August 2014


The peril of ignoring public sector costs

By Mauro Chiesa

In a recent column, I called for mining companies to factor public sector costs into their financial projections for future projects in development. My rationale was that this would facilitate a more inclusive and expedient public sector role in the project’s funding and approvals. Yet the comments I received from this column suggested that financial resources are already limited, and that the public sector should be left to its own processes. The need to assess the public sector costs should not be underestimated, however, as it is essential for determining the viability of a project and a company’s strategic decision-making.

Since capital is scarce and will remain so, mining companies will require careful queuing of their in-development projects to replace their depleting assets. This scarcity arises because many institutional investors are dismayed with an industry whose 40 largest players, according to PricewaterhouseCoopers’ Mine Report 2014, had to collectively write down $97 billion of assets in 2012 and 2013. Meanwhile, governments are running deficits and are no longer able to readily assist future mining projects. If governments were able to co-invest, they would now look for a higher return on the public sector co-investment. This means a “double-queue” for the company: one for the permits and one for the public co­investment approvals. Recent examples include Ontario with the Ring of Fire and Mongolia with Oyu Tolgoi.

A hypothetical example may help illustrate the value of factoring in public sector costs: Company X has three candidate projects but can only afford one with its $1 billion of capital. It finds that Project A offers an internal rate of return (IRR) of 18 per cent, Project B offers 22 per cent and Project C offers 26 per cent. The board agrees to pursue C first, followed by B as a fallback option. Project A is sold to its competitors.

Overlooked in this process is the public sector capital required. This can include technical training, environmental cost-sharing, infrastructure, energy subsidies, and social costs. If each project had been fully costed, Company X would have discovered that Project A requires no public sector capital, and B and C each required $300 million and offer the respective returns of 10 per cent and four per cent to the public sectors, when the tax and royalty revenues are factored in.

Such oversight hides several vital issues. For instance, development speed is not factored into the decision. Project A, with its 18 per cent IRR needs no co-financing and offers the opportunity to bypass the double queue. The government may even endorse this project because it brings jobs, satisfies the permits required and does not need any public funds while generating royalty and tax revenues.

However, if the public sector has the capital to co-invest, Project B would be the win-win candidate, as the public sector would see a 10 per cent return. Such a win-win situation would also be wise given the public’s current perceptions that a mining operation only profits companies. Project C could actually invite detractors because the private sector would be seen to make handsome returns while the public sector would not. Regardless of the return of public sector funds, the end result for both is a double queue that would only require more time – thus more inflation – more public scrutiny and increased anxiety from shareholders with high expectations, given Project C’s announced IRR.

By fully costing all options before making any strategic decisions, Company X also places itself in a better position to negotiate “asset swaps” with the public sector. For instance, Company X can see a lower return in exchange for financing more assets (like a power plant) and possibly encourage a faster approval process by reducing the funding load on the public sector and enhancing its return. The company could also simply hold on to Project A rather than let it go prematurely.


Mauro Chiesa has 33 years of experience
in financing and advising extractive
and infrastructure projects, including with
multinational banks in New York, the
World Bank Group in Washington, D.C.,
and EDC in Ottawa.

The bottom line is that a company must fully cost all strategic options, as the new projects must not only be delivered on time, on budget and on spec, but may require greater co-investment from a public sector that is financially challenged. The “greenfield” or “frontier” nature of some new projects further underscores this need. Failure to fully cost all options may invite unexpected delays and additional political risk, creating potential gaps in production plans because of a double queue. Today’s investor does not welcome these situations, as they increasingly look for dividends and a more timely performance that “satisfies guidance.”

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