Measuring Sustainability: Is there enough and efficient rent capture in the Peruvian mining industry?

Transcription

1 Measuring Sustainability: Is there enough and efficient rent capture in the Peruvian mining industry? Graduate Program Requirement Student Name Student ID Supervisor Faculty Institution Master of Science in Public Policy and Human Development Master Thesis Daniel Alberto Anavitarte Santillana i Dr. Chiung Ting Chang, Ph.D. Maastricht Graduate School of Governance Maastricht University Date August 15,

2 Abstract The objective of the research is to evaluate if the conditions for a weakly sustainable mining industry in Peru are met. This will be done by determining the level of resource rent captured by the government from the Peruvian mining industry and by evaluating the public investments financed from these rents in order to achieve the required capital substitution to keep the total stock of capital constant. To address the main objective of the research, the study will first determine the value of the mineral rents and the depleted natural capital through 2004 to The methodology chosen is the one proposed by the World Bank that takes the Hotelling rent as its foundation but uses average costs instead of marginal costs for data availability reasons. After this, data on fiscal income by mining taxes and dedicated funds for each year will be also obtained and followed until their final use whether it is for capital investments or not. Finally, a comparison can be made between the depleted natural capital value and the new manmade or human capital investments value. The research will show that the national and sub-national levels of government are not capable to build the necessary conditions for a weakly sustainable mining industry. The main reasons are that, while the country s national capital is being depleted, the government is deficient at the time to execute the required investments into man-made and human capital and incorrectly employs mineral rents into consumption expenditures that do not account for capital accumulation. Moreover, the conducted study will give evidence about the insufficient level of rent capture by the government and society. Although there is no rule for the exact proportion of resource rent that should be collected and then reinvested, the rate of capital substitution found in the analysis shows that the available funds are not enough to assure intergenerational equity and therefore, sustainability. 2

3 Table of Contents I. Introduction Problem statement Relevance and motivation Methodology II. Peruvian mining industry A brief historical review Production Mining exports III. Economics of exhaustible resources Non-renewable resources Resource rent and Hotelling rule Natural resources valuation An economic model IV. Sustainable Development Three-pillar approach Ecological approach Capital approach Intergenerational equity Hartwick s rule Weak vs. strong sustainability Genuine savings V. Previous studies VI. Analysis Internal taxes Dedicated funds: Canon Minero, Rights of Force and Mining Royalties Private investments Results VII. Conclusions VIII. References

4 List of Figures Figure 1: Canon Minero distribution Figure 2: Canon Minero distribution List of Graphs Graph 1: Annual growth rate for international prices of selected minerals ( ) Graph 2: Annual growth rate for Peruvian mineral production ( ) Graph 3: Peru s mining and total exports ( ) Graph 4: Structure of mining export for 2009 (%) Graph 5: Average Genuine Savings measures for the years Graph 6: Fiscal income contribution by economic activity Graph 7: Contribution of the mining activities to Peru s total fiscal income Graph 8: Funds collected by Canon Minero ( ) Graph 9: Funds collected by the Rights of Force ( ) Graph 10: Funds collected by the Mining Royalties ( ) Graph 11: Mining companies private voluntary investments Graph 12: Rent capture, Graph 13: Execution of the dedicated funds into actual investments List of Tables Table 1: Peru s main economic indicators ( ) Table 2: Peru s World and Latin American mineral production ranking Table 3: Genuine Saving measures (% of GNI) Table 4: Resource depreciation, capital loss and rent capture in the Peruvian mining industry, (US$ million of 2006) Table 5: Mining rent capture (in current US$ million) Table 6: Capital substitution obtained from actual investments financed by the dedicated funds and private voluntary contributions (in current million US$) Table 7: Capital substitution rates comparison ( ) Table 8: Peruvian s central government Sustainable Budget Indicator ( )

5 Abbreviations and Acronyms BCRP GDP GNI GS MEF MINEM NNP NPV SBI SEEA SNIP SUNAT UN UNEP VAT WB WDI Central Reserve Bank of Peru Gross Domestic Product Gross National Income Genuine Savings Peruvian Ministry of Economics and Finance Peruvian Ministry of Energy and Mines Net National Product Net Present Value Sustainable Budget Indicator Integrated Environmental and Economic Accounting Handbook Peruvian National Investment System National Superintendence for Tax Administration United Nations United Nations Environment Program Value Added Tax World Bank World Bank Development Indicators 5

6 I. Introduction Peru has been one of the countries with the best economic growth rates during the first decade of the new century. It reached growth rates of 8.8% for 2010, a result quite impressive considering how the financial crisis affected the world economy in the two previous years (BCRP, 2010). One of the main drivers behind this economic boost in Peru has been the metallic mining sector. According to the Peruvian Central Bank, the metallic mining activity accounted for more than 60% of the Peruvian total exports in 2009 and was the third most important taxpayer industry to the National Treasury. It is also one of the most attractive and profitable industries for foreign investment because of the Peruvian policies promoting the settlement of international mining companies. There has been an increase of more than 400% of foreign mining investments to Peru since 2004 reaching US$ 4,000 million in 2010 (MINEM, 2010). Additionally, Peru is currently the third world best destiny for mining exploration investments and the first one in Latin America. As a result, Peru is considered a mineral economy as defined by Auty (1993) by having a contribution of the mining industry to GDP greater than 5 per cent accruing more than 60% to export earnings. Natural resources can be considered a source of financing development. While produced assets yield profits that can be consumed or invested, natural resources yield profits over and above this level in the form or resource rents. However, the economic growth led by the natural resources industries has another side of the story that could be not as positive as the first one. The depletion of resources that takes place during the mining activities reduces the country s wealth as it diminishes its natural capital and consequently could undermine the Sustainable Development of the country as a whole. Furthermore, the resource curse concept suggest that resource-rich countries don t benefit from a favourable endowment of natural resources and perform worse than less well-endowed countries. (Auty & Mikesell, 1998) The underperformance of mineral economies is usually due to the mining production function, domestic linkages and deployment of mineral rents. As Auty (1993, p.7) describes: 6

7 ... Mineral production is strongly capital intensive and employs a very small fraction of the total national workforce with large inputs of capitals from foreign sources [...] It [the mining sector] yields modest local production linkages (i.e. few local factories are established to supply inputs or to further process the mineral prior to export). It also displays low revenue retention since a large fraction of export earning flow overseas to service the foreign capital investment [...] consequently, fiscal linkage (i.e. taxes) may dominate the mining sector s contribution. It is precisely this fiscal linkage that will be analyzed in the present research. In this way, the study will evaluate the capture of the mineral rents by the Peruvian government through taxes and other instruments, and more important, the public investments financed by these rents. This exercise is based on the famous Hartwick rule that states that by investing all the rents from exhaustible resources in reproducible capital, consumption per capital will remain constant over time, given constant population, therefore assuring intergenerational equity. The concepts of intergenerational equity and Hartwick s rule are the stepping stone for the measurement of the concept behind weak sustainability. First introduced by Pearce & Atkinson (1993) and influenced by the work of neoclassical economists Robert Solow (1974, 1986, 1993) and John Hartwick (1977, 1978, 1990), it proposes that for an economy to be sustainable it should maintain its total stock of capital over time, allowing capital substitution to achieve the goal. Only by keeping the total stock of capital constant over time, intergenerational equity will be assured. In other words, to analyze if an economy is weakly sustainable we need to know if the investments in man-made and human capital are big enough to compensate for the natural capital depletion. For the man-made and human capital to compensate the depletion of the mineral resources, a strong assumption of substitutability for the natural capital is employed. As Solow (1974, p. 41) stated, Earlier generations are entitled to draw down the pool so long as they add to the stock of reproducible capital. It is precisely with this assumption of capital substitution that the current research is shaped. As a result, it is the objective of this study to evaluate if the conditions for a weakly sustainable mining industry in Peru are met. This will be done by determining the level of resource rent captured by the government from the Peruvian mining industry and by evaluating the public 7

8 investments financed from these rents in order to achieve the required capital substitution to keep the total stock of capital constant Problem statement According to Lange (2001), fostering national wealth from natural capital involves transforming one form of wealth, natural capital, into others. There are three steps in the transformation of natural capital into other forms of wealth: 1. Natural resources must be managed to maximize the generation of resource rent. 2. Resource rent must be recovered by an agent capable of reinvesting it. 3. Resource rent must be used for productive investments that are capable of generating income and employment once resources are exhausted. Regarding these three steps, it is precisely the second one that will be of interest for this study. The research takes for granted that condition number one, i.e. natural resources must be managed to maximize rent, is fulfilled. This mainly because it is already the common practice in mineral production as it is capital intensive and managed by large scale commercial operations (Lange, Hassan & Hamilton, 2003). Proposition number three is not evaluated in this research as it depends first on the capacity of the government to capture the resource rent and reinvesting it. When the state is the legal owner of the natural resources, it has the right to charge for the use of these resources as a private business will do. But this right should always be accompanied with the responsibility of reinvesting these rents into productive investments. While both ideas are supported by economic theory, empirical evidence is usually only found for the right to charge proposal and not for the reinvestment part (Lange et al., 2003). The role of the government as the agent in charge of recovering the mineral rents and reinvesting them into productive assets is of high importance. Common (1995), Auty & Mikesell (1998), Day (1998) and (Lange et al., 2003) present an overview of the reasons why the government must be the agent that should capture the rents. A summary is described below: 1. As already mentioned, for non-renewable resources, economic sustainability requires reinvestment of rent. In the case of resource exploitation by foreign companies, it is highly 8

9 likely that large amount of the rent will be repatriated and not reinvested in the country providing the resource. In the case of domestic companies, they may limit their domestic investment to private opportunities following the capitalistic approach of maximizing the shareholder wealth. Consequently they are likely to underinvest in capital that is critical for most developing countries: human capital and infrastructure as it will not be profitable. 2. Low rent capture drive private companies exploiting natural resources to over extract as fast as possible in anticipation of new government policies to improve rent capture. 3. Rent recovery promotes intragenerational equity if the investments financed by these revenues are allocated to support development projects such as education or health. In this way, the benefits will reach many citizens, not just the small minority involved in resource exploitation. 4. Under some assumptions, taxes on rent are less distortionary than other taxes such as sales or profit taxes. 5. Unrecovered rents could artificially increase private sector profits. This will in turn reduce the incentive for efficient economic production in the extracting industry or in downstream resource processing industries. For the Peruvian case, National Constitution rules that all natural resources, renewable or not, are patrimony of the country and that the state is sovereign in their use (Constitución política del Perú, 1993). Consequently, the Peruvian government has the right to charge for the extraction of the country s mineral resources and, at the same time, it should turn this income into productive investments to continue building national wealth. As a result, the problem statement of the present study is: Are the mineral rents being efficiently captured and later on reinvested by the government in order to create the basic conditions for a sustainable path of the mining industry in Peru? 9

10 1.2. Relevance and motivation The current research is relevant because of the great pressure exercised over the Peruvian mining industry to bring economic development for the country. As it was already described, Peru is considered a mineral economy because of the high level of export earnings coming from this activity. Nevertheless, the country also struggles at the same time with low linkages from the mining sector to the rest of the economy. In consequence, clear benefits for society are still to be seen, especially for the citizens in rural areas where the actual mineral extraction takes place. Also, a strong feeling of environmental damage is commonly associated with the mining industry by ordinary citizens. In addition, given that the main companies operating in Peru have foreign capital investment, a sense of natural resources rip-off by them is also present in public opinion (Glave & Kuramoto, 2007). One of the results of the negative consequences of mining is social conflicts. As Markandya & Averchenkova (2001, p. 289) state, where state assets have been divested in a way that allows a few individuals to get their hands on valuable assets at knockdown prices, there is a transfer of wealth that is resented and that creates social conflicts. According to the Peruvian Ombudsman Agency, from the 217 social conflicts reported for June 2011, 118 where related to mining activities somehow. This accounts for an impressive 54.4% of all the social conflicts in the country (Defensoría del Pueblo, 2011). In return, the newly elected president of Peru, Ollanta Humala 1, decided to address this issue during his campaign and now in power he has promised to keep up his word. The main policy measure that the new government is planning to implement is a tax for extraordinary mining profits. Currently, the mining companies only face regular internal taxes and even have several tax exceptions, especially during exploration activities (Figueroa, Orihuela & Calfucura, 2010). In this way, the current research accrues relevance as it evaluates whether the current tax scheme is sufficient enough to establish the conditions for a sustainable path of the Peruvian mining industry or more action is needed as the current government thinks. If public investments into man-made and human capital, financed by mineral rents, are big enough to compensate for the 1 He assumed his position on July 28,

11 depreciation of natural capital, an explicit policy of sustainable development is not even necessary for then sustainability is guaranteed quasi-automatically (Neumayer, 2010) Methodology The current section presents the methodology that will be used to evaluate the objective of this research, i.e. the level of mineral rent capture by the government and the investments financed by them. The analysis will be conducted for the years 2004 to Throughout all the research mining industry will refer exclusively to metallic mining leaving oil and gas extraction aside. The analysis will first compare each year s mineral rent against the level of rent effectively captured by the government. In this way the study will show the level of recovery of these rents by the government for each year. Then, given that what is important is not just the capture of the rents but the actual investments made from them; an evaluation of the Peruvian public investments will be made. The research will assess the magnitude of public investments financed by mineral rents in order to analyze if there is enough wealth creation to substitute for the depletion of natural capital. Consequently, the first step will be to estimate the rent from mineral activities in Peru for the selected years. To obtain the mineral rent value the research follows the methodology proposed by The World Bank (2011) where: rent production value unit resource rent (1) unit Unit resource rent price average cos t unit price (2) As the reader will tell, a transformed version of the Hotelling rent presented in Equation (2) is employed with the difference of using the average cost instead of the marginal one because of data availability. The data is obtained from the World Bank Development Indicators database and is presented in current US dollars. Once the mineral rent for each year is estimated, data for rent capture will be obtained. Two main instruments to collect rent by the government will arise: internal taxes and dedicated funds. The 11

12 internal taxes in Peru are basically the income tax, the general sales tax and the selective tax on consumption. Dedicated funds stands for mandatory contributions from mining companies to designated recipients in order to compensate for the damage caused by mineral extraction. Three of them are present in Peru s regulatory system: Canon Minero, Mining Royalties and Rights of Force. All of these instruments will be explained in detail in Section 6.2. Additionally, voluntary private investments made by the mining companies will also be added as rent capture. Although they are not collected by the government, the society still benefits from them therefore creating a sense of a social capture of the mining rents. Then, data will be obtained for investments into man-made and human capital financed by mining rents to analyze the country s wealth evolution. Due to how the fiscal statistics are collected and organized in Peru, it is impossible to track the internal taxes until their final expenditure. However, the same problem is not present with the dedicated funds. Consequently, the research will present two different analyses to cope with the untraceable internal taxes. First, a direct comparison will be made between the depleted natural capital and the actual investments financed by the dedicated funds. As it will be explained in Section 6.2, the dedicated funds are reserve solely to regional and local governments. Therefore, this comparison allows getting an understanding of the capacity of these governments to effectively execute the desired public investments. Furthermore, the assessment will lead to obtain a rate of capital substitution for the analyzed years to determine if the total stock of capital is maintained constant over time. Natural capital value for each year is calculated following the Net Present Value method that will be explained in detail in Section 3.3 and is employed by the World Bank as follows: Mineral Depletion rent,4% discount rent, exhaustion time NPV exhaustion time (3) Then, the transformation of mining rents captured by internal taxes into actual investments will be analyzed using the Sustainable Budget Indicator (SBI). The SBI is the ratio of non-investment spending to current (non-mineral) fiscal revenues: Spending non investment SBI (4) Re venues current non mineral 12

13 It was developed in 1994 by the Botswana government to evaluate their fiscal behaviour towards reinvesting the rents obtained from diamond extraction. A value of 1.0 or less is obtained when all the current consumption of the government is being financed by other sources than revenues coming from mining activity. As a result, all the mining fiscal income is being employed into public investment. A value greater than one would mean that to finance government consumption, the government income obtained from all the productive activities except for mining is not enough, therefore some part of the mining fiscal revenue would have to finance current consumption (Lange & Hassan, 2003). It is important to notice that, while the dedicated funds are exclusively for regional and local governments, internal taxes are the main source of income for the central government. As a result, the SBI will evaluate the capacity of the central government to employ the captured rents into investments. Consequently, these two different analyses will permit to evaluate the capacity of the different Peruvian government levels to effectively execute the required public investments for sustainability. The depletion of natural capital is obtained from the World Bank Development Indicators database and is presented in current US dollars. Public investment data and education expenditures are obtained from the official statistics of the Peruvian Ministry of Economics and Finance (MEF). Educational expenditures consist of wages, social benefits and goods and services purchased for education and they all will be considered as investments into human capital. Fiscal income data is retrieved from the National Superintendence for Tax Administration (SUNAT). The data for the funds of Canon Minero, Rights of Force, Mining Royalties and mining voluntary private investments are obtained from the Ministry of Energy and Mines (MINEM). Finally, current national spending and revenues will also be obtained from official statistics of the Peruvian Ministry of Economics and Finance (MEF). All of them are converted into current US dollars using the average annual exchange rate calculated by the Central Reserve Bank of Peru (BCRP). The research is shaped in the following manner: Section 2 describes the Peruvian mining industry in a concise way. Section 3 presents the main ideas in economics of exhaustible resources theory. There important concepts as resource rent and the Hotelling rule are described. Additionally, it also illustrates the methodologies for exhaustible resources valuation and introduces the economic model that will serve as a basis for all the conducted analysis. 13

14 Section 4 introduces basic concepts of Sustainable Development and extends over the economic definition of it by describing the capital approach. Moreover, this section elaborates on the theory behind intergenerational equity and Hartwick s rule in order to arrive to the comparison between weak and strong sustainability. Finally, it also presents the most well known indicator of weak sustainability called Genuine Savings. Section 5 elaborates a brief review of previous similar studies. In section 6 the analysis is conducted. First, an analysis of the rent capture and the means to collect it by the Peruvian government is presented. After that, an evaluation of the level of public investments made from that rents will follow. Finally, in the last section the conclusions and recommendations are presented. 14

15 II. Peruvian mining industry The current section elaborates on the Peruvian mining industry. The purpose of this section is to familiarize with the industry and understand its development and potential trends. It also highlights the vulnerability of the industry with the economic and political context of Peru as well with the international markets. An overview of the history of the industry since the 1950 s until 2009 is presented first. Then, the production of the main minerals extracted is described as well as their importance in the world ranking. Finally, the mining exports volume and structure for Peru are also described A brief historical review In 1950 the Peruvian government enacted the Mining Code in order to create economic incentives for attracting new mining investments into the country. The policy was a success at the time and led to the creation of the Toquepala mine, mainly for copper extraction and at that time considered one of the biggest in the world. Additionally, during this decade several business groups established in the industry promoted by the attractive regulatory environment and the international high metal prices. Consequently, Peru became one of the best attractive destinies for mining investments in the world (Glave & Kuramoto, 2007). The expansion and profitability of the sector continued during the decade of the sixties until a point where its contribution to the country s economy started to be questioned. The National Parliament criticized the operator of the Toquepala mine, Southern Peru, for its overwhelming profits and the repatriation of this income without letting the local economy to benefit from them. In this way, the idea to expropriate and nationalize the mining operations begun to be discussed (Becker, 1983). After the 1968 coup, several nationalization processes begun throughout all the Peruvian industries. For the mining sector, the former operators were asked to present investment projects beneficial to the country in order to be exempted from the expropriations. Only Southern Peru submitted a later approved proposal, all the other large mining operations were nationalized. At the same time, the military government began to invest into mining projects like Tintaya and Cerro Verde and on the construction of the Ilo and Cajamarquilla refineries. The process was considered as a success by the government by obtaining considerable revenues from the mineral extraction 15

16 promoted mainly because of the peak for metal prices during the 1970 s decade (Glave & Kuramoto, 2007). After the reestablishment of democracy in the beginning of the 1980 s, the mining industry entered into its biggest historical crisis. The international prices fall drastically leading to the closure of several mines throughout the country. Furthermore, the macroeconomic stability of the country began to worsen: inflation was uncontrollable with excessively high rates, the government controlled the exchange rate reducing the exporters profits considerably, the investments decline and as a result the wages of the employees were also cut down even resulting in massive layoffs. At the same time, terrorism struck the country and mining facilities were common attack targets. In the end, it was a lost decade for the industry as well as for the country (Pascó-Font, 2000). To tackle down the crisis of the last years of the 1980 decade, the newly elected government of Alberto Fujimori in the early nineties began a privatization process of all the public mining operations. As a result, all the most important mines controlled by the government were given to private operators at low prices so the purchase investment would still be profitable. Since then the Peruvian mining sector began a modernization process that has help to locate it as one of the most important mineral industries in the world. As a result, Peru is the third destiny in the world for mining investments. In 2009, the mining investments reached US$ 2,821 million, 165% more than in Besides, the decentralization policies enacted by the government in 2003 have allowed the different regions of the country to promote mining exploration in their territory to attract investments to their territory. Consequently, the regions of Cusco, Arequipa, Cajamarca and Ancash obtained around 50% of all the investments made in (MINEM, 2010) Currently the mining industry is categorized into three groups: Large and medium mining industry; small mining industry; and handcrafted mining industry. The large mining industry represents the operations that are vertically integrated. In that way the same operator performs the activities of exploration, extraction, concentration of the minerals, refining and boarding. It is usually highly mechanized and capital intensive and exploits open pit deposits. The medium industry groups around 100 companies that operate mining units mainly underground. This sector is also highly mechanized and capital intensive but limits its operation to 16

17 only the extraction and concentration of the mineral letting the further processes to be conducted by the companies in the large mining industry. The small and handcrafted mining industries are mainly dedicated to underground auriferous activities and to the extraction and processing of non-metallic minerals. Until 2009, there were 9,008 registered mining title holders. From the total 43% correspond to the large and medium category, 37% to the small and 20% to the handcrafted mining industry (MINEM, 2009) Production Peru is a mineral economy as it was already defined. The mining production is based on the extraction of precious metals for subsequent exports. The mining GDP continued to grow until 2008 where due to the international financial crisis the imports of minerals of industrialized countries decline affecting the Peruvian mining industry. As a result, the mining exports decline leading to a decrease of the mining GDP. Additionally, there has been a loss of competitiveness for the Peruvian exports as the exchange has been appreciating throughout the years. Table 1 summarize the main mining indicators for Peru. Table 1: Peru s main economic indicators ( ) GDP (annual % growth) Mining GDP (annual % growth) Inflation Exchange rate Exports (US$ millions) Mining Exports (US$ millions) Source: BCRP, MINEM The most important minerals extracted in Peru are: copper, gold, silver, lead, iron, zinc, tin and molybdenum. The amount of extraction for these minerals is strictly correlated to their international price for each year as it will be introduced in Section 3.2 by the Hotelling rule. As a 17

18 result, the production of most of these minerals started to decline in 2009 after consecutive years of steady grow as the international prices also began to decrease due to the financial crisis. Graphs 1 and 2 are constructed to illustrate the dependence of the mineral production to the international prices. The price trends for copper, gold, zinc, silver, lead and tin are presented in Graph 1. All the metal international prices decreased when the financial crisis led to several countries to cut back their consumption of minerals. The result of these decreases of the international demand and therefore of the prices had important repercussions over the Peruvian mining production. Consequently, the production of all the metals decreased except for silver for the years 2008 and 2009 as Graph 2 shows. Graph 1: Annual growth rate for international prices of selected minerals ( ) 130.0% 110.0% 90.0% 70.0% 50.0% 30.0% 10.0% -10.0% % -50.0% Copper Gold Zinc Silver Lead Tin Source: MINEM 18

19 Graph 2: Annual growth rate for Peruvian mineral production ( ) 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% % -15.0% -20.0% Copper Gold Zinc Silver Lead Tin Source: MINEM For almost all of the most important minerals extracted, Peru is placed on top of the world ranking regarding production. As Table 2 shows, Peru is the first producer of silver in the world, the second of zinc, third of tin and number six in gold. Furthermore it is always the first or second producer of metallic minerals in Latin America except for iron. Table 2: Peru s World and Latin American mineral production ranking World Latin America Silver 1 1 Zinc 2 1 Tin 3 1 Lead 4 1 Gold 6 1 Copper 2 2 Molybdenum 4 2 Iron 17 5 Source: MINEM 19

20 Millions US$ 2.3. Mining exports Regarding the exports, they have grown from US$ 7,124 million in 2004 to US$ 16,631 in That accounts for an increase of 130%. Furthermore, the mining exports account on average for 60% of total exports since Graph 3 present the evolution of Peru s mining and total exports for the analyzed period of years. Graph 3: Peru s mining and total exports ( ) Total exports Mining exports Source: BCRP, MINEM It is important to notice that the decline in the exports value of 2009 are due to the decrease of international metal prices given the lower demand for them due to the financial crisis. The main minerals exported regarding value are copper, gold, lead and zinc. The primary destinations for the mineral production are China and Japan for copper; Switzerland, Canada and the United States for gold; and China again for zinc and lead. In 2009 the structure of the mining exports was led by gold with a 42% of market share followed by copper and zinc with 36% and 7.5% respectively. Graph 4 presents the whole mining export structure. 20

21 Graph 4: Structure of mining export for 2009 (%) Gold Copper Zinc Lead Tin Iron Molybdenum Silver Others Source: MINEM 21

22 III. Economics of exhaustible resources The current section will elaborate on the economic theory for the extraction of exhaustible resources. First it will give a brief overview over the definition and different types of nonrenewable resources. Then, the resource rent concept is described in order to arrive at the Hotelling rule for exhaustible resources. This rule is the basic economic notion to lead the depletion of exhaustible resources. Afterwards, two different methodologies of natural resources valuation will be presented: net present value and net price. Finally, an economic model that integrates the consumption of natural resources is constructed. This model will be the basis for the conducted analysis in the following sections Non-renewable resources Non-renewable resources are those whose renewable rate is so slow that it does not offer a significant increase of its stock over time (Galarza, 2004). The non-renewability of the resources places a new variable in the production process for a mine owner. Besides having to allocate the optimal combination of capital and labour, the mine owner will have to decide how fast to exploit the fixed stock of the reserves. The consumption of one unit today will mean that there will be one less unit in the future. Consequently, time plays an essential role in the analysis. According to Tietenberg (2000) there are three concepts used to classify the stock of depletable resources: current reserves, potential reserves and resource endowment. A brief description of each follows: Current reserves: refers to the known resources that can be extracted in a profitable way given the market current prices. Potential reserves: also already discovered resources but with the distinction that can only be extracted if there is willingness to pay for them. For example, if prices for the resource go up, then higher investments could be done to reach the mineral or to enhance the current technology for a more efficient extraction. 22

23 Resource endowment: are the undiscovered resources in the earth s crust. It is a geological definition as prices have no influence on the size of the resource endowment. It represents the upper limit on the availability of the resources Resource rent and Hotelling rule Resource rent along with the Hotelling rule for the optimal extraction of non-renewable resources are considered the basic principles for the exploitation of exhaustible natural resources. This section will describe first the concepts and then elaborate on the optimal methodology for nonliving resource extraction. The concept of rent and the different types of it is very well described in Lange et al. (2003): Economic rent refers to the price paid for a resource whose supply is fixed and inelastic to price at the moment. The supply of the resource could increase in the future in return to price changes but at any given moment the supply is fixed. When economic rent relates to natural resources, the term resource rent is used. Resource rent is also called royalty, depletion premium and marginal user cost (Pearce & Turner, 1990). Resource scarcity rent is measured by the unit price of in situ reserves and represents the present value of future benefits from an additional unit of resource stock. It is frequently measured as the difference between the market price and the long-run marginal costs of production (including a normal return to fixed capital). Ricardian rent refers to different payments made to different units of a resource that appears to be homogenous. These rents arise when the units of the resource actually differ in some way that affects their value in production. Monopoly rent stands for increased prices obtained due to artificial restrictions placed on the supply side of the market, rather than constraints arising from any natural cause. Hotelling rent (Hotelling, 1925) measures the dynamic scarcity value of resource assets, based on the opportunity cost of waiting rather than liquidating the resource now, and establishes the rules for optimal resource exploitation over time. The Hotelling rent is the stepping stone for the Hotelling rule of optimal resource extraction. 23

24 The resource rent concept plays an important role in order to decide the optimal amount of production or extraction of the natural resource in the different time periods in order to maximize benefits. Following basic microeconomic theory, the profit maximization of a firm occurs when the marginal revenue equals the marginal cost of production. If we take the simplest case of a market in perfect competition we will have: P c (5) Where P is the price of the resource and c is the marginal extraction cost of the last resource. But given that for the case of non-renewable resources there is a finite stock of resources, an opportunity cost arises each time resources are depleted given that they will not be available for future production. In this way, the opportunity cost of extracting one more resource unit will be not obtaining the future capital gains that the increase in price due to resource scarcity will create 2. Therefore the profit maximization rule will include this opportunity cost or marginal user cost by: P c Opportunity cost (6) If we arrange (6) we obtain an expression of the resource rent described lines above. In this way, the resource rent also represents the opportunity cost of extracting one more unit of the resource in a given period of time. Opportunit y cos t Resource rent P c (7) Given that in a perfect competition model the price is given, in order to achieve the profit maximization condition the resource owner will have to decide over the amount of resource extracted in every period of time as well as the number of time periods to extract the resources. Therefore, an intertemporal maximization condition is needed that incorporate Equation (7) to obtain the right amount of resource extraction. Economic theory treats resources in the ground as assets; therefore by preserving them the resource owner can expect capital gains as the price rises through time due to resource scarcity. In this way, to keep this economic asset, it has to earn the same net rate of return as the other assets 2 A central element of non renewable economic theory is that the price will increase over time. 24

25 in the resource owner portfolio do. Otherwise, it will make sense to liquidate the natural resources in order to invest in the other more profitable assets of the portfolio (Neumayer, 2010). For that reason, if the interest rate rises in subsequent periods of time, then the resource rent should rise proportionally, considering the interest rate as a representative rate of return on other assets. As an example, one can consider the consequences if the resource rent rise at a lower level than the interest rate. The resource owner will liquidate the resources and save the revenues in the bank as it will be more profitable than to preserve the resource on the ground. In the opposite case, if the resource rent rises at a higher rate than the interest rate, the owner will preserve the resource to extract it later on in order to obtain bigger profits. Consequently, in a perfect competitive market, the resource rent must rise at a rate equal to the interest rate for a given stock of non-renewable resources therefore having: r P t c Pt 1 c P c t 1 (8) where r stands for the interest rate, P is the resource price at different time periods and c is the marginal extraction cost that is considered constant over time. Subtracting the marginal extraction cost to the resource price leaves the already explained resource rent. This requirement is called the Hotelling rule after Harold Hotelling s work about The economics of exhaustible resources in In his work he stated the following: Since it is a matter of indifference to the owner of a mine whether he receives for a unit of his product p0 now or a price p0ert after time t, it is not unreasonable to expect that the price p [in a competitive market] will be a function of the time of the form p = p0ert. (...) The various units of the mineral are then to be thought of as being at any time equally valuable. Except for varying costs of placing them upon the market. 3 (Hotelling, 1931, p. 140) Hotelling rule therefore calls for the present value of resource rents to be the same in all periods. Therefore, it is the intertemporal profit maximizing condition that will allow the resource owner to decide the right amount of extraction in every period of time. Given that the price is given and the 3 In Hotelling s work, he assumed extraction costs as cero; therefore the resource rent will be the resource price. 25

26 extraction costs are constant for the proposed example, production (or extraction) will be the only variable that can achieve the desired equilibrium. Hotelling rule stands for either an infinite or finite period of time. It is also not affected if the resource owner is not a price taker, like in a monopoly. However, for this rule to hold it is necessary a degree of certainty about the size of the resource stock, the date of exhaustion, the existence and marginal costs of a backstop technology among others (Neumayer, 2010). Nevertheless, it is important to recognize that there is not an academic consensus about the empirical validity of the Hotelling rule. The main problem in trying to find empirical evidence for the Hotelling rule is that resource rent is not directly observable and therefore inherently difficult to measure. Regarding the non-conclusive studies conducted about the topic one can find Miller & Upton (1985), Farrow (1985), Halvorsen and Smith (1991) among others Natural resources valuation In order to place an economic value on a natural resource one should always use market prices or, if market prices don t exist, apply methodologies to obtain the closest possible estimate to a market price. In this way, when market prices are not at hand, the next choice is to estimate the net present value of future benefits accruing from holding or using the asset (UN, 2003, p. 272). This methodology will lead to a close estimate of market price given that if the value of the future benefits from the natural resource doesn t at least match the market price, then the asset would not be a cost-effective purchase. Two methods have been used to value natural assets: net present value (NPV) and net price. Net Price method (Repetto et al., 1989; Bartelmus et al., 1992; Van Tongeren et al., 1991; UN, 2003) applies the net price, i.e. price minus extraction costs, in a given year to the entire remaining stock. Based on an interpretation of Hotelling s rule it is equivalent to the NPV method under the restrictive assumption that the real net price increases every year at the same rate as the discount rate (Hartwick & Hageman, 1993). The NPV method is the discounted sum of its future net income stream or rent. It is considered the theoretically correct method for asset valuation and it is recommended by the Integrated Environmental and Economic Accounting Handbook (SEEA). Resource rent, as already described, is 26

27 calculated as the value of production minus the marginal exploitation costs, which includes intermediate consumption, compensation of employees, consumption of fixed capital and the opportunity cost of capital invested in business (Lange et al., 2003). Given that there is a lack of availability and measurement of marginal costs, average production costs are often used to calculate resource rent. Consequently, following Lange et al. (2003), the resource rent will be the outcome of: Rr t TR IC Ce CFC NP (9) t t t t t and NP i K (10) t t t Where Rr = resource rent TR= total revenue from the mining sector IC = intermediate consumption Ce = compensation of employees CFC = consumption of fixed capital NP = normal profit, a return on fixed capital K = fixed capital stock invested in an industry i = the rate of return considered the opportunity cost of capital It is important to realize that resource rent allows for a normal profit that will be equal to the opportunity cost of maintaining the exhaustible resources as an asset in the land owner portfolio as it was described in Section 3.2. The best way to estimate this opportunity cost is by calculating the rate of return of capital in the market in order to obtain the yield that the investor would have obtained in the best option left aside. 27

28 Taxes and subsidies are not considered in the calculation because, as Figueroa et al. (2010, p. 160) discusses, Indirect taxes have to be considered as a rent transfer between institutional agents (firms and governments) * + and subsidies are not considered either since conceptually they are not part of the value generated by mining resource production. By already calculating the proper resource rent, the value of the mineral assets will be the net present value of the future rents that will be obtained from the exploitation of the mineral resource until its depletion as the following formula describes: V t T t p Q t t t 1 r, (11) R t pt (12) Qt and S t Tt (13) Qt Where V = value of the asset p = unit rent price of the resource Q = quantity of resource extracted r = the discount rate R = total resource rent T = the remaining lifespan of the resource S = the stock of mineral reserves at the close of the accounting period 28

29 As the reader can tell, this derived formula is the one presented in Equation 3 of the methodology section of the research. As a consequence, it assures the soundness of the data obtained from the World Bank for Peruvian mineral depletion value. Nevertheless, attention has to be given to the discount rate used to value natural capital. Discounting reflects the fact that income received in the future is not as valuable as income received today. The social discount rate is typically employed instead of a private discount rate. While growth theory gives the proper formula to calculate this social discount rate as: C r i u (14) C where i is the pure rate of time preference, u the elasticity of the marginal utility of consumption and C C is the percentage growth rate in per capita consumption. The actual calculation differs in each scenario and context considering their appropriate circumstances (Pearce & Ulph, 1999; Hanley & Spash, 1993) An economic model The current section presents an optimal growth model based on Hartwick (1990) that identifies the relation between the depletion of the natural capital and the value of produced capital goods. In this way, the model proposes the procedures to arrive to the correct measure of the Net National Product (NNP) that, as Samuelson (1961) and Weitzman (1976) agree, it is the best welfare measure under standard national income methodologies. The model is constructed following Neumayer (2010) for a better understanding of the objective of this research and consequently it is slightly modified from Hartwick s original version 4. Consider a closed economy that produces a composite good, has a stock of non-renewable resources and maximizes welfare within an infinite time period by: 4 Especially regarding environmental damage. 29