NEWS & ANALYSIS

Our critique of the Draft Mining Charter - HSF

Anton van Dalsen says policy does not take into account certain basic realities

Submission on the Draft Broad-Based Socio-Economic Empowerment Charter for the Mining and Minerals Industry 2018

INTRODUCTION

This brief summarises the HSF’s submission to the Department of Mineral Resources, in response to the Draft Broad-Based Socio-Economic Empowerment Charter for the Mining and Minerals Industry, 2018 (“the Draft Mining Charter”) which was published on 15 June 2018 for public comment. To view the full submission, click here.

KEY FEATURES OF SOUTH AFRICAN MINING AND ITS IMPORTANCE TO THE ECONOMY

In assessing the contents of the Draft Mining Charter, it is important to keep in mind not only the importance of the South African mining industry in the national economy, but also its specific characteristics. 

In 2017, it constituted 6.8% of the economy, contributing R312bn to GDP. It exported R307 billion worth of produce, representing 27% of the country’s exports. 464 667 persons were employed in the industry in 2017.[1] Based on the estimate that every employee supports between 5 and 10 dependants, the industry supports up to 4.5 million people.[2] 

Mining is risky, not just from a technical perspective. The financial risks are substantial and the amounts which mining projects require for development are considerable. South African mining is hugely dependent on USD-denominated commodity prices, set in international markets, and on the USD/ZAR exchange rate (there are some exceptions, such as coal companies that sell locally to ESKOM). As price takers, mining ventures are unable to increase their selling prices to address unexpected additional expenses, such as those arising from the Draft Mining Charter. The mining industry globally is vulnerable to the commodity cycle. Revenues may fluctuate substantially from year to year, and periods of substantial profit may be followed by periods of financial break-even or losses.

Large mining projects require investments of billions of Rand and take many years to reach completion (and capital spent on such projects is only typically recouped years after completion, if the project is successful). This is especially so in deep-level mining ventures in South Africa. As a result, mining companies and their shareholders need confidence that the regulatory regime will not change at short notice in a manner that affects them in an unforeseen and adverse manner. Governments which enact such changes will damage their reputations, finding it harder to attract new capital into the mining industry. Any additional regulatory risk will simply increase the returns that are required by investors, which may lead to a decision not to invest, as the required returns are not seen as being achievable.

Many South African mining companies are currently in a loss-making situation and placing additional financial burdens on these companies will endanger their survival. It is common knowledge that approximately 60% of the platinum industry is making losses, as is the case with at least half of the gold mines in South Africa.[3] The South African mining industry has become smaller and less profitable, becoming less able to shoulder the burden of additional regulatory measures that have financial implications. 

Between 2011 and 2017 (the life of the second Mining Charter), the value of aggregate income in the mining industry (in current prices) rose by 5.1% per year on average, whereas the value of aggregate expenditure rose by 8.1% per year. The result has been a squeeze on net profit.[4]

THE ATTRACTIVENESS OF INVESTING IN SOUTH AFRICA’S MINING INDUSTRY

It is important to consider South Africa’s mining industry through the eyes of potential investors. The Fraser Institute’s Survey of Mining Companies is a well-known independent research report, based on an international survey, which is often referred to in comparative analyses of the attractiveness of individual countries for mining investment. 

The Fraser Institute’s latest survey, published in February 2018, makes the following findings regarding South Africa:[5]

- In the table reflecting the attractiveness of official mining policy (“the Policy Perception Index”), South Africa is placed at position 81 out of a total of 91 countries. Out of 15 African countries in the table, only the Democratic Republic of Congo and Zimbabwe have a lower score than South Africa;

- In contrast, in the table reflecting mineral potential, assuming policies are based on “best practices”, (“the Best Practices Mineral Potential Index”), South Africa appears in place 21 out of 91 countries. Only Ghana and the Democratic Republic of Congo score more highly in Africa; and

- In the resulting composite “Investment Attractiveness Index”, which gives a 40% weighting to the Policy Perception Index and a 60% weighting to the Best Practices Mineral Potential Index, South Africa is at place 48 out of 91 countries. In Africa, three countries are placed higher than South Africa in this composite index: Botswana, Ghana and Mali.

The Fraser Institute’s ranking effectively means that South Africa is internationally perceived to have first class mineral potential, but this potential is undermined by a very negative view of Government’s mining policy. The Draft Mining Charter, with its changed goal posts, will simply confirm this perception, if enacted in its current form. 

MOVING THE GOAL POSTS: INCREASING BLACK OWNERSHIP OF EXISTING MINING RIGHTS

Existing mining right holders who are compliant with a 26% BEE shareholding, are recognised in the Draft Mining Charter as being compliant. However, the Draft Mining Charter requires them to increase the shareholding to a minimum of 30% within five years. This increase is therefore to be applied to companies who were under the impression that they had complied with the BEE requirements of the Mining Charter of 2004. This is a classic example of how “moving the goalposts” can have a destructive consequence. It is not only from an outside investment perspective that this aspect is relevant, but also from an internal company perspective. Companies who thought they were compliant would now have to devote financial and other resources to addressing unexpected new requirements. 

For these reasons, the increase in the requisite BEE-shareholding from 26% to 30% in the case of existing mining rights should be discarded.

BEE IN RELATION TO NEW MINING RIGHTS

On the other hand, the objection of moving the goal posts does not apply to the requirement of a 30% BEE shareholding for new mining rights, as changes are not being made to existing rights. The issue here is rather how many applications for new mining rights there will be, given the conditions attached to them and their relative attractiveness, compared to other mining jurisdictions.

In respect of new mining rights, the Draft Mining Charter stipulates that of the requisite 30% BEE ownership, each of employees and host communities are to hold 8% (thus 16% in total), with 5% of each of these tranches to be in the form of a free carried interest (amounting to a total of 10%). This effectively means that 10% of any mining company’s shareholding must be transferred, at no cost, to employees and host communities (this is tantamount to expropriation without compensation). The remainder of 14% (over and above the employees’ and host communities’ share of 16% out of the total 30% BEE ownership) is to be held by BEE entrepreneurs[6], as it is phrased in the document. It is further not clear from the Draft Mining Charter why this latter 14% has to be held by “BEE entrepreneurs”, as opposed to communities or employees. 

All of this boils down to the following: 10% of the equity in a mining company has to be transferred for free to employees and mining communities, i.e. at the cost of the current owner/s of the company’s share capital. The current owners will now own only 90% of the shares. In addition to the 10% free carry, a further 20% has to be held by a combination of BEE entrepreneurs, employees and mining communities. These categories of new share owners will often not have the funds available to purchase their shares and the mining company will therefore have to finance the acquisition of its own shares by these categories of new shareholders (through what is known as vendor-financing) and probably at a discount.

In addition, it is not clear whether another consequence of the 30% BEE ownership requirement is appreciated by the Draft Mining Charter. A rights issue may be required to supplement a company’s funding in order to start a new project or to deal with the negative effects of a downturn in the commodity cycle. BEE owners will, in most cases, be unable to participate. This places the funding burden on the remaining 70% of shareholders, thereby increasing the cost of capital of these majority shareholders and reducing the attractiveness of the investment jurisdiction.

HOW CAN BEE ENTITIES BE EXPECTED TO INVEST IN A COMPANY THAT IS LOSS-MAKING OR HAS NO PROSPECTS?

The Draft Mining Charter places a blanket requirement on the sector as a whole as far as BEE shareholding is concerned, and makes no distinction in regard to profitability, which has a clear adverse effect on companies that are already struggling financially. 

The question is: how can the Draft Mining Charter expect that BEE entities will be prepared to purchase shares in companies that are in financial difficulties or have no or little prospects to become or remain financially successful? This question arises irrespective of whether BEE entities are funded by their own resources or vendor-financed, since they will end up in a position where there may be a cost for them to exit from a company that is in liquidation, together with potential legal complications. 

The Draft Mining Charter therefore expects BEE entities to become shareholders even where it may be to their financial detriment. 

BEE REQUIREMENTS FOR PROSPECTING RIGHTS DAMAGE THE JUNIOR MINING SECTOR

The Draft Mining Charter states that it also applies to prospecting rights. The essential problem here is, once again, one of not taking into account the financial realities of prospecting companies. Mining prospecting is a very high risk activity, since the likelihood of finding an economically viable deposit is extremely low - but mining prospecting requires substantial financial outlays to fund its activities of drilling, sampling, geological modelling etc., with no foreseeable cash flow for many years. 

How can it therefore be expected that the owners of such a company should give up 30% of their company to an entity that is not able to contribute to the company’s funding? 

A better policy would be to exclude such exploration companies from BEE requirements. If the exploration reveals a resource whose exploitation does turn out to be economically viable, BEE requirements could then be met when a mining right is issued. In the interests of future mining development, it makes no sense to obstruct exploration activities in South Africa. 

GREATER EMPHASIS ON MINING COMMUNITIES

Whilst it is commendable that the interests of mining communities are increasingly being put in the foreground, the question needs to be asked about the degree to which mining companies are expected to assume the obligations of local authorities and municipalities, in order to address the infrastructure and service requirements of communities. This is especially relevant as there is widespread underspending by municipalities on a national scale (R53 billion over the year to June 2017).[7] Are mining companies being expected to make up for the lack of effort or competence of local municipalities? No other sector has similar onerous social and financial responsibilities and the mining sector competes with those other sectors in the economy for capital.

If we consider that an estimated R7.5 billion in royalties was collected by the State in the tax year 2017/18 in terms of the Mineral and Petroleum Resources Royalty Act of 2008,[8] should a mechanism not be devised whereby at least a portion of that amount is made available for the needs of mining communities? 

We submit that it better serves the interests of communities, the mining industry and democracy in the wider sense, for local municipalities to meet their constitutional responsibility to provide infrastructure and services to people within their jurisdictions, as determined in Section 152 of the Constitution. Rather than placing additional burdens on mining companies in this respect, the focus should be on supporting municipalities to fulfil their constitutionally assigned role.

THE INAPPROPRIATE BASIS FOR CALCULATING “TRICKLE DIVIDENDS”

The Draft Mining Charter requires a mining company to pay a “trickle dividend” of 1% of its earnings from the sixth year onwards to employees and host communities, if no dividends are declared.

The Draft Mining Charter uses the criterion of EBITDA for calculating the “trickle dividend”, i.e. earnings before interest, tax, depreciation and amortisation. However, calculations derived from a non-cash flow concept such as EBITDA, may well mean that a company which already has negative cash flow, nevertheless has to pay a dividend to certain shareholders. It is difficult to imagine that the intention of the Draft Mining Charter is to implement measures which have such damaging consequences. 

THE HSF’S APPROACH

In order to be ‘open for business’, South African mining needs to escape its present stagnation and realise the growth potential of its plentiful mineral resources. The Draft Mining Charter as it stands would make matters worse rather than better, by;

damaging an already poor policy reputation;

increasing risk;

imposing unsustainable burdens;

creating incentives for BEE shareholders to exit mining as soon as they can;

choking off prospecting; and

failing to invest resources taken from mining companies in community development.

The sensible approach is to focus on three principles:

1. The investing entity needs to have confidence in attaining its return on capital and at the same time, Government will need to feel that its empowerment and social objectives are attainable. Otherwise, there is nothing, and 14%, 26%, 30% and 51% of nothing are all nothing. The Draft Charter shows no evidence of financial conditions in the mining sector having been considered.

2. In order to reduce risk, the burden of fiscal and social policy appropriations should increase when conditions in markets are favourable and reduce when conditions are difficult. A determination to extract a steady flow of resources from mining companies, come what may, has the effect of increasing risk in an already risky industry, entailing both increased company bankruptcies and an increased required rate of return on mining projects, to compensate for increased risk.

3. The principles of taxation indicate that the best approach to distributive issues is to design one or two taxes to care of them, rather than loading impost after impost on the system. The more taxes you have, the greater is the probability of adverse unintended consequences as they accumulate.

Gold mining company taxation has long recognised these principles. The rate of tax drops to zero when profit margins are less than 5%, while rising towards 34% as margins increase. 

One avenue which should be investigated further, is how the royalty mechanism can be used and whether the current formula is still fit-for-purpose. The royalty amount payable should be linked to the actual profitability of a company and not to turnover, as the latter approach may just add yet another cost to what may already be a loss-making enterprise. In the final analysis, the trick here is to ensure that a royalty level is reached which does not disincentivise the industry by becoming too burdensome, but where at the same time, it can make a contribution to social goals. The proceeds from taxation and royalties should be used for all relevant purposes: a contribution to the general revenue fund, promotion of BEE and community development.

CONCLUSION

Much can be achieved by Government and the mining industry in reviewing how the latter is incentivised, to increase the effect of their joint efforts regarding black ownership and employment. However, the focus needs to be directed at making use of a company tax and profit-based royalty system in a much more substantial way, in order to develop an efficiently run, sensibly regulated and growing mining industry. On the other hand, increasing BEE ownership requirements without regard to the financial health of any particular mining company, will often simply worsen the company’s financial constraints. In addition, it will not only not encourage further investment, but may actively discourage it.

The authors of the changes to the Mining Charter seem to have proceeded from the assumption that they can change whatever they think is appropriate and that the mining industry will make the necessary amendments to comply and will have sufficient funding to do so. This approach does not take account of the following:

- the high risk and capital-intensive nature of the mining industry; and

- the fact that over the longer term, optimal taxation of the mining industry will increase government revenue and the resources available for BEE entrepreneurs, workers and communities. 

The Draft Mining Charter’s approach is akin to that of a centrally planned economy, where the state takes all economic decisions on its own and places little reliance on what consumers or investors want, and what industry can profitably produce. Global events over the past decades have discredited this as an economic model. It is disheartening to see that the planned economy model persists in the Draft Mining Charter.

Whilst it is accepted that the Draft Mining Charter has been prepared with the best of intentions, it unfortunately adds to the effective cost of mining in South Africa, without providing the incentives to invest in and to continue operating businesses in a sector which is not only technically difficult but also subject to commodity prices and exchange rates over which it has no control.

The Government’s desire to broaden black ownership and employment in the mining industry is laudable, given South Africa’s history. This policy is supported by the HSF. However, a radical change of approach by Government is needed: the industry needs to be supported by allowing an adequate return on investment, on the assumption that Government will be able to rely on taxes which will flow in a favourable economic climate. A longer term and more strategic view needs to be taken, rather than the short-term approach contained in the Draft Mining Charter. The current approach has the effect of placing additional burdens on the mining sector in the bad economic times, which will not only prevent companies from making the necessary investments to blossom in the good times, but will also scare away new investors. The net effect of this is that the mining sector will not obtain the funding that is required not only for its growth, but for its survival. Simply put, the policy approach needs to change, in order to support the mining industry.

Anton van Dalsen, Legal Counsellor

Helen Suzman Foundation

Footnotes:

[1] Statistics taken from the Mine SA 2017 Facts and Figures Pocketbook, published by the Minerals Council of South Africa.

[2]Mine SA 2016 Facts and Figures Pocketbook.

[3] https://www.businesslive.co.za/bd/companies/mining/2018-07-11-minerals-council-says-75-of-sas-gold-mines-unprofitable/

[4] All data are taken from Statistics South Africa, Mining Production and Sales (Statistical Release P2041) and Quarterly Financial Statistics (Statistical Release P0044), various years

[5]https://www.fraserinstitute.org/studies/annual-survey-of-mining-companies-2017

[6] “BEE Entrepreneur” refers to Black enterprises that are at least 51% owned by black persons in which Black persons hold at least 51% of exercisable voting rights and 51% of economic interest, or an organ of State excluding mandated investments

[7]https://www.businesslive.co.za/bd/national/2018-02-05-malusi-gigaba-warns-on-councils-underspent-budgets/

[8]http://www.treasury.gov.za/documents/national%20budget/2018/review/FullBR.pdf, page 199