Royalties have historically been the most common

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Royalties have historically been the most common method used by governments to gain revenue from the exploitation of the nation’s mineral endowment. Royalties are based on either the volume (“ unit ” or “ specific ” royalty) or the value (“ ad valorem royalty) of production or export. 68 Unit royalties impose burdens that vary in inverse relation to changes in market price, while ad valorem royalties vary in direct relation to price for any given level of production or sale. In the petroleum industry, royalties are typically calculated on a net-back basis:. the price base for royalty calculation is adjusted from the point of export to the wellhead by deducting transportation and other marketing costs. Advantages and Disadvantages to Host Governments Royalties are attractive to governments because they ensure an upfront revenue stream as soon as production starts. As they are attached to production or sales, they can be estimated with a reasonable degree of predictability. They are comparatively easy to calculate, collect, and monitor. Royalties are a regressive form of taxation. 69 High levels of royalties distort investment decisions and may encourage uneconomic choices. To mitigate their regressiveness, some countries apply sliding scale royalties based on production levels or sales values, water depth or well depths, or R-factors. ( continued )
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38 World Bank Working Paper Table 8. Royalties ( Continued ) Effect on Investment Decisions Royalties have a tendency to distort the levels of recovery, although this effect is relevant only when the royalty is the most important part of the tax rent and when important differ- ences in quality occur in crude oil or gas produced from a given contract area. In particular: Unit royalties reduce the effective price by the same nominal amount each year. Since the net present value of the royalty decreases over time, investors will have an incentive to prefer future production over current production when future prices are expected to increase. In addition, a royalty imposed on the volume of production or sales may encour- age the investor to delay the production or sale (subject to technical considerations) of the lighter, sweeter crudes or higher heating content gas if the discounted value of future prices is expected to increase. Ad valorem royalties reduce the discounted price of crude oil or gas by the same percentage in each year. Therefore, if the prices are expected to rise in real terms, investors would prefer increasing production (subject to technical considerations) in the present. As royalties are payable whether or not the project is profitable, they can constitute a major deterrent to investment.
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