As the new royalty bill has moved from the lower chamber to the Senate, and the Government has shown ease to immediately oppose a new bill that in principle was labelled as unconstitutional by the executive, the industry is looking at potential scenarios moving forward.
The legislators’ debate is also occurring in a hectic political environment. The newly elected Constitutional Convention officially started on 4 July and the upcoming presidential election is characterised by opposing views in this matter.
CRU has recently published a Special Feature that provides an overview of the impact a new royalty could have in the cost profiles of Chilean copper mine operations: New royalty threatens Chilean copper supply.
The bill approved by the lower chamber would stablish a 3% royalty (ad valorem) for copper and lithium mining producers and a sliding-scale, price-based structure, with the highest bracket set at 75% for copper prices above $4/ lb. For this Insight, CRU Consulting tested the impact of this new royalty – assuming it is implemented on its current form as presented by the lower chamber – on two dimensions: i) the valuation of a new hypothetical greenfield project; and ii) free cash flow in an existing mine operation.
Impact on new greenfield projects
CRU modelled one hypothetical greenfield project in Chile, scheduled to start construction in 2022 and production in 2024. This project would have an annual average copper production of 175 kt Cu in concentrate for a life-of-mine of 30 years. Based on current industry benchmarks and Chilean cost profiles, we estimate a $3.2bn Capex and 2,830 $/t cash cost.
Considering an 8% discount rate, the results show that with the existing tax regime the project would have a $1,826mn NPV (net present value to 2022) and 15% IRR. This translates in a payback of investment at year 12. In contrast, with the new proposed royalty and considering CRU price forecast, the project value would decrease by 71% to $521mn NPV, resulting in a 10% IRR and almost double the payback of investment to year 21.
Looking at the total tax burden, with the existing tax regime the project would pay on average $265mn in aggregated taxes per year (this takes into account corporate income tax, mining special tax and accelerated depreciation), totalling $8,202mn over the life of the mine. With the new proposed royalty (as proposed in the bill), the project would pay on average $380mn in taxes per year, totalling $11,786mn over the LOM. This means the total tax burden over net revenues would increase from a 39% rate to 53% (annual averages).
Risk of cash shortfall for existing operations
Not only could the valuation of new projects be impacted, but also the financials of existing operations. Furthermore, this impact will not be equal for every mine as it will vary depending on the cost profile, sustaining capex investments and other considerations. For this example, the operating cash flow for an existing Chilean mine operation was modelled and the free cash flow calculated for the 2010-2025 period. For these calculations the existing tax regime was assumed as base case and contrasted with the assumption that the new proposed royalty has been implemented since 2010. It also considers that the existing Specific Mining Tax, Corporate Income Tax, and the accelerated depreciation benefit remain in effect in addition to the new proposed royalty.
The first point to note is that negative cash flows in this example are the result of actual capex investments. The results show that there is on average a 45% cut in free cash flow per annum across the 2010-2025 period if the new royalty would have been in place. This change is highly variable, in this example ranging from 15% to 114% difference in free cash flow across the period. As expected, due to the price sliding-scale nature of the royalty, the differences are exacerbated in periods of high prices scenarios. While the results show that for this example the cashflows don’t turn negative – ultimately destroying any value of the asset – this drop in free cash flow could impact credit scores and risk profiles of mining companies. This can be particularly true for Tier 2 assets, that generally have lower cash to debt ratios.
Decision making moving forward
Mining companies, financial institutions and investors alike will have to navigate months (if not years) of potential uncertainty up until the new mining royalty discussion is settled in Chile. If the bill were to maintain its current form and be approved, as the number one copper producing country in the world, the impact will likely percolate at different scales across the sector: from shifting the industry cost curve to new projects’ valuation and up to changing the views to the long-term incentive price.
However, this is an ongoing process and the Senate commission in charge of reviewing the bill has called a wide range of industry participants (from academia up to mining companies) to adequately discuss the impact of a new tax regime for the mining industry. Up until the dust settles, the industry will likely take into account multiple scenarios, especially when evaluating new projects.
