The role of royalties in resource extraction contracts

The manner in which governments charge mineral resource producers has been the subject of considerable debate. In particular, there is a continuing debate about whether royalties should be reduced or eliminated, the preferred alternative then being some variant of an income-based charge such as a resource rent tax, a policy adopted in Norway, the United Kingdom and Australia. The argument for avoiding royalties is based on analyses demonstrating that royalties and other quantity-based charges distort production decisions and lead to outcomes such as high-grading and premature mine closure. We argue that it is inappropriate to infer that royalties are inefficient from the perspective of the resource owner (typically a government on behalf of society). Rather, the royalty serves a key pricing purpose and should be interpreted as the capital loss on the resource owner's balance sheet from extracting marginal reserves. We demonstrate this result under various conditions of uncertainty and informational asymmetry, using an incentive-based framework which enables us to highlight the separation of asset ownership from asset use. The principal-agent framework is consistent with the contracting problem encountered by governments who as resource owners contract with private sector firms for extraction rights