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• 3. Relaxation of Rules

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• 3.1 Issues
• 3.2 Design Features
• 3.3 Exploration on Existing or New Permits?
• 3.4 Partial or 100% of Exploration Expenditure
• 3.5 Expenditure in Specified Areas?
• 3.6 Existing or Future Production?
• 3.7 Gas Production Only?
• 3.8 Indexing Costs

3.1 Issues

Under current royalty rules, exploration expenditure must be recorded against the relevant exploration permit where it is incurred. The expenditure is only deductible against production revenue from an area within that permit area.

The project team has discussed whether (and how) these rules should be relaxed to allow exploration expenditure in other permits to be offset against production revenue in a wider range of circumstances.

3.2 Design Features

The incentive should also be designed so that the explorers are rewarded for future exploration effort, rather than past effort. Consequently, the project group considered that any relaxation of the ring fencing rules should apply only with respect to expenditure incurred after a specified commencement date.

We should point out that this incentive would not necessarily provide the producer with a permanent saving. If the additional exploration carried out is successful, the producer cannot also deduct that same exploration expenditure against production revenue from the newly discovered permit.

3.3 Exploration on Existing or New Permits?

The project group noted that those holding existing permits are already committed to work programmes. The question was asked whether those explorers should be rewarded for doing only what they had already planned to do. It was however noted that it may be counterproductive to restrict the lifting of the ring fence to new permits, given that there is significant prospectivity in the current permit areas.

One suggestion has been that existing holders could apply for ring fence removal if they agree to increase the intensity of the planned work programme. There is an element of discrimination in this option, as in some cases the explorer's work programme may be as intensive as reasonable exploration practice will allow.

3.4 Partial or 100% of Exploration Expenditure

We have assumed that 100% of qualifying exploration expenditure could be allowed. Although it could be scaled back to a proportion, it would diminish the effectiveness of the incentive without significantly saving the fiscal cost.

3.5 Expenditure in Specified Areas?

The project group considered the merits of a constraint along the lines of "exploration expenditure can only be offset in calculating an APR liability in respect of production in the same region".

It was considered that the expenditure should not be confined to specific areas as the Crown wants to gather knowledge about the prospectivity of all areas within New Zealand. There is also the possibility of a discovery in any region.

In addition, such a constraint any could effectively lock explorers into a region when they would otherwise prefer to explore elsewhere.

3.6 Existing or Future Production?

This was one of the most critical issues in terms of the design of the incentive. The ability to offset exploration expenditure against current production greatly increases the economic benefit of the incentive. Consequently, it would be of far greater benefit to existing producers. The project group is also aware that many of these producing companies are holding some of the most promising exploration acreage. They are also well placed to rapidly exploit any significant finds.

Restriction of the offset to production from subsequent discoveries would defer and therefore diminish the potential benefit. The key argument in favour of this approach is that it does not discriminate between existing producers and other explorers.

Tables 4 and 5 illustrate the differences in potential impact between allowing a out-of-licence exploration expenditure to be offset against APR liabilities on future vs current production.

From Table 4, restricting the offset of exploration expenditure to future production delivers a material benefit - in these examples, around the same benefit as a capped reduction in the APR rate. However, Table 5 indicates that the benefits would be around three times larger if explorers were permitted to offset exploration expenditure against current production.

3.7 Gas Production Only?

The project group considered that it was not practical to restrict the relaxation of ring fencing restrictions to exploration expenditure on gas prone prospects.

However, it would be possible to restrict the lifting of the ring fencing to the royalty on gas produced. This option would present a number of allocation difficulties as most fields produce a mixture of both oil and gas.

It is also important to remember the objective of the incentives is to encourage exploration now. This expenditure will be incurred in advance of future production. Presently, all exploration for hydrocarbons is of importance to New Zealand (whether the prospect is believed to be oil or gas prone); the product resulting from that exploration is not strictly relevant to the incentive. In summary, the project group's view is that the incentive should reward any company that is prepared to explore, whether it ultimately produces oil or gas.

3.8 Indexing Costs

The Australian Commonwealth's Petroleum Resource Rent Tax ("PRRT") on offshore petroleum exploration is conceptually similar to the APR but with the important difference that accumulated exploration and development costs are carried forward with interest calculated by reference to the risk-free rate plus an allowance for risk (broadly, 15 percentage points for exploration expenditure and 5 percentage points for development expenditure).

Indexation of costs under the APR could be considered as either a complement or an alternative to relaxation of the `ring fencing' rules for exploration expenditure.

There are two principal economic arguments for adopting this approach:

• Lack of indexation under the APR means the present value of deductions for exploration expenditure is lower for longer-lived projects, distorting investment decisions away from offshore toward onshore exploration. Given an appropriate interest rate, this distortion is removed with indexation.²
• Indexation will place all explorers on a common footing, unlike allowing an offset against current production which only benefits an explorer with an existing production base.

The main argument for proceeding cautiously with indexation is that, since it effectively replaces the APR regime with a resource rent tax, the move has the appearance of a fundamental reform and may therefore require more widespread consultation.

²The distortion between projects with different lives will only be fully removed if the interest rate used to adjust carried forward expenditures is set equal to the pre-royalty, pre-tax internal rate of return on a marginal project - say 20 percent. But a rate this high will create additional distortions, most importantly by incentivising explorers to defer production. We understand this is a determinant of the "split rate" approach under the Australian PRRT, whereby a high rate applies in the initial years and a lower rate subsequently.