End This Coal Subsidy Now (Part 2): One Loophole Closes and Another One Opens

Under New Rules Proposed by the Office of Natural Resources Revenue, Coal Producers Might Pay Zero in Royalties

U.S. taxpayers own most of the coal in the Powder River Basin, which yielded about 43 percent (400 million tons) of all coal produced last year in the U.S.  The federal government leases the coal to companies like Peabody Energy and Arch Coal, who mine it.

Under the terms of the leasing deals, the private companies are allowed to mine the coal, set the price and sell it anywhere and to anyone they please. The only thing the Office of Natural Resources Revenue (ONRR) requires is that the producer pay a per-ton royalty of 12.5 percent on revenues received on domestic sales.

A different—and outdated—set of rules applies to federally owned coal that is mined and shipped ultimately to Japan, Korea, Taiwan, China and so on, markets that generally provide a higher return. This loophole shortchanges the U.S. government—and U.S. taxpayer.

If the price of Powder River Basin (PRB) coal is $11 per ton in the U.S., which is about what it is now, but a ton of coal fetches $60 on the international market, which is about what it is getting now, only that $11-per-ton coal is subject to the 12.5 percent royalty (minus transport and coal-preparation deductions). The roughly $50-per-ton difference is exempted from royalty rules governing the treatment of income and expenses related to exports.

The coal industry likes this arrangement. During the run-up of prices in 2008-2011, when the price of coal peaked at $140 per ton in 2011, the industry worked hard to expand the advantage it gained from the exemption. It proposed various initiatives to increase the level of federally owned coal being exported from 8 million to 12 million tons per year to as much as 200 million tons per year, according to one estimate.

That’s when the federal government realized it had not audited its coal-lease program in 30 years. Upon review it decided, wisely, that the royalty rules needed to be tightened up so that U.S. taxpayers would share in the benefits of coal exports.

ONRR is proposing changes to fix the core flaw in the current rules.

The solution put forth by THE AGENCY would no longer recognize the validity of the business model used by the coal companies to separate the domestic price from the international price.

The new rules would base the royalty revenue from federally owned coal on the price paid when it reaches a U.S. port and is loaded onto a ship. The revenue derived from this “free on board” coal is then subject to certain reasonable transportation deductions approved by ONRR. The remainder of the revenue is what the 12.5 percent royalty applies to.

However, this royalty scheme wouldn’t quite work like it’s supposed to when prices are low, because it would yield little or nothing. The chart here illustrates this point, showing how royalty payments would compare in low-price and medium-price environments under the new rules. We ran the numbers based on our interpretation of the regulations; more discussion and clarification from ONRR will likely illuminate just how the agency expects the royalty changes to work in various market scenarios.

After prices collapsed in 2011, global thermal coal is trading at about $60 per ton. Under current market conditions, and under the new rules, the companies—because they are taking losses—would pay zero in royalties (some U.S. coal companies are selling federal coal overseas at a loss just to maintain existing contracts and business relations).

Price and Deductions Low Price Market $ Per Ton Medium Price Market $ Per Ton
PRB Coal Price (using proxy of price of Indonesian Sub-bituminous to South Korea) $60.00 $90.00
Ocean Freight U.S. Port to South Korea (17.00) (17.00)
Free On Board – In vessel 43.00 73.00
Inland Transport – U.S. Rail (mine to port) (35.00) (35.00)
Port Fees (8.00) (8.00)
PRB – Domestic Price (11.00) (11.00)
Royalty Margin (11.00) 19.00

 

Under the current and unreformed rules, coal producers pay the royalty on the domestic price of coal, about $11 per ton, which translates to $1.37 per ton in royalties. Under the new rules, a producer would pay zero in a low-price environment like today’s because PRB coal, which is fetching $60 per ton internationally, is selling for a loss.

As the chart indicates, in a medium-price environment the royalty basis would be on a gain of $19 from a PRB coal price of $90. A higher-price environment would mean higher royalties. ONRR has closed the royalty loophole in one way, but perhaps opened another one.

SO WHEN COAL PRICES ARE LOW, THE NEW RULES WILL FALL SHORT OF THEIR INTENT, and the effect could be long lasting. Our research indicates that low prices of international seaborne coal are likely to persist for the better part of the next decade. Some PRB coal will be exported even in the face of adverse financial conditions. The question, then, is does the U.S. government—and do U.S. taxpayers—want to forego any revenue at all during this down period?

The answer of course is no—public property should never be sold at an unnecessary loss to its owners—and the fix seems straightforward. Under no circumstances should the new rules result in a lower per ton revenue collection than occurs under current rules. On all export sales, royalty revenues should be calculated on the basis of the new rules, either the “free on board” price minus reasonable deductions or the domestic price of coal, whichever produces greater revenue for the federal government.

And let’s not forget the states’ share of royalty revenues.

Wyoming-based Cloud Peak Energy, a prime beneficiary of the existing regulatory system, objects to the proposed reforms, even though the global thermal coal market is in such bad shape that Cloud Peak’s new royalty payments would de minimis to the company.

What taxpayers in Montana and Wyoming would gain from the new rules would be significant, however. With as much as 12 million tons of coal coming out of the Powder River Basin, the states of Montana and Wyoming could collect perhaps $12 million per year over the next decade. How many school teachers’ salaries would that pay?

No coal producer should be allowed to operate on a business model that shortchanges taxpayers. Any such arrangement is a shameless subsidy.

Tom Sanzillo is IEEFA’s director of finance.

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