if that is specified in the original notice inviting cash-‐bid applications. In contrast, work-‐bid exploration permits originally granted in response to an application invitation issued on or after 1 January 2003 may be renewed twice, for 5 years each time. The United States Government's cash bidding regime for offshore petroleum leases also transfers/allocates highly conditional tenure. Leases in shallow water are available for only 5 years, unless a discovery is made. In deep water, lease periods may be 8-‐10 years. Again, longer tenure than this is conditional on making a discovery. Tenure conditions apply pressure to bring-‐forward exploration activity from the time considered commercially and economically optimal. When tenure underlying cash bidding is subject to 'find quickly or relinquish' or 'use it or lose it' conditions, as in Australia and the United States, resources can be misallocated and resource rent dissipated, notwithstanding the neutrality of cash bidding with respect to resource allocation. To the extent that such conditions apply and are binding, cash bids would be lowered to allow for requirements to undertake premature activity. The reduction of bids would reflect resource rent dissipation caused by these tenement conditions. This can be illustrated by reference to Figure 3, a modified version of a diagrammatic model provided by Ken Willett (2002) and based on an earlier version formulated by Mason Gaffney (1967a). The details of the model have been explained in section 6.2. Cash-‐Bid Exploration Permit Regime 149 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ If an exploration permit offered for cash bids expires prior to time C so that long-‐term tenure is conditional on making a discovery before that date, no bids would be submitted, even though the "value of right to exploit" is significantly positive at PC. This is because "immediate exploration cost" would exceed the sum of "value of right to exploit" and "discounted efficient exploration cost".53 If a discovery had to be made no later than time 0 (base year) in Figure 3 to gain long-‐term tenure, an enterprise would bid only a small amount (the sum of the "value of right to exploit" and the "discounted efficient exploration cost" less the "immediate exploration cost"54). Ex ante resource rent (X0) would be largely dissipated by premature activity induced by the tenure arrangements. The large portion dissipated is represented by the difference between the "immediate exploration cost" and "discounted efficient exploration cost" lines. If discovery was required before time A to obtain long-‐term tenure, ex ante resource rent (NA) would be partly dissipated (less than half), as indicated by the difference between "immediate exploration cost" and "discounted efficient exploration cost" lines at that time. The cash bid would be the sum of the "value of right to exploit" and the "discounted efficient exploration cost" less the "immediate exploration cost", which in this case would be just over half the ex ante resource rent. If conditions of an exploration permit awarded by cash bidding meant discovery was required not long before time B for long-‐term tenure to be attainable, the amount of ex ante rent dissipated would be relatively small, as indicated by the difference between the "immediate exploration cost" and "discounted efficient exploration cost" lines at that time. The cash bid, represented by the sum of the "value of right to exploit" and "discounted efficient exploration cost" less the "immediate exploration cost", would capture most of the ex ante resource rent. Box 23 Fane and Smith on Rent Dissipation by Short Tenure even with Cash Bidding "....... as soon as year T* (not long after C in ACIL Tasman's Figure 3) is reached companies will be willing to make positive bids for the area; if this willingness quickly induces the government to gazette and release the area -‐ as seems probable -‐ then all the potential rents will again be dissipated. Just as a work program bidding system together with open competition can dissipate all the potential rents through excessive exploration expenditures, so cash bidding, under limited tenure together with open competition, can dissipate all the potential rents through premature exploration and development." Source: Fane and Smith (1986), p. 227. 53 There is an important distinction between the "immediate exploration cost" and the "discounted efficient exploration cost". The "immediate exploration cost" at any particular time is the current exploration cost if exploration commences at that time. It declines over time in real terms as technology and knowledge improve. The change in the "immediate exploration cost" over time is depicted by the curve RK in Figure 3. The efficient exploration cost is the exploration cost current at the optimal time to commence the exploitation sequence. When that cost is discounted back to earlier times it is the "discounted efficient exploration cost" at those earlier times. The change in the "discounted efficient exploration cost" over time is depicted by the curve ZK in Figure 3. 54 For analytical convenience, taxes on realised outcomes have been ignored. Cash-‐Bid Exploration Permit Regime 150 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ George Fane and Ben Smith (1986) formulated a conceptually similar diagrammatic model to the one presented in Figure 3. The Fane-‐Smith model was also less detailed and differently specified. Fane and Smith focussed only on two cases: one equivalent to the first illustration above, and another equivalent to a time not long after time C when the sum of the "value of right to exploit" and "discounted exploration cost" just exceeds the "immediate exploration cost". They commented that it seemed probable that government would release areas when this occurred. They concluded that ex ante resource rents would be completely dissipated in these circumstances. An excerpt from their analysis has been re-‐produced in Box 23. It is clear from the illustrations using Figure 3 that the strength of the tendency of tenement conditions to dissipate resource rent depends on timing considerations. Specifically, these timing considerations are the length of pre-‐discovery tenure and the size of the gap between the expiry date of the exploration permit and the optimal time to commence the exploration-‐
assessment-‐planning-‐development sequence (the exploitation sequence), represented by time B in Figure 3. Obviously, the adverse consequences of highly conditional pre-‐discovery tenure are severe in areas released prematurely for cash bidding, and diminish in importance as timing of releases approaches the optimal time to commence the exploitation sequence. The critical importance of timing issues has been overlooked in United States cash bidding policy. Since the Area Wide Leasing policy was implemented in 1983, almost all unleased offshore areas have been made available for bidding at each release. These included thousands of frontier, deepwater tracts that for many years were not "ripe" for exploration. Robert Porter (1995), Ken Hendricks and Robert Porter (1996), and Cynthia Lin (2009) found from analysis of 2404 Gulf of Mexico tracts auctioned under the United States cash bidding regime that tracts with high pre-‐auction values and high winning bids tended to be explored early in the duration of lease periods. However, the relatively short tenure period (5-‐years standard; 8-‐10 years for deep water tracts from 1983) and " ǳ
exploration leases tended to bring forward drilling of other tracts to just before expiry of leases, and sometimes this drilling was not completed until after the nominal lease period. The resource rent dissipation problem could be ameliorated by deferring release of less prospective areas for bidding until they become "prime targets" or "ripe" for exploration. It could also be ameliorated by offering lengthy exploration tenure. The former might require greater analysis by government's geo-‐scientific advisers. The latter might raise concerns about firms sitting inactively on tenements, although this may be commercially and economically appropriate in many cases. More of one of these measures would mean less of a role is required for the other. A combination of these measures would appear to be pragmatic policy. Porter (1995), Hendricks and Porter (1996), and Lin (2009) analysed another economic inefficiencies caused by short offshore exploration tenure associated with the United States cash bidding regime in the Gulf of Mexico. The tendency of short tenure to bring forward Cash-‐Bid Exploration Permit Regime 151 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ drilling of ex ante low value tracts to just before expiry of exploration leases resulted in premature, duplicative, inappropriately sequenced exploration, which undermined the value of external benefits of information "spillovers", at least when separate tenements in a particular area had been issued at the same time and therefore expired at the same time. This is contrary to efficient resource allocation. Lin (2009) explained that this effect occurred because the option value of waiting goes to zero at the end of the lease period. These lease arrangements undermine the potential value of ǲǳ Ȃ areas involving low value/bid tracts. Earlier contextual observations on this matter by Hendricks and Kovenock (1989) have been reproduced in Box 24. Box 24 /ŶĨŽƌŵĂƚŝŽŶ͞^ƉŝůůŽǀĞƌƐ͟ĂŶĚƚŚĞKƉƚŝŽŶsĂůƵĞŽĨƌŝůůŝŶŐsĞƌƐƵƐtĂŝƚŝŶŐ ǲǤǤǤǤͳͻͷͶͳͻ͹Ͳǡ oil firms allowed leases on 308 federal tracts off the coasts of Texas and Louisiana (29per cent of the total sample) to expire without drilling any wells. The average price paid for these leases was US$800,000 (in 1972 dollars). Thus, either firms expected to earn positive returns from drilling these leases at the time of purchase, and subsequent information caused them to revise their beliefs and abandon them, or firms valued the option to drill. Since oil and gas prices were quite stable during this period, a positive option value is an indication that firms anticipated the possibility of obtaining information from subsequent drilling activity which would cause beliefs to be revised upward. Both explanations rely upon the presence of information spilǤǳ Source: Hendricks, Kovenock, (1989), p. 165. These considerations tend to undermine suggestions that tenement conditions designed to force the pace and increase the amount of exploration activity could have a redeeming feature as ǲ ǳ exploration information ǲǳ (see sub-‐section 2.4.1). It is clear that such conditions are likely to do more harm ǡǲǳȋsub-‐section 2.4.2). 7.3
Cash Bidding as an Ex Ante Royalty Cash bidding is not just a mechanism for allocating tenements. It is also a device for charging an ex ante, lump-‐sum royalty determined in the market for rights to explore for and extract resources. In section 7.1, cash bidding was assessed as a tenement transfer/allocation mechanism, although it was not possible or sensible to ignore this system's royalty aspects. This section has provided a more complete assessment of royalty aspects of the cash bidding regime. 7.3.1
Assessment in the Absence of Policy and Market Failure Cash bidding is an economically efficient royalty and tenement allocation system. It does not distort exploration, investment and operating decisions by the tenement-‐holder subsequent to the bidding process, because the cash payment is a sunk-‐cost when those decisions are Cash-‐Bid Exploration Permit Regime 152 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ being made. Cash bidding does not tax returns to any inputs other than the potential petroleum resource and sources of other location-‐specific inputs. When formulating a bid, a rational bidder would exclude returns to all inputs other than the potential resource and other location-‐specific inputs (see section 3.3). To the extent that mobile, firm-‐specific rents exist, the bidder excludes them from the bid amount. Cash bidding is an equitable royalty system. It complies with the benefit principle of equity that beneficiaries of goods and services provided by government should contribute in accordance with the benefits they receive. Each bidder determines what it is prepared to pay in the differing circumstances of each prospect, having regard to all expected outcomes and revenues and costs, including risk and uncertainty. It is a flexible mechanism for capturing the highest price for each prospect in the circumstances prevailing at the time of the tenement auction. It is consistent with intergenerational equity concepts because it does not destroy any of the resource rent. Cash bidding is an administratively efficient royalty system because it does not involve any administration costs additional to those required for its operation as a tenement allocation system. Moreover, the administration costs involved in operating this system as a tenement regime are substantially lower than administration costs associated with the alternative work program bidding regime, which does not collect any royalty revenue. Therefore, cash bidding is far superior to any combination of an ex post royalty regime and an existing tenement regime in respect of the administrative efficiency criterion. The case for using cash bidding as a royalty regime as well as tenement allocation system is strong, at least in the absence of interacting policy and market failures. However, the implications of such interacting sources of resource misallocation should be taken into account. Relevant issues have been analysed in subsequent sub-‐sections. 7.3.2
Interacting Policy and Market Failures Three policy or market failures may affect the performance of cash bidding as a royalty regime:

flawed tenure arrangements associated with tenements allocated by cash bidding ǲ ǳ
neutrality of the system with respect to the efficiency of resource allocation the possibility of the value to government of ex ante royalty revenue from cash bidding being undermined by an inadequacy of risk-‐sharing/spreading devices available to exploration and mining enterprises. Policy Failure -‐ Inefficient Tenure Arrangements The analysis in section 7.2 demonstrated that the revenue yield of cash bidding could be severely undermined by tenure conditions that force the pace of exploration. These conditions misallocate resources, tend to dissipate resource rent, and result in lower cash bids. This occurs despite the neutrality of cash bidding with respect to resource allocation. Cash-‐Bid Exploration Permit Regime 153 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ This problem certainly does not justify rejection of cash bidding as a royalty system. Instead, it means that implementation of this system must be accompanied by reform of tenement conditions. As explained in section 7.2, substituting cash bidding for work program bidding is not enough. In the context of appropriate, comprehensive tenement reform, the strong case for cash bidding as a royalty system remains intact. Policy Failure -‐ Sovereign Risk Kenneth Dam (1976) pointed out that the capacity of cash bidding to yield revenue by capturing ex ante ǲǳǤ
Around the time when use of cash bidding was under consideration as a mechanism for allocation of Australian offshore petroleum exploration permits, the "sovereign risk" issue was highlighted by various contributors to the Australian economics literature on taxation and royalty policy for the mining (including petroleum extraction) sector.55 This issue has also been raised in subsequent literature on taxation of mineable resources.56 The argument runs as follows. If risk and uncertainty at the time of bidding are perceived to be high and bidders are risk-‐
averse, the winning bid may be low. If the winning bidder subsequently earned substantial returns, government might be tempted or pressured to capture a larger portion of the better than expected realised returns. If the government succumbed and applied a new tax or royalty to the project, it would create fear of future intervention of this type in other cases. In the absence of prompt intervention to take more of the resource rent, fear of action could still prevail. Potential bidders could be discouraged from participating in tenement auctions or reduce ǲǳǯ
degree of aversion to risk and uncertainty. This, in turn, could further increase the likelihood of government intervention to increase its "take" if a project yielded high returns, thereby ǲǳǤwould be lower bids, less government revenue, and discouragement of exploration activity. A counter-‐argument is that sophisticated governments and their advisers would recognise the ǲ ǳ ǡ
Ǥ ȋͳͻͺͳȌ ǲ ǳ ment is probably irrelevant in the Australian context, where fear of expropriation of realised resource rent is much less than in developing countries. An appropriate, precautionary response would be to make any tenement offered for cash bidding subject to a pre-‐determined royalty/tax system based on realised outcomes that would capture a sufficiently large portion of realised resource rent to minimise the temptation For example, see Smith (1984), Swan (1984), Bergstrom (1984), and Porter (1985). 55
56 See Smith (1997), Lund (2009), Boadway and Keen (2010), and Tordo, Johnston and Johnston (2010). Cash-‐Bid Exploration Permit Regime 154 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǲǳ. The Australian Government took such a step by establishing the petroleum resource rent tax at approximately the same time (mid-‐1980s) as the Petroleum (Submerged Lands) Act 1967 was amended to provide for cash bidding. Bids under the United States' Government's cash bidding system for offshore petroleum tenements are made in the context of a high ad valorem royalty rate and a company income tax rate at the top end of the international scale. A potential issue with this approach, which was raised by Diderick Lund (2009a), is that enterprises might still be concerned that government could be tempted to increase the ex post royalty/tax rate when product prices soared. While some "sovereign risk" could linger, its significance would obviously be less than without a royalty/tax on realised outcomes like the petroleum resource rent tax. Prominent public economics specialists, Robin Boadway of Queens University and Michael Keen of the International Monetary Fund, pointed out that another way of avoiding the "sovereign risk" problem was to conduct bidding on the basis of the rate of an economic profit or resource rent-‐based royalty/tax. They explained that this would also provide some assurance against the related potential problem of "unduly low" cash bids (Boadway, Keen , 2010).57 Market Failure -‐ Exploration Information Public Good and External Benefits In the context of long-‐term tenure with minimal conditions, exploration activity could be undertaken too little, too late because of the public good of information from early-‐stage exploration and external benefits of information "spillovers" from later exploration, as explained in section 5.1. To the extent that this occurs, revenue from cash-‐bidding would be reduced. These "market failures" could be corrected by government funding of early-‐stage exploration, and government acquisition and prompt release of exploration data generated by subsequent private sector exploration. These government activities would improve the efficiency of resource allocation and increase the revenue yield of cash bidding. Market Failure -‐ Asymmetric Information As explained in sub-‐section 7.1.3, under the sub-‐heading "Asymmetric Information", uncorrected information asymmetries in exploration could undermine the efficiency and revenue yield of cash bidding. However, as explained there, asymmetric information "market failure" could be addressed by government funding of early-‐stage exploration, government acquisition and prompt release of exploration data generated by subsequent private sector exploration. In addition, cash bidding would tend to correct the problem. 57 Boadway and Keen's (2010) preferred approach was to combine cash bidding with a non-‐distorting tax based on resource rent. Cash-‐Bid Exploration Permit Regime 155 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Debateable Market Failure Ȃ Inadequate Risk-‐Sharing Various market-‐related instruments have been developed to lay-‐off risk and uncertainty. Those relevant to petroleum exploration and extraction include joint ventures, portfolios of exploration tenements, multiple extraction activities, commodity diversification, geographical diversification, off-‐take contracts, currency hedging, issues of company shares to institutional and private investors, and conventional insurance policies. However, it has typically been assumed in the relevant economics literature that these devices in combination would still fall short of the equivalent of a perfect and complete set of contingency claim markets. Such a shortfall is a ǲǳǤ-‐averse behaviour in response to the residual risk and uncertainty would mean less risk-‐taking and therefore less exploration and investment than is socially desirable. The response proposed by Hayne Leland (1978), supported by several Australian economists,58 was ǲ-‐ǳ
cash bidding in conjunction with a relatively non-‐distorting royalty/tax regime based on realised outcomes. A simple account of their approach has been provided below. If an enterprise is obliged to pay for the right to explore and extract only if it exploits a deposit, the initial burden of risk and uncertainty is shared by the government and the tenement-‐holder. The closer the basis for payment is to realised resource rent, the greater is the share of the initial burden of risk and uncertainty carried by the government, and the smaller is the reduction in exploration and investment caused by the royalty/tax regime. Conversely, a base for ex post payments that is not closely related to imputed nett value, such as gross value-‐ or volume-‐based levy would impose a much greater initial burden of risk and uncertainty on enterprises and a correspondingly smaller burden on governments, as well as causing greater adverse effects on exploration, investment and extraction. The greater is the initial burden of risk and uncertainty carried by the government, the more enterprises w ould be prepared to pay on an ex post basis for the right to explore for and extract petroleum. Hayne Leland and his followers argued that a government may alter the risk-‐adjusted value to itself of its royalty/tax revenue without adversely affecting the efficiency of resource allocation by combining cash bidding with an ex post royalty/tax based on realised resource rent. The spectrum of possible combinations ranges from complete reliance on cash bidding for tenements when the rate of the ex post royalty/tax is zero, to complete reliance on the royalty/tax based on realised resource rent in the absence of cash bidding. If, at a point on the spectrum, it is perceived that the government is less risk-‐averse than relevant enterprises, the risk-‐adjusted value to the government of the combined royalty/tax take could be increased by government acceptance of some additional risk/uncertainty in the form of some greater variability of royalty/tax revenue. That outcome could be achieved, prior to a tenement auction, by increasing the rate of royalty/tax to apply to realised resource 58 Emerson, Lloyd (1983), Emerson, Garnaut (1984), Lloyd (1984), Fraser (1998). Cash-‐Bid Exploration Permit Regime 156 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ rent and receiving smaller cash bids. Another approach would be to deny a deduction for any cash bid from the royalty/tax base linked to realised outcomes, which would reduce cash bids and increase the royalty/tax base. Conversely, if it is perceived that the government is more risk-‐averse than enterprises at a particular point on the spectrum, it could reduce the rate of royalty/tax to some extent for the realised resource rent-‐based system before auctioning tenements, and consequently rely more on receiving higher lump-‐sum cash bids. Alternatively, any cash bid could be made deductible for the royalty/tax base linked to realised outcomes, which would result in higher cash bids. In each case, the nett effect would be an increase in the risk-‐adjusted value to the government of the combined ex ante and ex post royalty/tax revenue. The combination of ex ante and ex post arrangements that would maximise the risk-‐adjusted value of royalty revenue from the perspective of a government is not clear. It would depend on the relative degrees of risk aversion of government and mining enterprises in different circumstances. This would be influenced by relative size, and relative capacities to manage/ameliorate risk and uncertainty through various mechanisms. Only in the event of either a mining enterprise or government being risk-‐neutral would the risk-‐adjusted value to the government of the revenue be maximised in the context of total reliance on ex ante or ex post royalty payments, respectively (Leland, 1978). Strong doubts has been expressed about the efficiency of compulsory risk-‐sharing through a royalty/tax based on realised resource rent in the context of the wide range of risk management devices already available to enterprises engaged in exploration and extraction.59 Some of the issues have been briefly discussed below. Enterprises involved in petroleum exploration and extraction hold diverse portfolios of tenements and enter into joint ventures to reduce residual risk and uncertainty. Individual investors in those enterprises also hold portfolios of shares in multiple enterprises from a range of sectors. Cash bidding does not interfere with use of those mechanisms. In any event, on the basis of detailed studies of tenement auctions in the Gulf of Mexico over many years, Walter Mead (1994) concluded that there was no evidence of risk-‐averse behaviour in the aggregate. If a royalty/tax based on realised resource rent provided full loss-‐offsets,60 it would effectively add an additional joint venture partner or investor to each project in the relevant jurisdiction, and add a substantial interest in each project in that jurisdiction to the portfolio of assets held by the relevant government. The former might simply distort or partly displace risk-‐
sharing/spreading arrangements that enterprises would otherwise put in place themselves. 59 See Smith (1997), Mead (1994), Mead, Moseidjord and Muraoka, (1984), and Bergstrom (1984). 60 The petroleum resource rent tax falls short of providing full-‐loss offsets because it does not refund a share of losses, including unsuccessful exploration outlays, at the tax rate. Cash-‐Bid Exploration Permit Regime 157 RevieǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ ǯ ight otherwise be allocated by markets to investors who for a price and by choice are prepared to accommodate the associated risk and uncertainty. Another problem with the risk-‐sharing argument is that the government as owner of rights to explore and extract mine would not be able to avoid the cost of bearing risk and uncertainty, regardless of the mix of ex ante and ex post royalty/taxation regimes chosen. It may carry this cost in one or more ways. First, any enterprise bidding for the right to explore for, and extract petroleum would allow for perceived residual risk and uncertainty and its degree of aversion t o risk and uncertainty. This means that the government, as owner of the resource, would ultimately bear the cost of residual risk and uncertainty as estimated by the enterprise, even though the initial incidence was on the enterprise. Second, with a royalty/tax base not closely related to realised resource rent, such as an ad valorem system, the government would be able to charge only a low royalty/tax rate if it wanted to limit adverse effects on exploration, investment and recovery decisions. Third, with a royalty/tax base closely related to realised resource rent, the government would bear risk and uncertainty through variable outcomes. Fourth, with a combination of cash bidding and an ex post tax/royalty regime, government would bear risk and uncertainty in two different ways. 7.4
Cash Bidding with Petroleum Resource Rent Tax There are several arguments for combining cash bidding for relatively unconditional exploration and extraction rights with a royalty/tax based on realised resource rent. These relate to the relative merits of royalties/taxes based on realised resource rent and those applying to other bases, the relative merits of cash bidding and work program bidding, and complementarities between cash bidding and royalties/taxes based on realised resource rent. First, a shift to cash bidding for relatively unconditional exploration and extraction rights from work program bidding and existing tenure arrangements would improve the efficiency of resource allocation and thereby avoid dissipation of resource rent by tenement arrangements. A less thorough reform such as a move to the United States model of cash bidding would not be adequate, because it involves highly conditional tenure, which tends to dissipate ex ante resource rent. Second, the complete shift to cash bidding with relatively unconditional tenure would not only provide revenue from cash bids, but also additional revenues from the petroleum resource rent tax regime, because the new tenement regime would preserve, rather than undermine the tax base. This tenement regime shift would also be a pre-‐requisite for refinement of the petroleum resource rent tax to reduce deadweight losses arising from its design. Third, cash bidding facilitates government capture of a higher proportion of resource rent without having to increase the petroleum resource rent tax rate or the tax base, both of which Cash-‐Bid Exploration Permit Regime 158 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ would have adverse effects on resource allocation by discouraging activity at the margins of extraction, investment and exploration. Fourth, cash bidding would allow reforms to the petroleum resource rent tax in the form of provision of improved loss offsets and a higher tax rate. The former would reduce deadweight losses associated with the petroleum resource rent tax with or without a higher tax rate. A higher tax rate would compensate for short-‐term revenue loss from improved loss offsets, and gain more revenue in the longer-‐term. Under the work program bidding system, economic efficiency and government revenue benefits of improvements to loss offsets and a higher tax rate for the petroleum resource rent tax would be voided by ex ante resource rent dissipation caused by the tenement regime. Fifthǡ ǲ ǳ associated with cash bidding could be greatly reduced, when it is combined with a relatively efficient royalty/tax based on realised resource rent that is already well-‐established at the time of bidding. The latter system would provide a pre-‐existing mechanism for capturing realised resource rent in circumstances in which ventures turn-‐out much better than anticipated at the time of bidding. Sixth, implementation of a combination of a royalty/tax based on realised resource rent with cash bidding for relatively unconditional exploration and extraction rights would facilitate an increase in government royalty/tax revenue, which could be used to partly displace inefficient taxes and charges in the economy generally, reducing aggregate inefficiencies caused by the tax system as a whole. Alternatively, governments could increase expenditure with benefit/cost ratios in excess of one. Either way, the efficiency of resource allocation in the Australian economy would be improved. Sixth, the combination of cash bidding and royalty/tax on realised resource rent could be varied by adjusting the royalty/tax rate or by adjusting deductibility of the former from the base of the latter. If cash bids were fully deductible, bids would be higher and petroleum resource rent tax revenue would be lower than if bid payments were not deductible. Partial deductibility would yield an intermediate outcome. If the petroleum resource rent tax rate was lower (or higher), cash bids would be higher (or lower) than otherwise. If the petroleum resource rent tax was reformed by improving the extent of loss offsets, cash bids would be higher. A decision on the appropriate mix should take into account the extent of deadweight losses associated with the base and rate of the petroleum resource rent tax, and economic efficiency implications of competitive advantages possessed by very large enterprises under a cash bidding regime. Effectively, cash bidding and a realised resource rent-‐based royalty/tax tend to be highly complementary. The former certainly improves the performance of the latter in respect of equity and economic efficiency criteria. The latter improves the performance of the former in respect of these criteria to the extent thaǲǳ
risk-‐sharing mechanisms are valid. Consequently, the combination is superior to either of its constituents or the status quo on economic efficiency and equity grounds. Cash-‐Bid Exploration Permit Regime 159 Review of AustralŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The administration costs associated with a combination of cash bidding with minimal tenure conditions and the petroleum resource rent taxed system would be less than under the status quo in which work program bidding with highly conditional tenure is the dominant tenement regime. This follows from administration costs under cash bidding with relatively unconditional tenure being clearly lower than under work program bidding with highly conditional tenure. 7.5
Scope of Application of Cash Bidding In 1985, when the Commonwealth Government amended the Petroleum (Submerged Lands) 1967 to enable use of cash bidding in offshore areas, it advised that this regime would be used only in highly prospective areas (Evans, 1985). However, the legislation did not and still does not incorporate either such a restriction or criteria for determining when and where cash bidding is to be used. Cash bidding was used in only a minor way in Australian offshore areas from 1985 to 1992 in areas considered highly prospective. It has not been applied in Australian offshore areas since that period. Commonwealth Department of Finance and Deregulation (2011, pp. 107-‐108), in its Strategic Review of Geoscience Australia, suggested: "..... cash bidding is only viable for allocation of permits in regions that have demonstrated resource potential, such as commercially successful production. .......... Neither extreme of exclusive use of work program bidding or exclusive use of cash bidding seems sustainable as a universally optimal solution." APPEA's members have argued that cash bidding is appropriate only in a narrow range of circumstances as indicated by the following comments in APPEA's submission to ACIL Tasman in respect of this review.61 "Cash-‐bidding could only be considered for areas that have both been previously explored and contained a declared discovered resource. Such areas could be subject to cash bidding for future exploitation as these discovered resources could progress to the development phase with minimal appraisal work rather than major exploration effort (for example, the release of acreage that contained the discoveries of Ichthys (previously Brewster), Laminaria, Cornea, etc.). These specific cases need to be dis Ǯ ǯ ȋ
mentioned in the Geoscience Australia review) as there is more exploration uncertainty in such areas (for instance, applying cash-‐bidding in the vicinity of a recent discovery in the outer Carnarvon Basin, such as Alaric, would be premature as the acreage is yet to have its prospectivity fully appraised). Such cash bid areas would need to be limited to the bounds of the actual discovery." "An identified shortcoming (of work program bidding) is where highly valuable discovered hydrocarbons are contained within a bid block. In this case, the exploration work program bid system is distorted by the assessed discovered value, as was the case at Cornea (42 well bid). These issues may 61 See Appendix C, "Some General Comments" and responses to ACIL Tasman questions 3 and 12. Cash-‐Bid Exploration Permit Regime 160 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ have been avoided with a judicial use of cash-‐bonus bidding. This provision currently exists within the legislation, but is rarely used (e.g. Golden Beach gas field in ~1986)." "Introduce very selective cash bidding on very small blocks or blocks completely covered by high quality 3D seismic where a well bid may not be the next logical investment." In response to the question, "Should the cash-‐bid exploration permit regime be used more often than it has over the past 26 years and if so, in what circumstances?", APPEA members asserted: "Yes, but in very limited and specific circumstances:
Small number of blocks (1-‐3 graticular blocks) already covered by a very good coverage of recent 3D seismic data could be considered for cash bidding.
Also for small high value blocks (ex retention lease) or with discovered volumes where block outline is conforming to a field outline.
Difficult to compare GoM (Gulf of Mexico) as there are some structural differences between Australia and USA, including geology, markets etc. While cash bid can be deemed to work in the ǡǯ Ȃ the sins of the bid system are masked by an amazingly generous natural endowment of hydrocarbons, proximity to market and service base etc." In contrast, the Henry Tax Review recommended that consideration be given to use of exploration permits, instead of work program bidding and conditional first-‐come-‐first-‐served systems. The only exception suggested was in "small exploration areas" where a conditional first-‐come-‐first-‐served system could be used (Henry, others, 2009). In the economics literature, the typical recommendation is that cash bidding or royalty/tax rate bidding, or profit/production share bidding should be used to transfer/allocate all exploration tenements. The major practical application of this approach is in United States offshore areas, where it has been used almost exclusively since 1954. Cash bidding has not been confined solely to highly prospective areas. Opponents of cash bidding have emphasised that the main location for use of cash bidding in United States offshore licences is the Gulf of Mexico, which they observe is highly prospective, because of both geological and geographical considerations. However, this system is applied universally, including areas considered weakly prospective. ACIL Tasman's research has indicated that outright opposition to cash bidding or arguments that it should be applied only in a narrow range of circumstances have typically not been adequately supported by analysis. One exception is that the relative merits of cash bidding and royalty/tax or profit/production share bidding have been discussed in the economics literature on the basis of analytical considerations. Some arguments against cash bidding could equally be arrayed against work program bidding, as explained in various parts of this chapter. However, there are numerous deficiencies of work program bidding that do not apply to cash bidding, as explained in detail in chapter 6, where it has been pointed out that work program bidding is just as inappropriate Cash-‐Bid Exploration Permit Regime 161 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌe Petroleum Exploration Policy in weakly prospective areas as in highly prospective areas. A conditional first-‐come-‐first-‐
served system has similar deficiencies, as noted in the literature review in section 6.1. Choice between systems should be based on detailed comparative analysis in the context of plausible circumstances. ACIL Tasman's extensive literature search was not able to find any clearly articulated case based on solid analysis for confining cash bidding only to highly prospective areas or to an even more restricted range of circumstances. Similarly, the thorough analysis of the pros and cons of cash bidding documented above did not reveal any analytically based reasons for confining cash bidding to a very narrow range of circumstances. 7.6
Cash Bidding Versus Royalty/Tax Rate Bidding Some economic analysts have suggested royalty/tax rate, profit share, or production share bidding as alternatives to cash bidding. These mechanisms have been advanced as ways of dealing with some of the most common criticisms of cash bidding. 62 Such criticisms include reduction of funds available for exploration, advantaging large companies with a consequent, potential reduction of competition, and a "sovereign risk" problem if cash bidding is used as a primary royalty/tax. The various criticisms of cash bidding have been discussed in sub-‐
sections 7.1.3 and 7.3.2 above. Because bidding in respect of a loading on the petroleum resource rent tax rate, or a profit or production share would make payments dependent on outcomes, it would not suffer from competition issues arising from advantages to large, diversified companies in the case of cash bidding with bid amounts payable up-‐front. In addition, misleading arguments that cash bidding reduces funds available for exploration would be weakened in the case of tax rate bidding or profit or production share bidding. Also, concerns about "sovereign risk" arising from low cash bids would be avoided. Like cash bidding, royalty/tax rate or profit/production share bidding would serve dual purposes, as a tenement transfer/allocation mechanism and an additional source of royalty/tax revenue. The major difference is that cash bidding is an ex ante royalty, while the other mechanisms are ex post royalty/tax arrangements. This alters the timing of payments to government, the initial distribution or incidence of the burden of risk and uncertainty, the royalty/tax rate applying ex post, and the expected present value of revenue to government. Two major issues in the case of royalty/tax rate, profit share, and production share bidding arrangements are the design of the basis of payment and the rate of payment. These issues are avoided in the case of cash bidding. If the base is well-‐designed, being close to economic profit rent or resource rent, deadweight loss or adverse effects on the efficiency of resource allocation would be minimal. In contrast, a poorly-‐designed base, such as gross well head value (as for United States offshore 62 For example, see Dam (1974, 1976), and Cramton (2010). Cash-‐Bid Exploration Permit Regime 162 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ petroleum) or production volume, would result in discouragement of activity at the margins of extraction, investment and exploration. If bidding is on the basis of profit share or production share, arrangements for sharing should be defined to approximate sharing of resource rent. Because Australia already has a tax on resource rent tax, the simplest arrangement would be bidding in respect of a loading on the resource rent tax rate. If the combined rate of tax resulting from statutory royalty and tax arrangements plus the tax rate or share bid is very high, deadweight loss would occur, even with a well designed base, because of impairment of the incentive to realise economic profits or resource rent, and the possible entanglement of mobile, firm-‐specific rents with immobile, location-‐specific rents (see section 3.3). In contrast, cash bidding would allow the government to keep down the combined effective rate of tax on realised rent. The resource rent tax rate premium would create difficult administration and economic efficiency issues that would need to be addressed. Exploration expenditures could be transferred within a firm from an exploration prospect subject to the standard tax rate to a producing project subject to a higher tax rate. Those transferred from a prospect subject to a premium tax rate to a producing project paying the standard tax rate would be rebated at the standard rate. Tax avoidance would be a problem in the former case and increased asymmetry of treatment of gains and losses would occur in the latter case. These problems would not arise if a "real" cash flow (Brown or R base) tax was substituted for the petroleum resource rent tax or if the latter was modified to provide immediate rebates at the tax rate for exploration expenditure as recently proposed by Ross Garnaut (2010). In these cases, expenditures would be rebated in the same period at the tax rate that is bid. Substitution of a profit share bidding or royalty/tax rate bidding scheme for cash bidding would change the expected present value of revenue to government. If the base for such a contingent payment scheme is efficiently formulated, the expected present value of revenue to government would rise, as indicated by the analysis of Robert Hansen (1985), in combination with earlier work by Paul Milgrom and Robert Weber (1982). However, inefficiencies associated with base design imperfections and high bid rates would reduce the revenue gains indicated by Hansen's analysis. 7.7
Findings and Recommendations 7.7.1
Findings Cash bidding could perform dual functions as a transfer/allocation mechanism for tenements and as an ex ante royalty/tax. Its performance of both functions rates highly in respect of economic efficiency, administrative efficiency and equity principles. In contrast, the current dominant allocation system, work program bidding, performs poorly as a transfer/allocation Cash-‐Bid Exploration Permit Regime 163 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵExploration Policy mechanism on the basis of these principles, and does not have a role as a royalty/tax instrument. The strong economic efficiency and equity attributes of cash bidding could be substantially offset by tenure conditions designed to advance the timing of exploration activity, combined with sub-‐optimal timing of release of areas for bids, as occurs in Australian and United States offshore areas. While cash bidding preserves and captures ex ante resource rent, such tenure conditions tend to dissipate resource rent, with the extent increasing as timing of release of areas for bidding is brought forward. This is a major flaw in the design of the cash-‐bid petroleum exploration permit regime available in Australian and applying in United States offshore areas. Concerns that cash bidding for tenure with relatively few conditions would result in "warehousing" or "speculative" holding of tenements without activity, and that such behaviour is economically undesirable or antisocial are not supported by ACIL Tasman's analysis. It is commercially rational and economically desirable that companies commence exploration as close they can to the time when the immediate exploitation value of an area stops rising faster than the risk adjusted opportunity cost of capital. The primary cause of a preference to hold a tenement without activity is release of areas before they are "ripe" for exploration. Premature release extinguishes the real option value of waiting otherwise available to the community through government. That real option value would be captured by explorers. The appropriate policy response is to release areas for bidding only when they are "ripe" for exploration. The cost of the extra analysis required to make releases at the "right" time from an economic perspective should be much less than the economic waste of resource misallocation and associated dissipation of ex ante resource rent caused by the combination of premature releases, work program bidding, and highly conditional tenure. "Market failure" in the form of under-‐provision of the public good of information from early-‐
stage exploration and external benefits of information "spillovers" from subsequent exploration could mean exploration is undertaken too little, too late from a social perspective. Highly conditional tenure designed to force the pace of exploration and/or replacement of cash bidding with work program bidding are not appropriate policy instruments for addressing those "market failures". They are best dealt with through government funding of generation and dissemination of data from early-‐stage exploration, and government collection of exploration data from explorers and early release of that data to interested parties. There are good grounds for increased funding of early-‐stage exploration activity by government, and earlier release of data from private sector exploration in the context of cash bidding and relatively unconditional tenure. Such exploration information policies are important complements to cash bidding. They facilitate sound decision-‐making regarding timing of releases of areas for bidding, which would limit "warehousing" of permits without activity. They also provide a basis for setting of reserve prices, and rejection of bids, which are important devices for improving competition Cash-‐Bid Exploration Permit Regime 164 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ and reducing collusion. Effectively, the combination of these mechanisms and information inject the government into the auction process as a more informed back-‐stop bidder, increasing competition. In addition, these information policies reduce uncertainty for bidders and reduce information asymmetries, encouraging more bidding overall. The increase in competition and bids for areas offering more promise is likely to more than offset results of reduced interest in areas offering less promise. A common assertion by individuals in administering authorities and petroleum exploration and extraction enterprises is that exploration activity would fall under a cash bidding regime. The most commonly asserted reason is that payment of cash bids would leave less funding available for exploration. These assertions relate to changes relative to activity, the timing, quantity and location of which is effectively heavily subsidised. They ignore the important point that most of the change would be deferment, not reduction of exploration activity, and they reason on the basis of implausible assumptions of irrational corporate budgeting and adverse effects on capital accumulation. They also ignore the positive effects on exploration of reforms to exploration information policy and the ex post royalty/tax regime that logically would accompany tenement policy reform. Claims that cash bidding would erect a participation-‐deterring barrier to smaller firms and a consequent impediment to competition, not present in the case of work program bidding, are not supported by ACIL Tasman's analysis for a variety of reasons. These include the greater magnitude of work program bids than cash bids, joint bidding opportunities, experience in United States offshore areas, variability of bids with prospectivity or attractiveness of areas, and the proposed greater length and security of tenure of cash-‐bid permits, which would provide a better foundation for capital raising, than under work program bidding. In any event, perceived adverse effects of cash bidding on participation by small companies, and competition for permits, could be addressed by deferment of payments. One option would be to allow payment of cash-‐bid amounts over time with interest at a rate consistent with the risk-‐adjusted opportunity cost of large, diversified companies. This is not the preferred option. Another option would be to substitute petroleum resource rent tax rate bidding for cash bidding. Intermediate options would include adjusting royalty/tax arrangements applying to realised outcomes to change the up-‐front and outcome-‐related proportions of government revenue from petroleum exploitation. Cash bidding and a royalty/tax on realised resource rent, such as the petroleum resource rent tax, would complement each other in other ways. The presence of the petroleum resource rent tax would ameliorate "sovereign risk" concerns that might arise if cash bidding was the primary mechanism for government capture of resource rent. Cash bidding allows government capture of more resource rent without having to increase the tax rate or broaden the tax base, which would add to deadweight loss or adverse effects on resource allocation. While resource rent tax rate bidding would avoid a possible participation-‐deterring barrier to smaller firms associated with cash bidding, it would raise the ex post royalty/tax compared to a combination of cash bidding and petroleum resource rent tax. The ex post tax increase Cash-‐Bid Exploration Permit Regime 165 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶPolicy would increase the asymmetry of treatment of gains and losses under the petroleum resource rent tax, with a consequent increase in deadweight loss. In addition, differing tax rates for different projects would create difficulties in administration of the tax, because of a tax avoidance loophole in the context of transferability of exploration expenditures between projects within a company. 7.7.2
Recommendations Cash bidding should be adopted as the primary transfer/allocation system for Australian offshore petroleum exploration permits. A hybrid cash bidding/work program system could be used as a second-‐best transition measure, only if considered necessary to deal with sensitivities relating to departure from long-‐standing preferences for work program bidding on the basis of tradition and protection of vested interests of system administrators and providers of services to exploration. A second-‐best hybrid system would involve allocation on the basis of the highest cash bid, subject to commitment to an undemanding, tailored minimum work program pre-‐determined by government or a program deemed equivalent. It is essential that cash bidding be accompanied by focussed effort to defer release of less attractive areas for bidding until they are attractive targets. Cash bidding should also be accompanied by at least substantial easing of tenure conditions that force the pace of exploration. This policy change should also be made for any hybrid transition arrangement. The extent of the reduction in conditionality of tenure could be traded-‐off against deferment of release of areas for bidding. The more that release is delayed, the less important is the reduction in conditionality of tenure.63 The proposed changes to release and tenement allocation arrangements warrant important changes to the activities of Geoscience Australia (GA). More analytical effort would be required from GA and the Department's economic advisers to determine the timing and location of releases of areas for bidding. Moreover, the exploration information-‐generation and interpretation roles of GA should be expanded. In addition, analysis of appropriate settings for reserve prices for cash bids, and whether or not any or all bids should be rejected by government would replace assessment of differing work and expenditure programs under the work program bidding system, and determination of programs to be included in conditions of initial and renewal exploration permits. Exploration information generated by titleholders should be released earlier than allowed at present to complement cash bidding by encouraging more competition and, addressing information "market failures". Data releases should be no later than one year from acquisition 63 Delaying release reduces the tendency of highly conditional tenure to dissipate resource rent. Cash-‐Bid Exploration Permit Regime 166 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ in the case of basic exclusive data and no later than two years from completion of an operation in the case of interpretative data. The following key design elements of an Australian offshore petroleum cash bidding regime are recommended:

simultaneous, first-‐price sealed bid auctions a back-‐up auction mechanism that could be deployed when areas are highly prospective, such as a modified Anglo-‐Dutch auction or a package clock auction
reserve prices that would not be disclosed and finalised until bids have been reviewed a right to reject any or all bids.
Cash-‐Bid Exploration Permit Regime 167 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽlicy 8
,ǇďƌŝĚtŽƌŬWƌŽŐƌĂŵͬĂƐŚŝĚĚŝŶŐZĞŐŝŵĞ Various parties have suggested that a hybrid work program/cash bidding system could be used to transfer/allocate offshore Australian petroleum exploration permits, instead of work program bidding or cash bidding. Some have perceived a hybrid system as a compromise between economists' strong advocacy for cash bidding, and exploration managers' and government technical advisers' strong preference for work program bidding. Others have taken the view that neither work program bidding nor cash bidding is suitable in all circumstances, providing scope for a hybrid system. For example, the Commonwealth Department of Finance and Deregulation (2011, p. 108) stated in its Strategic Review of Geoscience Australia: "Neither extreme of exclusive use of work program bidding or exclusive use of cash bidding seems sustainable as a universally optimal solution. Further, there would also seem to be scope for consideration of hybrid models in any acreage release, such as cash bidding against minimum work program requirements or, if operationally possible, inviting bidders to decide the mix of cash and work program commitments that would be included in any bid." The case for hybrid systems has not been clearly articulated by its proponents. In addition, there is a very wide range of hybrid possibilities between the extremes of cash bidding and work program bidding. The Offshore Petroleum and Greenhouse Gas Storage Act 2006 (the Act) provides that a hybrid work program/cash bidding regime may be used to transfer/allocate petroleum exploration permits in a specific, narrow range of circumstances -‐ in relinquished areas considered to contain petroleum. However, the Act provides very little guidance regarding the intended system design. The Commonwealth Department of Finance and Deregulation (2011) recommended investigation application of either cash bidding or hybrid cash/work program in offshore areas that have already demonstrated resource potential as a result of commercial exploration or production. This would widen the circumstances in which the Act currently provides for use of a hybrid system. In this chapter, the hybrid concept has been assessed not just in the particular circumstances described in the Act, but as a more general allocation mechanism that might be used instead of work program bidding and cash bidding. The assessment has covered indicative variations of the hybrid concept. 8.1
Existing Arrangements The Offshore Petroleum and Greenhouse Gas Storage Act 2006 (the Act) provides that a hybrid work program/cash bidding regime may be used to transfer/allocate a special petroleum exploration permit or a petroleum production licence over blocks from a surrendered, Hybrid Work Program/Cash Bidding Regime 168 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ cancelled, or terminated petroleum production licence, retention lease or exploration permit, in which the administering authority considers there is petroleum. This mechanism has never been used to allocate a petroleum production licence in Australian offshore areas. It has been used only once to allocate a special petroleum exploration permit. The permit was allocated over an area off the Victorian coast in 1986 Release 1. The winning bid involved a cash payment of $1.2 million, a minimum guaranteed work program for years 1-‐3 of 500 km of seismic work and two wells, and a secondary work program of 200 km of seismic work and two wells. The permit was relinquished before commencement of the secondary program. The administrative arrangements for the hybrid allocation regime follow those for cash bidding, with notable exceptions. 8.2

A notice calling for applications does not have to specify conditions of the grant and matters to be taken into account in deciding whether or not to reject an application.
A ǯ
expenditure in respect of the area available (as well as the cash amount the applicant is prepared to pay for the grant of the production licence).
An application for allocation of a production licence by the hybrid system does not have to provide ǯ available technical expertise and financial resources (but an application for a special petroleum exploration permit, like an application for a cash-‐bid exploration permit has to do so).
A deposit of 10 per cent of the cash amount offered is payable with the application. Assessment The hybrid system specified in the Act provides the administering authority with substantial discretion to reject applications for special petroleum exploration licences and production licences without reference to cash bids. The administering authority would be able to choose to reject an application on the basis of its accompanying proposed work program. In the case of permits it may reject an application on the basis of a judgement regarding adequacy of technical and financial resources available to an applicant. In the case of a special petroleum exploration permit, but not a production licence, the administering authority also has discretion to specify conditions requiring work, timing thereof, and expenditure, as in the case of a work-‐bid exploration permit. The administering authority has discretion regarding relative weighting of cash bidding and work program bidding elements of the hybrid mechanism. The Act does not provide guidance on this matter. An administrative decision could be taken to adopt a transfer/allocation mechanism anywhere on the cash-‐bid to work-‐bid spectrum, including one end or the other. If an administrative decision was taken to reject all applications except the one offering the work program subjectively judged to be most desirable by the administering authority, cash bids Hybrid Work Program/Cash Bidding Regime 169 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚore Petroleum Exploration Policy would be redundant and the allocation mechanism would effectively be work program bidding. Alternatively, an administrative decision could be taken not to reject any application on the basis of the work program offered. Then, the allocation mechanism would become cash bidding. An intermediate arrangement would involve rejecting bids offering a work program judged to be inferior to some selected benchmark and then choosing the successful application from those above the benchmark on the basis of cash bids. The discretion in respect of relative weighting of work program and cash bidding in the hybrid system specified in the Act would allow variations in relative weightings from case to case. This provides the administering authority with considerable flexibility in tailoring the system to particular circumstances. However, this flexibility means sacrifice of transparency. The work program element of the hybrid regime also is inconsistent with transparency. The hybrid transfer/allocation system applying to special petroleum exploration permits is characterised by substantial administrative discretion. The extent of discretion appears to be even greater than that applying under the work program bidding system of allocation of tenements, because the hybrid system specified in the Act allows considerable additional discretion regarding relative weighting of cash and work program bids, as well as great discretion regarding ranking of work programs. APPEA recognised this point, observing:64 "Hybrid systems can be difficult to set up and administer, causing confusion (via lack of transparency) around the criteria for a successful bid." The assessment of work program bidding in chapter 6 was strongly negative. It was shown that this system performs poorly with regard to economic efficiency, administrative efficiency and equity principles. Relative to the same principles, the analysis in chapter 7 demonstrated that cash bidding performed well, but that could be undermined by highly conditional tenure arrangements, particularly in the case of release of prospects for tender that are ex ante marginal. The analysis in chapters 6 and 7 has important implications for a hybrid work program/cash bidding system. The work program bidding element of the hybrid system would detract from the performance of the system in respect of economic efficiency, administrative efficiency, and equity criteria. While a hybrid system would result in less resource rent dissipation than a pure work program bidding system, this would occur only because the capture of some of the ex ante resource rent by the cash bidding element of the hybrid system would leave less for the work program element to dissipate. The performance issues of the hybrid system would be exacerbated by the high degree of conditionality of tenure that is subject to allocation/transfer. Initial tenure is relatively short (6 years) in the case of special petroleum exploration permits, as for work-‐bid and cash-‐bid exploration permits. While special petroleum exploration permits, like work-‐bid exploration permits, may be renewed more often than cash-‐bid exploration permits, renewal of special 64 See Appendix, response to ACIL Tasman question 21. Hybrid Work Program/Cash Bidding Regime 170 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ exploration permits, like renewal of work-‐bid exploration permits, would be subject to applicants' committing to a work program specified at the discretion of the administering authority. Also, renewal is subject to relinquishment of 50 per cent of the permit area. Because of this analytical result, ACIL Tasman does not support APPEA's view that the cash bidding element of a hybrid scheme, rather than the work program bidding element, has adverse economic consequences. APPEA stated: "Any system that loses benefits of competitive work program bidding has a short-‐term money focus and will be at the expense of national future prosperity." "...... any removal of funds from work program commitments will result in less exploration being carried out. In most cases, this will have negative consequences....." The resource misallocation and ex ante resource rent dissipation effects of highly conditional tenure have been explained in sub-‐section 6.2.2 and section 7.2. There, it was shown that adverse effects are more severe the earlier tenements are offered for bidding, relative to the optimal time to explore. 8.3
Potential Modifications While the hybrid system broadly defined in the Act could be characterised as more discretionary and even less transparent than work program bidding, it could be modified administratively to involve less discretion and subjectivity, and more transparency than work program bidding. Two options have been suggested by some parties. One option would be to require that a minimum work program be specified for each area in advance of its release for offers. Bids offering a work program judged to be inferior to that benchmark would be rejected, before selection from the remaining applicants on the basis of cash bids.65 This would greatly reduce subjective, opaque assessment requirements for determining the "best" work program under work program bidding. However, minimum programs would have to be determined for each area offered, and that would involve application of considerable expertise. These modifications would lower compliance costs for companies. The higher work programs are set, the greater the extent of dissipation of ex ante resource rent and the smaller cash bids would be. In the interests of economic efficiency and equity, the ideal minimum work program would be equal to or less than the commercially and economically optimal program. In the interests of administrative efficiency, the ideal minimum program would be zero. This would not interfere with pursuit of economic efficiency and equity unless there are reasons 65 This option was mentioned by the Commonwealth Department of Finance and Deregulation (2011, p. 108) in its Strategic Review of Geoscience Australia. Hybrid Work Program/Cash Bidding Regime 171 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ why companies would not undertake commercially optimal programs or socially optimal programs would be larger and earlier than commercially determined programs. The latter issue would arise if external benefits of information "spillovers" are significant. However, as explained in section 6.6, they are most likely to be significant in frontier areas. Setting relatively high work programs in those areas to increase "spillovers" would render them commercially unattractive, because such programs would exceed ex ante resource rent. In any event, as explained in sections 5.1 and 6.6, there are more efficient ways of addressing information "spillovers". A second option would be to use work program bidding to determine the successful applicant, subject to a requirement to make a cash payment to government, the amount of which would be specified prior to the bidding process. The cash payment could be uniform across all tenements or could be specified on a case by case basis. The cash payment would capture a portion of ex ante resource rent and reduce the extent of dissipation of ex ante resource rent by the work program bidding component of the hybrid system, provided that the required payment is less than estimated ex ante resource rent. However, if potential explorers estimated that ex ante resource rent is less than the required payment, they would not submit a work program bid. If the required cash payment does not vary with ex ante resource rent, it would discourage applications for exploration permits not considered particularly attractive. Unless the flat rate payment is set higher than estimated ex ante rent for all prospects, the work program bidding system would still tend to dissipate ex ante resource rent for superior areas. To avoid discouragement of applications in some cases and resource rent dissipation in others, the required cash payment would have to be set on a permit by permit basis. However, it would be extraordinarily difficult for government to achieve this in practice. It is difficult to see how a hybrid work program/cash bidding system could perform any beneficial economic function better than cash bidding. It is easy to see that a hybrid system would be inferior in terms of economic efficiency, administrative efficiency and equity criteria. The gap would depend on the relative importance of, weight attached to the work program bidding element of the hybrid system, or the size, composition, and timing of the minimum work program combined with cash bidding. One possibly redeeming feature of a hybrid system is that it could be used as a pragmatic mechanism to ease a transition from work program bidding to cash bidding as the main device for allocating exploration permits. This could reduce concern in some parts of government and the petroleum exploration and extraction sector to departure from tradition and protection of vested interests of system administrators and providers of services to exploration. The particular hybrid arrangement least in conflict with economic efficiency, administrative efficiency, and equity principles would be a combination of cash bidding to allocate tenements subject to minimum work program requirements that are not demanding having regard to prospectivity, uncertainty, and supporting infrastructure. Hybrid Work Program/Cash Bidding Regime 172 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 8.4
Findings and Recommendations 8.4.1
Findings A hybrid work program/cash bidding system is inferior to cash bidding in respect of economic efficiency, administrative efficiency and equity principles. While the hybrid system broadly outlined in the Act involves more discretion and even less transparency than work program bidding, it could be modified administratively to be less subjective and discretionary, and more transparent than work program bidding. This would require that a minimum work program be specified for each area in advance of its release for offers. Such a system would be superior to work program bidding on the basis of economic efficiency, administrative efficiency and equity principles. The smaller is the minimum work program, the closer its performance would be to cash bidding with respect to these criteria. The only defensible reason for adopting a hybrid system as a general transfer/allocation mechanism would be policy pragmatism. A hybrid system involving specification of minimum work programs could be useful in transitioning from work program bidding to cash bidding as the main device for allocating exploration permits. This could reduce inflammation of sensitivities in government and the petroleum exploration and extraction sector to departure from tradition and protection of vested interests of system administrators and providers of services to exploration. 8.4.2
Recommendations A hybrid cash bidding/work program system could be used as a means of transitioning to cash bidding as the primary transfer/allocation system for Australian offshore petroleum exploration permits. This transition arrangement should be used only if considered necessary to deal with sensitivities relating to long-‐standing ideological preferences for work program bidding. A second-‐best hybrid system would involve allocation of tenements on the basis of the highest cash bid, subject to commitment to undemanding minimum work programs specified by government or programs deemed equivalent. Hybrid Work Program/Cash Bidding Regime 173 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 9
ZĞƚĞŶƚŝŽŶ>ĞĂƐĞZĞŐŝŵĞ 9.1
Rationale and Arrangements According to the 1985 bill amending the Petroleum (Submerged Lands) Act 1967 to provide for petroleum retention leases, their purpose was to: ǲ -‐commercial discoveries. Retention leases will allow explorers to retain tenure over discoveries until they become commercial and should provide an additional measure of encouragement for companies exploring in deep water or gas prone Ǥǳ A petroleum retention lease may be granted to the holder of a petroleum exploration permit or a life-‐of-‐field petroleum production licence, over a block or blocks in that permit or licence containing petroleum, recovery of which is not currently commercially viable, but considered likely to become commercially viable within 15 years. An application for a petroleum retention lease must propose work and expenditure in respect of the area, and provide details of current and future commercial viability of petroleum recovery. The Act provides that work and expenditure conditions may be specified in respect of a petroleum retention lease. The Act stipulates that the lessee must comply with a request to re-‐evaluate the commercial viability of production from the lease area (otherwise than by drilling wells) within a period of 90 days. No more than one re-‐evaluation can be required in a lease period. The duration of a petroleum retention lease is 5 years. On application, a lease may be renewed for further 5-‐year periods. Renewal applications and grants are handled like initial applications and grants, except that past performance is taken into account for renewals. A petroleum retention lease may be revoked if the results of a re-‐evaluation of commercial viability requested of the lessee by the administering authority lead the latter to form an opinion that recovery of petroleum from the lease area is commercially viable and the lessee's response does not change that opinion. The lessee may apply for a petroleum production licence. 9.2
Assessment The creation of petroleum retention leases in 1985 provided discoverers of sub-‐commercial resources with a form of post-‐discovery tenure over those resources. This has strengthened the capacity of work program bidding and highly conditional exploration tenure to induce too much exploration, too soon and in the process, dissipate ex ante resource rent. In the absence of retention leases, the motivation to explore too much, too soon would be diminished as it would be much more difficult to retain tenure over sub-‐commercial resources. Effectively, retention leases facilitate dissipation of ex ante resource rent by work program bidding and highly conditional exploration tenure. Retention Lease Regime 174 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Retention leases also dissipate resource rent in their own right. This occurs because of the high degree of conditionality of tenure, involving 5-‐year lease and lease renewal periods, work and expenditure conditions, and commercial viability assessment requirements. These conditions create pressure to undertake additional premature, pre-‐emptive exploration activity and premature, pre-‐emptive development. This was noted by the Henry Tax Review (Henry, others, 2009, Part 2, Volume 1, p. 230). It was pointed out by George Fane and Ben Smith (1986) when petroleum retention leases were first proposed, as indicated by their comments shown in Box 25. Box 25 Fane and Smith on Retention Leases "The proposed introduction of retention leases would increase security of tenure over a range of discoveries which are not immediately viable, but would provide little scope for deferred production in areas where current recovery would at least cover costs, but would be less efficient, from the viewpoint of maximising the value of the resource, than extraction at some later date. The nature of the conditions applying to retention leases and production licences is clearly designed to ensure that recovery takes place as early as possible, subject to commercial viability. Taken literally, this could mean that projects would be undertaken which earned revenues only sufficient to compensate for the diversion of capital and labour from other activities and which yielded no rents." Source: Fane, Smith (1986), p. 233. In addition, the Productivity Commission (2009) suggested that resources could be misallocated because of lack of clarity in respect of criteria and processes, particularly the commercial viability test, applied to determine whether or not applications for initial retention leases and renewals should be granted. The Commission pointed out that criteria and processes should be clearly articulated, and this should be accompanied by a demonstration that their application would deliver nett social benefits. There have been suggestions that conditions of retention leases be tightened to force the pace of development. This would have three important effects, which are outlined below. First, in the case of already discovered resources, dissipation of ex ante resource rent through distortion of exploration behaviour would be compounded by forcing development before the commercially and economically appropriate time. That optimal time is when the assessed immediate exploitation value of the discovered resource stops rising faster than the relevant risk-‐adjusted opportunity cost of capital. It is not commercially and economically appropriate to develop a resource as soon as the nett present value of future cash flows exceeds zero (see sections 6.2 and 6.7). Forcing development at the latter time would add to the problem of rent dissipation through work program bidding and highly conditional exploration tenure. Second, tightening conditions of retention leases to force the pace of development would reduce the future tendency of work program bidding and highly conditional exploration tenure to cause too much exploration, too soon. It would do so by increasing the difficulty of holding prematurely discovered resources and reducing their potential realisable value, Retention Lease Regime 175 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ which would reduce the incentive to commit resources to capture value provided by grant of tenement under the work-‐bid exploration regime. Third, highly conditional post-‐discovery tenure designed to force the pace of development would create an important long-‐term disincentive to explore for petroleum, which would later flow into reduced development and extraction activity. This would result from uncertainty regarding post-‐discovery tenure and "sovereign risk" issues created by changing the "rules of the game" in respect of sub-‐commercial resources already discovered. While it would be economically desirable to eliminate the tendency of work program bidding and highly conditional exploration tenure to induce too much exploration, too soon, a policy of trying to force the pace of development of premature discoveries would not be an economically sensible policy response. Not only would it introduce economic inefficiencies in the form of further resource rent dissipation through premature development of already discovered resources and long-‐term discouragement of petroleum exploration and extraction, but also it would be a crude way of addressing the inefficiencies associated with premature exploration caused by work program bidding and highly conditional exploration tenure. Economically appropriate responses to economic inefficiencies associated with forcing too much exploration, too soon would be abandonment of work program bidding and highly conditional exploration tenure, rather than tightening of retention lease conditions. Then, reform of the retention lease system could focus on avoidance of dissipation of resource rent caused by pressure to explore for, assess and develop resources prematurely. Because exploration involves substantial risk and uncertainty, some resources could be discovered well before they are "ripe" for development, even when the tenement transfer/allocation system and tenure arrangements do not force the pace of exploration. Similarly, risk and uncertainty could result in discovery of some resources later than desirable in an ideal world. To ensure that incentives to explore are not unnecessarily damaged, it is economically appropriate that discoverers be able to maintain tenure over sub-‐commercial resources and not be forced to undertake exploration and development activities, the timing and extent of which is commercially and economically sub-‐optimal. Security of tenure would also avoid resource rent dissipation. Consistent with the analysis above, it is important to revise the commercial viability test under the retention lease regime. It should focus on whether or not the immediate exploitation value of the discovered resource has stopped rising faster than the relevant risk-‐
adjusted opportunity cost of capital, not just on whether or not that value is positive. The Productivity Commission (2009) criticised suggestions that retention lease conditions be tightened to advance development. Its finding on this matter has been re-‐produced in Box 26. An important point not included in the analysis of the Productivity Commission is that the retention lease system helps to reinforce the tendency of work program bidding and highly Retention Lease Regime 176 Review of AustralŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ condition exploration tender to misallocate resources, and in the process, dissipate resource rent. If the retention lease system was to be kept in its present form or modified to reduce pressure to bring forward development as suggested by the Commission, the tendency of work program bidding and highly conditional exploration tenure to dissipate resource rent would be reinforced. The retention lease system should be reformed to make tenure less conditional, simultaneously with abolition of work program bidding and highly conditional tenure arrangements. Box 26 Productivity Commission on Retention Lease Policy "Given that companies have typically undertaken costly exploration work to discover resources, it would seem that a retention lease is a legitimate instrument when the discovery is not yet considered commercial. What is considered commercial involves a complex assessment of extraction methods (which optimise overall resource recovery), long term costs and realisations in resource markets, and comparisons with international investment alternatives. Governments wishing to encourage commercialisation as well as ongoing investment in exploration must carefully balance incentives, costs, and rewards for the companies investing and for the community as a whole. An automatic 'use it or lose it' policy is a blunt instrument subject to significant risks of regulatory error and may result in the perverse long-‐term outcome of both reduced exploration and reduced commercialisation of resources." Source: Productivity Commission (2009), p. 95. A recurring message in a discussion paper on offshore petroleum retention lease policy prepared by the Commonwealth Department of Resources, Energy and Tourism (2009) was that the Commonwealth Government sought commercial development of resources as early as possible.66 However, the paper recognised that it was important that adjustment of retention lease arrangements to bring-‐forward development of petroleum resources should not discourage investment in petroleum exploration and extraction. It envisaged that a trade-‐off between bringing forward development, and encouraging exploration and other investment would be required. However, it seemed to regard achievement of each as a different aspect of efficiency.67 It did not appear to recognise that intervention to bring-‐forward development would be in conflict with an economic efficiency objective, as demonstrated in chapter 6 and reiterated in this section. For an economic case to be made for revision of retention lease policy to increase pressure to develop resources earlier than suggested by commercial considerations, it would be necessary to identify market or policy failures (causes of misallocation of resources) that result in delayed development. The Productivity Commission (2009) in its Review of Regulatory Burden on the Upstream Petroleum (Oil and Gas) Sector was unable to identify any market failures impeding efficient timing of development. ACIL Tasman's investigation has yielded the same result. 66 See Commonwealth Department of Resources, Energy and Tourism (2009), pp. 4, 9, 14, 16, 22, 32, 33. 67 See for example, pp. 14, 25, 26. Retention Lease Regime 177 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The Productivity Commission (2009) highlighted a policy failure impeding efficient development timing. It argued (p. 96): "The registration fee for transfers and dealings has the potential to slow the desirable transfer of the title to a discovery from one party unwilling to commercialise it to another party that is. Not only is the fee an inhibitor but the time taken to agree valuations and make transfers is a regulatory burden in its own right........... Impediments to voluntary, mutually beneficial lease transactions should be removed. In this regard, Australian Governments should abolish the registration fee for transfers and dealings as this may have the perverse outcome of inhibiting transfers that might otherwise improve the probability of discovered resources being commercialised expeditiously. This would also be consistent with cost-‐
reflective charging arrangements." ACIL Tasman's analysis has highlighted an additional "policy failure" affecting the timing of development. The current retention lease system could be administered in ways that would bring-‐forward development from its economically timing. This could result from application of an inappropriate commercial viability test. 9.3
Findings and Recommendations 9.3.1
Findings The current retention lease regime facilitates the tendency of work program bidding and highly conditional tenure to dissipate ex ante resource rent by inducing too much exploration, too soon in an exploration permit area, from an economic perspective. The retention lease system could also dissipate resource rent by requiring additional premature exploration and assessment activity and creating pressure to advance development. Suggestions that retention lease conditions be tightened to force earlier development would counteract the tendency of work program bidding and highly conditional exploration tenure to cause too much exploration, too soon. However, such changes would cause resource rent dissipation in the case of already discovered resources, and discourage future exploration for other resources, which would reduce future investment. The registration fee for transfers of, and dealings in tenements may impede transfer of title to a discovery to a party more interested in early development. Impediments to voluntary, mutually beneficial tenement transactions are inconsistent with efficient resource allocation. 9.3.2
Recommendations The retention lease system should be modified to eliminate requirements and pressures to undertake premature exploration, assessment, and development activities. This should be undertaken simultaneously with abandonment of work program bidding and highly conditional exploration tenure. Retention Lease Regime 178 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The commercial viability test under the retention lease regime should be revised to ascertain whether or not the immediate exploitation value of the discovered resource has stopped rising faster than the relevant risk-‐adjusted opportunity cost of capital, not just whether or not that value is positive. Impediments to voluntary, mutually beneficial transfers of exploration permits and retention leases should be identified and removed. This should include removal of registration fees for transfers of, and dealings in tenements. Retention Lease Regime 179 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 10
ZŽǇĂůƚǇͬdĂǆĂƚŝŽŶ The potential petroleum resource "product" that government "sells" under a concession system is framed by tenure arrangements defining exploration and extraction rights, including conditions attaching to those rights. The "sale" is conducted via a transfer or allocation mechanism. The price of the "sale" is determined by bids under the allocation system and royalty and relevant taxation arrangements based on realised outcomes of exploration and extraction activities. In the case of Australian offshore petroleum, the applicable royalty and taxation arrangements are:

tenement rentals ex ante royalties through cash bids for exploration permits (discussed in chapter 7) de facto royalties in the form of the petroleum resource rent tax ad valorem well-‐head value royalties applying to North West Shelf petroleum crude oil excise, a de facto royalty applying to North West Shelf petroleum liquids
company income tax applying to companies in all economic sectors. All of these systems, apart from tenement rentals and cash bidding, apply to realised outcomes. The company income tax system can be categorised as a form of de facto royalty because it captures a share of resource rent not captured by the other de jure and de facto royalty arrangements. From 1 July 2012, the petroleum resource rent tax is to be extended to North West Shelf petroleum. The ad valorem royalty and crude oil excise are to remain in place thereafter, but payments are to be credited against petroleum resource tax liability. 10.1
Tenement Rentals In general, Australian offshore petroleum tenement rental rates are much lower than offshore rentals for comparable countries with concession systems. They are unequivocally much lower than for the United Kingdom, Norway, and the United States. Canada has zero rental rates for exploration permits and retention leases (significant discovery licences) for 5-‐6 years and very much higher rental rates than Australia thereafter. New Zealand has higher rental rates for exploration permits than Australia, but lower rental rates for titles equivalent to retention leases and production licences.68 Australian tenement rental rates are flat, as are those for New Zealand and Norway. Rental rates for United Kingdom and Canadian offshore permits equivalent to those for offshore Australia escalate over time. The United States has applied rental rates that escalate over time 68 See subsection 4.3.5 for Australian rental rates and Appendix A for rental rates applying internationally. Royalty/Taxation 180 Review of AusƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ for some areas in recent lease auctions. United States rental obligations cease when production commences. The purpose of escalating and high pre-‐production tenement rentals, and cessation of rentals when production commences has been to speed up exploration and development. These measures have been applied in the context tenement transfer/allocation systems that are markedly different. It is useful to analyse the interaction of these policy instruments to provide guidance for future Australian policy. They tend to be contradictory. It does not appear that the implications of their co-‐existence have been properly thought through by policy-‐makers. High rentals siphon-‐off ex ante resource rent, at a rate independent of exploration and extraction outcomes. This offsets the tendency for work program bidding and highly conditional tenure to induce pre-‐emptive, premature exploration and therefore, offsets the resource rent dissipation effect of these tenement arrangements. Further increases in rental rates under rental escalation arrangements reinforce the offset effect. In effect, high and escalating rental rates slow the pace of exploration in the context of work program bidding and highly conditional tenure, rather than increasing it. If the estimated present value of rental payments exceeded the ex ante value a potential explorer placed on a prospect, a work-‐
bid would not be forthcoming from that explorer. In the context of cash bidding, the ex ante resource rent siphoned-‐off by high and escalating rental rates would reduce the size of cash bids. This would effectively spread cash bids over time, improving the ability of smaller companies to compete for exploration permits (see sub-‐
section 7.1.3, under the sub-‐heading, "Warehousing and Speculation"). It would also limit any advancement of exploration activity in time. Of course, if the ex ante value placed on a prospect by a potential explorer was less than the estimated present value of rental payments, the entity would not be willing to make a cash-‐bid. If high and escalating rentals do not cease on commencement of production, they could provide an impediment to development of marginal and slightly better than marginal resources. If the rental obligation ceases on commencement of production, the impediment disappears. 10.2
Petroleum Resource Rent Tax 10.2.1
Origins of Petroleum Resource Rent Tax The petroleum resource rent tax was based on a mining (including petroleum extraction) taxation concept first proposed and described as a resource rent tax by Ross Garnaut and Anthony Clunies-‐Ross (1975, 1979, 1983). The tax was designed to charge a price for access to mineable resources (a de facto royalty) through capture of a share of realised resource rent Royalty/Taxation 181 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ in a way that involved substantially less adverse effects on the efficiency of resource allocation than typical royalty and company income tax regimes. 69 A resource rent royalty may be progressive or proportional. It is widely recognised that a progressive version is more likely to discourage risk-‐taking and damage incentives for efficient management.70 Presumably, this is why the
ǯdecided to adopt a proportional system when the petroleum resource rent tax was introduced in the mid-‐1980s. The resource rent tax concept has considerable similarities to a "real" cash flow tax, upon which it is based. ǲǳ refer to the difference between revenues and costs, including capital as well as operating costs, determined on a periodic basis. "Real" cash flows exclude financial items such as interest and dividend payments and receipts, and capital raisings and repayments. ǲǳ ȋͳͻͶͺȌ
system.71 It would involve same-‐period rebates by government at the tax rate in the case of ǲǳ ǡ government at that rate in the event of ǲǳǤȋͳͻ͸͵Ȍ
brought to prominence in the public economics literature by a U.K. Institute for Fiscal Studies taxation committee headed by James Meade (1978).72 A tax of this type has been referred to as a Brown tax or R base cash flow tax. The latter term was applied by the Meade Committee, ǲǳȋȌǤ Mason Gaffney (1967a) pointed out that a share of realised resource rent could be captured ǲǳ
type would not impose an excess burden or deadweight loss (not adversely affect the efficiency of resource allocation) provided the tax rate was not very high. However, he explained that at very high rates, there would be little incentive to realise the resource rent. Australian economist Peter Swan (1976) advocated application of "real" cash flow system as a mining (including petroleum extraction) royalty regime. Swan argued this regime would be neutral (not impose a deadweight loss). He pointed out that a tax or royalty of this type was superior on economic efficiency grounds to the resource rent tax system proposed by Ross Garnaut and Anthony Clunies-‐ȋͳͻ͹ͷȌǲ
ǳǤ 69 Realised resource rent is immobile or location-‐specific. It could include rents deriving from location-‐specific packages of attributes such as political, judicial and social structures, physical infrastructure, workforce skills and education, and geographical and climatic conditions, not just attributes of deposits ( see chapter 3). 70 See, for example, Boadway, Keen (2010), pp. 38-‐39. 71 A neutral tax would not affect the pre-‐existing allocation of resources and therefore not impose any economic efficiency cost known as an excess burden or deadweight loss. 72 Both Vernon Smith and James Meade are Nobel Laureates in Economic Sciences. Royalty/Taxation 182 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ A resource rent tax differs from a "real" cash flow tax in that the former does not provide same-‐ǲǳȋȌǡ
and instead allows carry-‐forward of ǲǳ
from future positive cash flows. Carry-‐forward rates are set to compensate taxpayers for lack of full loss offsets. The "real" cash flow system treats positive and negative cash flows symmetrically (known as provision of full loss offsets), while the resource rent tax system treats them asymmetrically, effectively providing smaller percentage rebates for negative cash flows than percentage "takes" from positive cash flows. The upward adjustment of carry-‐forward rates addresses the asymmetric treatment of positive and negative cash flows by treating positive cash flows even more favourably increasing the asymmetry further. Critics have argued that arbitrary upward adjustments to carry-‐forward rates may lead to discouragement of exploration and investment in some circumstances, and over-‐encouragement of investment in others. Proponents of the resource rent tax concept have argued that its departures from the structure of a "real" cash flow tax are advantageous, because they avoid the politically unpalatable prospect of refunding a proportion of all negative cash flows as they occur in exploration and extraction enterprises. A discussion paper released by the Commonwealth Government in 1983 canvassed the possibility of transfer of petroleum resource rent tax credits for negative cash flows between projects and sale of unused credits between companies (Commonwealth Department of Resources and Energy, 1983). This would have moved the petroleum resource rent tax towards provision of full loss offsets. However, the option of higher carry-‐forward rates without transfer or sale of credits for negative cash flows was preferred by the Government. On 25 June 1984, the Commonwealth Government announced that a resource rent tax would ǲǳ -‐shore petroleum projects from 1 July 1984, except for the North West Shelf and Bass Strait. This new de facto royalty regime replaced an ad valorem royalty of 10-‐12.5 per cent of well head value and a de facto royalty in the form of an excise duty regime for crude oil involving marginal rates of tax that increased with production rates. The top marginal rate of excise duty was 87 per cent of the import parity price of crude oil. The royalty and excise arrangements remained in place for the North West Shelf and Bass Strait. The petroleum resource rent tax rate was set at 40 per cent of positive cash flows. Negative cash flows, including exploration and development outlays, were carried forward for future deduction at a rate of return (threshold rate) equal to the long-‐term Commonwealth Government bond rate plus 15 percentage points. In 1990, the Commonwealth Government modified the petroleum resource rent tax by:
allowing immediate company-‐wide deductibility of exploration costs in areas subject to the tax
reducing the threshold rate for carrying forward development and other non-‐
exploration expenditures to 5 percentage points above the long-‐term bond rate Royalty/Taxation 183 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
restricting applicability of the threshold rate of the long-‐term bond plus 15 percentage points to exploration expenditure incurred within 5 years of the date of lodgement of data required for the grant of a production licence
allowing other exploration expenditure to be carried forward for future deduction at the GDP deflator (maintained in real terms). The Government also extended application of the petroleum resource rent tax to the Bass Strait fields in place of the ad valorem royalty and crude oil excise regimes. The North West Shelf remained subject to the original royalty (shared with the government of the adjacent state) and crude oil excise (100 per cent Commonwealth) arrangements. 10.2.2
Extension of Application of PRRT RSPT Detour On 2 May 2010, the Commonwealth Government announced new tax arrangements for petroleum extraction and other mining activities:
application of a resource rent-‐based de facto royalty, the Resource Super Profits Tax (RSPT), at a rate of 40 per cent to all onshore and offshore mining (including petroleum extraction) activities, other than those subject to the petroleum resource rent tax (unless an election to switch to the RSPT was made)
refund of royalty paid by mining companies in accordance with royalty regimes in place or announced before 2 May 2010
a reduction of the company income tax rate from 30 per cent to 28 per cent (for all companies, not just mining enterprises) a Resource Exploration Rebate scheme to provide refunds at the prevailing company income tax rate for expenditure on exploration in Australia.
The RSPT was derived from the work of the Henry Tax Review (Henry, others, 2009), which proposed a project interest-‐based tax on economic rent from mining based on the Allowance for Corporate Capital (ACC) tax concept. An ACC tax concept would treat gains and losses symmetrically through provision of effective full loss-‐offsets at the tax rate. The ACC tax concept has been discussed in sub-‐section 10.2.6 below The mining sector, some sections of the media, and the main opposition political parties conducted a high profile public campaign against the tax changes, based on a combination of misunderstanding and misrepresentation of the proposals. In response, on 2 July 2010, the Commonwealth Government announced the following revised mining taxation arrangements:
abandonment of the RSPT

abandonment of the Resource Exploration Rebate scheme a company income tax rate of 29 per cent, instead of 28 per cent extension of the existing petroleum resource rent tax to cover extraction of onshore and North West Shelf petroleum, and coal seam methane, all of which had previously been exempt from the petroleum resource rent tax Royalty/Taxation 184 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
application of a Minerals Resource Rent Tax (MRRT) to iron ore and coal mining operations with assessable MRRT profits in excess of $50 million per year.73 Extended Application of PRRT The petroleum resource rent tax, including the tax rate of 40 per cent, remains unchanged, except for:
its application from 1 July 2012 to oil and gas extraction operations previously excluded

transition arrangements for existing projects previously excluded from the tax ǲǳ
areas previously excluded from the petroleum resource rent tax. Under transition arrangements, the tax payer may elect to use as a starting value for deductible expenditures at 1 May 2010 either the market value of past investments, including the value of the resource or the written down book value of past investments, excluding the value of the resource or actual expenditure over the 8-‐year period from 1 July 2002 to 1 May 2010. The starting asset value as at 1 May 2010 and subsequent eligible expenditure can be uplifted at the carry-‐forward rate applicable to general project expenditure in the case of market value and book value estimates, and at rates relevant to the type of expense in the case of the look-‐back method of estimation. The carried forward starting value and subsequent eligible expenditure is to be deductible in full at 1 July 2012 for producing tenements and on commencement of production for other tenements. Investments from 1 July 2012 in projects previously excluded from the petroleum resource rent tax are to be deductible in full in the year incurred when calculating petroleum resource rent tax liability, as is the case for petroleum extraction projects previously subject to the tax. ǲǳ
deduction (uplifted) at multiple rates of return applicable to categories of expenditure, as has been the case since 1990. 10.2.3
Assessment of PRRT If negative cash flows could be carried forward with interest for guaranteed full recovery at the tax rate (effective full loss offsets), the carry-‐forward rate could be set not too far above the long-‐term government bond rate to preserve the present value of those deductions, as explained by George Fane and Ben Smith (1986) and Fane (1987). This form of resource rent tax would be equivalent in effect to a "real" cash flow (Brown) tax, which is the economic efficiency benchmark for a tax linked to realised outcomes, because it would not cause departure from an efficient allocation of resources, except at very high rates. 73 Material released at the time did not explain if the $50 million lower limit for application of MRRT related to projects, project interests or companies. Royalty/Taxation 185 Review of Australia͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Because the petroleum resource rent tax did not provide a guarantee of deductibility of carried forward amounts with interest, a high carry-‐forward rate was set to compensate for inadequate loss offsets. This compensation mechanism has been criticised in the economics literature for three reasons. First, it would not provide appropriate compensation for the unavailability of full loss offsets in many cases, with the result that gains and losses would be treated asymmetrically. If an exploration venture or a mining project yielded negative nett cash flows that could not be recouped with interest at an appropriate rate at a later time, the frequency/probability distribution of nett present values would be skewed negatively by the tax. The expected (anticipated average) nett present value of some investments could become negative. Investment in exploration and development would be discouraged to some extent, and ranking of investments could be affected (Mayo, 1979). Second, setting a high carry-‐forward rate to compensate for inadequate loss offsets would tend to favour low risk investments and very large companies with low costs of capital and better loss offset opportunities. In those cases, overcapitalisation or "gold-‐plating" may be induced.74 Third, constraining the carry-‐forward rate to avoid overcapitalisation means the carry forward rate could be too low in some cases. Consequently, part of the minimum required return to investment would be taxed. This would discourage investment. In response to these criticisms, changes were made to the petroleum resource rent tax in 1990. These ameliorated but did not fully address the problems identified by critics. Allowing company-‐wide deductibility of exploration costs in areas subject to the petroleum resource rent tax provided only partial loss offsets. Smaller companies and new entrants without multiple projects subject to the tax remained particularly disadvantaged. Provision of the separate lower carry-‐forward rate for development investment would have ameliorated overcapitalisation effects. However, the analytical rationale for the rate is not known, and the rate appears to be quite arbitrary. In some cases, it could increase the likelihood of discouragement of investment. A single rate for all development investment does not allow for differences between enterprises and between circumstances relating to different development investments. The provision of two widely differing carry-‐forward rates for exploration expenditure is problematic for four reasons. First, the analytical bases for these rates are not known, and rate selection appears to have been arbitrary. Second, each rate could encourage too much exploration investment in some cases and discourage activity in other cases. Third, it could be expected that exploration activity undertaken within 5 years of the date of lodgement of data 74 This is a form of the Averch-‐Johnson effect (Averch, Johnson, 1962). Royalty/Taxation 186 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ required for the grant of a production licence would involve less risk and uncertainty than earlier exploration, but the allowed carry-‐forward rate is much higher in the former case. Fourth, it is possible that the provision of a zero real (GDP deflator) carry-‐forward rate for early exploration may have been selected to offset the tendency of work program bidding and highly conditional tenure to cause too much exploration, too soon, but it would be better to attack the cause of the problem, the flawed tenement regime, rather than a symptom. Setting a low carry-‐forward rate would discourage activities involving high risk and uncertainty, not just provide an offset to the adverse resource misallocation and associated resource rent dissipation effects of the tenement regime. An early proposition in the literature on the resource rent tax concept was that there could be combinations of carry-‐forward interest rates and tax rates that would avoid adverse effects of the tax on exploration, development, and extraction activities. The notion was that a higher tax rate could offset subsidies to low-‐risk investments associated with a carry-‐forward rate adjusted upwards to compensate for unavailability of full loss offsets. Alternatively, it was suggested that a lower tax rate could offset the investment-‐discouraging effects of a lower threshold rate specified to avoid subsidising lower risk investments. A detailed analysis of this proposition by Ben Smith (1999) demonstrated that there is no single set of neutral set of resource rent tax parameters that could be neutral even in the case of a specific project. Neutrality would necessitate tailoring resource rent tax parameters to each specific investment, but that is not a practical option. Obviously, the appropriate carry-‐
forward rate would vary between enterprises, investments, and project phases. A different set of threshold rates could be required for each project and these would need to be determined before exploration commenced in each case. A further complication is that the appropriate carry-‐forward rate would be affected by the extent of the inadequacy of loss offsets. Designing an efficient tax on realised resource rent is seriously impeded by the extreme difficulty of selection of economically appropriate carry-‐forward rates, unless the tax system incorporates effective full loss offsets, as proposed by George Fane and Ben Smith (1986). Some recent, pertinent remarks by Ben Smith have been reproduced in Box 27. Box 27 Carry-‐Forward Rate Dilemma with Resource Rent Tax "......... a general problem of the RRT is that the (unknowable) uplift rate that is high enough not to discourage investment significantly at the margin ex ante can subsequently provide strong incentives for inefficient behaviour at the expense both of the government's revenue and of efficient resource exploitation. There are various band-‐aid ways of reducing these problems, some of which are employed in the treatment of exploration expenditure under the Petroleum RRT, but these are necessarily arbitrary. One possibility would be not only to allow but also to require companies to pool RRT assessable income and deductions across projects. That would increase the extent to which investments in new projects were immediately expensed against assessable income from more mature projects, so that the RRT uplift rate became irrelevant. But that is simply to say that the solution to the problems of the RRT is to convert it to a ...... ("real" cash flow) Brown Tax. Source: Smith (2010), p. 12. Royalty/Taxation 187 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ It is clear that the petroleum resource rent tax is not a neutral tax. It would have significantly greater adverse effects on the efficiency of resource allocation than a "real" cash flow tax. In the public economics and mining taxation literature, a "real" cash flow tax, a resource rent tax modified to provide effective full loss offsets, and an ACC tax providing effective full loss offsets are widely regarded as neutral in principle.75 However, five reasons have been cited as to why such taxes are not strictly neutral in all circumstances, as discussed below. First, at very high rates of tax on realised resource rent, the incentive to realise resource rent would be impaired, as Gaffney (1967a), Willett (1985), Smith (1997) and others have observed. This is because the penalty on inefficient operation is low and the incentive to avoid tax is high. It has been suggested by critics of the petroleum resource rent tax that a combined rate of tax of 58 per cent, falling 57.4 per cent, is "not internationally competitive". The claim has not been clearly articulated or supported by meaningful evidence. Its proponents have not distinguished between:

the rate of tax on resource rent in Australia and elsewhere differences between tax bases rates of tax on resource rent and on "normal" returns to mobile equity capital. With company income tax currently at a rate of 30 per cent, and petroleum resource rent tax at a rate of 40 per cent, the effective tax rate on resource rent is 58 per cent (0.4 + [0.30 x 0.6]) ǲǳ͵ͲǤ76 The rate of tax on resource rent is not high by international standards, but the rate of tax on "normal" returns to equity capital is relatively high, but certainly not the highest. Specific comparisons based on material in the summary of international offshore petroleum policy regimes in Appendix A help illustrate these points. The combined rate of company income tax and special petroleum tax applying to resource rents from Norway's offshore petroleum is 78 per cent, and the tax on "normal" returns to capital is 28 per cent. The Norwegian special petroleum tax system is a type of resource rent-‐
based tax, but the tax base underestimates resource rent, because of the way depreciation, the uplift rate for depreciation, and interest deductions interact. An important feature of the Norwegian special petroleum tax and company income tax regimes since 2006 is that a high level of loss offsets for petroleum activities is provided, including payments by the Government at the tax rates for deficits derived from exploration following each annual tax 75 See Fane, Smith (1986), Fane (1987), Smith (1997), Bond, Devereux (2003), Lund (2009a), Henry, others (2009), and Boadway, Keen (2010). 76 With a company income tax rate of 29 per cent, t he effective tax rate on resource rent would be 57.4 per cent (0.4 + [0.29 x 0.6]) and the rate of tǲǳʹͻǤ Royalty/Taxation 188 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ assessment, and payments by government to cover the tax value of any unrecovered deficit if a company ceases activities on the Norwegian continental shelf. In contrast, the Australian petroleum resource rent tax base is likely to be higher than resource rent, because of lack of full loss offsets, particularly for companies without other petroleum resource rent tax liabilities against which they can offset exploration expenditures. On the other hand, Australia's combined rate of tax on resource rent (from immobile factors) is much lower than Norway's combined rate. Of more importance, is the point that Australia's company tax system applies a higher rate of tax to returns to mobile equity capital and also provides inferior loss offsets and less generous depreciation allowances, which increase the tax base. So, Australia's company tax rate and the tax base for petroleum extraction companies are larger than Norway's tax rate and base. The United States fiscal regime for offshore petroleum combines cash bidding with a standard ͳ͸᪟statutory company income tax rate of 35 per cent. The combined rate of tax on resource rent is far higher than for Australian offshore petroleum. Also, the rate of tax on "normal" returns to equity capital resulting from the royalty and company income tax systems is much higher than for Australia. Moreover, the ad valorem royalty effectively taxes returns to all inputs (including labour and debt capital), not just resource rent and "normal" returns to equity capital. The Australian combined rate of tax on resource rent from offshore petroleum could not reasonably be regarded as too high. In any event, what is most important for "international competitiveness" is the rate of tax applying to mobile inputs to petroleum exploitation, not the rate of tax applying to immobile resource rents. While Australia's effective marginal company income tax rate, which applies to "normal" returns to equity capital (excludes rents), is about 5 percentage points above the unweighted OECD average, Australia's petroleum resource rent tax roughly exempts "normal" returns to capital and returns to other inputs from tax and it has largely displaced ad valorem royalties and the crude oil excise in offshore areas. A case could be made that the rate of tax on returns to mobile equity capital should be lower, while the effective rate of tax on resource rent should be raised to compensate for revenue losses from reductions in inefficient taxes. This position was taken by the Henry Tax Review. A second important issue bearing on the effects of a "real" cash flow tax, an equivalent tax such as an ACC tax or a modified resource rent tax, or the petroleum resource rent tax is that the tax base might include mobile, firm-‐specific rents, as well as immobile, location specific resource rents. As discussed in section 3.3, mobile, firm-‐specific rents could derive from synergistic combinations of corporate capabilities, which earn returns in excess of payments to individual components of, or inputs to the package of capabilities. These packages of capabilities might be deployed elsewhere in response to a tax on a base that includes the rents attributable to the packages (Osmundsen, 2005; Sørensen, 2007; Sørensen, Johnson, 2009). The persistence of mobile, firm-‐specific rents in the long-‐term has been questioned on the grounds that shortages of scarce inputs (including expertise in building a diversified Royalty/Taxation 189 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ petroleum exploration and extraction enterprise), which would underpin firm-‐specific, mobile rents, would result in high rewards that would elicit additional supply (Bjerkedal, Johnson, 2005; Lund, 2009a; Boadway, Keen, 2010). In any event, it could reasonably be argued that a 40 per cent rate of tax on resource rent and a company income tax rate of 30 per cent would leave 42 per cent of all rents and 70 per cent of "normal" returns to equity capital with petroleum extraction companies. A 42 per cent share of resource and other location-‐specific rents should be sufficient to offset taxation of any firm-‐specific, mobile rents. A third reason why a tax targeting resource rent might adversely affect efficiency of resource allocation is that neutrality would depend on the future tax rate being known and constant (Sandmo, 1975; Bond, Devereux, 1995; Boadway, Keen, 2010). The tax rate is more likely to ǲǳǲǳǡ
considered generous to petroleum companies, which would tempt a future increase. In any event, the petroleum resource rent tax rate and base have remained unchanged since the mid-‐
1980s. This stability is remarkable by international standards. A fourth issue bearing on the effects of a tax on resource rent on the efficiency of resource allocation is that some enterprises ǲǳ hen deciding whether or not to proceed with projects. Then, if the nett present value is below a particular level, which would vary between companies, a decision would be made not to proceed. In such circumstances, a tax that reduces nett present value b ǲǳ
could result in a decision not to develop a resource, even when the tax did not cause a positive nett present value to drop below zero (Osmundsen, 2005). ǡ ǯ ǲǳ threshold, it could still proceed later. Indeed, if the value of the option of waiting exceeds the nett present value, it would make sense to wait. Moreover, as large companies could be expected to have higher ǲ" thresholds than smaller companies, the project could be purchased by a smaller ǲ" threshold. Development could then proceed. Indeed, changes of ownership and subsequent development of mineable resources are common. Fifth, the general equilibrium effects of a tax on resource rent on the interest rate and pricing of risk and therefore the cost of capital have typically been ignored. However, this may not be a problem to the extent that Australia is a price taker in world capital markets. Since Australia is a small-‐medium sized open economy, this appears to be a reasonable assumption (Bond, Devereux, 1995, 2003). Despite these issues, which would influence the resource allocation effects of the petroleum resource rent tax and more neutral alternatives, the petroleum resource rent tax is clearly superior to the company income tax system, and vastly superior to ad valorem, specific and hybrid ad valorem-‐specific royalty/regimes in terms of economic efficiency. Royalty/Taxation 190 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨshore Petroleum Exploration Policy The company income tax regime does not treat the cost of equity capital as a cost. Therefore, it taxes returns to equity capital, impeding investment, with the extent of the discouragement depending on relativities to effective tax rates internationally. The United States and Australian ad valorem royalty and the Australian crude oil excise regimes ignore all costs upstream from the taxing point, and therefore, tax returns to all upstream inputs. These regimes tax poor outcomes relatively much more than superior outcomes. They effectively subsidise superior outcomes, because they capture a relatively small proportion of the resource rent. As a result, such systems increase the riskiness of cash flows to mining enterprises, discouraging exploration and other investment in relatively risky mining activities. The petroleum resource rent tax, like the "real" cash flow tax, allows for variations between nett values of units of resource within a deposit and for differences in nett value between deposits. Units of resource and deposits that are supra-‐marginal (nett value exceeds zero) or marginal (nett value is zero) would in general remain supra-‐marginal or marginal, respectively after the royalty/tax is levied. However, the petroleum resource rent tax does not allow for costs, as well as the "real" cash flow tax does, because of imperfect recognition of exploration costs and the cost of capital. 10.2.4
Treatment of Crude Oil Excise and Ad Valorem Royalty under Extended PRRT An issue with the extension of the coverage of the petroleum resource rent tax is that existing levies are to be credited against the resource rent tax, and if necessary, carried-‐forward for future deduction, rather than refunded as had been proposed for the RSPT case. This means that projects and portions of resources that are marginal or a little better than marginal before crude oil excise and/or royalty would still be rendered uneconomic by existing tax/royalty arrangements, even though their petroleum resource rent tax liability could be zero or minimal. Some other projects that would pay more to government under existing royalty/tax arrangements than under the petroleum resource rent tax may not recover all material that would be economic in the absence of the ad valorem royalty and crude oil excise, because decisions at the margin of extraction could still be influenced by those levies. If the ad valorem royalty and crude oil excise were replaced by the petroleum resource rent tax, rather than retained and payments credited against petroleum resource rent tax liability, the riskiness of post-‐royalty/tax cash flows from the perspective of enterprises would decline because of the removal of imposts at the margins of extraction and investment. This would induce risk-‐taking by investors from a social perspective, despite higher taxation of petroleum extraction than other sectors. This effect would be greater if the petroleum resource rent tax was improved by one of the approaches discussed in sub-‐section 9.1.6 below.77 77 For a theoretical analysis of differential taxation of returns to capital in the context of full loss offsets, see Sandmo (1989), pp. 55-‐59. Royalty/Taxation 191 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ 10.2.5
Transitional Arrangements Allowing deduction of the market value of assets, including the value of resources, as at 1 May 2010 after being carried forward at the relevant allowable rate of return (uplift rate) would remove expected resource rent from the tax base. However, the tax base of a petroleum resource rent tax is meant to be resource rent as it is realised by extraction and disposal of products. These transition arrangements will reduce the tax base to the growth in nett value of resources between 1 May 2010 and the time of extraction. This growth could occur because of petroleum price increases, cost reductions, or additions to resources and improvements to their definition. This is a very large concession to those holding tenements over well-‐defined reserves and resources as at 1 May 2010. 10.2.6
Improving PRRT "Real" Cash Flow Tax The most radical reform would be to replace the petroleum resource rent tax with a "real" cash flow tax, which periodically taxes positive "real" cash flows and rebates negative "real" cash flows at the same rate. In the economics literature, a "real" cash flow tax is typically regarded as the most efficient (albeit not perfectly efficient) mechanism for taxing realised resource rents. The efficiency advantages of a "real" cash flow tax over a petroleum resource rent tax would translate into less resource rent destruction from interference with incentives at the margins of extraction, investments and exploration. This means a "real" cash flow tax would also perform better in terms of the benefit principle of equity. The "real" cash flow tax is the easiest of the relatively efficient reforms to comprehend and explain. It would be involve lower administration and compliance costs than the petroleum resource rent tax, because the former avoids carry-‐forward issues involved in the latter. These include accounting issues associated with the carry-‐forward feature and multiple carry-‐
forward rates, and issues relating to selection of appropriate carry-‐forward rates. A "real" cash flow tax completely eliminates the discount rate selection problem. The main obstacle would be political acceptability issues associated with provision of full loss offsets through rebates for exploration outlays, development investment, and operating losses at the tax rate. It would be important to accompany this reform with changes to the tenement regime to address tendencies of this regime to cause too much exploration, too soon from a social perspective (see chapters 6-‐9). A "real" cash flow tax would not impede those tendencies in any way because of its neutrality with respect to the timing, quantity and composition of exploration. Royalty/Taxation 192 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Hybrid RRT/"Real" Cash Flow Tax In 2010, an originator of the resource rent tax concept, Ross Garnaut (2010a,b) suggested that the resource rent tax problem of inadequate loss offsets and mismatched compensation through carry-‐forward rates could be ameliorated by a hybrid of the "real" cash flow tax and a resource rent tax. His proposal was provision of rebates at the tax rate for exploration expenditure incurred prior to issue of a production licence. This would confine carry-‐forward arrangements in the resource rent tax manner to negative cash flows arising from later exploration expenditure, development expenditure, and operating losses. Garnaut's proposal would improve the efficiency of the petroleum resource rent tax by providing full loss offsets, like a "real" cash flow tax, for exploration expenditures. This reform would address two major, interrelated inadequacies of the petroleum resource rent tax system:
asymmetric treatment of successful and unsuccessful exploration activities for companies without petroleum resource rent liabilities against which to apply exploration outlays
arbitrary carry-‐forward rates for exploration expenditure. However, Garnaut's proposal would eliminate two counters to the tendency of the work program bidding regime and highly conditional tenement arrangements to induce too much exploration, too soon from a social perspective. The current very low carry-‐forward rate applicable to exploration expenditure incurred more than 5 years before the date of lodgement of data required for the grant of a production licence would tend to discourage premature exploration activity. In addition, incomplete loss offsets under the petroleum resource rent tax reduce the adverse influence of current work program bidding and highly conditional tenement arrangements. This is not an argument against Garnaut's resource rent tax reform proposal. It does mean the reform would have to be accompanied by changes to the tenement regime to address deficiencies discussed in chapters 6 to 9. Fane-‐Smith RRT The efficient reform requiring the least change to the petroleum resource rent tax would involve modification of the petroleum resource rent tax to provide effective full loss offsets, simplify the carry-‐forward rate selection problem, and avoid substantial rebate payments in periods of major capital outlays. George Fane and Ben Smith (1986) proposed such a system, which would:
provide the equivalent of full loss-‐offsets
avoid payment of rebates at the royalty/tax rate during periods of substantially negative cash flows, such as the development and expansion phases of ventures Royalty/Taxation 193 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
avoid impractical tasks of setting different threshold rates for different enterprises, projects and phases of projects, or determining a compromise threshold rate that induces either under-‐ or over-‐investment in particular circumstances. This system has two key aspects. First, within a resource rent tax framework, the government would guarantee to pay rebates at the royalty rate for any accumulated losses, compounded at the carry-‐forward rate, which remained unrecovered when ventures were wound-‐up. Second, the carry-‐forward rate would appropriately be set not far above the nominal medium-‐term government bond rate, because of the guaranteed availability of rebates. The appropriateness of this setting has been explained below under the sub-‐heading "Carry-‐Forward Rate Controversy with RRT and ACC Tax". Instances of payment of rebates by the government could be reduced by sale of losses with interest between enterprises, as well as between ventures within an enterprise. Opportunities for transfers/sale of losses with interest to present or future ventures with royalty liability under this variant of the resource rent tax would be exhausted before payment of any rebates. Of course, the potential competitiveness of the market for losses would need to be investigated. The Fane-‐Smith resource rent tax could approximately match the economic efficiency and ǲǳ the petroleum resource rent tax. It is clearly superior on economic grounds to the ad valorem royalty system and the crude oil excise applying to North West Shelf petroleum production. In terms of the administrative efficiency criterion, a Fane-‐Smith resource rent tax could be expected to rank between the ǲǳpetroleum resource rent tax systems. Revenue deferment issues for government would be less than those under the petroleum resource rent tax because of a lower carry-‐forward rate. The issue of political acceptability of government recompense for losses at the tax rate should be of less concern than in the case of ǲǳ because of deferred timing of such payments. A potential political problem with the Fane-‐Smith resource rent tax is the potential for misunderstanding and misrepresentation of the low carry-‐forward rate. This matter has been discussed below under the sub-‐heading, "Carry-‐Forward Rate Controversy with RRT and ACC Tax". ACC Tax The Henry Tax Review (Henry, others, 2010) proposed a project interest-‐based tax on economic rent from mining (including petroleum extraction) calculated according to the Allowance for Corporate Capital (ACC) tax concept. This system included symmetrical (even-‐
handed) treatment of gains and losses through provision of effective full loss-‐offsets at the tax rate. In 2000, the Norwegian Petroleum Tax Commission proposed that Norway's special petroleum tax be replaced by an ACC tax. However, the Norwegian Government chose the less Royalty/Taxation 194 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ efficient and less controversial alternative of modifying the special petroleum tax (Bjerkedal, Johnsen, 2005). This was undertaken in two steps, the second occurring in 2006. The special petroleum tax now has much of the character of an ACC tax. The ACC concept originated with Boadway and Bruce (1984), who had focussed on design of a neutral company taxation system. They did not consider a project-‐based or project interest-‐
based system. The ACC system proposed by Boadway and Bruce was based on economic profits, unlike the Australian company income tax system, which is based on accounting profits. Rather than provide full loss offsets like the "real" cash flow tax through refunds at the tax rate as losses occurred, Boadway and Bruce suggested that losses could be sold to others or carried forward ǲǳǤ
future profits, losses (including interest at the carry forward rate) would eventually be refunded at the tax rate. Bond and Devereux (1995, 2003) argued that provided that full loss offsets and compensation for delay in receiving them were guaranteed by government, the carry-‐forward rate under an ACC tax system should be the ǲnominal interest rate on default-‐free bondsǳ. This argument was borrowed from the work of Fane and Smith (1986) and Fane (1987),78 which was outlined in the previous sub-‐section. The appropriateness of this setting for the carry-‐forward rate has been explained under the sub-‐heading "Carry-‐Forward Rate Controversy with RRT and ACC Tax" below The ACC system was designed to avoid adversely affecting the efficiency of resource allocation through adoption ǲǳǡ:
avoiding up-‐front payouts at the tax rate by government in respect of pre-‐production expenses for large projectsǡǲǳ
reducing the extent of deferment of revenues to government compared to a "real" cash flow tax and a conventional resource rent tax, like Australia's petroleum resource rent tax. The ACC tax approach addresses these matters by:
allowing depreciation of capital expenditure over time, rather than immediate write-‐
ǲǳǡ

transfer of resulting losses to other projects within the same group of companies, or carry-‐forward of these losses with interest for guaranteed future rebate at the tax rate. The version of the ACC tax proposed for mining (including petroleum extraction) by the Henry Tax Review departed from strict application of the ACC approach by allowing immediate write-‐offs (but not necessarily immediate refunds) for exploration expenditure, rather than 78 See also Fane (1987). Royalty/Taxation 195 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽre Petroleum Exploration Policy depreciation over time. This was a logical adjustment to the ACC tax concept to apply it to mining activities. In terms of the administrative efficiency criterion, an ACC tax could be expected to rank ǲǳ leum resource rent tax systems. The depreciation allowance feature of an ACC tax would make it more complex than a F ane-‐Smith resource rent tax. Revenue deferment issues for government would be less than those under the petroleum resource rent tax, because of a lower carry-‐forward rate and inclusion of depreciation allowances, rather than immediate deductions. Revenue deferment should also be less than under a Fane-‐Smith resource rent tax. The issue of political acceptability of government recompense for ǲǳ
flow tax regime because of deferred timing of such payments. As with the Fane-‐Smith resource rent tax, a potential political acceptability problem could arise from misunderstanding and misrepresentation of the appropriateness of a carry-‐
forward rate equal to the interest rate on default-‐free government bonds. This characterised responses to the ACC tax proposals of the Norwegian Petroleum Tax Commission and the Henry Tax Review. The carry-‐forward rate controversy has been discussed in the next sub-‐
section. Carry-‐Forward Rate Controversy with Fane-‐Smith RRT and ACC Tax Under the Fane-‐Smith resource rent tax and ACC tax regimes, un-‐recouped losses are carried-‐
forward at a rate not far above the long-‐term government bond rate for guaranteed future deduction. This arrangement is meant to be equivalent in effect to provision of full loss offsets under the "real" cash flow tax system. Equivalence is pursued through treatment of deferred refunds at the tax rate as loans to government to be repaid with interest. Since repayment of the loans with interest is backed by a government guarantee, the rate of interest, in theory, should be a nominal medium-‐term government bond rate. Australian bonds are regarded as "risk-‐free", being AAA rated. This line of reasoning is based on the seminal analysis of George Fane and Ben Smith (1986),79 and has been widely endorsed in the economics literature on corporate taxation and mining taxation and royalties.80 It was also supported by the Norwegian Petroleum Tax Commission in 2000. The problem is that, in practice, an enterprise would not be able to raise capital to finance the loan to government at a cost equal to the rate of interest applicable to medium-‐term 79 See also Fane (1987). 80 See Bond, Devereux (1995, 2003); Auerbach, Devereux, Simpson (2010), p. 877; Griffith, Hines, Sorensen (2010), pp. 976-‐977; Boadway, Keen (2010), p. 36; Lund (2009a), pp. 299-‐300; Henry, others (2009), pp.234, 245; Mirrlees, others (2011), p. 423. Royalty/Taxation 196 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ Australian government bonds. Fane and Smith (1986, p. 217) acknowledged this, but suggested that the appropriate rate would not be far above the relevant government bond rate. This qualification has been glossed over in the subsequent economics literature on mining taxation and corporate taxation, including the report of the Henry Tax Review. The effective rate of interest applying to debt finance to cover the loan to government would include an increment above the long-‐term bond rate. Lenders could be expected to apply a ǲ ǳ ǲǳ
establishing either the Fane-‐Smith variant of a resource rent tax or an ACC tax, because of the possibility that a future government might eliminate or dilute effective full loss offsets arrangements for budgetary or political reasons.81 ǲǳ-‐forward rate could be addressed by issuing government bonds or an equivalent instrument supported by a government guarantee, which could be held as security by lenders, but would be realisable only in the event of default. Alternatively, the carry-‐forward rate could be adjusted to include an appropriate increment above the medium-‐term government bond rate. The increment should not be large given the arguably firm, fair and efficient design of a Fane-‐Smith resource rent tax or an ACC tax. However, government borrowing from mining companies at an interest rate above the relevant government bond rate would be less efficient than debt capital raising through the issue of government securities in financial markets, as Ben Smith (2010) observed (see Box 28). Smith pointed out that it would be less costly for government to borrow directly in financial markets to meet its share of mining project costs up-‐front. This suggests government should adopt a "real" cash flow tax, rather than a Fane-‐Smith resource rent tax or an ACC tax system. Box 28 Potential Inefficiency of Borrowing from Petroleum Extraction Enterprises "If in this case, financial institutions can satisfactorily secure lending against the government's guaranteed payments, they will not need to charge any risk premium. All this, of course, is critically dependent on the credibility of the government's guarantee, an issue that would not arise under the ....... ('real' cash flow tax) approach. Whether companies could or couldn't finance their compulsory lending to the government at an interest rate as low as the long-‐term government bond rate is a matter for speculation, leading to argument about whether the ....... (ACC or Fane-‐Smith carry-‐forward) rate should be higher than this and by how much. But it would be inefficient for the government to borrow from mining companies at a rate higher than it pays to borrow in the market generally. Since the government can borrow at the long-‐term bond rate, why should it not do so and meet its 40 per cent share of project costs up-‐front, converting the ....(ACC or Fane-‐Smith resource rent tax) to a transparent Brown ("real" cash flow) tax? Source: Smith (2010), pp. 10-‐11. ".... 81 Lenders would also require a return for the opportunity cost of the resources required to set up and manage a loan facility. This could be covered by establishment and account maintenance fees, rather than an interest rate increment. This would apply whether or not a tax of the Fane-‐Smith or ACC type applied. Fees should not ǲǳǤ Royalty/Taxation 197 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ The ACC tax and Fane-‐Smith resource rent tax have been criticised by naive finance sector analysts on the grounds that they reduce internal rates of return. It has been suggested that this could result in internal rates of return for otherwise economic projects falling below hurdle rates of return (discount rates) for project assessment purposes. These analysts have failed to recognise that the Fane-‐Smith resource rent tax and ACC tax should reduce hurdle rates as well as internal rates of return. Their confusion has been exacerbated because a "real" cash flow tax would not reduce the internal rate of return of projects or hurdle rates, while all three regimes would reduce the nett present value of a project by a proportion determined by the tax rate. ACC tax and Fane-‐Smith resource rent tax systems should reduce hurdle rates applicable to projects, because the guaranteed future deductions or refunds they provide at the tax rate for losses reduce:

the equity beta in the cost of equity capital calculation under the capital asset pricing model, because the low risk attaching to deductions for capital expenditure reduces the overall riskiness of cash flows (Lund, 2002, 2009b)82 the cost of debt capital, as explained above. If analysts do not recognise these important attributes of ACC tax and Fane-‐Smith resource rent tax systems, they could mistakenly undertake spurious assessments of projects subject to such a tax. Indeed, spurious assessments of illustrative projects have been presented as part of arguments against the application of ACC taxes in the mining sector. In the case of North West Shelf projects, hurdle rates should also be lowered if the ad valorem royalty and crude oil excise were replaced by more efficient alternatives, the Fane-‐Smith resource rent tax, the ACC tax or "real" cash flow tax, rather than payments credited against liability in respect of those more efficient taxes. This would occur because the riskiness of post-‐royalty/tax cash flows from the perspective of enterprises would decline because of the removal of royalty/tax liability at the margins of extraction and investment. By way of illustration, modelling in a real options framework by Paul Bradley (1998) compared a 40 per cent "real" cash flow tax with a revenue-‐neutral ad valorem royalty regime and revealed that in the latter case, a significantly higher hurdle rate should be used for project assessment than in the former case. Some enterprises exploiting sub-‐surface resources have criticised the carry-‐forward rate associated with the ACC tax and Fane-‐Smith resource rent tax concepts by arguing that they place no value on the effective full loss offsets feature of these systems, because they do not explore and invest with the intention of making losses. In addition, they have argued that the higher hurdle rates associated with a conventional resource rent tax like the petroleum resource rent would be more appropriate economically because they are more like risk-‐
reflective discount rates applied by enterprises. 82 Diderik Lund drew on earlier insights of Lawrence Summers (1987). Royalty/Taxation 198 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ This argument either represents confused thinking or its proponents think the public and policy makers are easily misled. The argument fails to distinguish between the risk and uncertainty associated with exploration and extraction, and the very different risk associated with a government guarantee of a rebate for exploration and development expenditures and operating losses at the tax rate (effectively a government guarantee of repayment of a loan with interest). If enterprises place no value on full loss offsets, the government guarantee of future rebates for expenditures and losses at the tax rate would have no value. Therefore, it would not be necessary to provide them with a higher carry-‐forward rate or rates as compensation for not providing a guarantee of effective full loss offsets (Smith, 2010). A political problem with the Fane-‐Smith resource rent tax and an ACC tax is that they are prone to misunderstanding and political misrepresentation because of the subtleties of their supporting arguments in respect of the value of full loss offsets, the guaranteed loan element, and the effect of these systems on internal rates of return and hurdle rates for investment analysis. Clear explanations of these matters would have to be transmitted to the public to reduce the impact of spurious criticisms of the Fane-‐Smith resource rent tax and an ACC tax. 10.3
Company Income Tax
ǯ͵Ͳ
per cent to defined company accounting profits that in general are sourced in Australia. A dividend imputation system means double taxation of returns to domestic shareholders is avoided. Because the company income tax system allows deduction of interest, the tax falls on the full Ǥ ǲǳ
capital and surplus returns or economic rents. However, it exempts the "normal component of returns to investment in exploration, for companies with taxable income, because it allows immediate deductibility of exploration expenditures. The company income taxation system has two basic functions. First, it taxes income earned by non-‐residents through ownership of shares in Australian companies or Australian Ǥǡǲǳǡ
tax on income earned by Australian residents through shares in Australian resident companies. This reduces or eliminates advantages that might arise from delaying tax on income earned until dividends are paid or shares are sold. ǯresource allocation because:
it does not provide full loss offsets, treating gains and losses asymmetrically, and therefore is biased against risky activities
allowable depreciation deductions typically do not reflect the true decline in the value of assets Royalty/Taxation 199 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
it discriminates between debt and equity financing
ǲǳǡ
investments can be funded by borrowings, interest on which is deductible
firm-‐specific, mobile rents are taxed
it discourages inbound investment in Australia. The adverse effects on resource allocation increase with the degree of international mobility of capital and sources of firm-‐specific, mobile rents. There has been increasing acceptance of the view that the mobility of these resources has increased in recent decades. Therefore, there has been a strong international trend to declining statutory and effective marginal and average company income tax rates, particularly in small, open economies. While declining statutory rates of company income tax have typically been accompanied by broadening of tax bases, the nett effect has been declining effective marginal and average tax rates (Henry, others, 2009; Sørensen, Johnson, 2010). ǯncome tax rate dropped below the unweighted OECD average when it was reduced to 30 per cent in 2001. However, the Australian statutory rate is currently about 2 percentage points above the unweighted OECD average, and about 5 percentage points above of the unweighted OECD average excluding the six largest economies. However, the Australian statutory rate is not the highest. It is 5 percentage points below the United States company income tax rate. Since 2001, the gap between the Australian effective marginal company income tax rate and the unweighted OECD average of effective marginal rates has widened to about 5 percentage points. The gap is significant. Relocation of capital and sources of mobile, firm-‐specific rents because of a higher effective rate ǲǳ
matter of concern, because it would lead to underinvestment in the Australian economy. This means relatively immobile factors of production, like labour, and completely immobile factors, like land and mineable resources, would be less productive and would earn lower returns. Therefore, the burden of a higher effective rate of tax would tend to be shifted to relatively and completely immobile factors of production. There is mounting evidence that in a small, open economy like Australia, the burden of a higher effective company income tax rate would be borne to a substantial extent by workers in that economy (Henry, others, 2009; Sørensen, Johnson, 2010). Indeed, Arnold Harberger (2008), a highly respected expert on tax incidence, has estimated that workers would bear a very high proportion the burden of company income taxation in the long-‐run and that this proportion could be as high as 130 per cent. The Henry Tax Review cited other analyses indicating that a very high proportion of a higher effective company income tax rate would be borne by workers in the form of lower wages in the long-‐term. Royalty/Taxation 200 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚroleum Exploration Policy However, there are important circumstances applying in Australǯ
magnitude of the mobility problem to some extent. These have been briefly outline below First, capital is not completely mobile. Various sources of friction exist. Second, countries with worldwide corporate income taxation systems offer credits for company income taxes paid in countries that are sources of the income. These credits are capped at the level of tax applying in countries in the former group. About half of foreign direct investment in Australia has originated from countries that apply worldwide corporate income taxes with foreign tax credit arrangements (Sørensen, Johnson, 2010). Such systems mean a reduction of Australian company income taxation could transfer revenue to another government without any increase in investment in Australia. However, there is a trend away from these systems (Henry, others, 2009). Third, opportunities to capture location-‐specific economic rents, such as resource rents, would still attract investment, at least in industries relying heavily on sources of those rents. Of course, this would not justify higher effective rates of tax on capital in such industries or the economy as a whole when location-‐specific rents could be separately, precisely targeted. The Henry Tax Review pointed out that company income taxation has been an important device for capturing a share of resource rents for the Commonwealth Government. However, it has acted as a backstop mechanism in this role, rather than a primary mechanism, because it allows deduction of payments under royalty, crude oil excise, and petroleum resource rent tax regimes for the purpose of calculation of income tax liabilities. The third point above was an important focus of the Henry Tax Review. Two broad approaches to reform of company taxation and taxation of resource rents were considered:
lowering the statutory company income tax rate, but increasing government's share of resource rents through separate tax or royalty regimes that directly and precisely target resource rents
adjusting and narrowing the company tax base to represent economic profits/rents ȋǲǳȌ in one of a few alternative ways, with either a higher rate or rates for ring-‐fenced mining activities or separate tax or royalty regimes precisely targeting resource rents. Both approaches ǲ
ǳ Ǥ This, together with tax incidence analyses, indicates that both approaches would also be more consistent with intra-‐ and inter-‐
generational concepts of equity. The Henry Tax Review recommended the first approach. Specifically, it proposed:
a cut in the company income tax rate from 30 per cent to 25 per cent
exploration expenditure rebates at the company income tax rate for small Australian listed companies Royalty/Taxation 201 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ
application of an ACC tax at a rate of 40 per cent to mining (including petroleum extraction) projects to replace existing royalty and de facto royalty arrangements, with the possible exception of high volume-‐low value products.
However, the Henry Tax Review suggested moving in the medium-‐ to long-‐term to an economic rent-‐based company taxation regime. Reasons given for deferment of adoption of such a system were related risk and practical issues. An excerpt from the Henry Tax Review on this matter has been provided in Box 29.
The Henry Tax Review appeared to recognise that a cut of 5 percentage points in the tax rate under the existing company income tax system would be only a stop-‐gap measure. If the downward international trend in company tax rates continues as it has over the past 25 years, the new Australian rate could be uncompetitive again in a few years. Box 29 Reasons for Deferment of Economic Profits-‐Based Company Tax Regime "..... a significant concern for the Review is that there has been limited or no practical use of such taxes for this purpose. Replacing the current company income tax system with one of these alternatives would therefore involve considerable risks. For example, the practical implications from a tax administration and compliance perspective are unknown. From an international context there may be opportunities for tax arbitrage if Australia is one of only a few countries using a system. .......... It is possible that other economies will move towards such systems over coming years and it could be in Australia's interest to join this trend at an early stage. An example of a blueprint for the reform of Australia's company income tax system, based on an allowance for corporate equity (tax concept), is presented in Sørensen and Johnson (2010)." Source: Henry, others (2009), p. 165. The Henry Tax Review suggested adjusting upwards the rate of tax on resource rent to offset revenue losses from further reductions in the income tax rate below 25 per cent. It proposed a formula that would maintain the combined rate of tax on resource rent from the two regimes at 55 per cent. For example, if the company income tax rate was reduced from 25 per cent to 20 per cent, the rate of tax on resource rent would rise to 43.75 per cent. The Henry Tax Review did not explain the basis for its proposed cap of 55 per cent on the combined rate of tax on resource rent. This combined rate and the recommended company income tax and ACC tax bases are all smaller than those applying in the case of petroleum at present. However, the Henry Tax Review envisaged a higher proportion of resource rent than 55 per cent would be captured by government, because it also recommended use of cash-‐bidding. The Henry Tax Review's approach of shifting the tax burden from mobile capital to immobile natural resources was sound for economic efficiency reasons. It would reduce discouragement of investment and improve the productivity of labour and natural resources. The approach strategy was also sound for equity reasons because it would reduce the effective, ultimate burden of the tax system on labour income, which currently bears the bulk Royalty/Taxation 202 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ of the burden of Australia's higher effective marginal tax rate on capital than in OECD countries on average, and in small open advanced economies in particular. The nett result of political deliberations in 2010 was a petroleum resource rent tax at a rate of 40 per cent starting in 2012-‐13, a company tax rate of 29 percent starting in 2013-‐14, resulting in a combined rate of tax on resource rent of 57.4 per cent. The rate of tax on "normal" returns to equity capital would be 29 per cent, instead of the rate of 25 per cent recommended by the Henry Tax Review. The combined rate of tax on realised resource rent, and the tax rate on "normal" returns to equity capital would be higher than recommended by the Henry Tax Review, and the underlying tax systems would be less efficient. The petroleum resource rent tax system is less efficient than the ACC tax recommended by Review, as explained above. The company income tax system is less efficient than the revised regime recommended by the Review, because of neglect of the Review's proposal that exploration expenditures by small companies be eligible for rebates at the tax rate. Several options for an improved company taxation regime have been discussed in the relevant economics literature. They fall into three categories: source-‐based, destination-‐based, and residence-‐based systems. The first and last of these capture shares of economic profits/rents. In Australia's circumstances, the source-‐based taxes may be the most appropriate category to consider, because they would capture shares of economic rents derived in Australia. Four source-‐based systems could be considered:

ǲǳȂ often referred to as an R base cash flow system or Brown tax83 an R+F base cash flow system84 -‐ adds non-‐ǲǳ
flows to cover the financial sector, close the loophole of lowering prices in exchange for higher interest on credit to customers, and avoid debt repayment problems on transition to the new system
an allowance for corporate capital (ACC) system85 -‐ allowing company-‐determined depreciation allowances, but disallowing interest, and instead providing an allowance to exempt normal returns to debt and equity capital from tax through carry-‐forward of the written down asset base at an appropriate rate of return on capital
an allowance for corporate equity (ACE) tax system86 -‐ allowing interest deductions and company-‐determined depreciation allowances, but also providing an allowance ǲǳ -‐forward of net equity (the written-‐down asset base less debt) at an appropriate rate of return on equity capital. 83 Devised by Brown (1948) and revived by Meade, others (1978). 84 Proposed by Meade, others (1978). 85 Devised by Boadway and Bruce (1984) and developed by Bond and Devereux (1995, 2003). 86 Formulated by the Institute for Fiscal Studies Capital Taxes Group (1991), which included Devereux and Freeman (1991). Royalty/Taxation 203 ZĞǀŝĞǁŽĨƵƐƚƌĂůŝĂ͛ƐKĨĨƐŚŽƌĞWĞƚƌŽůĞƵŵǆƉůŽƌĂƚŝŽŶWŽůŝĐǇ In the context of guaranteed availability of deductions at some point in time, with guaranteed full compensation for delays in receiving them, the appropriate rate of return allowance under the ACE and ACC systems would be not far above the nominal, medium-‐term government bond rate, typically regarded as a "risk-‐free" rate of return, as discussed in sub-‐section 10.2.6 under the sub-‐heading "Carry-‐Forward Rate Controversy with RRT and ACC Tax". Such an arrangement would be equivalent to immediate write-‐offs and refunds of negative cash flows at the tax rate, ensuring symmetric treatment of gains and losses. This would make the ACE system equivalent to an R+F base cash flow tax and the ACC system equivalent to an R base or Brown cash flow tax. Analysis of these and other options for improvement of company taxation is beyond the scope of this report. However, preliminary analysis indicates that a case could be made for adoption of an R+F base or ACE company tax system. It has often been assumed that replacement of the company income tax system by an ACE or R+F base tax system would mean a higher tax

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