Metals&Mining in Russia_eng_10s

Metals and MiningReview of trends in the metals and mining industry – 2010

Metals and Mining in Russia and the CIS

ii PricewaterhouseCoopers

Welcome to this inaugural edition of Metals and Mining in Russia and CIS, published by PricewaterhouseCoopers Russia. The metals and mining sector in this region has always been a core driver of economic activity. The health of the industry is essential to the creation of wealth – through employment, infrastructure development, taxes to governments, and profits to owners. For the last six years PwC has published a global mining survey of the 40 largest public mining companies in the world, which has become a flagship publication used by stakeholders in the industry around the world. Over that period of time we have seen the development of the sector in Russia and the CIS. As such we felt it was time for a separate publication dedicated to this market place.

We have studied the financial statements of the twenty largest companies in the region covering Russia, Kazakhstan and the Ukraine which publicly issue financial information in accordance with either US GAAP or IFRS. We then aggregated their financial information to provide a snapshot of the industry over the two and a half years from the beginning of 2007 to the middle of 2009. We chose these companies because their financial reporting provides reliable information for analysis. Transparency in financial reporting is critical to the development of efficient capital markets, and we believe that providing an analysis of this information may be a catalyst for others in the industry to aspire to the level attained by these twenty companies.

What we found is not surprising in many respects. All these companies were deeply affected by the economic downturn which occurred in the second half of 2008 and continued into the first half of 2009. Commodity prices dropped drastically as demand for metals and mining products dried up. Profits in the sector declined 31% in 2008, and the level of debt to total capitalisation ballooned to 62% from 37%. But the companies in this sector have responded to the crisis by cutting costs and restructuring operations. The rebound of commodity prices in 2009 is perhaps an indication of the beginnings of a return to more profitable and sustained economic activity.

In addition to the financial analysis, we have included a number of articles on topics of interest. We examine the challenges associated with preparing a company for an initial public offering of its shares. With the opening up of the capital markets, we expect many companies to follow the lead of UC RUSAL and pursue a public share offering. Our article identifies some of the pitfalls of the IPO path, and some strategies to avoid them. We also look at the legislative and regulatory landscape in Russia, Ukraine and Kazakhstan. Finally, we review the importance of sustainability as well as tax incentives in the metals and mining industry in Russia.

We hope you enjoy reading this publication and welcome any comments you may have. We look forward to continuing to study this industry and its impact on our region in future publications.

John Campbell Central and Eastern Europe Metals and Mining Leader PricewaterhouseCoopers

Foreword

Financial hightlights

2 PricewaterhouseCoopers

Metals and Mining in Russia and the CIS 3

Financial Analysis

Income statement 5

Industry in perspective 10

Balance sheet 14

Statement of cashflows 16

Articles

Thinking of an IPO? Is your company prepared? 19

Russia: opportunities, and legislative challenges 21

Mining in Ukraine 23

Taxation of the mining industry in Kazakhstan 25

Sustainability in mining 27

Tax incentives in the Russian mining sector 28

Appendix 30

Content

Industry in perspective

4 PricewaterhouseCoopersMetals and Mining in Russia and the CIS 4

Financial analysis


Income statement

Revenue increased from $93 billion to $120 billion, reflecting the significant impact of acquisitions made by a number of companies during the year, particularly the large integrated steel companies. However the increase in revenues of 29% was more than offset by an increase in operating costs of 45%. While the first half of the year was characterised by high commodity prices and robust volumes, the second half of the year witnessed the most severe economic crisis in Eastern Europe and the CIS countries since 1989. The collapse of demand for steel and most other commodities led to sharply decreased volumes. Currency devaluation in many Eastern European countries exacerbated the situation. High acquisition prices paid during the peak of the cycle resulted in significant asset impairment charges at the end of 2008.

Across the 20 companies, asset writedowns and impairment charges amounted to $8.2 billion, up from $2 billion, over half of which was attributed to Norilsk Nickel’s writedown of its LionOre assets. Severstal and Evraz also recorded large charges following earlier acquisitions of businesses in North America.

Operating Costs were up from $58.1 billion to $84.4 billion. Globally, the growth in operating costs exceeded revenues by 4%. In Russia and the CIS, growth in operating costs outstripped growth in revenues by 25%. In previous years one of the advantages of operating in the region was the relatively cheaper cost of inputs, especially labour and consumables. 2008 saw costs in the region escalate sharply as demand for skilled labour resulted in broad wage rises, and higher energy costs which resulted from record crude oil prices. While pre-tax profit was 17.8 billion, this is down 33% from the prior year. This dramatic decline highlights the need for management in the region to develop strategies for effectively responding to the margin squeeze, while ensuring operations are suitably positioned to respond to the inevitable economic upturn.

Exploration Costs: rose from $290 million to $430 million, reflecting the optimism present in the resources and metals sector during the first half of 2008. It is noteworthy that even during the peak of the minerals boom, expenditure on exploration is insignificant compared to overall operating costs.

2008 $ million

2007 $ million

Change %

Revenue 120,542 93,340 29

Operating expenses (84,399) (58,135) 45

Adjusted EBITDA* 36,143 35,204 3

Amortisation, depreciation (7,204) (5,701) 26

Impairment (8,199) (2,006) 309

PBIT 20,740 27,497 (25)

Net interest cost (2,910) (934) 212

PBT 17,830 26,563 (33)

Income tax expense (4,827) (7,773) (38)

Net profit 13,002 18,790 (31)

Aggregated income statement

* EBITDA adjusted to exclude impairment charges


Income statement

In the CIS region, the larger companies account for a significant portion of industry revenues. The Top 5 companies by revenue accounted for 66% of total revenues in 2008, consistent with 2007.

Severstal and Evraz revenue figures benefited from the major acquisitions these two companies made during the year. Severstal acquisitions included Sparrows Point, Esmark and WCI Steel, all located predominately in the eastern and northeastern United States. Evraz acquired Claymont Steel in the US, IPSCO in Canada, and various steel, iron ore and coking plants in Ukraine.

With the collapse of nickel prices in 2008, Norilsk slipped from 1st place in 2007 to 3rd in 2008.

Novolipetsk Steel (NLMK)’s revenues saw the benefit of the full year contribution from Maxi Group (Russia), acquired in December 2007, and Beta Steel (US), acquired in October 2008. The proposed $3.5 billion acquisition of John Maneely Company of the US announced in mid 2008 was aborted late in the year.

Magnitogorsk Iron and Steel (MMK) revenues increased in part due to its acquisition of an interest in Belon, a coal mining company in Russia, and the commissioning of a new steel mill in Turkey.

Company 2008 $ Billion

2007 $ Billion

2008 Net Profit Margin %

2007 Net Profit Margin %

Severstal 22.39 15.50 45 12

Evraz 20.38 12.86 3 17

Norilsk 13.98 17.20 26 31

NLMK 11.70 7.72 309 29

Magnitogorsk 10.55 8.20 (25) 16

Top 5 By Total Revenue


Income statement

Looking at the financial results for the first half of 2009 compared to the first half of 2008 even more clearly shows the impact of the fall in commodity prices.

The full year results for 2008 were somewhat shielded by the strong commodity prices enjoyed in the first half of the year. What is interesting to note is that companies continued to turnover significant volumes in sales during the second half of the year, yet at drastically reduced margins. The first half of 2008 contributed slightly less than 50% of sales revenues, but nearly 100% of net profit for Severstal and Evraz. Norilsk’s strong USD2.7 million first half result was wiped out in the second half of 2008 with the collapse in nickel prices. NLMK and MMK were able to build slightly on their 1st half result. Revenues for these two

companies were consistent through both halves of 2008, but similar to their metals industry rivals, at greatly reduced margins.

The first half of 2009 has not been a happy one for the Top 5 players. Revenues across the Top 5 are down on average 50%, and bottom lines have been significantly impacted. Interestingly it has been Norilsk, strongest hit by the collapse in commodity prices, which has been able to rebound the strongest. The only one of the Top 5 companies to turn a positive result, Norilsk has been able to take advantage of the encouraging rebounds in nickel prices (discussed in more detail in the next section). The effects of cost saving measures implemented in response to the commodity price crash were also noticeable.

Company Revenue 1H 2009 $ Million

Revenue 1H 2008 $ Million

Net Profit 1H 2009 $ Million

1H 2009 Net Profit Margin %

Net Profit 1H 2008 $ Million

1H 2008 Net Profit Margin %

Severstal 5,648 10,718 (989) (17) 2,019 19

Evraz 4,639 10,723 (999) (21) 2,039 19

Norilsk 4,078 8,311 439 11 2,682 32

NLMK 2,586 5,884 (242) (9) 1,531 26

Magnitogorsk 2,003 5,653 (51) (3) 816 14

A tale of two halves…


Many commodities saw peaks in prices in 2007, and continuing robust prices for the first half of 2008. The decline in prices in the second half of 2008 was particularly severe for copper, zinc, aluminium and nickel. The sharp decline in prices added to the pressure on margins, already squeezed by higher operating costs.

Copper $/Tonne

Gold $/oz

Nickel $/Tonne

Aluminium $/Tonne

2003 (Avg) 1,789 364 9,616 1,431

2004 (Avg) 2,868 410 13,840 1,717

2005 (Avg) 3,684 445 14,747 1,900

2006 (Avg) 6,725 604 24,270 2,568

2007 (Avg) 7,124 697 37,225 2,638

2008 (Avg) 6,938 872 21,048 2,567

2008 (Close) 2,902 862 10,808 1,454

2009 (Avg) 5,164 974 14,712 1,671

2009 (Close) 7,346 1,097 18,452 2,197

Income statement

Commodity Prices

0.000

0.500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

4.500

2003(Avg)

2004(Avg)

2005(Avg)

2006(Avg)

2007(Avg)

2008(Avg)

2008(Close)

2009(Avg)

2009(Close)

Copper

Gold

Nickel

Aluminium

2008 was highlighted by significant decreases across a broad range of commodity prices:

Commodity Prices rebased since 2003

Key commodity prices: 2003 - 2009


Rebounds

During 2009, most commodity prices rallied, gradually clawing their way back to levels approaching the ‘happy times’ of 2007 and early 2008. While some of the increase in commodity prices during 2009 can be attributed to the weakening of the US dollar, producers will be encouraged they remained robust throughout the year and into 2010.

Copper: Started recovering in Q1 2009 to $4,000 per tonne, and went on to average above the $5,000 per tonne mark for 2009. Welcomed in the New Year above $7,000 per tonne and in January 2010 is still encouraging at $6,700 per tonne.

Nickel: Savaged in 2008, the collapse in the Nickel price was enough to knock Norilsk from the position of top revenue earner in the region to that of number 3. Rose consistently during 2009. Now into January 2010, Nickel is up 70% from December 2008 at 18,500 per tonne.

Aluminium: Rusal’s high profile public offering came to fruition in January 2010. Investors will hope aluminium prices continue to recover, up 25% since December 2008.

Gold: One of the few commodities to emerge unscathed from the economic downturn. Gold has continued its appreciation in value since 2003. Historically gold has been subject to less severe fluctuations than other commodities. Gold broke the psychological USD$1,000 per ounce barrier in 2009.

Income statement


2007 Revenue 2008 Revenue

Steel segment contributors

The Metals and Mining industry in Russia and the CIS is dominated by the large integrated steel companies. Pure mining revenue represents only 31% of the total, down from 38% a year earlier, as the steel companies expanded their operations.


38%

47%

15%

The steel industry in the region is characterised by a high level of vertical integration of operations. Most large steel producers have both coal and iron ore mines to provide the raw materials to feed their steel mills.

Supplies of these raw materials from subsidiary companies to steel operations within the same group amounted to approximately $3.2 billion in 2008, up from $2.3 billion in 2007.

Steel

In 2007 and 2008, four of the top five revenue generating companies operating in the metals and mining industry in the CIS are steel producers.The steel segment alone accounts for 52% of the total revenues generated by the Group of 20 companies, up from 47% in 2007.

The steel processing segment is dominated by a small number of large companies operating primarily in Russia. Out of the Group of 20, only six are involved in steel processing, yet these six are responsible for such a significant percentage of industry revenue.

0%

5%

10%

15%

20%

25%

30%

35%

Evraz

Severs

tal

TMK

Mag

nitog

orsk

Novolip

etsk

Mec

hel

2008

2007


is expected to be maintained as some encouraging signs of economic recovery begin to emerge. Is it just a matter of time before Russian steel producers look for more involvement in Chinese, and other Asian markets?

Russian steel prices, $/tonne FCA


The contribution to total steel segment revenues by the six companies has been consistent in 2007 and 2008. No individual company in the segment has been more adversely or advantageously affected by the economic climate in relation to share of revenues.

Like almost every other segment in the industry, steel prices were adversely affected by the global economic downturn. Drastic falls in prices in the second half of 2008 forced significant production cuts in the industry.

Steel producers hope to see some positive effects from these production cuts in 2009, but as can be seen from our analysis of the Top 5 revenue earners, it looks like the effects are more likely to be felt in the second half. An advantage that most Russian steel makers have is a high level of upstream integration into Iron Ore, and to a lesser extent, coking coal. This has at least allowed steelmakers to control these input costs, to an extent.

1.200

1.000

800

600

400

200

0

Dec

’07

Jan’

08

Feb

’08

Mar

’08

Apr

’08

May

’08

Jun’

08

Jul’0

8

Aug

’08

Sep

’08

Oct

’08

Nov

’08

Dec

’08

Jan’

09

RebarHot rolled coil (HRC) Cold rolled coil (CRC)

Source: Chermet, Troika estimates

New Markets?

China’s demand for steel has historically been satisfied by producers in Japan, Taiwan and local Chinese producers. As a result of the Chinese government’s stimulus package, demand for steel was up strongly in 2009, and this level of demand


Mining segmental analysis by revenue


0%

5%

10%

15%

20%

25%

30%

Fertilizergroup minerals

2008

2007

Copper Zinc Iron ore Diamonds Coal Nickel Platinum Gold

Mining

Despite relatively lower production compared to nickel and copper, gold revenues increased on the back of robust prices.

Unique to the CIS is the significance of the mining of potash and other minerals used in the fertiliser industry. Prices were not as adversely affected as other base commodities and this sector of the mining industry now ranks near nickel and above coal and iron ore in terms of revenues.

Highlights

The story in the mining segment in 2008 is largely about the decline in revenue of nickel, which dropped from almost 30% of the total segment, to just over 15%, as prices declined.

As noted in our global Mine publication, iron ore and coal prices remained robust as most deliveries are made under fixed term contracts, and these are negotiated in Q2 2009. Although prices eased during those negotiations, they remained buoyant for the full year in 2008.


Revenue by customer location


0%10%20%30%40%50%60%70%80%90%

Asia Pac N&S America Europe Other

2008

2007

Overall customer spread

in the years ahead more companies operating in the CIS look to expand their markets into Asia. We expect to see Asian industrial companies diversify their supply of raw materials away from Australia and Indonesia, to access the rich mineral resources in Central Asia and Eastern Europe. However massive investments in infrastructure, especially railroads, will be necessary to fully take advantage of these resources.

The mineral hungry Asian economies are primarily served by significant commodity producers in the region such as Australia and Indonesia. As industrialisation and urbanisation continues in China and India, we would expect Asian markets to continue to grow in the medium to long term. While geographically well placed to serve European markets, most of Europe is only now showing the first signs of recovery from a deep recession. It will be interesting to see whether

% of non mining revenue

Other

Highlights

The percentage breakdown of revenue in this sector remained relatively stable year on year.

Several companies involved in the industry in CIS generate significant revenues from energy and utility operations, for example ENRC, Mechel and Norilsk all own significant power generation assets.


Balance sheet

2008 $ Million

2007 $ Million

Change %

CURRENT ASSETS

Cash and cash equivalents 14,773 13,451 10

Inventories 17,561 13,676 28

Receivables 14,301 13,163 7

Other current assets 5,808 12,016 (52)

Total current assets 52,443 52,306

NON-CURRENT ASSETS

Investments 8,657 6,384 36

Property, plant and equipment 76,806 77,152 0

Goodwill 6,472 8,451 (23)

Other non-current assets 11,513 10,272 12

Total non-current assets 103,448 102,259

Total assets 155,891 154,565

CURRENT LIABILITIES

Payables (13,029) (12,480) 4

Borrowings (20,472) (15,272) 34

Other current liabilities (3,741) (1,809) 107

Total current liabilities (37,242) (29,561)

NON-CURRENT LIABILITIES

Borrowings (29,086) (19,069) 53

Deferred taxation liabilities (6,348) (10,158) (38)

Other non-current liabilities (3,868) (3,792) 2

Total non-current liabilities (39,302) (33,019)

Total equity 79,347 91,985

Net assets 79,347 91,985 14


Balance sheet

The companies included in our survey also experienced a significant increase in borrowings during 2008. In the early part of the year these borrowings were caused by the major business acquisitions made by many of the companies in the sector. In the latter part of the year borrowings for some companies were required to fund cash flow shortfalls caused by the sharp deterioration of business conditions. A further complicating factor was that most companies have borrowings denominated in US dollars. With the decline in value of the Russian Rouble by approximately 20% and the Kazakh Tenge by 22% (in February 2009), this US dollar denominated debt suddenly became much more expensive, creating an additional strain on many companies. Overall, the ratio of debt to total capitalization in the sector deteriorated from 37% to 62%.

Highlights

Increase in inventories: During peaks in commodity prices in 2007 and early 2008, the focus was on production. Growth in volumes took precedence over controlling costs. When the effects of the financial crisis snowballed from being isolated to the banking sector to triggering a general global downturn, demand for commodities declined and many operations found themselves with inventory levels at the end of 2008 much higher than anticipated.

Other current assets are comprised mainly of short term deposits and financial investments. This number halved during 2009 as entities drew down their deposits to compensate for decreased cashflow generation. The value of short term equity investments held at year end was also significantly less than in 2008 as global market indices fell to record lows.


Statement of cashflows

2008 $ Million

2007 $ Million

Movement %

Net operating cash flows 26,243 22,303 18

Cash flows related to investing activities

Purchases of property, plant and equipment (17,491) (11,724) 49

Purchase of investments excluding controlled entities, including advances

(4,601) (5,127) (10)

Purchases of, or increased investment in, controlled entities (10,073) (14,445) (30)

Purchases of financial assets (902) (4,005) (77)

Other (1,338) (2,869) (53)

Investing cash outflows (34,405) (38,169) (10)

Proceeds from sale of property, plant and equipment 458 588 (22)

Proceeds from sale of investments 1,179 988 19

Proceeds from financial assets 3,841 2,778 38

Other proceeds 3,475 1,330 161

Net investing cash flows (25,453) (32,485) (22)

Cash flows related to financing activities

Proceeds from ordinary share issues 237 4,807 (95)

Proceeds from interest bearing liabilities and borrowings 45,550 34,956 30

Repayment of interest bearing liabilities and finance leases (32,921) (20,534) 60

Transactions with shareholders

- Dividends paid (7,807) (5,561) 40

- Share buy back and other distributions to shareholders (3,287) 1,271 (359)

Other (300) (297) 1

Net financing cash flows 1,473 14,641 (90)

Net increase/(decrease) in cash and cash equivalents 2,262 4,459 (49)

Cash and cash equivalents at beginning of period 13,452 8,239 63

Effect of foreign currency exchange rate changes on cash and cash equivalents

(940) 754 (225)

Cash and cash equivalents at end of period 14,773 13,452 10


Statement of cashflows

Highlights

Investing activities: Down from $19.6 billion to $14.7 billion – most 2008 transactions occurred in the first half of the year, prior to the decline in commodity prices. Overall, business acquisitions declined 30% in value compared to 2007.

PP&E: Up from $11.7 billion to $17.5 billion – again mostly in the 1st half of 2008 as producers scrambled to improve infrastructure and capacity to take advantage of record prices.

Financing: Gross proceeds from borrowings up 30%, while gross repayments also up 60% as companies repayed debt taken on as a result of transactions in 2007 and 2008.

Share raisings: Down from $4.8 billion to $237 million – very little in the way of capital raising in 2008.


Articles


Going public is a major challenge for any company and not just from the point of view of increased public scrutiny, enhanced market expectations and additional reporting requirements post flotation. You may have considered the implications of an IPO for your business – from the benefits such as increased shareholder value and wider access to capital to the potential drawbacks such as a loss of control – but what about the run-up to flotation?

In our experience, the most successful listings are those that are well planned, have adequate resources and benefit from clear leadership and ownership provided by senior management. While each global exchange has its own eligibility requirements, the key, wherever you decide to list, is in the planning and preparation. Indeed, there is always a significant amount of work needed upfront to get the company ready for an IPO; this is not simply about appointing advisers but about ensuring that the company is fit to be listed on a public market.

So what are some of these key challenges?

• Early planning and preparation – a company should have a clear timeframe in mind for going to market and a clear action plan designed to achieve this. Even in challenging economic environments, such as those experienced in the past eighteen months, early and focused preparation will enable a company to be ready to float when the markets recover, potentially stealing a march on the competition for the reopening windows of opportunity. In addition, many flotations take longer than initially envisaged; this is often due to issues uncovered during the due diligence; changing market conditions; unrealistic timetables and the complexity of preparing the financial history. The earlier the process is started the better.

• Quality of the team – assembling an experienced and dedicated team, including the right executive management team and first class external advisers, is crucial for providing clear guidance and direction as a company prepares itself for an IPO. As part of this team, the company will normally be required to engage reputable reserve engineers to prepare a competent person’s report (‘CPR’) to assess the

quality of the company’s mineral reserves. Early engagement and scoping is key to allow sufficient time for completion, since this report has a direct bearing on the valuation of the company.

• Awareness of the impact – an IPO process consumes a significant amount of time and resource from a senior management level down through the organisation. The IPO preparation process is in addition to everyone’s day jobs. The impact of these extra demands is often underestimated, from the implications for the overall governance environment, increasing the risk that day-to-day business issues are not addressed in a timely fashion, to the impact on the morale of the company’s employees as a result of the increased workload. Awareness of this risk will enable the impact to be managed, such as through the development of an incentive structure aligned with the IPO process that motivates and retains key employees.

• Establishing robust governance and reporting environment – before going to market, a company needs to have in place a high quality corporate governance environment underpinned by robust management information and reporting systems. Effectively, the entity should be operating as a public company before it floats. This may require significant changes to the current governance, reporting and control environment with improved transparency (such as around related party transactions) and better corporate housekeeping, including good documentation. Changes may range from improvements in the budgeting and forecasting function or internal control environment to strengthening the executive management team and establishing a new board of directors. Willingness throughout the company to accept and implement such change is crucial.

• Presentation of the financial history – the requirement to provide historical financial information in the Prospectus can often prove more challenging than at first anticipated. This could involve issues such as presentation of complex financial histories in the event of significant acquisitions in recent periods, consideration of complex IFRS accounting and reporting issues and choice of the appropriate IFRS accounting policies, or sourcing additional information for disclosure.

Thinking of an IPO? Is your company prepared?


it will also greatly increase the prestige of the company as well as provide an exit strategy for existing shareholders, and funds to drive the business forward. In short, the benefits usually outweigh the challenges of getting there.

In order to achieve as smooth a listing process as possible, careful thought and planning are required, even before any detailed work on the flotation begins. Companies that acknowledge this and prepare accordingly are those that gain the most from the process. By planning early and engaging the key internal stakeholders as well as external advisers, important issues can be highlighted and addressed up front, thereby minimising any unpleasant surprises and saving time and money.

Once a company begins its life as a listed company, it faces a new set of challenges as it needs to maintain effective communications with investors and analysts, grow shareholders’ value by delivering on promises made at the time of the IPO and fulfill its continuing listing obligations. An IPO is only the beginning of a long journey to excellence, market leadership and business prosperity. Upon becoming a public company, it is then that the challenge of being a listed company begins!

In addition to the presentation of the financial information, there is increasing focus in the markets on non-financial measures, such as management’s experience and the corporate strategy, as well as integrity of the non-financial KPIs. Careful consideration needs to be given to the compilation and presentation of this data.

• An attractive investor ‘story’ – the preparation of a well constructed, attractive investor ‘story’ is crucial and a key ‘suitability for listing’ criterion. This should clearly identify the unique features of your company and articulate the objectives of the offer, the rationale behind them as well as future plans. More than ever, investors are placing emphasis on a credible equity story together with the potential to improve underlying operations. Alongside the preparation of this ‘story’, the ability to provide your potential investor base with timely and reliable information about the company’s progress and key business issues is vital during the IPO preparation process.

However, despite the challenges associated with going to market, a listing does give a company access to significant pools of capital and a diverse investor base;

Thinking of an IPO? Is your company prepared?


With an area of over 17 million square kilometres –

about twice the size of the US – Russia is one of the

most mineral rich countries on earth. Russia ranks

first in the world in nickel production, and boasts

the world’s largest known reserves of the metal.

Russia also ranks among the world’s top 3 producers

of platinum, gold, diamonds, iron ore

and coal. The abundance of diverse minerals has

also enabled Russia to develop a mature metals

processing industry. Russia is the world’s second

largest producer of aluminium and fourth largest

steel producer. Despite the highly attractive

prospects on offer, Russia represents a challenging

environment for mining companies. Bureaucratic

complexities, along with significant capital

investment requirements, present formidable barriers

to entry – especially for foreign companies.

Of significant concern to foreign mining companies in Russia are bureaucratic delays and corruption – these significantly escalate the costs of doing business. The Russian state holds rights over all mineral tenements. Historically, these tenements have been auctioned to mining enterprises for development. However, these auctions can be unpredictable and non-transparent. Once a tenement is obtained, mining license terms for the ongoing use of the tenement can be onerous and inflexible. However, the most significant recent legislative development relates to the extent to which foreign companies can in certain instances participate in Russian mineral operations. In April 2008 the outgoing President, Vladimir Putin, signed a law restricting foreign investment in sectors of strategic importance and amending the subsoil law. Among other areas, such as defence, technology and nuclear energy generation, this piece of legislation also categorises certain mineral deposits as being of strategic importance to the Russian Federation. The law limits foreign investment in operations related to developing such deposits. Minerals of strategic importance covered by the new version of the law include (among others): platinum, nickel, cobalt, uranium, diamonds and large deposits of gold and copper.

Impact on foreign investors:

The law restricting foreign investment in sectors of strategic importance applies when a foreign investor, or group of foreign investors, has direct or indirect control over 10% or more of the total votes, as represented by voting shares in the share capital of the strategic subsoil user (in instances when a foreign investor is controlled by a foreign state or an international organisation). This is deemed as “control” over an organisation of strategic importance using federal subsoil. Alongside the legislation, a special government body known as the Governmental Commission for Control Over Foreign Investments in Russia (the “Commission”) was created. Headed by the Russian Prime Minister, the Commission grants consent to the acquisition of control. In addition, the Federal Antimonopoly Service (“FAS”) was empowered to support the Commission. In order to obtain consent, applicants must submit for consideration to FAS necessary documents together with an application for receiving consent to the acquisition of control. This is followed by a final decision from the Commission to refuse or accept the application. The Commission is also authorised to approve the application provided that the foreign investor assumes certain obligations.

Implementation of the law restricting foreign investment

The law is still in its infancy and, as yet, there has been relatively little in the way of implementation experience. Since early 2009, the Commission has met on average once every two or three months. In that time it has ruled that a few dozen applications do not fall under the provisions of the strategic law, and the Commission therefore had no authority to consider them. While this may be encouraging for potential foreign investors, what is of concern is the backlog of applications which still require processing. There are currently more than a few hundred applications being considered by the FAS, and with only an average of 10 – 12 being reviewed at each Commission meeting, there is a risk that the process could evolve into a complex bureaucratic bottleneck that hinders the momentum of transactions and creates uncertainty in the business community. Frustratingly, there is no public information available on the grounds under which applications were rejected, as neither the FAS nor the Commission are required to publish such information.

Russia is not only a country of great opportunities – but also legal challenges


of this is foreign banks operating in the Russian Federation. In order to protect the integrity of their information systems, they use complex encryption software and hardware for encrypting information. Under the law, the use of such technology is deemed to constitute grounds for considering the whole activity of the entity as ‘strategic.’ Although this situation has not led to any demands for these banks to lodge applications for FAS approval, it serves as a vivid example of how cumbersome the application of the law can be in practice. Another trigger for an application to the FAS and preliminary consent from the Commission can arise where a group structure, established and managed from Russia and holding licences for strategic deposits, contains foreign entities.

Conducting business in Russia, especially in the extractive industries, is strewn with both opportunities and challenges. To succeed, a clear understanding of the often vague and broad sweeping legislative requirements is a must. However, our experience has shown that although this law places significant additional requirements on potential foreign investors, with the right support and knowledge these can be overcome.

IIn addition to adopting the law restricting foreign investment, significant amendments were made to the subsoil law. In line with these changes, if during the geological survey of a subsoil plot a foreign investor discovers new mineral deposits which will be recognised as being of strategic importance, then the Russian Government will be entitled to terminate the company’s right to further develop the discovered deposits. In this case, the Russian Government will be required to compensate the company’s costs incurred in connection with prospecting and evaluating the discovered deposits and pay a fee for discovering the deposits of 30%-50% of the company’s costs, depending on the type of the mineral.

PricewaterhouseCoopers is currently actively involved in assisting several clients with applications to the FAS. Our legal support group assists in preparing documentation supporting the applications and liaising with the relevant government agencies. From our experience to date with this law, we have encountered situations where foreign companies have become ‘accidentally’ caught up in the law restricting foreign investment, as a result of the broad nature of the industries defined as ‘strategic’; in fact, the law can cover practically all Russian industries. An example

Russia is not only a country of great opportunities – but also legal challenges


Ukraine, the country with the largest territory in Europe after Russia, holds significant amounts of diverse mineral resources. It is among the largest holders of proven reserves of iron, manganese, titanium, uranium and zirconium ores, kaolin and coal. Ukraine has developed a strong iron ore extracting and steel processing industry, with large mining groups servicing the European, Middle Eastern and Asian markets. The diversity of the minerals and their abundance, as well as Ukraine’s favourable geographic access to markets in Europe, provides incentive for further development of the mining industry.

The Ukrainian mining industry has great potential and attracts attention from outside Ukraine. It is notable, however, that after 18 years of Ukrainian independence the previously state-owned mining industry is now substantially concentrated in the hands of tycoons and politicians. This, along with sometimes vague and inefficient legislation raises challenging barriers for foreign investors wishing to enter Ukraine.

Operations related to the mining of natural resources are subject to the Government’s regulation and approval. Here arises the key problem of obtaining and holding special permits for the exploitation of mineral deposits and fields. The process of granting mining permits is quite opaque and bureaucratised. The permit can be obtained via participation in a special auction organised by the Government. From a practical perspective, only legal entities registered in Ukraine are allowed to participate in these auctions. A serious drawback of the system is the right of state-owned entities to receive mining permits without such a requirement. Only a relatively small number of permits have been granted to private companies in recent years.

On the other hand, foreign investors can participate in the Ukrainian mining sector via joint venture agreements with local entities (independent of the type of ownership) holding valid permits. In spite of its apparent simplicity, this mechanism bears certain risks. Ukrainian tax authorities use legal imperfections to try to restrict the use of joint venture agreements and claim that only the permit holder is obliged to pay rent and other obligatory payments. The tax authorities disallow any further recharging of these

payments to the joint venture. The Ukrainian business community operating in this segment has repeatedly raised this issue with government officials, however to date no significant change has been introduced and the legal and tax treatment of joint venture agreements remains unclear.

In the field of taxation of mining companies, no substantial changes took place in 2009. Currently mining companies are obliged to pay:

• payments for the use of mineral resources (established primarily as fixed rates applicable to the amount of resources mined);

• a duty for geological surveys in cases where they were financed from the state budget;

• charges for the issuance or re-issuance of permits (separate from the payment made for the purchase of such permit); and

• rental payments, such as additional charges for producers of oil, gas and gas condensate.

There are no indications that mining payments and tax rates are going to increase significantly, however some changes may be introduced with the adoption of the Law on State Budget for 2010. Taking into consideration the continuing financial market uncertainty, economic slowdown and growing budget deficit, the currently low rates of mining payments might be increased with the aim of balancing the state budget. There is also a draft law on rental payments suggesting replacement of payments for the use of mineral resources with rental payments which will be linked to the market price of minerals. Due to the strong lobbying power of the mining industry it is unlikely that this draft will be adopted anytime soon. It is also difficult to judge how the outcome of recent Presidential elections will influence the Ukrainian mining sector.

Recently, the Ukrainian mining industry has been faced with the substantial and growing redistribution and concentration of natural resources by the government. The intention of politicians is to improve their position in the mining sector by reinforcing the position of state companies and establishing State-owned specialised holdings. At the same time, certain state-owned companies are likely to be privatised in the near future. The presidential election has sharpened the struggle for these entities.

Mining in Ukraine


Both legal and illegal methods are used by various mining groups to establish their control over the main companies subject to privatisation in mining and related sectors.

Recent developments related to KGOKOR (Kryvyi Rih Oxidized Ore Mining and Processing Plant, one of Ukraine’s more strategic entities in the mining industry) highlight these challenges. Construction of KGOKOR began in 1985 and after the dissolution of the USSR it was closed down. Construction still has yet to be completed and Ukraine is obliged to repay about USD500 million to investors. Recently a joint venture including the participation of Russian mining groups was established for the purpose of completing construction. At the end of 2009 the project was restructured whereby a part of the assets of KGOKOR were transferred to a private firm. The Government responded quickly, declaring the sale void and cancelling the resolution establishing the joint venture.

PricewaterhouseCoopers is the leading firm providing professional services to energy, utilities and mining companies. Our Tax and Legal team has extensive experience in provision of services to mining companies both in Ukraine and other jurisdictions, including due diligence services, tax support during business restructuring, compliance with tax law requirements, assistance to clients in preparing documentation required for auctions and support during tax litigations.

Mining in Ukraine


a significant challenge to develop the secondary and service sectors of Kazakhstan’s economy into efficient and commercially successful enterprises without the assistance of major foreign (Western) companies.

2009 was a turbulent year for the Kazakhstan economy due to it being largely dependent on the export of mineral commodities. The oil, gas, and mining industries were hit hard by the sharp decline in commodity prices, exaggerated by an increased taxation burden. This situation spurred talks within the industries and in government circles of lowering taxes. This is, however against the official policy of the Kazakhstan Government of generally increased taxation of subsurface users. This stance was manifested in the “new tax code” which was implemented in the midst of high commodity prices and record industry revenues in 2008. At the time, increased taxation of these revenues seemed logical. With lower revenues and rising cost pressures forcing miners to cut production and in many cases employee numbers (ArcellorMittal Temirtau alone has sent on unpaid leave 4,200 of its employees2), the Government went ahead and lowered the Mineral Production Tax, but only to mining companies that were forecasting to have ‘zero profitability’.3 This initiative has received a mixed reaction, with mining companies concerned that the ‘zero profitability’ qualification is vague. They also point out that if the project is not profitable it would make more sense to be subject to zero percent tax.4

Recent times have been challenging for subsurface users in Kazakhstan. With diminishing revenues from royalties and taxes, the Government has been more aggressive in finding new sources of state revenues. New initiatives have been enacted which obliges subsurface users to purchase at least a quarter of their inputs from Kazakhstan producers. Through this mechanism, the Government is hoping to capture a sizeable portion of the twenty two billion US dollars that leaks from the Kazakhstan economy in the form of foreign purchases by subsurface users. Subsurface users are concerned however, as local producers are often relatively new to the market and users are reluctant to invest with untested partners.

Kazakhstan is one of the world’s most mineral rich countries, with reserves of many commodities ranging from coal to uranium. After the break up of the Soviet Union in the early 1990’s, Kazakhstan initially struggled to lure foreign investors into the country, however it was not long before international mining companies and investors made their presence felt on the Kazakhstan steppe. Today, oil, gas, and hard minerals make up the lion’s share of Kazakhstan’s exports (roughly 70% of total exports, with 17% being metals). The mining industry value alone is estimated to become 21.69 billion US dollars by the end of 2010.1

Despite being such a significant contributor to the Kazakhstan economy, there are certain areas within the mining industry which require further development. Such areas include the development of the processing capabilities of the mining industry, together with the use of efficient, up to date technology and the associated training and skill enhancement necessary with such technological implementation. This matter is currently receiving attention at official levels, with the Kazakhstan Government proposing the lowering of the Mineral Production Tax by 50% for mining companies who will process their raw minerals into final products within the territory of Kazakhstan.

Such policy direction is one example of how the Government is seeking to diversify the largely commodity-based economy. A significant amount of investment is required to develop such large scale value add capability within the mining industry, but the Government is committed to its policy of encouraging industrial innovation in an effort to transform its largely extractive industry based economy into a more balanced one. For this policy to succeed, the Government understands that it needs to encourage expertise and financial resources that only major Western companies are able and willing to bring. Kazakhstan feels strongly about developing the expertise of its own national mining companies and to take a leading role in all significant projects. The Government recognises however, that it will be

Taxation of the mining industry in Kazakhstan

1 Business Monitor International, Kazakhstan Mining Report Q1 2010, January 20102 Sergei Domnin and Aizhan Shalabayeva, “Running with obstacles”, www.expert.ru, 23/11/20093 Karina Nurtayeva, “Metalurgists Would Not Be Helped”, www.kursiv.kz, 16/04/2009 4 Salauat Rakhmetov, “Small receive little”, www.expert.ru, 25/03/2009


resources sector. Looking back it is clear that the Government did not reach its goals, mainly due to the global financial crisis which adversely impacted Kazakhstan as a whole.

One of the main taxes for subsurface users, the Mineral Production Tax (which replaced the royalty regime) has proven to be a main Government revenue raiser and the people see it as a mechanism for clamping down on the profits of the oil, gas, and mining companies. Another significant tax on the industry is Excess Profits Tax (whose calculation methodology has changed along with the Kazakhstan Government’s changing priorities). Such taxes set the tone for how the Government views the role of the extractive industries: on the one hand, as a rich industry requiring taxation and regulation; but also as a significant contributor to national development requiring certain fiscal incentives.

As taxation and regulation evolve in Kazakhstan, it will be important for the government to develop a consistent strategy and approach to the industry.

The subsurface users are asking for a reduction of the Mineral Production Tax or other taxes in order to offset the effects of this legislation but indications are the Government is not planning to back down. The Government is planning on enforcing the legislation through a system of fines, penalties, and even through annulations of subsurface use contracts.5

The Government is sensing that a recovery from the global financial crisis is far off, and with it will come robust commodity prices. Subsurface users are bracing themselves for a return to a higher tax environment. The Kazakhstan Prime Minister Karim Masimov recently stated that due to the global financial crisis the Government had been soft on subsurface users, however in near term the taxes will be raised as the natural resources belong to the people.6

With the adoption of the new version of the Kazakhstan Tax Code late in 2008 (with effect from January 2009), the taxation burden on companies developing the natural resources sector was set to increase so that the Government of Kazakhstan could get their fair share of revenues generated in the natural

5 Asan Kuanov and Aleksei Khramkov, “Oil companies: Give us preferences, then we will buy domestically”, www.liter.kz, 25/11/20096 Kazakhstan Today, “The Government of the Republic of Kazakhstan in the near future is going to raise taxes in the subsurface sector – Massimov”, www.kt.kz, 29/12/2009

Taxation of the mining industry in Kazakhstan


Mining companies in Russia have all taken up the challenge of sustainability reporting, perhaps more than many other industries. But has this flurry of reporting led to generation of value in companies or helped them to improve how they operate?

There is no doubt that the mining sector faces numerous challenges that fall within the sphere of sustainability. These include social issues operating in remote regions, ensuring a supply of highly trained professionals, local economic impact, environmental management, climate change, mine closure and more. And although some issues are specific to companies operating in the CIS region, their challenges are not unlike those facing all companies in this industry today.

Sustainability is more than just reporting. There is no doubt that all of the issues noted above are being actively managed by mining companies operating in this region. Likewise, information about all or most of these issues is being published by companies in their annual reports. But for sustainability to really get traction it must be integrated into the overall strategy of a company, as well as in its day to day management and operations.

Robust management of sustainability in any company must come from the top. This is accomplished in many companies by the formation of a sustainability committee at the level of the board of directors. This committee has responsibility for setting the overall vision and strategy of the company’s sustainability activities, within the context of its overall business goals.

The fact that this plays a crucial role in the effective management of sustainability in a company is evident by the large numbers of companies who employ such a practice, despite the fact that there are no legal or regulatory obligations to do so. In fact, the trend of late is to appoint a Chief Sustainability Officer, or CSO, in order to highlight the important role this plays in a company.

In order to support this board level entity and the CSO, best practice dictates the need for a team of people forming a sustainability department. This group is a cross-functional team that plays a key role in coordinating all the various efforts that are undertaken in sustainability. While specific departments may be responsible for implementing these programs, the sustainability department acts to coordinate actions to ensure that all the possible benefits are achieved across the whole company. This is especially important for companies whose operations cover more than one region or country.

Sustainability in mining

The current practice of many companies of placing sustainability activities in one department or another (typically HR, Investor Relations or Environment) is one that cannot bring the entire benefits of strongly embedded, cross functional sustainability management represented at the highest levels in a company.

Mining companies cannot work in isolation on this issue. Robust sustainability management is an important first step, but collaboration on this issue is also vital, allowing companies to work together to solve issues that face them all across a certain region.

Public pressure has led the mining industry to work perhaps more than most industries to address sustainability issues over the past decade. Although its products are necessary for everyday life, strong criticism around poor environmental management, lack of social contribution, local economic impact and corruption forced the industry to come together to work out ways to improve its reputation, but also work to improve how the industry operates.

From 2000 to 2002 a landmark study, the first of its kind, was undertaken called Mining, Minerals and Sustainable Development (MMSD). This independent study for the mining industry looked not only at the contribution to society of the mining and minerals sectors, but also at how these sectors’ contribution to society could also support sustainable development.

During this process, the International Council on Metals and Mining (ICMM) was formed, and has since developed a range of voluntary standards and guidelines for the industry, as well as position papers and guidance documents on a range of issues facing the industry today.

In many countries around the world where mining plays an important role there are also country level organisations that serve to promote good practice in sustainable mining, as well as knowledge sharing and, in some cases, voluntary standards. Canada, South Africa and Australia all have such organisations, generally supported by industry, governments and NGOs.

Given the size and impact of the Metals and Mining industry in Russia and the CIS, the time is right for the creation of a similar organisation in the CIS region. This would not only benefit the industry, but also allow it to work together to solve many of the social and environmental challenges facing the mining sector in the region today.

28

In recent years the Russian Government has

implemented a number of general tax incentives

to stimulate the development of the Russian

economy and help the recovery of national

industries from the economic crisis, which hit

Russia hard in the second half of 2008 and

caused a significant decline in demand and

prices for Russian mining commodities.

Tax incentives in the Russian mining sector

Key tax incentives included:

• reduction of corporate income tax rate from 24% down to 20% from 1 January 2009;

• introduction of accelerated depreciation for newly commissioned fixed assets (for example, the 10% depreciation premium applicable starting from 1 January 2006, was increased to 30% on 1 January 2009 for certain types of fixed assets);

• faster recognition of expenses connected with acquisition of subsoil licenses;

• loosening of statutory tax deductibility limits for external borrowings aimed at aligning tax rules with the realities of debt markets in crisis conditions;

• changing VAT recovery rules to allow faster recovery of input VAT on acquired goods and services.

These incentives are relevant for all businesses operating in Russia, including mining companies, allowing them to free up cash-flows for investing and operating activities. The reforms, however, were not implemented specifically for the benefit of the mining sector.

The Russian mining sector is similar to the oil and gas industry in terms of the commercial, infrastructural, technical and political risks involved. Also presenting challenges are certain administrative barriers in the form of legislation limiting the access of foreign investors into strategic industries. Interestingly, the Russian mining sector has not enjoyed the same level of taxation concessions which have historically been available to oil companies*.

It is doubtful that taxation incentives alone would be capable of restoring investor confidence in the mining sector back to the levels, experienced prior to the economic downturn. The introduction of industry specific measures and simplification of taxation administration rules and practices in Russia could, however, assist in increasing the attractiveness of this capital intensive sector for both domestic and foreign investors.

* Oil companies are granted tax incentives in the form of mineral resources production tax (MRPT) holidays on new fields located in certain remote undeveloped regions of Russia, lower MRPT charges on depleted fields, as well as recently introduced export duties breaks for East-Siberian oil.


Tax incentives in the Russian mining sector

In order to help stimulate investment in the Russian mining sector, the administration could consider implementing a number of tax incentives and measures such as:

• tax holidays for newly developed deposits, especially where deposits are located in the distant regions with minimal pre-existing infrastructure;

• reduction of Mineral Resource Production Tax payments for deposits with lower quality of reserves and difficult geological conditions, as well as depleted and smaller deposits, whose development would not be economically justifiable under the standard tax regime;

• introduction of efficient tax grouping and loss utilisation rules to allow mining groups to utilise tax losses from unsuccessful exploration projects against profits generated on successful mining projects;

• introduction of tax loss carry back provisions which could allow minimising irrecoverable tax losses at the liquidation/decommissioning phases of the mining projects;

• extension of tax loss carry forward period would be generally relevant for longer mining projects (currently taxpayers may carry forward tax losses for ten consecutive years after losses are incurred);

• more active granting of profits tax and property tax incentives by the regional authorities in exchange for a long-term commitment from mining companies to make investments in local projects, to employ local personnel and to use local suppliers and contractors;

• implementing less burdensome procedures for the recovery of input VAT to assist cash flow management for companies at the exploration and development phases.

To increase the chance of taxation reform that is meaningful and beneficial to the industry, mining companies need a more clear and coordinated approach to their communications with federal and regional authorities. The onus is on the industry to convince the authorities that such incentives will not simply mean higher profits for mining companies, but a more attractive and reasonable environment for strategic investment which will spur development, employment and benefits to the economy as a whole.


Appendix


The financial overview was performed using

the financial information of 20 companies which

operate in the mining and/or metals processing

industries in the CIS region. The companies

selected for analysis produce publicly available

financial information in accordance with either

IFRS or US GAAP.

The companies included in the analysis are:

Alrosa

Chelyabinsk Zinc Plant

ENRC

Eurochem

Evraz Group

Ferrexpo plc

Highland Gold Mining Ltd.

KazakhGold Group

Kazakhmys plc

Magnitogorsk Iron & Steel Works

Mechel

MMC Norilsk Nickel

Novolipetsk Steel

Polymetal

Peter Hambro Mining plc (now Petropavlovsk plc)

Polyus Gold

Raspadskaya

Severstal

TMK

Uralkali


Russia

David Gray Partner, Energy, Utilities and Mining LeaderRussian, Central and Eastern Europe+7 495 967 [email protected]

John Cambpell Partner, Metals and Mining Leader Central and Eastern Europe+7 495 967 [email protected]

Yana Zoloeva Partner, Legal Services+7 495 967 [email protected]

Alexei Smirnov Partner, Tax Services+7 495 967 [email protected]

Robert Gruman Partner, Advisory+7 495 232 [email protected]

Ukraine

Nilesh Lad Partner, Assurance Services+380 44 490 67 [email protected]

Ron Barden Partner, Tax & Legal Services+380 44 490 67 [email protected] Oleg Tymkiv Partner, Advisory +380 44 490 67 [email protected]

Kazakhstan

Dana Inkarbekhova Partner, Assurance Services+7 727 298 [email protected]

Courtney Fowler Partner, Tax Services+7 727 298 [email protected]

Key contacts


Acknowledgement

This publication would not have been possible without the drive

and enthusiasm of Tony Hanrahan, who led the project from start

to finish. Thanks also to the following professionals at PwC who

provided commentary and contributed articles to this publication:

Saltanat Suleimenova, Adil Mergaliyev, Daniyar Tulegenov,

Tim McAllister, Oleg Shudra, Vladimir Sokolov, Douglas Grier,

Andrey Soldantenko, Kirill Cherny, Irina Avdeeva, Irina Kostina,

Dmitry Skornyakov, Viktoria Kabala.

www.pwc.ru

.

© 2010 PricewaterhouseCoopers. PricewaterhouseCoopers. All rights reserved.

“PricewaterhouseCoopers” and “PwC” refer to the network of member firms of PricewaterhouseCoopers International Limited (PwCIL). Each member firm is a separate legal entity and does not act as agent of PwCIL or any other member firm. PwCIL does not provide any services to clients. PwCIL is not responsible or liable for the acts or omissions of any of its member firms nor can it control the exercise of their professional judgment or bind them in any way. No member firm is responsible or liable for the acts or omissions of any other member firm nor can it control the exercise of another member firm’s professional judgment or bind another member firm or PwCIL in any way.

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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