‘Time passing’ and measuring depletion

‘Time passing’ and measuring depletion London Group Brussels, September/October 2008 Peter Comisari Australian Bureau of Statistics

Overview • Natural resources: asset values; depletion and ‘time passing’. • Is ‘time passing’ a holding gain for the owner of the natural resource? • Does ‘time passing’ arise from production? If not, could it nevertheless be considered ‘income’ by following a Hicksian notion of income? • Implications of proposal…

Measuring the value of natural resource assets and their depletion • Where market values unavailable, natural resource assets can be valued using NPV. • Asset value = NPV of expected stream of benefits (resource rents) flowing from developing the natural resource. • But resource rents are not observable and must instead be inferred from reported gross operating surplus (GOS) of the extractive industry.

Measuring the value of natural resource assets and their depletion, continued… • Depletion is the decline in value of the natural resource as a result of its physical extraction. • Depletion could be thought of as the amount we need to set aside from present operating surplus to allow replacement of the natural resource. • What price should apply to the natural resource?

Extraction of the natural resource • When natural resource extraction takes place, the below-ground resource changes into an above-ground resource. They are different products. Extractive activity causes the change. • Extraction takes place on the assumption that the price above-ground will exceed that below-ground. • The depletion charge seeks to replace the natural resource at its below-ground price.

Resource rent is based on ‘above ground’ prices

Extraction of the natural resource, continued... • Typically, as we move forward one accounting period, operating surplus (containing the resource rent) is earned from production - we need to capture depletion • We must estimate (and remove) the income element of the resource rent to derive depletion. • But we only know opening asset value (V1) and the resource rent (RR)

Extraction of the natural resource, continued... • So the income component of RR must be calculated as: income = RR – V1 * r (where r is the expected return on the natural resource asset) • i.e. as production proceeds, we ‘release’ one year of RR value from the asset stock – we must also estimate the income component to derive depletion.

‘Time passing’ • ‘Time passing’ is the unwinding of the income component of the natural resource asset value. It is the r * V1 component of the equation depletion = RR – r * V1 • It is an essential component of our NPV model • But income earned from extractive activity is captured through our regular income sources and methods

‘Time passing’, continued… • ‘Time passing’ effect is not an issue where market values are available. • It is a feature of the NPV model, but we do not have to explicitly articulate ‘time passing’ when accounting for changes in asset stock values. • In the production and income accounts, depletion-adjusted operating surplus needs only to identify the depletion variable- No need to also show resource rent and ‘time passing’ elements (already included in GOS)

‘Time passing’ in the SNA • ‘Time passing’ effect has been known about for many years in the derivation of consumption of fixed capital. • Where NPV is used to derive SNA consumption of fixed capital, conventional practice is to simply net-off ‘time passing’ against capital services. • SNA produced capital :: consumption of fixed capitalSEEA natural capital :: depletion (consumption of fixed capital)

SNA treatment of consumption of fixed capital (CFC)

SNA treatment of consumption of fixed capital (CFC)…..not…

SNA: possible reasons for asset value change… • Essentially, change in value of an asset is accounted for in one of three ways in SNA:- 1. stock change due to consumption within productive process. Or acquired / disposed of in transactions with other economic entities- 2. changes due to events not related to economic events e.g. catastrophic events.- 3. changes due to asset price changes. These holding gains/losses recorded in revaluation account • SNA: depletion recorded in the first grouping.

Is ‘time passing’ benefit a holding gain? • Because the ‘time passing’ effect increases the (NPV) modeled value of the natural resource (and this happens even if no production occurs), surely this must be a holding gain? • But this effect occurs independent of any observable price change. A holding gain without price change? • NPV model operates on an assumed expected production schedule. Results are usually useful and intuitive - but not always!

‘Time passing’ as a holding gain… • Assume that we decide to treat the ‘time passing’ effect as a holding gain, what are the implications? • Depletion equals entire resource rent i.e. we now make provision to replace not only the natural resource, but also the income earned from using the resource. • But we only do this where NPV technique used. Where market values available, we calculate depletion as decline in asset value due to extraction.

‘Time passing’ as a holding gain, continued… • Where NPV valuation used, depletion-adjusted operating surplus for extractive industries would largely disappear. • This ignores realities of potentially substantial income (and tax revenue) derived from extraction. • Fundamental change in our basic accounting principles.

‘Time passing’ as income (redefined, Hicksian) • Problems in previous slides are placated by treating ‘time passing’ as a redefined (Hicksian) income. • i.e. that ‘time passing’ does not arise from productive activity but nevertheless gives rise to income. • Creates a major difference in the accounting principles applying to SNA and to SEEA.

‘Time passing’ as Hicksian income, continued… • would for example lead to different treatments in SNA and SEEA for the same natural processes • e.g. Natural growth of forests: for plantation (cultivated) forest is ‘production’ in SNA; but not production in SEEA. But income arises in both cases. • Would require re-think of treatment of new discoveries and reclassifications of natural resources. Can these give rise to income directly, i.e. in absence of any productive activity?

Questions… • Natural resource assets will change in value over time. How do we best explain ‘time passing’ in this context? • Is it simply an input to our (modeled) measure of depletion? Or is it a holding gain? • If the latter: Are we comfortable in creating fundamental differences in accounting principle between SNA and SEEA? • If the former: Do we still consider NPV approach appropriate for valuing natural resource assets?

‘Time passing’ and measuring depletion