Revenue Framework: How Royalties and Fees Are Set and Collected
Oil and gas reserves are publicly owned resources and governments are entitled to collect royalties or fees for their exploration and extraction. The challenge governments face is to design a revenue framework (a specific mix of revenue sources and their associated rules) that maximizes the benefits for society while still fostering continuing private capital investments, which are necessary to realize economic benefits over the long term. In some instances, governments may decide to set royalty rates below those in other jurisdictions in order to attract investments and boost economic diversification outside of urban centres. In the end, royalty rates and fees depend on a government’s specific socio-economic objectives.
In designing revenue frameworks for oil and gas extraction, governments must establish their fiscal objectives (such as revenue stability, revenue maximization, economic efficiency, and administrative efficiency) and make a number of key decisions about which revenues sources to adopt and how each one will operate. Different revenue frameworks will accomplish different goals and will fit different circumstances. For example, a strictly volume-based royalty regime will provide predictable revenues from the start of production at a new site, but will not allow a government to benefit fully from large price increases in energy markets. On the contrary, a profit-based royalty regime can allow governments to benefit from sharp price increases, but will not generate revenue until a company declares profits and will provide less revenue when resource prices are very low. Governments must carefully consider which regime (the volume-based and profit-based regimes are only two possibilities) will be more likely to achieve their fiscal objectives.
Governments must also ensure that their royalty regime and other fees are reviewed and updated from time to time, to ensure that the rates they charge for resource extraction are still:
- competitive compared with other jurisdictions;
- aligned with fiscal objectives;
- reasonable, considering factors that may affect profitability, including evolving extraction technologies and environmental requirements; and
- adapted to prevailing circumstances in the energy sector.
In addition, legislation and regulations need to be in place to provide a legal framework that allocates clear roles and responsibilities to government and private sector organizations. Controls and administrative capacity also need to be established to ensure the accuracy and completeness of royalty assessments and to manage the collection of royalties and other revenues. Government departments responsible for natural resources management are often responsible for collecting royalties from oil and gas extraction, although in some instances this responsibility is shared with a revenue agency.
The collection process often requires oil and gas companies to make monthly or quarterly payments to a government based on estimated production, sales, or profits. An annual royalty return is then filed at the end of each year. After processing and review, a final payment is made if there is a balance owing or a reimbursement is issued if too much has been paid by a company. While royalties are usually paid in cash, they can also be paid in kind. For example, an oil company gives barrels of oil to a government, which then sells this oil itself or uses it to fuel its own operations.
While this collection process may seem simple at first glance, it can be quite complex in practice.
- Royalty payments are required from the owners of each production site. In practice, a site can have many owners, each with a different share of the project. Royalties must then be paid in proportion to the ownership share.
- Royalties are often calculated after allowable expenses have been deducted. The rules about what is and what is not an allowable expense can be quite elaborate and, in many jurisdictions, expenses for one project can be used to lower royalties owed on another project.
- Royalties owed are assessed on the basis of information provided by private companies. To ascertain that they are receiving the correct amounts, governments must verify this information and conduct audits of production and expense data.
Finally, governments are responsible for ensuring that all oil and gas companies submit their royalty payments on time and for collecting penalties and interest as prescribed by regulations.
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