Lifting the Hood on Alberta’s Royalty Review

After some delay and significant trepidation in the energy sector, the Government of Alberta has released the panel report on the structure of a new royalty regime. While panel members, government officials and energy sector analysts understand the intricacies of the changes that have been made, there is need for an analysis that makes the changes understandable to Albertans. This report attempts to do that. At first glance it would seem that the report calls for very little change to Alberta’s royalty structure. The oil sands framework remains virtually unchanged. Existing crude oil and natural gas wells are grandfathered under the current system for 10 years. And the “modernized royalty framework” (MRF) for new wells will initially provide the same industry returns and same government take as the current system would achieve. These similarities, however, fail to reflect important underlying changes that greatly improve the structure of Alberta’s royalty framework. Albertans will be pleased to learn that the new structure better represents the costs and revenues from oil and gas extraction. Why does this matter? Albertans, as owners of the resource, can lay claim to the resource rent: the revenue from the sale of oil and gas less all the costs to develop and produce it. By poorly reflecting costs, the old system led to distorted outcomes. It both discouraged investment in otherwise profitable projects, and overly encouraged bad ones. The new framework better targets the rent while reducing distortions and inefficient behaviour. This leads to greater value for resource owners and industry alike. The most important feature of the MRF is its new drilling and completion cost allowance (DCCA). The DCCA essentially creates a cost formula used for every well in the province. Rather than a plethora of drilling incentive programs, the MRF offers a low royalty rate until cumulative revenues equal the DCCA. In essence, the new framework aligns with what economists view as the most efficient form of resource taxation: a revenue-minus-costs model. Importantly, the formula is based on depth and length – key drivers of costs – not the actual costs themselves. This benchmarking creates an innovation incentive for companies to affect more efficient production. Over time, lower costs mean larger resource rents. This gets returned to Albertans as the DCCA for future wells is adjusted annually based on a cost index of all wells recently drilled in the province. Using a calculated benchmark as opposed to actual costs also eases the administrative burden that would otherwise be required for complex and costly monitoring. For oil sands, transparency is the focus. The rates and structure of royalties remain the same, as the royalty framework already uses the efficient revenue-minus-costs model. To ensure Albertans have the confidence in the process, the panel proposed that all oil sands projects annually publish information on bitumen production, revenues, operating and capital costs, and royalties paid. The report also includes a recommendation for streamlining cost-dispute resolutions. By focusing on the structure, as opposed to the split, the panel’s report takes seriously the economic theory of efficient resource taxation. The panel’s recommendations are focused on increasing the size of the pie, not haggling over how a small pie gets divided.

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