coal subsidies

For many decades, natural resource industries would work their land, sell their minerals, and abandon their sites for somebody else to deal with.  There are tens of thousands of such sites around the US, associated with both energy and non-energy minerals; here's a sampling, compiled by the enormously important NGO, Earthworks.  But the costs of these sites can run into the billions, and neither public taxpayers, nor government entities "hosting" the mess, were particularly happy to inherit the problem.

Polluter Pays Principle needs to apply to closure and post-closure liabilities

The policy response has generally followed a two-pronged approach, at least in the US.  Financial assurance regulations were added into many environmental statutes to provide financial coverage for closure and post-closure care and reclamation to existing and new mine sites.  Trust funds, often funded via excise taxes on the mine type or mineral associated with the legacy sites being addressed, were implemented to reclaim old sites with no solvent owner. 

This response has been much better than doing nothing.  But many countries still lack either the regulatory framework or the enforcement capability to shift responsibility for post-closure care onto the firms benefiting from the minerals.  And even in countries with an appropriate regulatory framework (such as the US), the policy approach often breaks down in two main ways:

• Assurance requirements too low.  For existing operations, governments are under continual political pressure to ensure compliance with the financial assurance requirements are not "too burdensome."  As a result, coverage levels, particularly bonding for reclaiming damaged sites in the case of a corporate bankruptcy, have been routinely too low.  Site cleanups often still require public subsidy.  Similarly, the least expensive forms of financial assurance (self-bonding based on balance sheet strength or third party "term" insurance that must renew each year) evaporate just when they are most needed -- when a firm (or an entire industry) runs into financial distress yet still faces the full cost to clean up a mine site. 
• Trust fund collections inadequate to address site backlog.  For legacy sites, excise fees tend to be too low, or insufficiently managed, to fully address the backlog of sites in a reasonable period of time.  As a result, environmentally-compromised sites can persist for decades and public money may sometimes be used as well.

These are not new problems, nor are they a surprise.  Where the financial costs associated with properly closing, managing, and reclaiming single assets are consistently very high, regulatory policy has sometimes required more expensive, but much more secure, forms of financial assurance. 

Decommissioning nuclear power plants, for example, must be funded on an annual basis, evaluated actuarially by independent third parties, and accrued in a legally segregated trust fund that cannot be touched even if the reactor owner goes into bankruptcy.  Trust funds may still be somewhat subsidized and underfunded (see discussion in Section 7.1 here), but the system works much more effectively that what exists in many other countries, the UK included; or in other resource areas with weaker assurance mechanisms.

So the recent upsurge in concern over the strength of "self-bonding" coverage by the major coal producers in the US did not come out of the blue.  Major coal producers, such as Peabody, have looked to "guarantee" their ability to fund their own site cleanups as cheaply as possible.  During the massive run-up in commodities a few years back, Peabody and other similar firms could have used their outsize profits to ensure adequate funding of their cleanup liabilities -- much as a non-energy corporation might use profits from a big new product to stabilize its underfunded worker pension funds.  But that would have taken real cash, and it was cheaper to self-bond their liabilities, kicking the can down the road.

But self-bonding has allowed the most financially fit coal companies to leave a share of their total liabilities uncovered.

Four of the nation's largest coal producers - Peabody Energy Corp, Arch Coal Inc, Cloud Peak Energy Inc and Alpha Natural Resources Inc - are all making use of the self-bond program.

All of those companies have seen their share price plummet in recent years as the industry has been battered by an abundance of natural gas, environmental regulations and a weak export market.

You can't buy life insurance once you are diagnosed with cancer

Now coal futures and coal prices don't look good at all.  And states such as Wyoming, as well as the federal government, are looking to force Peabody to buy third-party policies because they will be at least a bit more secure than corporate promises (which is what self-bonding really is) to pay for cleanup by a company considered highly speculative in the markets.

Regulators may be caught in a dilemma since enforcing self-bonding rules could just add another costly burden to a struggling industry.

"If the regulator demands more financial assurances in whatever form, it might just push a coal company past the brink," said William T. Gorton, a mining lawyer with Stites & Harbison in Lexington, Kentucky.

A problem, to be sure; but not a surprise one.

Interesting that both this article in Bloomberg, and this one in Reuters, describe self bonding as a lower cost way to insure for reclamation in the case of a bankruptcy.  This is incorrect:  self-bonding is limited to firms that are financially strong for the very reason that the bankruptcy risk is very low and there is a general belief by regulators that the firm's operations will be able to pay for cleanup and not dump liabilities onto taxpayers via bankruptcy.  Bankruptcy would render this self-bonding largely worthless.

Peabody coal failed the tests for eligibility to self-bond, but is relying instead on Peabody Investments Corporation, a subsidiary set up for this purpose.  The subsidiary is not publicly traded, and data on its financial condition are sorely lacking.  According to Reuters, financial data has not been released despite their efforts at the state level under freedom of information act requests. 

Inadequate provision for asset decommissioning is not just an issue in the coal and nuclear industries.  There are thousands of abandoned oil and gas wells nationwide, and a combination of taxpayer and excise collections fund abandoned well identification and plugging programs.  Most US states have a specific agency tasked with managing the lifecycle of wells within the state.  Less visible are decommissioning needs and funding for hydroelectric and wind installations, where important gaps remain as well.

Regular payments to an external fund would largely avoid these problems

Common rules should apply to all of these types of assets -- with regular and actuarially-sound funding of closure and post-closure care over the productive operating life of the asset.  Funds should be paid into an external fund independent of the corporation, to ensure there is actually money available when needed even if the firm is gone.  Third-party insurance should be required to cover decommissioning risks outside of the "norm" -- such as higher than anticipated costs to remove an asset or clean a site; or premature closure before adequate accruals have been collected.  And this information should be succintly summarized in a one or two page standardized form that the asset owner files each year so that funding shortfalls are visible to both investors and the public.

Harvard economics Professor David Glaeser has an interesting editorial on the role of mining in Australia, published yesterday by Bloomberg.  The basic thrust of his argument is that capital-intensive coal and iron ore industries dominate Australian exports, but harm long-term competitiveness.  He mentions two main causes.  The first is the role of natural-resource-led exports bidding up the value of Australian dollars (sometimes referred to as the "Dutch Disease"), making it more difficult for other sectors to be competitive.  This dynamic is important, but is not particularly novel:  it has been documented in many countries around the world.  More interesting is his conclusion that the capital-intensive, mining-led, exports also crowd out small scale entrepreneurial ventures.  The mining firms themselves are huge, and tend to buy and sell with other massive mulitnationals. The lack of smaller firms diminishes the vibrancy and flexibility of regional job creation and entrepreneurial risk-taking.  (Link to his review here).

Coal Mining Creates Few Jobs, Stifles Entrenpreneurship

The conclusion is based not just on Australia, but on a historical review Glaeser has done with co-authors William Kerr and Sari Pekkala Kerr on mining regions in the US.  They conclude that:

...greater historical mining deposits are strongly correlated with reduced entrepreneurship in the middle of the 20th century. The link between entrepreneurship and local employment growth persists when instrumenting initial entrepreneurship with historical mines. These effects are evident in industrial clusters that are not directly related to mining, such as trade, fi…nance and services. They are also present in cities with warm climates, suggesting that these results do not simply re‡flect the Rust Belt’'s decline.

Glaeser further notes that

In Australia, iron ore and coal are mined by giant corporations such as Rio Tinto Plc and BHP Billiton Ltd., and giant enterprises typically work best with other big companies. Across U.S. metropolitan areas, we found that historical mining cities had fewer small companies and fewer startups, even today in sectors unrelated to mining or manufacturing, and even in the Sunbelt. These mining cities were also experiencing less new economic activity.

What about Coal Subsidies?

Glaeser touches only tangentially on the issue of subsidies, noting that "the share of miners’ 'resource profits' returned to the Australian government in the form of taxes and royalties fell from about 40 percent in 2001 to less than 20 percent seven years later."

However, there is much more that can, and should, be said about this issue. In our review of G20 actions to meet their commitment to phase out fossil fuel subsidies, (see Phasing Out Fossil-Fuel Subsidies in the G20: A Progress Update, June 2012)  Australia's response was simple:

1. “Australia does not have measures related to the production of fossil fuels that fall within the scope of the G20 commitments.”

No subsidies, no need to report to the G20.  Which they didn't. 

But surely there is more.  Political economy suggests that large and powerful firms with concentrated financial interests in a particular set of policies will be far more successful in shaping their policy environment than will emerging or fragmented industries.  Thus, although the mining and mining services sector contribute only about 10% to Australian GDP and employ about 2% of the Australian workforce, one would expect the sector to be politically powerful well beyond those numbers.  Further, the expectation is that at least part of that power would be used to extract favorable financial concessions from the government. 

This does seem to be the case.  The Australian government has narrowly interpreted the reporting requirements under the G20 commitment in order to better meet its objectives of not having to report at all.  Non-reporting is the most favorable outcome for subsidy recipients, as they continue to benefit from the financial support, but the absence of public data on how much they are getting greatly reduces their risk of a political backlash.

Consider these two further statements on subsidy reporting in updates to the G20 -- in both cases I've added the emphasis:

Government position:  “Australian Government budgetary support for fossil fuel production is limited to measures that are intended to support production of clean energy.” 

Implications: Policies that have the effect, but not the intent, of subsidizing fossil fuels don't count.  The framing also excludes any level of subsidies that make fossil fuels burn more cleanly -- even if those subsidies are what allow the fossil fuels to continue competing in the marketplace with emerging renewable resources.  In the same way that wind power pays an economic price for intermittency, one would want coal to pay a price for the development and implementation cost of lower-carbon power production or for carbon capture and sequestration.  Such pricing transparency is critical for the market to more accurately weigh complex trade-offs between energy options with differing strengths and weaknesses.

Goverment position:  “Australia does not have any sector-specific tax expenditures for fossil fuel production (although fossil fuel producers are able to access general measures that apply across the economy or across the mining and quarrying sectors as a whole).” 

Implications:  With this sleight of hand, the Australian government has excluded reporting on subsidies to extractive industries entirely.  Favorable provisions to expense (i.e., immediately write-off investments from taxable income), for example, have long been available.

A successful Freedom of Information Act request by Greenpeace resulted in exposure of some of the political considerations behind Australia's reporting strategy to the G20.  Many, though not all, of the released documents are now accessible online.  Unfortunately, even the subset of documents that are online have been substantially redacted prior to posting.  Further, the releases did not contain any correspondence between industry and the government, which is surprising:  such correspondence with industry is often part of FOI releases in the US and would be expected to exist in Australia as well. 

The core point here is that subsidies exacerbate the problems of concentrated mining investment that Glaeser et al. document.  Too few jobs, increased and risky rigidity in the economic structure of regional economies, suppression of entrepreneurial activity -- all of these get worse when subsidies elevate mining activities and industrial concentration above the level that market economics alone would justify.  And interestingly, these subsidies likely apply not only to Australian coal producers, but to coal transport and consumption in some of the country's large export markets as well. 

The subsidy picture from non-governmental sources is quite different from the official Australian position of "nothing to report."  Some examples:

• One report pegged coal and coal-seam gas subsidies in Queensland alone at A$6.9 billion over the past 5 years, with another A$13 billion in forecasted spending.  Another put national fossil fuel subsidies at A$12 billion per year, though includes a variety of subsidies to driving as well those directly to fuels.  Still, that study found nearly A$150 million in additional funding went to support clean coal research each year.
• China is the largest outlet markets for for Australian coal.  A scoping review we did two years ago on Chinese subsidies to fossil fuels indicated significant government support to coal transport and usage in the power sector.
• Although Australia introduced a new tax on coal profits this month, the change came with a bunch of benefits to the industry as well that make the net effect quite difficult to assess.  Consider just these three:
  
  • New investments will be given an immediate write-off, rather than depreciation over a number of years. According to the goverment, "this allows mining projects to access deductions immediately, and means a project will not pay any MRRT [Minerals Resource Rent Tax] until it has made enough profit to pay off its upfront investment."  Perhaps.  But massively capital-intensive mining operations can deduct all of their investments immediately, a clear and lasting subsidy that may distort capital investments across sectors and likely reduces the relative benefits of less-capital intensive strategies on the demand-side of the energy marketplace.
  • The MRRT will carry forward unutilised losses at the government long term bond rate plus 7 per cent.  There are two interesting elements of this concession.  First, the immediate deduction now allowed for all capital is likely to trigger much larger tax losses than in the past -- losses that can now be carried forward with interest.  Second, in a financial environment when money market funds earn less than 1/4% in interest, the risk-free financial return on loss carryforwards of 7% could be among the top performers in the firm's investment portfolio.
  • The MRRT will provide transferability of deductions. The government notes that "this supports mine  development because it means a taxpayer can use the deductions that flow from investments in the construction phase of a project to offset the MRRT liability from another of its projects that is in the production phase."  Look for declining tax revenues across the board.  I'd need to read more of the fine print of these rules to gauge whether the transferability is limited to other projects of the same firm, or extends to other firms as well (the US sometimes allows firms to sell unused tax credits).  If the latter, even bigger distortions may arise.

Houston-based DKRW Advanced Fuels has a dream:  they want to turn a chunk of Wyoming's vast coal reserves into 10,600 barrels of gasoline per day.  They want to capture most of the carbon emitted in the process and sell it to the state's oil and gas industry, which will use the CO2 to inject into wells, increasing oil and gas production.  In one fell swoop, the firm hopes to boost production of all of the state's major fossil fuels.  The facility would be located near Medicine Bow, a town that presently has about 300 people.

Dreaming with somebody else's money

Oh, and part of the dream that they don't broadcast quite so loudly is that they want to do it mostly with our money.  The firm has an application in with DOE for a $1.7 billion loan guarantee, which passed DOE preliminary review in 2009.  And they've recently gotten approval from the Carbon County Commission to issue $245 million in tax exempt bonds.  This debt is guaranteed by the project not by the County, but subsidized by taxpayers because the interest is free from taxation.  It will also use up most of the state's annual alotment to issue tax exempt, non-municipal bonds. 

There's more at the subsidy salad-bar:  the Commission also unanimously endorsed issuing $300 million in industrial development bonds, which DKRW has asked the state's Permanent Mineral Trust Fund to purchase.  From time-to-time, the Trust Fund does invest in Wyoming-based enterprises, and DKRW has indicated that they think their plant should be one of them.

The venture is also being supported by $10 million in state funding to support pre-construction studies both for the DKRW facility, and another project under consideration within WY that would convert natural gas into vehicle fuels. 

Bob Kelly, executive chairman of DRKW, is happy so far with the state's involvement.  As noted in a recent story in the Casper Star-Tribune, Kelly

said the bonds are "very helpful" in assembling the $1.7 billion to $2 billion needed to finance the plant's construction.  Kelly said the company is seeking bank financing to cover the rest of the plant's cost [emphasis added].

Where's the equity?

Billions at risk, leveraged from other people.  This should always be a flag that extreme due diligence is needed.  The fact that the entire top management team at DKRW Advanced fuels (Robert Kelly, Jon Doyle, William Gathman, Jude Rolfe, Robert Moss, and Wade Cline) are out of Enron does nothing to ameliorate the concern. 

Kelly's statement also begs the question "where's the equity"?  DOE's guarantees require a minimum of 20% equity investment.  It's not from DOE.  It's not in the tax-exempt bonds, and it's not in the "bank financing to cover the rest of the plant's cost."  That, perhaps, leaves the $300m that DKRW is trying to get the state of Wyoming to plow in.  That funding seems to be structured like debt, because there is no mention of the state getting a stake in the company for the money.  It is clearly like risk capital in terms of the investment it is supporting, however.  Nonetheless, the limited equity requirement under the DOE program was focused on aligning the incentives of managers with the venture's success by requiring them to have "skin in the game." Government money wouldn't seem to cut it.

To it's credit, Wyoming is approaching the investment with some caution.  The Treasurer's Office has requested input on deal soundness from the Wyoming Business Council, which in turn has asked for a technical review from Idaho National Laboratory.  Mike Martin, at the Business Council, did not think the INL review went beyond technical issues to include as well a review of the financial suitability of the project for the state's Mineral Trust Fund. He was also not clear whether the INL review would examine systemic risk factors, such as what would happen to plant economics should a price or cap on carbon emissions be instituted.  INL's review should look at both of these items, as federal and Wyoming taxpayers will have lots at risk if this plant moves forward with so much public subsidy.

A second check to the spending comes from the legislature.  An investment of $300m would require Legislative approval, making it more difficult to put state funds at risk foolishly.  However, investments up to $100 million would not, and State Senator Phil Nicholas, chairman of the Senate Appropriations Committee, has said the leadership would be comfortable with buying $50 to $100 million of the bonds.  As evident from the table below, even at these lower levels, the funding would materially alter the Trust Fund's asset allocations and DKRW would comprise one of its largest, non-diversified investments.

DKRW investment conflicts with the purpose of the Permanent Mineral Trust Fund

To look at the issue of financial suitability, I pulled existing data on the state's Permanent Mineral Trust Fund (summarized in the table below).  The purpose of this fund, and many others like it around the world, is simple:  mandate a portion of mineral revenues to go into an investment fund for the benefit of future residents of the resource-producing region -- be it a county, a state, or an entire country.  This solves two problems at once.  First, the mandate removes from political control at least part of the massive cash flow that comes from resource booms.  Without such a mandate, the potential benefits of resource booms were often lost as politicians squandered the surge in funds on foolish projects, empire building, or corruption.  Second, the Trust Fund approach requires an independent fund manager to invest in a widely diversified set of assets.  The income and growth of these other assets reduce the correlation between energy or mineral prices and the available revenues to the state, helping to dampen the boom-bust resource cycles as well. 

Based on the criteria for which the Mineral Trust Fund was established, investing in DKRW should be immediately rejected, even at funding levels well below the requested $300m.  Regardless of whether INL decides the plant is technically sound, the investment further concentrates Wyoming's financial exposure to energy prices rather than diversifying away from them, and therefore works counter to the intent of the Mineral Trust Fund. 

Further, as shown below, the scale of investment is far more concentrated that what currently exists in the Fund's portfolio.  At first blush, a $300m investment in the plant may not seem like a big deal, comprising well less than 10% of more than $5 billion in total holdings of the Trust Fund.  Yet, for any of the conceivable asset classes in which the investment could fit, exposure to DKRW would dominate the class, comprising at least than 2/3 of the resultant asset class sizing (current size plus DKRW holding) in every case.  This metric actually understates the risk since the existing portfolio has many small investments, rather than large lumpy ones like the proposed holding in DKRW.

I looked at four potential asset categories in which DKRW could possibly fit.  Because the investment would be debt with no equity interest, I considered corporate bonds.  However, the risk of this venture is far higher than what a normal corporate bond portfolio would entail; and if I were the Treasurer, I would require equity interests as well.  If we assume the state were to get an equity interest as well, conceivably small- to mid-sized (SMID) US equity would be an asset-class fit.  But again, the risk is higher than what a SMID portfolio would normally entail due to the high technology risks of the plant, and the investment would have some elements of debt rather than being pure equity.  Private equity is probably the best match in terms of risk level -- though one that would require much higher returns to the state than what is likely being considered at present. 

The final category considered was intra-Wyoming investments.  Like the other possible categories, DKRW would come to dominate the WY holdings at a $300m sizing.  Not only would be the size of the investment be larger than what currently exists within the intra-WY holdings, but many of the existing investments benefit multiple firms or people, not a single project.  Many of these projects also have a clear public interest component (beyond simple job creation), something that DKRW investment does not.

For additional reading on the planned DKRW coal-to-gasoline plant in Medicine Bow, Wyoming Public Radio just did an interesting series of reports.  Taxpayers for Common Sense also has a good backgrounder.  Update, 2/16:  An interesting op-ed in the Casper Tribune by Jason Lillegraven goes into some detail on problems with the environmental assessments done on the project to date, particularly with regards to water consumption.  For so many of these facilities, water is the achilles heel.  Too often, the facilities pay little or nothing for the amount of water they use.  Just as running a sensitivity on project returns assuming CO2 emissions won't always be free, it would be prudent to do the same with water.