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MINERAL RESOURCE POLICIES FOR GROWTH AND DEVELOPMENT: GOOD PRACTICE EXAMPLES – 1

EXPORT RESTRICTIONS IN RAW MATERIALS TRADE: FACTS, FALLACIES AND BETTER PRACTICES © OECD 2014

Chapter 7

MINERAL RESOURCE POLICIES FOR GROWTH AND DEVELOPMENT: GOOD PRACTICE EXAMPLES

Jane Korinek1

7.1. Introduction2

Previous chapters have documented the nature, frequency and impact of restrictions on exports of minerals and metals. It has been shown that the mining sector is the context for a large number of the export restrictions currently in place. Moreover, exporting countries use export restrictions on industrial raw materials to achieve a variety of stated policy objectives, including:

3, 4

Increasing revenue, in particular government revenue coming from the extractive industries.

Offsetting exchange rate impacts caused by substantial exports of a small number of raw materials that are potentially volatile.

Fostering spillovers to other sectors, particularly in order to promote the development of downstream or upstream industries.

Controlling illegal exports or other activities, in response to concerns over lack of effective governance.

Enhancing environmental protection, or protection of citizens’ health.

Attempting to realise optimum mineral extraction levels, when conditions are deemed to create an incentive to extract too rapidly.

However, it was shown in Chapter 2 that export restrictions are not necessarily effective tools for achieving these stated policy goals and are in most cases not the most efficient way of doing so.

5 Many countries with large mining sectors and important natural resource reserves prefer

to regulate mining operations using alternative approaches that do not rely on border policies, but which seek to promote longer-term development and economic well-being by other means.

The extent of the task, however, should not be underestimated. Mineral resources present not only a formidable source of wealth but also a formidable policy challenge in order to maximise social welfare from their extraction. Some resource-rich countries have been very successful in developing their economies and managing their revenue streams effectively; others have faced major challenges in doing so. One hypothesis suggests that mineral resources are the cause of slower or biased growth rather than increased growth and development (see Box 7.1 on the resource curse debate). Some further hypotheses suggest that weaker institutions, lower spending on education or the volatility that comes with relying on exports of mineral resources, are the intermediate link between resource wealth and low growth in some countries, and that dealing with these factors could help to diminish the correlation between resource wealth and low growth.

2 – MINERAL RESOURCE POLICIES FOR GROWTH AND DEVELOPMENT: GOOD PRACTICE EXAMPLES


Box 7.1. The resource curse debate

Resource abundance does not always bring sustained economic growth and development; it can have the opposite effect. There are a number of reasons for this, relating to the ways in which natural resource wealth differs from other sources of wealth. Unlike other sources of wealth, natural resources do not need to be produced. They simply need to be extracted, although there is often nothing simple about the extraction process (Humphreys et al., 2007, p.4). The generation of income from natural resources can therefore occur quite independently of other economic processes, without major linkages to the rest of economic activity and with low participation of the local labour force.

Resource-rich countries that experience a decline in previously buoyant sectors of the economy are said to suffer from the “Dutch disease”.1 The “disease” spreads in the economy as follows. A sudden rise in the value of natural resource exports produces an appreciation in the real exchange rate. This, in turn, makes exporting non-natural resource commodities more difficult and competing with imports across a wide range of commodities almost impossible. Foreign exchange earned through resource exports is used to buy cheaper imports, at the expense of domestic manufactures and agricultural products (the “spending effect”). Simultaneously, domestic resources like labour and materials move to the natural resource sector (the “resource pull” effect). Consequently, the cost of these resources on the domestic market rises, thereby increasing costs to competing sectors (Humphreys et al., 2007, p. 5). In this way, the extraction of natural resources sets in motion a dynamic that favours two domestic sectors – the natural resource sector and the non-tradable sector.

Many empirical studies have examined different aspects of the resource curse. In a pioneering study, Sachs and Warner (1995) find that resource-rich economies generally grow at a slower pace. Using a cross-section of 52 countries, they show that resource-rich countries had slower growth in manufacturing exports than those that were resource-poor, after holding constant the initial share of manufacturing exports in total exports. Stijns (2003) uses a gravity model to estimate the impact of a natural resources boom on real manufacturing exports and finds the resource curse hypothesis to be empirically relevant.2

The resource curse seems to be more damaging in some contexts than in others. In attempting to explain these differences, theories stressing political economy considerations such as rent-seeking behaviour and the importance of institutions have gained prominence. Studies suggest that resource abundance can hamper economic growth in the presence of weak institutions such as poorly defined property rights, poorly functioning legal systems, weak rule of law and autocracy (WTO, 2010, p. 93). Sala-i-Martin and Subramanian (2003) show that natural resource extraction has a strong negative effect on long-term growth through its weakening of political and social institutions. Mehlum et al. (2006) find that in countries with institutions of sufficient quality there is no resource curse. The most severe manifestation of the resource curse is the onset or continuation of civil conflict where warring groups fund their violent action with the proceeds of resource extraction, or through extortion of the resource extraction industry. This has led to various initiatives including the OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas.3

Another strain of the resource curse debate suggests that non-renewable resource rich countries that collect a substantial share of revenue from direct or indirect resource taxation may develop weaker non-resource tax systems. In some cases, this may be a rational choice whereby lower taxes are a means to share the wealth of natural resources with the current generation of taxpayers, but in others this may result from political economy considerations, in particular if the resource-extracting firms are small in number and incorporated abroad. It has been seen in some resource rich countries that personal income tax collected, for example, is lower than would be expected given the level of development and other factors (see, for example, Luong and Weinthal, 2006).

Some of the empirical work supporting the resource curse hypothesis has been called into question on grounds of endogeneity (Alexeev and Conrad, 2009, Wright and Czelusta, 2007) or omitted variables (Manzano and Rigobon, 2007). Endogeneity may be an issue due to the two-way relationship between a country’s economic growth and its natural resources exports. The omitted variable argument suggests that the GDP to debt ratio has not been properly accounted for and that the problem is public debt and risk management rather than resource abundance. Some opposition to the resource curse hypothesis comes from economic historians. Wright and Czelusta (2004, 2007) cite in evidence the development of the United States, which was for decades based on resource extraction. Similar cases can be made for Australia, Canada, Finland, Norway and the two countries examined in this chapter: Chile and Botswana.

Both proponents of the resource curse hypothesis and its detractors agree that the national context in which resources are extracted determines how and whether broader economic development takes place. The importance of strong institutions like balanced and enforced tax collection, oversight of the use of tax revenue, a climate of transparency and accountability, investment in education in order to allow economies to diversify, promotion of small and medium enterprise in order to foster backward and forward linkages, property rights including those of the natural resources, policy stability and political democracy cannot be overstated. _____________________________

1. This refers to the problem that beset the Netherlands in the 1970s after discovering natural gas in the North Sea. The Dutch manufacturing sector started performing more poorly than expect. 2. There is too much relevant literature for this section to be exhaustive. For a more in-depth review of the empirical studies in this area see, for example, Humphreys et al. (2007) or WTO (2010). 3. http://www.oecd.org/document/36/0,3746,en_2649_34889_44307940_1_1_1_1,00.html

http://www.oecd.org/document/36/0,3746,en_2649_34889_44307940_1_1_1_1,00.html



Although there is some debate over the role of resource extraction in promoting or retarding growth, there is no debate about the importance of institutions and regulatory oversight to capitalise on the benefits of the mining sector for economy-wide growth and development. Natural resource wealth can benefit the countries in which it is found through appropriate taxation and use of tax revenue, linkages and spillovers into other sectors of the economy, and increasing investment flows. Understanding how some countries have managed to grow, in part thanks to their mineral resources sectors, can provide lessons for others.

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It should be noted that this chapter is not a comprehensive overview of mining policies. It does not include many important aspects of mining regulation such as environmental policies, titling and allocation of natural resources, consultation with local communities, and health and safety requirements. This chapter includes some successful examples of policies in the mining sector that have been used to achieve the same objectives as those stated by users of export restrictions.

This chapter looks in more detail at two such countries, Chile and Botswana. Both countries have enormous mineral wealth, which contributes a substantial share of their exports, and both are known for their high level of regulatory quality and institutional rigour. Nonetheless, once we examine the detail of these countries’ experience, it is apparent that no approach can be applied as a one-size-fits-all solution and hence it is instructive to examine both these cases, to identify what they have in common and how they have adapted some general best-practice principles to their own national context.

Chile is a relatively small economy that has been growing swiftly for over two decades. Per capita growth was over 5% per year from 2010-13, well over the OECD average. The growth of the Chilean economy has been largely export driven and has in recent years been led by exports of mining products, mainly copper. Chile is the world’s leading copper producer and exporter with more than one third of the world’s copper production originating there. Chile accounts for 40% of total world copper trade.

Botswana is a large, landlocked, semi-arid country in Southern Africa. At the time of its independence in 1966, Botswana was also one of the poorest countries in the world, with almost no infrastructure and low indicators of health and education levels. It was declared a least developed country by the United Nations. The country`s ability to manage revenues from its vast deposits of natural resources has contributed greatly to its outstanding economic performance. The contribution of diamonds, copper and nickel to Botswana’s total exports is over 80%. Botswana’s prudent natural resource management has resulted in investment in infrastructure, health and education and accumulation of funds for future use (African Development Bank et al., 2013; Acemoglu et al., 2003). Botswana graduated from the list of least developed countries in 1995, one of only three countries to have done so (UN General Assembly resolution A/RES/49/133), and is now an upper-middle income country with per capita GDP about USD 9 537 in 2011.

The chapter is structured as follows. Section 7.2 contains a discussion of tax regimes and tax instruments in the context of the natural resource sector in both Chile and Botswana. Section 7.3 discusses how each country’s management of mineral resources tax revenue succeeds in stabilising the macro-economy, by offsetting the volatility that pervades global resources markets and dampening exchange rate impacts, and distributing the rents from their natural resources. Section 7.4 describes how both countries have sought to develop other sectors related to mining, capitalising on the comparative advantage in mining and creating additional jobs. Section 7.5 introduces the issue of illegal mining, another policy objective for which some countries use export restrictions. Section 7.6 summarises the main policy lessons to be drawn from the experience of each country.



7.2. Sharing the benefits of the mining sector through taxation

Considerations regarding taxation of the extractive industries

One of the main ways by which wealth from the mining sector is shared and can be used to promote growth throughout the economy is through taxation and subsequent investment and redistribution of tax revenue. An appropriate level of taxation implies that the government receives an equitable share of the profits from the mining sector while fostering a sustainable level of production and leaving room for sufficient investment in the sector. If the sector is taxed too heavily, investment and production are sub-optimal; if it is not taxed enough, an important source of budget revenue is needlessly foregone. When deciding the level and design of a tax system for the mineral resources sector, it is important to keep in mind the costs to mining sector firms in other mining countries that compete not only for market share but also for the allocation of investment funding. Tax costs are one of the factors determining the yield of any new investment, and firms will compare yields across countries and regions.

Natural resource taxation is particularly challenging, not only because of the potential for rent-seeking behaviour and political capture (see Box 7.1 for a reference to these issues in the context of the resource curse debate), but also because the extractive industries have certain characteristics that may make them more vulnerable to sub-optimal policies. Some of the relevant specificities of the resources sectors that must be borne in mind when reviewing taxation policy are given in the next paragraphs.

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Extractive industries are characterised, firstly, by high sunk costs and long production periods. Exploration, development and exploitation of a mine can last decades and cost many hundreds of millions of dollars. Much of the investment occurs before any production has started. Once an enterprise has invested heavily, the investor has little choice should the tax regime change; as long as variable costs are covered, production is more profitable than ceasing activity. This problem of time consistency implies that investors in the extractive industries, wary of potential regulatory “hold up”, consider with particular importance the regulatory and political stability in host countries.

Revenue, and profits, in natural resource extraction industries differ greatly over the lifecycle of a project. It may seem reasonable to tax away a large share of the excess of revenue over operating costs. It must be remembered, however, that a resource project’s life is divided into three stages: exploration, development and extraction. The first two stages require substantial investment; the first stage also implies uncertainty about the size and existence of potential deposits. Taxable income only occurs in the third stage, but tax design needs to recognise the exploration and development costs of the project, as well as the substantial risk involved in the exploration stage. Part of what looks like rent in the third stage is the return on these earlier costs.

Even taking this into account, tax revenue can be substantial and can make a very significant contribution to government revenue. Given the sheer scale of potential government receipts, tax receipts are not simply a side benefit of resource extraction but one of the core benefits. Proper tax design is therefore even more important in the area of resource extraction than in other sectors.

Firms in extractive industries are often multinationals based outside the country where they are operating and have sizeable market power. The relative scarcity of technical skills, access to funding and the ability to assume risk over the long term implies that few firms worldwide are able to compete in large mining ventures. International firms often face tax liabilities in numerous jurisdictions and whether they can obtain tax credit in their home country for taxes paid in the country of operation affects the potential return on a project. The interactions between the various tax systems will impact the way in which multinational firms structure their operations.

One particular characteristic of the extractive industries is the exhaustibility of the non-renewable natural resources. Although new deposits continue to be found, there is inevitably a trade-off between present and future production and consumption, and optimal extraction rates



calculated at present are a function of optimal extraction rates in future. The design of the tax system affects firm behaviour and incentives, and thereby impacts the balance of this inter-temporal trade-off.

In most countries, the mining sector is subject to a variety of different types of tax. What is important for motivating firm behaviour is their combined effect. Both the level and design of tax instruments influence mining firms’ decisions about future investments, the extent to which they undertake high-risk and high-reward exploration, the extent to which they develop operations, and exploitation decisions in the present and future.

Judging the optimal level of taxation (Otto et al., 2006) requires knowledge about current firm behaviour and potential trade-offs in future, as well as future revenue streams, which depend on future metal prices and production costs. Excessive taxes will dampen investment, resulting in sub-optimal levels of activity in any one or all of the three stages of the project. On the other hand, taxes that are too low represent foregone income for the government of the host country.

Box 7.2 summarises the different types of tax that are applied in the minerals sector. The optimal mix of these instruments involves finding a balance between advantages and disadvantages of each instrument with respect to economic efficiency, trade-offs between development at different stages of mining operations, and the optimal allocation of risks and rewards between the state and the exploiting enterprises. As for implementation of the tax regime, many other considerations come into play such as the ease of administration and the information gap between tax administrators and mining enterprise officials.

The choice and design of tax instruments affect firms’ decisions in many ways. An output-based royalty, for example, creates an incentive for firms to exploit mines that offer high-grade ore, but to stop exploitation once only lower-grade ores remain. Mining operations may therefore be closed sooner, and some mines be under-exploited, than if a profit-based tax is used. Depending on their structure, however, profit-based taxes can alter the economic attractiveness of new projects. They also give firms an incentive to avoid making any profit and have substantial compliance costs. Determining the basis on which to apply a profit-based royalty is more difficult than an output-based one.

The design of tax instruments, including royalties, affects the distribution of risk between firms and the state. Mining is a very risky activity: the probability of finding new, exploitable deposits at the exploration stage is low; metals prices are volatile and can make a seemingly good investment unprofitable. The development of new mines is a long-term activity that requires making judgements about a number of risky elements, including the investment and regulatory climate, future production costs and political and economic stability in the host country. Royalties are generally used to share risk between the public and private sectors since they are only paid when mining actually occurs, thus the public sector bears risk. Within the royalties structures, unit-based or value-based royalties shift more of the risk related to market prices to exploiting firms whereas profit-based corporate taxes shift a greater share of the risk to the state (Otto, 2000).

Different tax instruments affect mining operations along the life cycle of a project. Import duties on exploration and on development equipment tax mining firms before they are at the exploitation stage and therefore before they generate revenue. On the other hand, such taxes provide government revenue before the project reaches the exploitation stage. Revenue from unit- or value-based royalties commences as soon as operations enter the production stage. Profit-based royalties or corporate profit taxes provide revenue when exploitation is profitable. Each of these instruments offers different incentives for firms to invest and exploit deposits.

Tax regime stability is an important factor in firms’ decisions to invest in a mineral project. Firms that are considering investing hundreds of millions of dollars or more in a new mine are very wary of possible changes in the tax burden after their investment is made (Otto et al., 2006). Nonetheless, they are well aware of the difficulties of promising tax regime stability. First, a new government may be voted in once the project has started. Second, the bargaining power of mining firms is inevitably reduced once they have invested in the exploration and development stages as



Box 7.2. Most common taxes levied in the mining sector

Various different types of tax are levied on extracted minerals. Both the tax rate and the tax basis are important. Taxes are generally assessed either on the quantity of the mineral deposit or against the inputs or actions needed to exploit it, or on some definition of the net revenue extracted from the minerals, usually revenue minus qualifying costs (Otto et al., 2006).

Income tax: not specific to the mineral sector, the tax rate is commonly uniform for all tax payers, or for all tax payers at a given level of profit. In many countries, commercial tax payers are subject to a uniform tax rate; some countries have a progressive tax regime that imposes a higher rate to commercial entities with higher levels of profit. Tax policy often evolves through changes in the tax base rather than the tax rate.

Royalties: a payment made for use of a property or natural resource.1 This can be in the form of a tax on the amount of minerals extracted, either per physical unit of production – a specific royalty, or a percentage of the value of the mineral extracted – an ad valorem royalty. In some cases, the government collects a percentage of the value of production on a sliding scale based on price, i.e. a higher commodity price triggers a higher tax rate, which is referred to as a graduated price-based windfall tax. In the wider definition of profit-based royalties, the government taxes a share of the project’s profit (Hogan and Goldsworthy, 2010).

Surface rentals: in some countries, a fee is levied on economic activities like mineral extraction that use land. Such fees are often based on land area and are calculated by multiplying some standard rate for the type of activity by the land area being used. In some jurisdictions, this tax only applies to public land use (Otto, 2000).

Withholding taxes: many countries impose a withholding tax on remitted dividends. This generally takes the form of a percentage of remittances and can be a significant percentage. Although some governments define a high withholding tax rate, perhaps with the objective of promoting reinvestment, many enter into bilateral investment treaties or dual tax treaties of special arrangements with enterprises headquartered in key partner countries (Otto, 2000). Other types of withholding taxes are taxes paid on interest payments to foreign lenders and interest on payments for foreign services.

Import duties: Mining operations are capital intensive and the sophisticated machinery and equipment necessary for exploration, development and production are manufactured in few countries and generally imported. Import duties on such machinery have a direct impact on project feasibility in the early years of a mining project, i.e. before the exploitation stage.

Export taxes: In the middle of the last century, governments commonly imposed export duties on minerals in order to increase revenue and because their administrative reach did not allow estimates of profit or revenue (Otto, 2000). Export taxes have become more widely used, in particular on products of extractive industries, in recent years for a number of reasons (see Chapter 1).

Value-added taxes (VAT): Value-added tax is generally intended as a tax on final domestic consumption and should therefore have little impact on resource operations that are destined for export (Boadway and Keen, 2010, p. 44). In some countries, however, exported mining products are subjected to payment of VAT which is later reimbursed. Under some systems, VAT on inputs is also reimbursed. There have been cases of reimbursement that has not been done in a timely fashion, or cancelled for some products, which can be considered an indirect export restriction. ___________________

1. In most countries, minerals are owned by the state. Royalties are often placed on extractive industry firms since they exploit a non-renewable resource that they do not own. Alternatively, the minerals are owned by the landowner of the land where they are found. Royalties can be seen as a form of compensation for the exploitation of the property right.

invested capital is sunk and cannot be withdrawn from the country. This phenomenon is captured in the so-called obsolescing bargain model (Vernon, 1974) and is well-documented with respect to the mining sector.

Tax stability may be somewhat easier to ensure if the fiscal regime includes an element of progressivity. “There may be circumstances – as with the very high oil and minerals prices of mid-2008, perhaps – in which outcomes are so extraordinary, relative to what might have been conceived when tax arrangements were entered into, that some renegotiation is seen even by investors as generally reasonable” (Boadway and Keen, 2010, p. 57). The very substantial profits that are made by firms, many of them multinationals, may bring a strong reaction from local populations for higher taxation. A progressive tax, or additional tax when profits are very high, may be one way of foreseeing such situations. Generating confidence in the stability of tax structures is very important for the sector, but is not always simple to achieve.



Transparency of taxation systems and requirements are of great importance in the sector, as are guarantees that tax revenue is used for government services. The Extractive Industries Transparency Initiative (EITI) is a multi-stakeholder effort to strengthen governance by improving transparency and accountability in the extractive sector. Firms agree to publish all payments they make to governments and governments reveal all revenue that they have collected from extractive firms (www.eiti.org). Payments and revenues are reconciled by an independent auditor. Such initiatives are of particular importance in countries where governance has been challenged in the past.

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The administrative capability of the tax authorities determines in part the optimal tax design. Even for well-performing tax administrations, some tax instruments can prove challenging due to asymmetric information regarding revenue, marginal and fixed costs, and so on. Profit- and income-based taxes are more difficult to implement than unit- and value-based royalties. In the case of profit-based taxes, auditors will be needed to confirm levels of revenue and of costs that can be deducted. Some of these procedures, such as assigning a value to depreciated capital, are complex, and require relevant competence on the part of the tax authorities.

Since extractive industries are often dominated by large multinational firms, they will make investment decisions concerning their global operations cognizant of differing tax policies in countries in which they operate. Although this is only one of many inputs into such decisions, some countries have chosen to coordinate their taxation of extractive industries on a regional level. The West African Economic and Monetary Union (WAEMU) has adopted a mining code that specifies some tax benefits that may serve to limit members’ ability to compete by offering stronger tax incentives (Boadway and Keen, 2010). There has been discussion of adopting common limits on tax benefits in the South African Development Community (SADC). A case for coordination could also be made for enforcing maximum common rates, rather than minimum requirements.

Taxation of the mining sector in Chile

The tax regime

Taxation of the mining sector in Chile falls into four main categories: tax on the profits of Codelco, the state-owned copper mining firm; corporate taxes on private mining firms; a mining tax instituted in 2006, from which the smallest firms are exempt; and a tax on copper exports of Codelco-owned mines that goes directly to the Ministry of Defence.

Codelco is entirely state-owned and finances a substantial share of the government budget. In addition to the corporate profit tax and the mining tax, paid by all or most firms, Codelco is subject to an extra profit tax of 40% and a 10% tax on exports. Finally, Codelco pays dividends to the government, normally set at 100% of profits. As a result, Codelco has had to rely on debt financing to fund a significant part of its capital needs. Although Codelco does not benefit from an explicit government guarantee, it has access to preferential rates due to its high credit rating. Its current large investment programme may, however, be incompatible with the zero retained earnings policy that has prevailed in the past.

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Corporate taxes apply to mining firms as they do to other firms operating in Chile. The corporate tax rate is 20%. This was increased from 17% after the 2010 earthquake, applicable on income in 2011 (Ernst and Young, 2011).

10 The tax is applied to accrued income on a yearly basis.

It is paid on profit after acquittal of the specific mining tax. An additional tax of 35% is applied to income that is withdrawn, distributed as dividends or remitted abroad by non-resident individuals or legal entities. However, the legal entity receives a tax credit for the tax paid as corporate tax.

The tax base in Chile allows for deduction of accelerated depreciation and cumulative losses as well as interest payments in the total tax bill. Since the mining industry uses expensive capital inputs, the accelerated depreciation deduction is significant. This deduction allows capital-intensive enterprises to recoup a portion of their equipment costs by claiming large depreciation deductions in the early years of the expected life of the equipment. Allowing deductions for interest payments gives firms the incentive to finance projects with debt rather than equity.

http://www.eiti.org/



The mining tax was instituted in 2006 and applies to metallic and non-metallic mining. Previously, there was no specific tax or royalty levied on the mining sector. The tax is progressive and is paid on profit, or operating income. The tax is between zero and 14% depending on the firm’s profit. This tax is not paid by “small” mining firms. The size categories of firms are defined according to the volume of their annual sales of refined copper: small mining firms have sales of 12 000 tons or less, medium-sized firms have between 12 000 and 50 000 tons per year, and large firms have annual sales of more than 50 000 tons.

The rate of the mining tax is progressive, ranging from 0.5 to 4.5% between 12 000 and 50 000 tons. For firms producing more than 50 000 tons of refined metal equivalent or more, the rate is 5% if their operating margin is less than or equal to 35%, and increases progressively. The tax is applied in to reach a maximum of 14% for firms whose operating margins exceed 85%. These rates for large firms apply since the 2010 mining tax law, before which (from 2006 to 2010), the tax rate varied from 4 to 9% depending on the firm’s profit share.

With the passage of the 2010 mining tax law (Ley no. 20.469), firms were allowed to continue with the previous tax rates for eight years. If they chose to apply the new tax rates immediately, however, they would pay the higher tax rate of 5% (in the lower profit margin bracket) for three years, and then revert to the previous sliding scale of 4-9% for the next eight years. This complicated arrangement is a compromise between Chile’s foreign investment statute,

11 which

guarantees (under certain conditions) that tax conditions remain invariable after a contract is signed, and the pressing need for government revenue after Chile’s disastrous earthquake in 2010.

Finally, the tax of 10% on Codelco’s exports is procured directly by the Ministry of Defence (see Box 7.3, and Marcel (2012) for its implications). After several years’ discussion over reform of this law, the Chilean Congress decided in June 2014 that part of the proceeds of this tax would be paid directly into the government budget, earmarked for the reconstruction of Valparaiso (recently devastated by fire) and of the northern region (also recently hit by earthquakes).

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Box 7.3. Ley Reservada del Cobre1

The Chilean legal system includes some unpublished laws.2 One such law is No.13.196, the Ley Reservada del Cobre (LRC). The Ley Reservada commandeers 10% of Codelco’s sales abroad in foreign currency to be disbursed directly to the Ministry of Defence for use in financing equipment. In addition, the law establishes a minimum financial transfer of USD 180 million. If 10% of Codelco’s exports are not enough to cover this minimum threshold, the shortfall must be provided by the State.

The tax revenue, in US dollars, is deposited yearly in three separate accounts (used by the army, air force and navy) at the Central Bank of Chile. These accounts are maintained outside the treasury single account and are not subjected to congressional oversight.3

In the 20 years since the return to democracy in Chile, many congress delegates, political leaders and analysts have recognised the need to repeal or reform the Ley Reservada del Cobre. An initiative was proposed in 2009 which was to finance the armed forces on a yearly basis through the general budget but it was not approved. A new legal initiative was announced on 11 May 2011 to overturn this law and replace it with a multi-annual budget for the armed forces. In his 21 May 2012 public address, President Piñera pledged to repeal the law by the end of his term in office (www.gob.cl/destacados/2012/05/21/mensaje-presidencial-21-de-mayo-2012-chile-cumple-y-avanza-hacia-el-desarrollo.htm). _____________________________

1. Note that the information included in this box is the best available but cannot be confirmed due to the secret nature of the legislation described.

2. In August 2003, legislators introduced a bill that would declassify the secret decrees and laws enacted between 11 September 1973 and 10 March 1990. A year later, it was approved by the lower house and passed on to the Senate but has been held up in a Senate commission since that time. The bill however includes some exceptions to the declassification process, among them the Ley Reservada del Cobre. A somewhat puzzling section of the bill calls for declassifying these exceptions by 7 July 2014 (http://www.globalpost.com/dispatch/chile/090317/chiles-secret-laws?page=0,1).

3. A 2004 OECD publication indicated this practice was “highly inappropriate from a budgetary point of view”, while recognising that this is “a very sensitive area” (Blöndel and Curristine, 2004).

http://www.gob.cl/destacados/2012/05/21/mensaje-presidencial-21-de-mayo-2012-chile-cumple-y-avanza-hacia-el-desarrollo.htm

http://www.gob.cl/destacados/2012/05/21/mensaje-presidencial-21-de-mayo-2012-chile-cumple-y-avanza-hacia-el-desarrollo.htm

http://www.globalpost.com/dispatch/chile/090317/chiles-secret-laws?page=0,1

http://www.globalpost.com/dispatch/chile/090317/chiles-secret-laws?page=0,1



Chile’s taxation of the mining sector: International comparisons

Mining operations are often undertaken by large, multinational firms. In the headquarters of these firms, investment decisions regarding operations in their different subsidiaries are based on a comparative assessment of the availability and quality of the ore, future production costs, various risk factors, and the regulatory environment, of which the tax system is one element. Firms try to compare potential projects in one jurisdiction with those in another, and they evaluate taxation alongside all the other factors that affect their estimate of potential returns from, and risks of, the various projects.

Comparing different countries’ and jurisdictions’ tax systems is a challenging undertaking. Tax rates in different countries are applied to different tax bases. Deductions can be substantial, particularly capital depreciation and interest payments. The amount of taxable income can depend on how much firms invest and how much they pay in dividends. Some taxes can be used as credit against others. The tax burden faced by a foreign firm may depend on the terms of a bilateral tax treaty between its home country and the country of operations.

Having said this, various estimates have been made of the effective tax rate in the mining sector. Korinek (2013) reports estimates based on private interviews with analysts and advisors to the industry in the range 25-35% of profits, depending on how much firms invest and the extent to which they distribute dividends. Interviews with representatives of mining firms suggested higher estimates of the effective tax rate, up to 39-40%.

Furthermore, these representatives stressed that some costs other than tax requirements (including energy,

13 water and labour) were considerably higher in Chile, which firms would offset

against a lower effective tax rate.14

Cochilco, Chile’s copper advisory body, reports the unit production cost of producing copper cathode in different regions using a similar methodology, finding that Chilean costs are indeed higher on average than those in other Latin American countries and Asia, but lower than those facing copper producers in North America, Oceania, Africa and Europe (see Korinek, 2013, Table 2, p.27).

Chile’s taxation of the mining sector: an appraisal

An overview of Chile’s system of taxation of its mining sector suggests that it is transparent, predictable, balanced and within a range acceptable to the firms with international reach that inhabit the sector. The corporate income tax rate of 20% currently applies to all firms in Chile. Firms are, however, allowed accelerated depreciation deductions, which are particularly important to the mining sector. The mining tax, although a tax on operating income, functionally replaces a royalty and applies only to the mining sector. The structure of this tax is progressive, including higher tax rates during times of very large profits (14% in cases where the profit margin is 85% or more of total revenue). This probably makes the tax more politically acceptable in times of very high copper prices, and forestalls political economy concerns when metals prices are high that the state, although the ultimate owner of the minerals, does not obtain a “fair share” of profits.

The mining tax is also progressive in that it does not apply to small mining firms, thus giving support to small firms that do not benefit from economies of scale, and may not hold concessions. These firms are also supported through technical assistance initiatives from ENAMI. One of the results of this support is that the mining sector (particularly the smaller less capital-intensive firms) offers employment opportunities in some remote regions of Chile where few job alternatives exist.

It is difficult to compare effective tax rates across countries. Firms, however, do not look at the tax system in isolation: they compare the whole package of production costs in the different jurisdictions where they operate. It seems that unit costs of production of copper mining firms in Chile are neither the most nor least onerous compared to those in other countries, but that higher costs may serve to offset potentially lower tax rates.

Suffice it to say that taxation of the mining sector, including the changes enacted in 2010, has not curtailed foreign investment in the sector. Mining received 38% of FDI entering the country in 2010, and significantly more than other countries in the region. Surveys of the mining industry



confirm that Chile remains an attractive country in which to invest in mining. At the same time, the mining sector contributes significantly to government revenue, providing 21% of all tax revenue in 2010 (of which CODELCO contributed 13.1% of total government revenue), which is proportionately higher than its contribution to GDP The contribution of mining to government revenue is substantially higher than earlier: the mining sector contributed only 5.8% of government revenue on average during1995-2003.

Chile’s good governance is recognised globally. Quality of governance is probably enhanced by the overlapping institutional structure (see Annex 7A) where the Ministry of Mining and COCHILCO, the copper advisory body, are in close contact with private mining firms as well as ENAMI and SONAMI through the Mining Council. They are required to “have an ear to the ground” when decisions are made regarding the internal price of copper (at which ore is purchased by ENAMI, for example). The fact that the largest firm is state-owned, as well as the “invariability clause”, which implies certain tax stability, may facilitate the relatively consensual process undertaken by regulators of the Chilean mining sector. This approach is exemplified by the 2010 mining tax, which allows firms either to opt in to the tax changes voluntarily, or to continue with previous rates for a number of years.

One area where Chile’s tax collection procedures warrant review is the Ley Reservada del Cobre, where the state-owned enterprise awards 10% of its export earnings to the Ministry of Defence. The emergency modification to this law in 2014, referred to in the previous section, does not remove the need for it to be radically reformed in order to ensure the degree of oversight and public scrutiny of this income stream that would be expected in Chile’s present-day vibrant democracy.

Taxation of the mining sector in Botswana

The mining sector in Botswana is taxed through three separate instruments: a corporate profits tax, a royalty, and withholding tax on dividends. All private firms pay a corporate profits tax; mining firms, however, are subject to a specialised tax regime. The general corporate tax rate in Botswana has been 22% since 2011, whereas mining profits tax is calculated according to a formula: 70-1500/x, where x is the ratio of taxable income to gross income in percent (subject to a minimum of the general corporate tax rate). Mining firms may deduct capital expenditures made in the same year, with unlimited carry forward of losses. This formula effectively leads to a variable rate income tax, which increases with the profitability of the mining company. It is well designed, therefore, to capture mineral rents. It is also transparent and provides a degree of certainty to investors.

Royalties are calculated on the gross value of minerals as they leave the “mine gate”. Diamonds and other precious stones are subject to a 10% royalty rate; precious metals 5% and all other metals 3%. Payment of royalties commences when a mine goes into production, and, if the value of the goods produced is easily ascertained, this is a fairly straightforward tax to collect. There may be a problem, however, identifying the market price of rough diamonds as the market is very small and specialised and, within the De Beers network, quite firmly controlled. The issue of proper valuation of diamonds has been considered by the Botswana authorities and will be examined more fully later on in this paper.

Finally, investors pay withholding tax on dividends distributed to residents and non-residents of Botswana alike. Withholding tax is now 7.5% of the value of dividends.

In the case of Debswana, the joint venture between de Beers S.A. and the government of the Republic of Botswana (GRB), remaining profits are distributed equally between the GRB and De Beers SA within the terms of their joint venture (see Annex 7.B for a full description of the institutional structure of the mining sector). While the exact agreement between De Beers and the Government of Botswana is confidential, it is believed that the Government receives between 80 and 82% of the revenue after cost (including capital expenditure) of Debswana.

15 A very substantial

portion of the revenue from the diamond sector therefore goes to the GRB.



Botswana’s taxation of the mining sector: an appraisal

A major challenge facing many countries is proper implementation of their tax code. The tax system of some countries is very complex, and in some cases, contradictory. For example, high tax rates and generous tax incentives often lead to low compliance and high administrative costs (Barma et al., 2012). A simplified tax code is therefore preferable. Botswana’s tax policy falls into this category: it is clear and relatively transparent, not least of all in its implementation.

16

Many lower-income, resource-dependent countries have weak tax-collecting capacity and face governance challenges with regard to their revenue administrations. Foreign firms or investors may have access to accounting and tax expertise that allows them to reduce their tax liability. One reason the GRB entered a joint mining venture with De Beers and, years later, obtained two seats on the Board of Directors of De Beers S.A., was to gain experience and understanding of the diamond mining industry in a globally competitive, state-of-the art setting. This knowledge has been of critical importance for Botswana and has allowed the country to benefit greatly through its understanding of the constraints and the potential of diamond mining in Botswana. Most important, however, for the purpose of this discussion, it has helped the GRB to design and revise its tax policy and more generally its minerals policy in a balanced fashion.

One of the most important issues facing mining investors is the stability and predictability of policies that affect them, including taxation policy. On this criterion, Botswana performs well: its tax code has remained stable and changes have been instituted in stages. Botswana benefits from a strong reputation for good governance and transparency so that changes in the tax regime when necessary can often be made without damage to investor confidence.

Generally, the business environment in Botswana is considered to be relatively free from corruption. Mining firms rank the legal process in Botswana highly in terms of fairness, transparency, absence of corruption, timeliness and efficiency.

17 In fact, Botswana’s legal system

outperforms those of two Canadian provinces (Quebec and Ontario), eight US states (Alaska, Montana, Minnesota, Idaho, Colorado, New Mexico, California and Washington) and several European countries (including Finland and France) as regards mining activities.

This issue is of prime importance as regards the extractive industries since investors are wary of making the substantial investments necessary up front without being relatively sure of future revenue. For investors, the extractive sector is risky: it is capital-intensive and long term, and with a high degree of uncertainty and unpredictability in demand and production, price volatility, and varying extraction costs as higher grade ores are exhausted. For host governments, exploration and extractions risks, as well as commodity price volatility, make the revenue flow highly variable and cyclical. Both investors and government, therefore, benefit from stable fiscal policies (Barma et al., 2012).

The De Beers-GRB joint venture has aligned the interests of the GRB and its private sector partner. It has allowed the GRB to benefit from global private sector expertise in all aspects of the management and strategy of the company while retaining ownership of the resources being extracted. There are, however, substantial risks involved in such public-private partnerships. The GRB assumes a large part of the risk by being an equal (or even minority) shareholder. For reasons of credibility, the government may not choose to let a mining firm in which it has equity fail. The GRB has opted for a 15% equity share in some mining firms in the past in accordance with its equity option that is available at the time of granting of mining licences. It has in the past stepped in and invested additional funds to ensure continuous operation in some of these cases. This sort of undertaking can quickly become very onerous; additionally, the government is probably not best placed to manage this type of operation.

Maintaining close contact with private sector ambitions and processes has also given the GRB the potential to influence its minerals policies to its advantage. One issue that has arisen regarding tax and royalty payments is correct valuation of rough diamonds. The value attributed to rough diamonds is of utmost importance for calculating the amount of royalty due, whereas within the De Beers system rough diamonds are valued through a controlled process using information from buyers under contract with DTC, its selling operation (see Annex 7.B for an overview of this



process). Since the GRB has been closely involved in the overall management of the joint venture, and cognizant of the fact that valuation is of utmost importance to it, it has started to sell some of its rough diamonds through a parallel system outside the De Beers network. This new arrangement will be explored in more detail in a following section; its implications for royalty revenue are not negligible.

7.3. Sharing the benefits of the mining sector: Tax revenue management

General principles

It is commonly accepted that mineral production can either promote or hinder economic growth, depending in part on how governments manage and use the tax revenue they receive from the mineral sector (Otto et al., 2006). Therefore, although much of the public debate over mineral taxes focuses on the appropriate level of taxation, equally important for economies with rich natural resource endowments are the questions of tax revenue management and distribution. This section concentrates on revenue management, and principally on strategies to prevent revenues from the mining sector destabilising or distorting the country’s economy.

The main management challenges to economies relying on income from natural resource extraction stem from volatile metals prices and the presence of potentially substantial rents from mineral extraction. Volatile international prices for metals imply that profits from mineral extraction are subject to large fluctuations, with government tax revenue from the sector also cyclically linked to world market prices of metals. If high revenues in boom times allow governments to benefit from more favourable lending conditions on international markets, these revenue swings can be amplified. Surges in revenue create a strong incentive to increase government spending significantly, but money spent in this way is often poorly spent. Moreover, marked cycles in government expenditure can de-stabilise the economy as a whole, leading to greater consumption and over-heating during the boom, and low consumption and high unemployment during the bust. In general, the economic costs of such macroeconomic volatility are high (Humphreys et al., 2007, p.325). In order to dampen these cycles, strong mechanisms for revenue management are essential.

One way of countering these effects is for government to engage in counter-cyclical spending. This is facilitated by the use of a stabilization fund, which accumulates excess government revenue in boom periods and is drawn down to make up the shortfall in mining tax revenue in slack periods, thereby helping to smooth government expenditure. These funds might be held in foreign currencies (which avoids exacerbating the demand for local currency in boom periods) or other forms of shorter-term asset. If such funds are to be effective, however, “incentives need to be built in so that political leaders are not tempted to raid them” (Humphreys et al., 2007, p. 325).

Another risk that is strongly related to the threat of macroeconomic instability in economies that are heavily reliant on their metal exports is that their exchange rate may be strongly affected by substantial fluctuations in the value of their exports. When the international price of a metal increases steeply, the quantity of the metal demanded on the world market may fall, but if demand is inelastic, total export value increases. If these exports represent a major share of total export value, and they are valued in a reserve currency like the US dollar, the local currency will be affected, strengthening during the boom times and weakening during the bust. A strong local currency makes it more difficult to export other products, and therefore exports of sectors unrelated to the extractive industries will fall. This fall in demand, coupled with a potential rise in demand from the mining sector for additional services to fuel the boom means that other sectors of the economy are “crowded out” in the short term. When commodity prices fall and the national income generated from the extractive industries falls, fewer export sectors remain on which the economy can rely. In this way, rapid exchange-rate appreciation can set in motion the onset of “Dutch disease” (Box 7.1), permanently reducing the diversification of the domestic economy and leading to long-term distortions.



There are a number of ways that governments can counter-act exchange rate fluctuations, namely curbing excess spending and building up reserves in foreign currency (ideally in a stabilisation fund) or in other foreign assets during times of high commodity prices.

18 To attack

directly the effect of Dutch disease, government revenue can be invested “in alternative export sectors, in agriculture, and in education [to] help sustain growth and diversify risk” (Humphreys et al., 2007, p.325). However, engaging in strong expenditure domestically during the boom period can exacerbate the exchange problem, so investments need to be spread over time.

In all cases of tax revenue management, it is important to ensure that it is distributed with a high degree of transparency. This is particularly important where potential rents are very large. Better information on how the proceeds from extractive rents are distributed and according to what aims is of great importance, particularly when revenue falls again. The EITI, mentioned earlier in this chapter, gives guidelines for the reporting of revenue from the extractive industries and suggests how stakeholders can be more closely involved in the often contentious debate about their distribution.

Regarding the governance of funds established from government-owned financial assets or sovereign wealth funds (SWF) there are two sets of internationally sponsored principles, the Linaburg-Maduell Transparency Index and the Santiago Principles. The Linaburg-Maduell Transparency Index was developed by the Sovereign Wealth Fund Institute.

19 It awards one point

for compliance with each of ten principles. Currently, 51 funds are rated in terms of this index and the ratings are published, although not the details of which principles are met and which are not. The SWF Institute recommends a minimum rating of 8 in order to claim adequate transparency.

The Santiago Principles were developed by the International Working Group (IWG) on Sovereign Wealth Funds with the support of the IMF. The IWG agreed on a set of generally accepted principles and practices (GAPP) in 2008.

20 The IWG does not publish any assessment of

compliance of different SWFs with the Santiago Principles. However, the Oxford SWF project carried out an assessment of compliance in 2011.

Edwin Truman of the Peterson Institute of International Economics developed a scoreboard for SWFs. It uses 25 questions falling into four categories (1) structure, (2) governance, (3) transparency and accountability, and (4) behaviour, with the answers based on publicly available information. The rating was first carried out in 2007 (for the latest available update, see Bagnall and Truman (2013)). These different transparency indexes will be used in later sections.

Management of tax revenue in Chile

Chile adopted a structural balance rule in 2001, which involves estimating the fiscal income that would be obtained net of the impact of the economic cycle, and in particular of commodity price cycles, and spending only the amount that would be compatible with that level of income. In practice, this means saving during economic highs, when revenues known to be of a temporary nature are received, and spending the revenue in situations when fiscal income drops (Marcel et al., 2001, Rodríguez et al., 2007).

The 2006 Fiscal Responsibility Law (FRL) was an important step towards strengthening Chile’s fiscal framework (de Mello, 2008). The FRL created a legal framework for the structural balance rule, created a Pension Reserve Fund (PRF) to address pension-related contingencies; transformed the previous Copper Stabilization Fund into a broader sovereign wealth fund called the Economic and Social Stabilization Fund (ESSF) and introduced explicit, formal mechanisms for capitalizing the central bank. Responsibilities are allocated between the Ministry of Finance and the Central Bank of Chile: the former sets the investment policy for tax revenue with advice from a Financial Committee, and reports each month on the investments undertaken, return on investments, and the positions of the funds, whereas the latter is delegated as asset manager.

21

The structural balance indicator used in Chile calculates a measure of government revenue net of the cyclical impact of three variables: the level of economic activity and the prices of copper and molybdenum, a by-product in the production of copper. Thus, the structural balance reflects the



tax revenue that would have accrued in a particular year if GDP were at its medium-term trend, and copper and molybdenum prices were on their longer-term (10-year horizon) trend level. These projections are determined by an independent rotating panel of 20 persons from the private sector and academia and (for the copper price) representatives of COCHILCO, the copper advisory agency, and CODELCO.

22

This rule imposes discipline on government expenditure in times of high revenue intake, providing for stable sources of revenue during periods of low government income. From 2001-07, successive governments held themselves to budget surpluses of 1% of GDP. In 2008, the surplus was 0.5% of GDP. In 2009, when the financial crisis was most strongly felt, the budget was in an actual deficit of about 4%.

23

The fiscal saving rule implies that government revenue is allocated to different funds, depending on the extent of the fiscal surplus. If the current fiscal surplus is 0.5% or less, it is allocated to the Pension Reserve Fund (PRF); surpluses from 0.5 to 1% could serve to re-capitalise the Central Bank of Chile (through 2011); revenue from surpluses above 0.5% are deposited in the ESSF since 2012 (Figure 7.1).

Figure 7.1. Chile: Allocation of fiscal savings by destination

% of GDP

Note that the recapitalisation of the Central Bank of Chile ended in 2011.

Source: Ministry of Finance of Chile.

The aim of the PRF is to provide back-up for the government’s guarantee of basic old-age and disability solidarity pensions and solidarity pension contributions. In other words, this fund acts as a supplementary source for funding future pension contingencies. The fund seeks to spread over time the future projected increases in these expenditures and explicitly incorporate this responsibility into state finances. No withdrawals of principal are allowed on the PRF before 2016 when it is estimated the capital accumulation will have reached sufficient levels.

24

The ESSF is intended to ensure that a part of the fiscal surplus is saved during times of high growth and strong commodity prices in order to finance the budget during times of lower than average growth and low commodity prices. In this way, the fund insulates social spending from the swings of the economic cycle and of the prices of copper and molybdenum, while harnessing public saving in order to strengthen the Chilean economy’s competitiveness (Rodriguez et al., 2007).

The ESSF was established in 2007 with an initial contribution of USD 2.58 billion, much of which came from its predecessor, the Copper Stabilisation Fund.

25 As of December 2012, the

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market value of the ESSF was USD 15 billion. Contributions to the ESSF since its creation totalled USD 21.2 billion and withdrawals from the fund totalled USD 9.4 billion. The investments have generated additional resources for the total amount of USD 3.2 billion since the fund’s inception.

At the end of 2009, the two sovereign wealth funds represented around 48% of total financial assets held by the central government and were equivalent to about 125% of the country’s public debt (Marcel and Vega, 2010). Measuring the net position of government finances is key for the management of fiscal policy. Since 2003 Chile has used IMF’s 2001 Government Finance Statistics Manual (GFSM 2001). The GFSM 2001 integrates in a consistent manner stocks and flows, using the accrual basis criterion for assessing government transactions. It strengthens the methodology behind government accounting and increases consistency with private accounting practices and national accounts (Marcel and Vega, 2010).

Withdrawals from the ESSF to cover budget deficits in times of lower government revenue require approval from the Chilean Congress. Some withdrawals were made in 2009 to counter the negative effects of the financial crisis. Congress approves withdrawals and spending from the ESSF.

Until January 2012, the sovereign wealth funds (PRF and ESSF) were exclusively invested abroad in low-risk asset classes, similar to those used for international reserves. The strategic asset allocation for the ESSF is made up of 66.5% in sovereign bonds, 30% in money market instruments, and 3.5% in inflation-indexed sovereign bonds. As of 2012, the portfolio composition of the PRF is 15% in global stocks, 20% in global corporate bonds and 65% in global sovereign bonds. The currency composition of the funds is broken down as follows: 50% USD, 40% Euro, and 10% Japanese Yen.

26

It should be noted that revenue from the mining sector is not earmarked for the jurisdictions (municipalities, regional governments) of the territories where the mining industries are based, as is found in some other natural resource rich countries. The distribution of revenue at a national level in Chile may help to increase its efficiency, flexibility and strategic use.

In 2013, the ESSF was ranked third (with a score of 91) on the scoreboard of SWFs compiled by the Peterson Institute (Bagnall and Truman, 2013). In the second quarter of 2014, it shared top ranking with nine other SWFs according to the Linaburg-Maduell Transparency Index.

27

Lessons from Chile’s tax revenue management

By implementing its structural balance rule, Chile has stabilised its government expenditure, saving during boom years and spending its excess tax revenue during years of lower revenue. This makes expenditure more predictable over the medium term. Its success is a consequence of tying expenditure to structural rather than effective income which is far more volatile.

28 The benefit of the

stabilization fund was proven in 2009 when the Chilean government used part of the fund to cover its expenses due to lower tax income during the global financial crisis. The existence of the fund has ensured the financial sustainability of social policies, facilitating their long-term planning.

Curbing excess spending during boom years also helps to hold down the exchange rate of the peso which would tend to appreciate during such times. The sovereign wealth funds that receive excess tax revenue during times of high commodity prices are held in assets denominated in foreign currencies, thereby partially offsetting the upward pressure on the peso. This helps to avoid “crowding out” of other industries and exports that may have trouble competing globally if they undergo a high exchange rate. Investing in sovereign wealth funds abroad also helps to diversify risk.

29

The legal framework of the Fiscal Responsibility Law and the checks and balances that are in place help to ensure that the structural balance policies are followed. The Fiscal Responsibility Law institutes a formula, based on independent projections of GDP growth trend and long-term prices of copper and molybdenum, for determining a long-term sustainable level of government revenue and the corresponding sustainable level of government spending. During surplus years, excess tax revenue and profits from CODELCO are put into the two sovereign wealth funds.



These mechanisms encourage the sharing of political responsibilities and make it easier for policymakers to bear the political burden of not being able to meet social demands in a low-revenue environment and to limit the benefit of spending revenue windfalls in boom years (Arellano, 2006). By setting a formal budget target, the budget rule reduces discretion. The automatic nature of the rule has helped to lock counter-cyclical rigour into Chile’s finances.

“Chile’s SWFs are being managed transparently, and the government is committed to best practices in this area” (IMF, 2008, p.19). The authorities publish monthly reports on the size and portfolio composition of both funds, and more extensive quarterly reports discussing performance relative to financial market developments and established benchmarks. Moreover, both the Chilean authorities and their Financial Advisory Committee are committed to public discussion of the funds’ strategies, and all asset income and use of assets are included in the annual budget reports.

Chile’s counter-cyclical fiscal policy has reduced both uncertainty as to its medium-term performance and its need for foreign financing, as well as reducing the sovereign risk premium it has to pay when it does borrow on international markets. These are direct benefits that Chile has experienced from its sound management of tax revenue.

Chile’s counter-cyclical policies with respect to the exchange rate have helped to decrease volatility, especially during years when copper prices were high (Figure 7.2). Chile was rated highly (eight out of ten) in terms of currency stability in the Behre Dolbear 2011 ranking of countries for mining investment.

Figure 7.2. Chilean peso nominal exchange rate and copper prices

Source: IMF and OECD.

The stable, predictable, balanced policies put into place by Chile have been reflected in its high ranking in surveys of mining firms and investors. Chile received the highest score in the Behre Dolbear 2011 ranking of countries for mining investment, along with Canada and the United States. Chile was ranked number one out of 79 countries in terms of their absence of uncertainty concerning the administration, interpretation and enforcement of existing regulation by the Fraser Institute survey of mining companies in 2010/11.

Management of tax revenue in Botswana30

Fiscal institutions and policies in Botswana

Revenues from the minerals sector in Botswana are not institutionally segregated but are included in the general government revenue pool. Historically, the public expenditure policy framework specified that revenues derived from minerals, as they result from the sale of an asset,

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should be used to finance investment in other assets. The intention is twofold--both to preserve the country’s overall asset base, and to provide a basis for generating income that can replace mineral income when it eventually declines. A corollary to the asset replacement principle is that recurrent non-investment spending must be financed from recurrent, i.e. non-mineral, sources.

The implementation of this principle has been monitored since 1994 by the Sustainable Budget Index (SBI), defined as the ratio of non-investment spending to recurrent revenues. An SBI value of more than one means that non-investment spending is being financed in part from mineral, or non-recurrent, revenues. If the SBI is less than one, mineral revenue is either being saved or spent on public investment, while recurrent spending is being financed from non-mineral (recurrent) sources; an SBI of one or less is therefore interpreted as being “sustainable”. In calculating the SBI, the normal budget classification of expenditure is adjusted slightly in that recurrent spending on education and health is classified as investment in human capital.

It should be noted, however, that the SBI has no statutory basis. Neither the SBI nor the principle underlying it are mentioned in the current National Development Plan, NDP 10, which spells out the general policy objectives for a six-year period (Government of Botswana, 2009). It turns out that, for most of the period since 1983/4, the SBI has been less than 1; however, it remained above 1 between 2001 and 2005, after having been on an upward trend for many years, indicating that part of the recurrent spending was financed by mineral revenues. Since 2006, the SBI has been well below 1, as the share of development, including health and education, spending in the budget rose sharply.

In recent years increased attention has been paid (particularly by the International Monetary Fund in Article IV reports and other economic assessments) to the non-mineral budget balance as an alternative indicator of sustainability. This indicator looks ahead to the post-mineral era. It rests on the Permanent Income Hypothesis, and implies that it is sustainable to run a non-mineral deficit the size of the permanent annuity that would be generated if mineral revenues were not spent but were invested so as to provide a permanent annuity income (Clausen, 2008).

Figure 7.3. Non-mineral primary budget balance, Botswana

% of non-mining GDP

Source: Korinek (2014), calculations based on data from MFDP.

The IMF estimates that, according to its methodology, the sustainable non-mineral primary balance is around 5% of non-mineral GDP (IMF, 2012a).

31 Figure 7.3 shows that the non-mineral

primary balance, as a percentage of non-mineral GDP, has been consistently and substantially above this level since the early 1980s.

32

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An important institutional mechanism of public financial management in Botswana is the National Development Plan (NDP) process. NDPs establish general policy objectives and include all public investment projects over a six-year period and must be approved by Parliament. Box 7.4 describes the process whereby the content of each plan is established. Public funds cannot be spent on projects unless they are included in the NDP. The annual budget includes the provision of funds for recurrent spending for the year ahead, as well as the annual portion of development project funding for projects in the NDP. This also has to be approved by Parliament. Public finance discipline is reasonably effective and historically there has been little off-budget spending, although the amount of off-budget spending financed by various off-budget “levies” and dedicated funds has been increasing in recent years.

33

Box 7.4. Assessing development priorities: From Kgotla to Parliament

The National Development Plan (NDP) establishes the policy objectives and outlines all public investment projects for the upcoming six-year period. Preparation of the NDP is overseen by a multi-sectoral Reference Group. This group consists of employees from the Ministry of Finance and Development Planning (MFDP), the Office of the President and representatives from the private sector, non-governmental organisations, the Vision Council and the Bank of Botswana.

The District Planners Handbook explains the National Development Planning process as “... a ‘bottom-up’ approach whereby the people express their needs, and these needs, in turn, should be the basis for district and, eventually, national planning...”. The most important step in the process is consultations with local communities by the 16 local authority administrations. These local authority administrations include 10 district councils, two city councils and four kgotla or town councils. Part of this consultative process is based on a traditional structure: in pre-colonial and colonial times, the kgotla was a public forum in which issues of public interest were discussed (Acemoglu et al., 2003). It is during these consultations that local issues are raised by the community and possible solutions are envisaged. In this process, all Batswana1, including those in remote areas, can have input in the NDP, at least theoretically. During consultations, workshops are held with the local Dikgosi (chiefs), Village Development Committee (VDC) members, Councillors, and representatives from the business community, religious groups, women’s organisations, youth, the disabled and farmers’ committees.

After episodes of consolidation and refinement, issues raised by the community during the different workshops are then included in the Local Authority Key Issues paper (LAKIP). Each of the 16 local authorities prepares a LAKIP, which then feeds into both the local administration’s Development Plan and the Sectoral Key Issues Paper (SKIP) of the Ministry of Local Government. The latter in turn feeds into the Macroeconomic Outline and Policy Framework of the next NDP. Proposed projects during the NDP planning process will, after screening, make up the Development Budget of the NDP.

The process of proposing projects for inclusion in the NDP is thus largely “bottom up”. However, not all projects proposed at the community or district level can be accepted for implementation. First, projects are screened to ensure that they comply with national policy guidelines. These mainly relate to the size of the local population and the type of facility proposed (e.g. a settlement or district with a small population may not get a full-scope secondary school or a tarred road, even if the community so desires, because the facility would be underused). Second, projects that meet policy guidelines are prioritised in accordance with the availability of financial resources at national level. Although detailed cost-benefit analyses are not carried out for some projects, this system has largely been driven by technical expertise and not political considerations (Pegg, 2010).

The tension between local desires and national policies has become more acute in recent years. Many of the main national infrastructure priorities have been met (roads, schools, hospitals, water, electricity, etc.), and much of the remaining demand comes from communities where further infrastructure provision may not be cost-effective. This is particularly a problem in Botswana which has large and sparsely populated rural areas. While some such projects do proceed, they are justified in social or political terms, and yield little economic return. It has been argued that the bottom-up process has led to too much emphasis on social projects and not enough on projects that support business (e.g. internet bandwidth).

However, not all projects included in the NDP are proposed by the community; some are “top-down” and driven by national policy needs (e.g. core utility and transport infrastructure such as the electricity grid and airports). Nevertheless, these “top-down” projects retain a democratic consensus because they are informed by national policies debated and passed in Parliament. ________________________________

1. Botswana’s people are called Batswana.



There is an important legal restraint on the accumulation of public debt. Under the Stocks, Bonds and Treasury Bills act, Government borrowing is subject to a statutory limit of 40% of GDP with sub-limits of 20% of GDP for each of domestic and foreign debt and guarantees.

34 An

additional “fiscal rule” was introduced in the Mid-Term Review of NDP 9 in 2007, which sought to limit government spending to 40% of GDP on average throughout the economic cycle. It was, however, more of a guideline than an enforceable rule. According to sources in the MFDP, the 40% figure is to be brought down to 35% by the end of the NDP 10 cycle, and to 25% of GDP in the NDP 11.

Public financial assets

From 1983/4 up to 1997/8, the budget of Botswana was in surplus every year, although since 1998/9, there have been budget deficits in eight of the 15 years, most notably in the three worst years of the financial crisis (2008/9 to 2010/11). Public finance decision-making has generally been cognizant of the limits imposed by absorptive capacity constraints, and the government has felt under no obligation to spend all mineral revenues when there were concerns about overheating of the economy or when suitable investment opportunities could not be found. Therefore, over the period as a whole, there has been considerable accumulation of financial assets. It is important to note that these assets are accumulated as a fiscal residual rather than through any process of targeting specific amounts of financial savings.

Historically the government has accumulated significant financial savings and undertaken very little borrowing. The government of Botswana’s net financial savings reached 88% of GDP in the late 1990s (Figure 7.4). These savings were then partially depleted in the early 2000s by the decision to establish a new pension fund for government employees, which involved financing the contingent liabilities accumulated under the previously unfunded government pension scheme. Net financial savings were partially rebuilt in the mid-2000s, recovering to around 40% of GDP, but were then substantially depleted during the deficit years of the global financial crisis, when the deficits were financed by a mixture of draw-downs of savings and new borrowing.

Because financial assets are accumulated as a residual from the budget surpluses that result once spending decisions have been made, there are no rules regarding the payment of any mineral revenues into this fund, nor any rules regarding withdrawals. As a result, the fund could in principle be depleted quite quickly. Although no interest is paid on government savings balances, a nominal return is calculated and this is paid into the general government budget as a “dividend” from the Bank of Botswana.

The overall foreign exchange reserves are divided primarily into two parts: the Pula Fund and the Liquidity/Transactions Tranche. The latter is analogous to the foreign exchange reserves that central banks hold for the purposes of financing short-term foreign exchange needs for imports of goods and services, net income and capital outflows. The overall reserves change depending on balance of payment surpluses or deficits, and the size of the Pula Fund is determined as a residual once the Liquidity/Transactions portion of the reserves has been allocated, rather than through an active policy of maintaining a specific level of assets. There are no other rules prescribing the level of payments into or withdrawals from the Pula Fund.

The Pula Fund is sometimes referred to as Botswana’s Sovereign Wealth Fund (SWF). It has some similarities with other SWFs in that it is managed for long-term investment returns rather than short-term liquidity purposes. However, unlike some other SWFs it is not an independent entity; although it was established in its present form under the Bank of Botswana Act 1996, the Pula Fund has no separate legal status or balance sheet of its own.

Although the GRB’s savings have fallen as a percentage of GDP, both Pula Fund reserves and total foreign exchange reserves of the GRB have risen steadily with the except in the 2001-2003 period, when a previously unfunded government pension liability was fully funded, and during the 2009 economic crisis (Figure 7.5).



Figure 7.4. Botswana: Net public assets

Source: Authors’ calculations, based on data from MFDP and BoB.

Figure 7.5. Botswana: Pula Fund and total foreign reserves

Source: Bank of Botswana, authors’ calculations.

Although the Pula Fund is not a separate legal entity, a nominal Pula Fund Balance Sheet and an Income Statement are included in the Notes to the Bank of Botswana’s Annual Accounts. The accounts do not however explicitly present the rate of return on the Pula Fund.

The Bank of Botswana’s Annual Report and Accounts provides some information on the asset composition of the Fund, its notional balance sheet and an income statement. This information is provided annually, and the value of the Fund is published monthly as part of the Bank’s balance sheet. No reports are published specifically on the Pula Fund, and no information is provided on Fund transactions. As part of the foreign exchange reserves, the Pula Fund is invested entirely offshore. The detailed currency composition of investments is not published, but the Bank of Botswana uses an SDR benchmark for constructing the investment portfolio.

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The bulk of the Pula Fund is invested in bonds, with the second largest share in equities. Over the past four years (2008-2012), the composition of the Pula Fund has averaged 71.5% bonds, 25.9% equities, and 2.6% other assets. Fund managers have moved to invest a slightly higher percentage in the last year in equities, bringing the share to 65% bonds and 35% equities.

No public information is provided on the identity of the Pula Fund managers or on their asset allocation, mandates or performance, or on detailed asset holdings. Half of the short- and long-term fixed income investment instruments of the liquidity portfolio and the Pula Fund are managed by the Bank and half are managed by its nine fund managers.

Regarding the transparency of the Fund’s management, the SWF Institute lists a total of 69 SWFs around the world as at mid-2013. Of these, a smaller number are rated in terms of the Linaburg-Maduell Transparency Index. The Pula Fund obtained a score of 6 in the second quarter of 2014, placing it joint 26th out of 51 rated funds. The SWF Institute recommends a minimum rating of 8 in order to claim adequate transparency. Although the International Working Group that developed the Santiago Principles does not publish any assessment of compliance of different SWFs with the Santiago Principles, the Oxford SWF project carried out an assessment of compliance with these principles in 2011. The Pula Fund was rated 22

nd out of 26 SWFs, with only

15% compliance.

The Revenue Watch Institute compiles a Resource Governance Index (RGI) which measures the quality of governance in the oil, gas and mining sector of 58 countries.

35 The RGI

incorporates various aspects, including an assessment of mineral revenue management and natural resource funds. Botswana’s overall assessment on the RGI was rated as “weak”, with a score of 47/100, in part because of the poor quality of reporting for the Pula Fund.

Botswana is not a member of the Extractive Industries Transparency Initiative (EITI) although De Beers S.A. is a member. The GRB’s reluctance to subscribe to the EITI reflects a number of factors, including the historical secrecy of the diamond industry, the confidentiality of the revenue sharing agreements with De Beers, and a desire not to give away confidential commercial information to competitors.

36

Public expenditure patterns37

Public expenditure in Botswana has generally been counter-cyclical relative to revenue streams. Botswana has therefore been able to smooth out government spending despite the volatility of natural resource revenues by accumulating reserves during periods of relatively high commodity prices and drawing them down when prices slacken (IMF, 2012c). Policies pursued in the context of the Medium Term Fiscal Framework are expected to enhance the certainty and stability of government expenditures from the volatile revenue streams.

Expenditure on the different classes of assets can easily be traced, reflecting policy priorities as laid out in NDPs and other policy documents. Total mineral revenues at 2010 prices over the period 1983/4 to 2012/13 were P 347 billion. These can, in principle, be apportioned between spending on the different types of assets, or on recurrent spending in the case that the SBI constraint has not been observed.

Evidence presented in Korinek (2014) shows that, on average over the whole period, if not in individual years, mineral revenues were entirely devoted to investment in physical and human capital assets, and were not used to finance recurrent spending, which was financed by recurrent revenue (Figure 7.6). Public investment spending was allocated between physical assets (44%), education and training (42%) and health spending (14%).

Physical investment, excluding health and education facilities, has been undertaken across a range of assets with the three largest areas of investment being electricity and water (18%); housing and urban infrastructure (15%) and roads (13%).



Figure 7.6. Botswana: Gross accumulated mineral revenues and public investment

Source: Authors’ calculations, based on data from MFDP

Lessons from Botswana’s management of mineral revenues

Botswana has risen from least-developed country status to that of an upper-middle income country, in large part due to its handling of revenue from the minerals sector. The over-riding principle motivating expenditure from mineral sector revenues has been that these revenues result from the sale of an asset and should therefore be used to finance investment in other assets. An examination of the expenditure of minerals sector revenue in Botswana over the last three decades confirms that it has been spent in its entirety on human and capital investment and has not been used to finance recurrent spending. It is all the more remarkable that this has occurred without any formal partitioning of government revenue streams, or earmarking of mineral revenue for particular uses.

Use of mineral revenues for the purpose of investment in Botswana’s people and infrastructure has been monitored using Sustainable Budget Indicator (SBI). This has been the principal indicator of the use of revenue from mineral resources for investment in human and physical capital.

Public investment spending over the last three decades has been divided between spending on infrastructure, and on education and training (roughly equal shares) as well as on health. Investment on non-health and non-education related infrastructure has been undertaken across a range of assets with the three largest areas of investment being electricity and water, housing and urban infrastructure, and roads. Education expenditure has also been substantial. In addition to expenditure on local schools and the University of Botswana and other tertiary training, the GRB finances tertiary education overseas for many of its eligible citizens.

The decision-making process by which development priorities and expenditure on projects have been determined is an inclusive one. Expenditure on investment projects is determined within the National Development Plan process: no projects are financed outside the NDP process. The NDP process is bottom-up as well as top-down, and provides the forum where development projects are proposed and negotiated. Discussion about priorities takes place at all levels of government and civil society. Priorities and projects are proposed by inter-ministerial groups at the highest level of government; by local government authorities; by interest groups and representatives of different groups within the population; by the business community; and by local chiefs. Most of the projects retained in the six-year development plans come from bottom-up consultations, although not all projects proposed at that level can be accepted.

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This broadly based consultative system with consultations from the village level to the highest levels of government is a more open process than in many other countries. Stakeholders generally, therefore, feel committed to the resultant plan, with its outline of priorities and retained projects.

As a result of these policies, Botswana improved its socio-economic performance considerably over the past three decades. Access to education, health services, sanitation, and clean water increased dramatically, despite a widely dispersed population and low initial levels. About 95% of the population had access to clean water by 2004. Virtually all Batswana children now attend junior-secondary school (as compared with only 100 secondary school graduates in total at independence) and the adult literacy rate is more than 85% (Maipose, 2008).

The GRB has felt no obligation to spend all mineral revenues when there were concerns about overheating of the economy or when suitable investment opportunities could not be found. Expenditure patterns in Botswana have generally been counter-cyclical or acyclical relative to revenue streams. Botswana has therefore been able to smooth out government spending despite the volatility of natural resource revenues by accumulating reserves during periods of relatively high commodity prices and drawing them down when prices slacken or demand for diamonds drops.

These tendencies have provided Botswana with relative macroeconomic stability and avoided the boom-slump cycles that characterise many mineral-based economies (Lewin, 2011). The periodic slowdowns in the diamond industry have thus by and large not been passed on to the rest of the economy.

In order to save some of the revenues from its minerals assets for future generations and for shorter-term stabilisation purposes, the GRB created a long-term investment facility called the Pula Fund. The Pula fund is managed for long-term investment rather than short-term liquidity purposes. As part of the foreign exchange reserves, the Pula Fund is invested entirely offshore. The Bank of Botswana uses an SDR benchmark for determining the currencies in which the Pula Fund is invested. Investing offshore in foreign-denominated assets helps prevent pressure being exerted on the local exchange rate, an essential factor in preventing the “Dutch disease” phenomenon that besets many minerals exporters. Having said that, the lack of transparency surrounding this SWF raises questions as to whether its management could be improved further.

7.4. Creating spillover effects: Development of mining-related activities

Leveraging comparative advantage in extractives

Beyond the direct impact on resources covered in the previous sections, the mining sector has the potential to create spillover effects by contributing to the development of mining-related activities that cater to domestic and international extraction firms, or by promoting the development and involvement of local firms in downstream, value-adding activity. There is an incentive to explore the scope for creating such spillovers in order to leverage a country’s comparative advantage in natural resources to expand into sectors that are vertically or horizontally close to the extractive industries.

Mining sector participants in Chile do not believe that Chile has a comparative advantage in promoting downstream industries, i.e. increasing its capacity for further refining of copper.

38 In these

industries, margins are lower, energy inputs are substantial, and further refining of products is thought to be undertaken more efficiently closer to final markets. Instead, Chile has opted for a strategy of supporting sectors that service its mining operations, both in terms of equipment and services.

Chile has, therefore, focused on upstream or horizontal activities, which typically results in what is called a mining cluster. There are various successful examples of such clusters in other countries that, starting with mineral wealth or wealth in other natural resources, have developed services, capital goods and intermediate goods industries that support mining activities. In the United States and Canada, for example, a mining equipment industry emerged. In Australia, mining



technology services have developed: over 60% of software used in mining globally is provided by Australian firms. Finland has also leveraged its comparative advantage in mining to develop mining services by fostering close collaboration between producing firms, the public sector and universities (see Korinek (2014) for more information).

Botswana has chosen to concentrate on its processing sectors. The GRB has consistently, over the years, attempted to expand opportunities for Botswana firms down the diamond value-chain in order to extract greater value from its diamonds and to create jobs. It calls this process “beneficiation,” a word that is used most commonly in Southern Africa and most commonly in reference to the diamond industry. Beneficiation entails undertaking more and more processing within the country where diamonds are extracted.

Developing mining-related goods and services in Chile39

Organisational change has made it more feasible than in the past to develop a cluster that serves local mining activities and exports goods and services to the global mining industry.

40 In

mining in particular, firms have become more focused on their core business and have outsourced their remaining activities. In the past, mining companies were self-sufficient and supplied the majority of intermediate goods and services that they required. Thirty years ago, Codelco, the state-owned copper enterprise, had one employee from a contracting company for every five employees. Currently, for every five Codelco employees, seven contracted employees provide services in company facilities. This is the same ratio found in large, private mining companies. The trend towards outsourcing in Chilean mining, and the role of service providers, is more pronounced than in other countries. In Chile, the proportion of contracted workers with respect to the total mining labour force is over 60%; in Australia and Canada, it is 24%, and in the United States, 8% (Fundación Chile, 2011). This evolution in mining companies’ organisation has allowed a number of Chilean companies specialising in the provision of services to develop competitively. Indeed, several of them have started to export their services.

Apart from changes in company organisation, the demand for new technologies and knowledge has been growing and will continue to do so. Exploited minerals are of a lower grade with a more complex mineralogy, and they are deeper and will require underground mining, which is increasingly operated remotely. Also, environmental sustainability requirements demand more efficient use of basic resources like water and energy, and better treatment of waste and emissions. This poses new challenges and requirements, and opens up vast potential for technological development and the provision of specialised services. These are knowledge-intensive services due to their highly specialised nature and because of the need for continuous innovation and incorporation of technologies in order to find new, more efficient solutions for mining operations (Urzua, 2007).

Using the size of the mining sector as an indication of the potential for exports of mining-related goods and services suggests that compared to Australia, the United States or Canada, Chilean exports of mining-related goods and services could significantly surpass current levels. If Chile attained the same level of mining-related activity exports as a percentage of total mining exports that Canada has achieved, this would imply an increase of more than ten times the current level.

Chile is in the process of developing its mining services industry. Historically, the first step was to substitute imports of intermediate goods and services.

41 The proportion of domestic

intermediate goods rose from less than 25% in the 1950s to around 60% towards the end of the century.

42 This expertise led to greater exports of mining sector supplies. In the last 12 years,

exports of products and equipment used in the extractive industries grew from less than five to almost USD 300 million. The main supplies currently exported are grinding rolls, machinery and equipment, spare parts for machinery, equipment for mineral processing, and machinery and tubes for perforation and drilling (source: National Customs Service).

Exports of engineering services, which were approaching USD 10 million at the beginning of the 21

st century, exceeded USD 200 million in 2011. Growth is even greater if we consider the



previous import substitution of these services, which has fallen over the same period. The engineering of large mining projects built in the 1980s and 1990s was carried out abroad, while in the last 15 years, it has been carried out primarily in Chile. The activity of engineering companies, measured in person-hours, increased by 20% between 1992 and 2003, and between 2003 and 2011 grew by 115%. The main growth by far has been seen in mining-contracted engineering, which represented more than 50% of the total in 2011.

43

According to a recent study of engineering services in the Americas by a team from Duke University, “[the] Chilean engineering sector is strongly positioned within the Americas to take advantage of new opportunities emerging in the region. Chilean engineers are widely recognised by leading global firms for their excellent technical skills and they are considered to be world leaders in engineering for mining” (Fernandez-Stark et al., 2010a and 2010b). Chile is host to a number of global Centres of Excellence and firms draw on their Chilean staff to make decisions on projects around the world. Starting in the 1990s, several international firms began subcontracting local Chilean firms or forming joint ventures. Fluor, Bechtel, SNC Lavalin, AMEC and SKM Minmetals are among the firms that established greenfield operations in Chile and grew their offices organically. Currently, there are around 16 000 professionals working in the engineering consulting industry in the country, 70% of them in mining projects.

Developing a qualified workforce for the sector

The level of qualification of the workforce is a critical factor in explaining the different degrees of success that countries have had in increasing the impact of mining on their development. A recent study of human resource needs commissioned by the association of large mining companies concludes that “the gaps (or projected deficits) of the qualified labour force constitutes probably the greatest challenge that Chilean large-scale mining is facing for the 2011-2020 decade” (Fundación Chile, 2011). It is estimated that mining companies and large-scale mining contractors will have to increase their resources by 53% between 2012 and 2020, considering only extraction, processing and maintenance operations, a situation that becomes especially critical at specific levels and positions.

Although Chile saw significant development in higher education during the 20th century,

insufficient numbers of young people are enrolled in technological fields, and particularly in programmes related to mining, metallurgy and geology. This is a potentially serious limitation for the cluster's development and may even prove to be a limitation for existing mining operations. Chilean engineers are well qualified but insufficient in number to fulfil domestic and international demand. When Bechtel decided to hire extensively in 2007, for example, the labour pool for engineers in the mining sector did not meet the demand. Another factor is the international deficit in this area and the fact that many foreign companies recruit professionals in Chile.

There is a clear need for higher education institutions to work in close contact with the industry to increase enrolment in this area. In order to increase the impact on the development of its mining resources, it will become necessary to raise one or two consortia of Chilean universities to a high level of excellence, bringing in the best students from Chile and from abroad. Master's and Doctoral programs related to mining increased from 14 in 2002 to 27 in 2006. However, this substantial increase was marked by an excessive multiplication of programmes and a fragmentation of efforts. It would be advisable to have one or two world-class programmes drawing both Chilean and foreign students.

44

Public-private initiatives for mining development

In Chile, the government and the production sector have only recently begun promoting initiatives to foster the development of the mining cluster. During the first decade of the 21

st century,

a series of diagnostic studies were conducted on the current state and potential of this cluster and how to best promote it. A low level of cooperation among stakeholders was observed, as was the absence of a shared vision of how best to develop the sector (Boston Consulting Group, 2007). Moreover, it was considered that without the active participation of large mining firms the cluster is unlikely to develop (Meller and Lima, 2003). These studies suggest that export and development opportunities can be found in niches of the value-chain that are not being served by the large,



global firms that currently supply the core goods for the mining industry. It was estimated that exports of such niche goods and services, if they were to be exploited by new or existing Chilean firms, could more than triple in five years to reach USD 1 billion (Boston Consulting Group, 2007).

A substantial share of the innovation undertaken by Chilean firms is adaptive.45,46

Local firms, working closely with teams in the large mining firms, solve the challenges they face during their operations on the ground. Such innovation by proximity is a niche that global firms that manufacture mining equipment cannot fill. A partnership between BHP-Billiton, Codelco and Chilean equipment and services providers is building on these opportunities. These two large mining concerns partner with smaller firms that offer goods or services that they need and that are chosen for their ability to find innovative solutions to well-identified problems facing the industry. These partnerships are expected to develop local providers into world-class suppliers (see Box 7.5, for more details).

Box 7.5. BHP-Billiton, Codelco programme to develop world-class suppliers*

This programme, originally designed by BHP-Billiton, aims to increase the capacity of domestic suppliers and contribute to Chilean economic development, while increasing the competitiveness of its own mining operations. World-class suppliers are defined by their ability to export knowledge-intensive services and technology to other mining countries and sectors of the Chilean economy.

The programme brings together suppliers with development potential in order to solve, together with the mining firm, the problems that have been previously identified and prioritised by mining operational areas. In this way the programme seeks to create development opportunities in local firms, encouraging and preparing them to compete globally.

After identifying needs for specific innovative solutions and selecting participants from among the potential providers, the programme provides a framework to test ideas within real-time operations. In addition, it provides external consulting to give suppliers advice and training on competencies required to achieve world-class business performance, and promote links with local research centres and universities.

BHP-Billiton started this programme in 2008. Early in 2010, Codelco joined the programme. At the beginning of 2012, more than 60 suppliers were participating in the programme. By 2020, the programme aims to have developed more than 250 world-class suppliers.

The 60 projects on which the suppliers are currently working address various kinds of challenges. These include: dust reduction and management, water, energy, equipment maintenance, human resources, and leaching. Nine of these projects are defined by the leaders of the programme as "disruptive", i.e. with a high level of complexity; the other 53 are classified as "incremental", implying a medium level of complexity.

The programme builds on the commitment of mining firms to use their strong purchasing capacity to leverage the development of local providers, transforming or developing them into world-class suppliers. In order to do this the mining companies have had to partially modify their usual procurement process which is designed to obtain the lowest-cost goods and services efficiently and on a highly reliable basis. This system was not designed to purchase new solutions with less standardised specifications. It tended to avoid less well-known and less predictable suppliers, as may initially be the case with the providers that the programme aims to promote. These changes in procurement processes require commitment and trust from the leaders of the mining firms.

Thus the programme aims to achieve a win-win result for the mining firm itself and for the development of the domestic economy. It seeks not merely to draw on the existing competences of suppliers but to strengthen both their innovative and wider business capacities. This process should enable these firms to capture a larger share of the rising demand for knowledge-intensive goods and services both in Chile and internationally.

It is too early to evaluate the results of the programme. However, it is noteworthy that the programme is underway with 60 suppliers working with two of the world's largest mining firms using a methodology that was specially designed and successfully tested to identify specific demands and to select and support the potential suppliers. It is expected that other mining firms will take part in the programme as sponsors, and some of the large international providers of mining equipment could also sponsor part of this initiative. This process has required the collaboration of the mining firms’ operations teams, both in the production and procurement processes and has involved the participation of universities and technological centres. Also participating was a team of external advisers, mainly from Fundación Chile (a public- private institution that promotes innovation), which has developed capacity to support the new suppliers. __________________

* Osvaldo Urzua, who has led this programme, provided information about the progress made during the last two years. A policy note written by Barnett and Bell (2011) provides valuable information.



Another example where proximity and adaptive innovation have synergised is in responding to challenges created by the specific geography or geology of each mine. For example, Codelco operates the El Teniente mine, which is by far the largest underground copper mine in the world. This has given Codelco comparative advantage in state-of-the-art technological expertise needed to operate such a large underground mine, and it has developed local research and development capacity in that area. Codelco signed an agreement with Rio Tinto, a leading international mining group, three years ago to invest jointly in such development to solve some common challenges.

One rationale for the mining royalty when it was introduced in 2005 was to increase the resources needed to foster innovation, research and development in order to increase competitiveness and diversify the productive base. Eyzaguirre et al. (2005) outlines the strategy for encouraging innovation using the royalties collected. A large-scale effort to promote innovation was suggested, including an increase in spending in this area to 2.4% of GDP. The Chilean government has sought to encourage innovation at the start-up level with a view to attracting entrepreneurs worldwide that are keen to expand from a base within Chile. One example is Start-Up Chile, a programme created in 2010 by the Chilean Government to promote innovation throughout the Chilean economy.

47 The pilot programme brought 22 start-up firms from 14 countries to Chile,

providing them with USD 40 000 of equity-free capital and a one-year visa to develop their projects.

Another area where the government can play a decisive role in helping the industry is by promoting the introduction of common standards. Common standards can reduce the transaction costs for providers of equipment and services to the mining sector, with underlying benefits for mining firms. In the case of procurement, for example, the safety and security requirements defined by different mines could be further standardised and thus reduce the costs of access to the sites by contractors.

48 In the case of information technologies, common standards facilitate software

developers’ work with different companies. A collaborative approach is needed here: even if it were possible to take these steps independently by start-up or developing firms, it would be very expensive and slow. Thus, there is a clear role for government in promoting collaboration among mining firms and their local providers in setting standards in order to reduce transaction costs.

Lessons from Chile: Fostering growth from the mining sector

In line with its comparative advantage, Chile has adopted a strategy of supporting sectors that service its mining operations, both in terms of equipment and services. This strategy has been facilitated by a gradual change in the organisation of Chile’s mining industry. The last three decades have seen the mining sector develop from an industry of vertically-integrated operations that import all necessary inputs to one of a multitude of specialised contractors that contribute a specific good or service. In this way, contracted firms innovate and compete in their specialised, narrowly defined areas of expertise. This can strengthen their performance, encouraging them to become more efficient in their core businesses.

There is some recent evidence of successful partnerships (such as the BHP-Billiton-Codelco initiative) between large mining firms and specialised, contracted firms who partner with smaller firms that offer goods or services that they need. These partnerships are expected to develop local providers into world-class suppliers. There is a large, untapped potential for export of these adaptive technologies that build on Chile’s comparative advantage of proximity to mining operations.

The demand for new technologies and adaptation of existing ones has grown and will continue to do so. Environmental sustainability requirements, the need to drill deeper to get to new deposits, and exploitation of more complex or lower-grade minerals pose new challenges and open up vast potential for technological development and the provision of specialised, knowledge-intensive services.

A potential public good can be created by cooperation between government and private mining firms and their contractors with an aim to foster common standards. Two areas where



common standards could be enhanced are safety and security, and information technologies for the mining industry.

A strong need has been identified for internationally competitive, well-trained engineers and technicians. The need for high quality professionals is a known bottleneck in the global mining industry, and Chile is no exception. A large number of new educational programmes has been started to train professionals for a career in mining. It remains to consolidate the programmes to produce one or two recognised, world-class institutions with international links to other mining programs.

Further development of the mining sector, and the potential for creating spillovers into the wider economy, will need to be catalysed through a common vision of the sector. In a country like Chile where the linkages between private, public and regulatory bodies are close and overlapping, such a sector vision should focus energies on medium-term needs and priorities on which each of the market participants can then concentrate. Even more important than the predictive aspect of this vision is the process of its preparation and development.

Moving down the value-chain in Botswana

The Government of Botswana is cognizant of the fact that its diamond reserves, albeit the largest in the world, will not last indefinitely. The peak of production from Botswana’s diamond mines has passed, given all known reserves, and will decline further after 2030 when Botswana’s two largest mines move underground implying lower production levels at higher cost. It is considered unlikely that new diamond deposits will be found.

49

It has been seen above that the mining sector does not employ many people, compared to its share in the country’s GDP. The Botswana Core Welfare Indicators Survey 2009/10 conducted by the Central Statistical Office (CSO) of Botswana, recorded an unemployment rate of 17.8%.

50

The rate among secondary school graduates is higher. The CSO has estimated that in 2010, 19.3% of Batswanas were living below the poverty line

51, and in its review of the Botswana’s economic

outlook in 2013, the African Development Bank reports significant income inequality (a Gini coefficient of 0.61).

52 Thus, despite the country’s successful path of economic growth, which is at

least in part due to Botswana’s tax policies vis-à-vis the mining sector and its judicious use of revenue from the sector, large challenges remain. The GRB’s consistent efforts over the years to create employment downstream in the diamond value-chain are a response to the employment challenge. The following paragraphs review some of these initiatives, stage by stage of the value-chain.

Sorting, valuing, aggregation

A view of the diamond industry value chain is given in Figure 7.7. Botswana entered the diamond industry value chain at the Mining and Recovery stage when it started production in 1971. In 2004, the renewal of two 25-year mining licences for the Jwaneng and Orapa mines with De Beers provided the forum for the GRB to negotiate the opening of sorting and valuing operations in Gaborone. In 2008, the Botswana Diamond Trading Company (DTCB) expanded operations in Gaborone to sort and value the entirety of Botswana’s diamond production and started selling a portion of its production locally. DTCB is the world’s largest sorting and valuing facility and employs 400 people. It has opened a Diamond Academy to train sorters and valuing staff. Diamond sorters have as a minimum a secondary school education, and receive six months training in the Diamond Academy followed by 18 months training “on the floor”. Salaries and benefits in the sector are high.

53

Aggregation is the process by which sorted diamonds are combined according to specifications of rough diamond buyers. In the De Beers selling operations, rough diamond buyers are under contract for three years. Their contracts specify what types of diamonds they wish to purchase, and how many. They are then offered a set of diamonds that conform to the specifications of their contract in buying sessions that are held ten times per year. The aggregation



process prepares these “boxes” of diamonds for potential buyers. Aggregation of diamonds started in the Gaborone facilities at the beginning of 2013.

54

Figure 7.7. The diamond industry value chain

Source: DTC Botswana.

Selling rough

The GRB has recently negotiated a further move down the diamond value-chain. In a 10-year contract signed in 2011 governing the marketing arrangements between Debswana, DTCB and DTCI, the GRB obtained that the entire De Beers rough diamond selling operation be transferred to Gaborone by the end of 2013. This is the longest selling contract reached between the GRB and De Beers; previous contracts were for five years. By end 2013, all De Beers’ rough diamonds will be sold to all contracted rough buyers (Sightholders in De Beers terminology) in Botswana. All 81 Sightholders, or their brokers, comprising 200-300 diamantaires, travel to Gaborone ten times per year to view and purchase diamonds.

De Beers has thereby moved its entire selling operation from London to Gaborone. Eighty-four DTCI employees and their families have been relocated. Additionally, a number of new positions have been filled. The first Sightholders meeting was held in Botswana in November 2013. It is notable that despite the change in venue for Sightholders from London to Gaborone, not one of the 81 Sightholders has revoked its status. They will therefore travel from Europe, India, Israel and the United States in their majority to view diamonds in the small Southern African capital.

Other diamond mines have obtained licences in recent years as a condition that they market their diamonds in Botswana. For example, the Boteti Mining Company conducts rough diamond viewing in both Gaborone and Antwerp, and the GRB expects them to relocate the sales function fully to Botswana by 2015.

The GRB aims to create a “diamond hub” in Botswana before its diamond reserves diminish. Moving De Beers selling operations to Gaborone is a big step in this process. The GRB hopes the move will encourage other mining companies to sell their rough diamonds in Botswana. It also

Sorting

and

valuing

RetailJewellery

manu-

facturing

Polished

trading

Cutting and

polishingMining and

recoveryProspecting Aggregation



hopes the increased travel to Botswana and increased visibility will develop related industries such as tourism, financial services, business services, transport and security.

The 2011 contract negotiation for Debswana also specified that 10-15% of Debswana’s rough diamond production would be sold outside the De Beers Sightholder system. The GRB has established the Okavango Diamond Company to sell diamonds in a live, sealed-bid auction in Botswana to a selected cross-section of buyers. Okavango has also developed an online auction site through which to sell its diamonds. Up to 12% of Debswana’s diamonds will be sold to Okavango in 2013, rising by one percentage point per year to equal 15% of Debswana’s production by 2016. A pilot auction took place in Gaborone in June 2013 ahead of the launch in September 2013. The sale of diamonds outside the controlled De Beers selling operation will provide the GRB with an alternative independent mechanism for valuing its diamonds and will offer an opportunity to obtain greater insight into diamond market trends.

There may be a number of reasons why this initiative was not taken in the past. Rough diamond marketing has traditionally been done in a controlled environment among market participants that have long-standing relationships; it is a business based on trust. Part of the explanation for the way the diamond industry works is that it is based on the premise, established many years ago by De Beers, that diamonds are the materialization of love.

55 Underlying this

premise is the idea that price is a secondary criterion in the choice of a diamond. De Beers has traditionally kept the diamond price stable but rising, and has discouraged speculative behaviour in the market as this would go against the concept of a purchased diamond as an heirloom (Spar, 2006). It was quite natural that the GRB should market its diamonds through the stable, if somewhat opaque, marketing channels of its joint venture partner and industry leader, De Beers.

However, by selling its diamonds exclusively through the De Beers network, the GRB has foregone access to some market information regarding the value of its product. This has become more of an issue as diamonds have come on stream from firms outside the De Beers network that necessarily have different marketing and selling strategies. Until the end of the 1980s, De Beers controlled 90% of rough diamond sales; today the figure is 36%. Although it is still the market leader, many other selling strategies exist that may prove superior in maximising gains from the sale of diamonds. One study suggests that BHP-Billiton and some other market participants have obtained higher prices for their diamonds since 2010, generally through auction sales (Cramton et al, 2012). These results merit further study, however, since the sellers concerned have a smaller share in the rough diamond market and their prices are less stable than those for De Beers’ diamonds.

Another reason the De Beers Sightholder or Supplier of Choice system exists is to ensure stability of the supply of diamonds as a heterogeneous good. An example of this follows. Suppose a jewellery firm such as Tiffany and Co. wishes to market a heart-shaped diamond ring or necklace. A marketing campaign will be undertaken to create the demand for this unusually-shaped stone. The firm will contract to buy a substantial number of heart-shaped stones over the coming months and years. However, the proportion of rough diamonds that can efficiently be cut into heart-shaped polished stones is small. In order to be sure of obtaining a sufficient quantity of such stones, a firm like Tiffany and Co. would need to be part of a large network of rough diamond buyers that can ensure an adequate supply of these uncommonly shaped stones.. An auction or on-the-spot system could not do so, nor could a diamond mining firm that does not sell a substantial share of global rough diamonds.

Therefore, the success (or otherwise) of the Okavango Diamond Co. will be of great interest to the GRB, as well as to the rest of the industry, as an indicator of the value of Botswana diamonds in an alternative market structure.

Cutting and polishing

Knowing that diamond mining has brought substantial financial gain to Botswana but not high levels of employment, the GRB has attempted to develop the diamond processing industry further down the value-chain. It should be noted that, according to industry participants, the greatest



gains in the diamond industry are upstream and downstream, in other words in mining on the one hand and in retail sales on the other (Figure 7.7). Value added is small in the sorting, aggregation, cutting and polishing stages. These intermediate stages of processing do, however, require employment of semi-skilled labour. Moreover, they do not require the substantial long-term capital investments necessary in the upstream portion of the value chain (mining and recovery) nor the network of retail outlets and industry-specific commercial knowledge of the downstream (retail) portion of the value chain.

The GRB has been encouraging cutting and polishing firms to set up factories in Botswana using commercial access as leverage. In the 2006 negotiations for the five-year renewal of DTC Botswana’s contract, the GRB obtained the contractual agreement to sell a percentage of its diamonds in-country. Since 2007, a portion of Debswana’s production has been sold to local Sightholders, outside the central De Beers Sightholders system, that have set up cutting and polishing operations in Botswana. New three-year contracts for these Sightholders were signed in March 2012, raising the number of local Sightholders from 16 to 21.

56 Consequently, more of

Debswana’s production is sold locally: in 2012 it amounted to USD 800 million, up from USD 550 million in 2008. All 21 local buyers have opened cutting and polishing facilities in Botswana.

The cutting and polishing facilities now operating in Botswana employ 3 500 Batswana. Most firms are subsidiaries of larger firms that also cut and polish diamonds elsewhere: most of the global cutting and polishing industry is located in India with higher-end facilities in Tel Aviv or New York. Not all diamonds are efficiently processed in Botswana. Very small diamonds are still more efficiently processed in India due to lower labour costs and lower value-added of very small stones. Very large or unusual stones are generally cut and polished in facilities with deep experience given the value of the good and the substantial financial loss in case of error.

In order to maximise the quantity of stones actually processed in each facility located in Botswana, while allowing for some flexibility in the processing of very large or very small stones, local Sightholders are allowed to process up to 20% of their stones bought locally in their facilities outside Botswana. DTC Botswana checks cutting and polishing facilities periodically to ensure conformity with this requirement.

Firms that buy locally in Botswana do so partly because there is less competition for stones than in the general De Beers/DTC system. They have a better chance of obtaining the quantity and kind of stones that they desire by purchasing directly in Botswana and opening a cutting and polishing facility there. Local Sightholders are chosen according to a number of criteria, one of which is how much training and transfer of knowledge and technology that they are willing to undertake.

Lessons from Botswana: Beneficiation in the diamond value-chain

The Government of Botswana has been successful in leveraging its position as global leader in diamond reserves to move operations in the diamond value-chain gradually to Botswana. Whereas in the 1980s and early 1990s, it extracted more value from the mining and recovery stage of production, negotiations since the late 1990s have concentrated on creating facilities domestically with a view to creating a Diamond Hub. This has been done step by step, starting with the creation of sorting and valuing facilities. Botswana now successfully sorts and values its own diamond production in its entirety.

Aggregation of Botswana’s diamonds started at the beginning of 2013 and by year-end, all of De Beers selling operations were moved to Gaborone, Botswana’s capital. This move seems unprecedented. Approximately 30-35% of the world’s rough diamonds are now sold in Gaborone at ten Sightholders’ meetings each year.

Diamonds are not exchanged in an open consumer-driven market for reasons of history, heterogeneity of the product, the basis on which they are bought (sentiment as opposed to need), and the necessity of stability of supply for some types of stones. In order to verify the value of Botswana’s diamonds, and to sell a portion of its asset through alternative auction-based channels,



the GRB negotiated to be able to sell up to 15% of its production through a parallel firm, the Okavango Diamond Company. That firm had its first formal auction in October 2013.

Moving further down the value-chain, Botswana has welcomed 21 diamond cutting and polishing firms that have created 3 500 jobs for Batswana. Although this may seem a small number, it is significant on the scale of Botswana (population 2 million with a substantial share of young people) and compared to the entire mining sector which employs 12 000 directly. Cutting and polishing firms have been drawn to Gaborone in part due to the easier access to sought-after types of stones.

Without an in-depth study that estimates the number of additional jobs that have been generated due to the increase in local downstream activity, via normal multiplier processes, it is not clear whether this strategy—concentrated on the diamond value-chain—has had a greater impact on the economy as a whole than could have been made with a more diversified programme of employment creation. On the face of it, the strategy is astute and promising, as it plays to the country’s strengths as a recognised world player in the diamond business, and draws on the long-term investment Botswana has made in its successful private-public partnership with De Beers.

7.5. Avoiding the worst: Constraining illegal mining practices

Thus far, this chapter has outlined the policy context and the specific policies undertaken in two countries that have been successful in leveraging their raw materials endowments for wider development. Both Chile and Botswana have developed their extractive industries and fostered activities in upstream and downstream sectors without resorting to export restrictions.

57 The

preceding sections have outlined how Chile and Botswana have successfully implemented a tax system and used its revenue to respond to societal objectives. They have also been somewhat successful in fostering development in adjacent sectors such as mining services or processing industries. These policies have aimed to respond to societal objectives that some other countries try to achieve through use of export restrictions.

There are, however, other reasons given by countries using export restrictions on industrial raw materials; one of these is to control illegal exports of minerals products. The OECD inventory of export restrictions contains some cases where control of illegal exports is cited as rationale for imposing export restrictions (see Chapter 1).

The informal sector is large in many non-OECD countries. Although the share of the economy that is informal is by nature difficult to pinpoint, some estimates exist. For example, in the case of Colombia, the majority of economic activity takes place in the informal sector. The 2010-2014 National Development Plan noted that in Colombia in 2009, over 60% of workers did not contribute to social security and were thus considered part of the informal sector.

58 In Peru, one

estimate suggests that 60% of economic activity takes place in the informal economy there. CEPLAN, a Peruvian think tank, estimates that 74% of employment is in the informal economy.

59

Non-registered mining is prevalent in some areas of Latin America, including in Colombia and Peru (Box 7.6). Informal sector mining has brought a number of challenges to both countries. The foregone revenue to governments can be substantial; processes used can be dangerous for both humans and the environment; and illegal and informal mining have brought on a variety of social problems and even problems of basic human rights. There has been a push toward formalisation in both Colombia and Peru in order to reduce the size and scope of the informal mining sector. Although this is a difficult problem, some progress has been made. There has also been a concerted effort to tackle criminal mining in both countries, in an attempt to stop the most egregious practices present in the sector. Given the degree of informality and the corresponding foregone government revenue, export restrictions could be seen as a policy alternative to appropriate some of the rents from the informal mining activity. Colombia and Peru are avoiding this approach, however, and have adopted a multi-pronged strategy to tackle informal, illegal and criminal mining with a push towards formalization.

60



Informal and illegal mining present many challenges. It has been estimated that 87% of gold mining worldwide takes place informally. Firms are not registered, exploitation and environmental permits have not been issued, safety regulations are not enforced, taxes and social security contributions are not paid and labour, environmental and even basic human rights legislation is not adhered to. According to a Mining Census undertaken by the Ministry of Mines and Energy in Colombia in 2010-11, 63% of mining firms operate without a mining title. Sixty-five percent of mining firms do not pay royalties, most of them operating without a mining title. In Peru, 70% of informal miners have taken a first step toward formalization of their activity.

There are a number of reasons for implementing a process of formalization. One is that informal miners generally do not pay taxes, royalties or social security contributions. In Colombia, according to the 2010-11 Mining Census, 65% of mining firms (or “units of production”) do not pay royalties. Among informal miners, the figure is 81%. The contribution to the collection of royalties by the mining sector is therefore taken from only 35% of mining firms. In Peru, the tax office has estimated that foregone revenue from unpaid taxes and royalties equals USD 930 million.

There have been many well-documented incidences of environmental damage due to illegal mining operations. Eighty per cent of gold mining in Colombia takes place outside the formal sector and virtually all use mercury to extract the gold from the rock or sand (Box 7.7). Gold extraction using mercury in an uncontrolled environment, as is the case in most of the illegal mining sites in Colombia and Peru, is a serious threat to the health of communities in the area and to the environment on a potentially large scale. In Colombia, 75% of mining operations do not have environmental permits; among operations that do not hold a mining title, the figure is 93%. In Peru, it has been estimated that 30 000-40 000 hectares of forest have been destroyed due to illegal mining. Alluvial mining is particularly hazardous for the environment as chemicals and waste are carried downstream.

Box 7.6. Activities outside the formal sector: informal, illegal and criminal mining

In much of the Andean community, mining is a traditional activity in some regions. Many countries are mineral-rich and minerals are found in some remote areas where there is little other economic activity. Traditional mining is generally done in small family-owned or community operations. Gold mining is particularly prevalent in traditional mining activities. With the recent sharp increase in the price of gold, however, many non-traditional actors have invested in the sector. The non-traditional miners are using more highly mechanized production processes. There is also a criminal element to some of the gold mining operations since, according to Colombia’s Ministry of Defence, it has become more lucrative to mine for gold than to grow cocaine.

Three types of mining activity can be distinguished outside the formal sector. Although some categories of formal and informal and illegal mining overlap, the following typology is generally used among Andean Community members.

Informal mining refers to artisanal or traditional production units, generally families or small groups. They often live on or nearby their area of activity. They do not have an accounting structure, are not incorporated and do not keep inventory. Many do not possess the mining title for the land on which they mine. They are very lightly mechanized.

Illegal mining refers to the fact that production units are operating outside a legal framework. They may be larger-scale operations and may use heavy machinery. They may employ substantial numbers of people. They do not own a mining title, are not registered as miners, generally do not pay royalties or taxes and have not registered in the ongoing process of formalization. Many illegal mining operations are undertaken in restricted areas or in riverbeds where mining is prohibited.

Criminal mining has been a problem in many countries of the Andean Community. It can take many forms. On the one hand, gold mining has been used in money laundering of drug profits. A potentially more common form of criminal mining results from extortion of small or medium-sized mining firms. Armed operatives demand a share of mining profits under threat of violence. Another form of criminal mining involves organized crime groups operating production units. Workers are sometimes threatened or coerced into mining for local organized units; in this case, a wide variety of labour and human rights are not respected. Some criminal mining operations control access to inputs or machinery used in the mining operations. In Colombia, much of the criminal mining is thought to be controlled by organized groups like the FARC, ELN or Bacrim. The extensive network of these groups exacerbates the problem of criminal mining.



Illegal mining is a multi-dimensional problem that affects the entire Andean region. There has been some cooperation among Andean Community members in the area of illegal mining and illegal trade in minerals.

Box 7.7. Substance use in gold mining

In much of the Andean region trace quantities of gold can be found in rivers or extracted from rock. Gold mining lends itself to small-scale and artisanal mining since the requirements for large machinery and capital are lower than for other types of mining. It is a traditional economic activity in many countries. There are three ways used to extract gold: gravimetric (physical) methods to separate loose alluvial gold deposits; using mercury, either on the ore or on concentrated mineral; and cyanide. The traditional activity of panning for gold has been transformed by the use of mercury to extract gold and silver from ore. In Colombia, mercury is used in virtually all small-scale informal sector gold mining. In many cases, mercury is used on the ore deposits, as opposed to the concentrated mineral, so large amounts of mercury are required and the outcome extracts less gold from the deposit. Cyanide used in mineral extraction can be fatal in case of human contact but dissolves in conjunction with ultra-violet rays. Using cyanide to extract the mineral is more efficient and less environmentally harmful therefore but requires formality, larger scale operations and an initial capital outlay. It has been estimated that informal mercury use recovers 30% of the gold contained in the ore whereas cyanide processes recover 70% of the gold content.

Mercury has devastating consequences for human health and for the environment. Mercury—also known as quicksilver – is an element found in nature in various forms. Because it is an element, mercury does not break down in the environment. Instead, it cycles between the atmosphere, land and water and can travel large distances from the original source. Mercury can also build up in humans and animals and become highly concentrated in the food chain. This is a problem since low levels of mercury exposure can build up over time until concentrations are high enough to be harmful. The United Nations Industrial Development Organization (UNIDO) suggests that 100% of mercury used in artisanal and small-scale gold mining is released into the atmosphere. Using mercury in a controlled environment on concentrated mineral, as opposed to the less processed ore, can reduce emissions by 70-90%. The controlled environment suggests greater formality, acceptance of safety standards, and initial capital outlays which suggests larger scale operations than the traditional ASM unit of production.

The Minamata Convention on Mercury, a global treaty signed on 19 January 2013, was named after the Minamata disease, a neurological syndrome first discovered in Japan. The Minamata disease, first discovered in 1956, was caused by the release of mercury in industrial wastewater from a chemical factory. The local chemical and plastics firm, Chisso Corporation, dumped an estimated 27 tons of methylmercury into the Minamata Bay over a period of 37 years. The highly toxic chemical bioaccumulated in fish and shellfish in the Minamata Bay and when eaten by the local population resulted in mercury poisoning. Pollution was so heavy at the mouth of the plant’s wastewater canal that a figure of 2 kg of mercury per ton of sediment was measured, a level that would be economically viable to mine. The high contamination levels in the people of Minamata led to severe neurological damage and malformations and killed more than 900 people. An estimated 2 million people from the area suffered health problems or were left permanently disabled from the contamination.

The Minamata Convention on Mercury aims to protect human health and the global environment from the adverse effects of mercury. It includes a ban on new mercury mines, the phase-out of existing ones, control measures on air emissions, and the international regulation of mercury use in ASM gold mining. The Convention calls for the elimination of mercury use in ASM mining in 20 years

7.6. Policy lessons from the case studies

General remarks

None of the countries whose mineral resources policies have been described in detail in this chapter has resorted to trade instruments such as export restrictions to manage its minerals sector. Instead, they have relied on a combination of balanced taxation, good management of tax revenue, stable investment policies, a push toward formalisation of all mining activities, and initiatives aimed at promoting spillovers from the minerals extraction sector to other related sectors and to develop the economy as a whole for the benefit of their citizens.

The introduction to this chapter listed a number of policy objectives that resource-rich countries using export restrictions on their minerals exports often cite to justify the use of these trade measures. The debate surrounding the “resource curse” was also invoked, and the question was posed as to whether economies with a buoyant and profitable natural resource sector, which is



responsible for the greater share of export revenue and whose rate of growth outstrips that of other economic sectors, have difficulty in achieving sustained economic growth and development.

Many policy lessons can be drawn from the successful experiences of countries such as Chile and Botswana, and these have been underlined in the preceding sections. This section focuses primarily on examining the issues raised in the introduction against the evidence provided by the two case studies. Needless to say, the experiences of these countries have to be seen in their specific contexts, taking into account the complex web of interacting institutions in the public and private sectors, their stages of development, and other societal objectives.

Policy lessons from Chile

One of the most characteristic features of the mining industry is that it is highly capital-intensive and necessarily demands long term investments; once investments have been made, they are not transportable. Potential investors therefore attach great value to political and regulatory stability. Chile has been quite exemplary in this area: its trade and investment policies have been open and predictable. The tax environment has also been relatively stable. When the tax system was revised in 2010, consultation was undertaken and firms could opt in to the new system or retain the previous levels of tax rate for a given time. As is documented earlier in the chapter, Chile has succeeded over the years in drawing substantial foreign investment into its mining sector and its wider economy.

61 Surveys of the perceptions of potential overseas investors regarding the

investment climate and potential in Chile regularly give the country a rating that is more than satisfactory.

The tax structure applied to the Chilean minerals sector includes tax rates that are progressive according to two parameters: volume of production and, within each volume class, the size of the profit margin. This system is flexible enough so that, in boom times when world market prices are high, a substantial share of the surplus is captured as tax revenue without resorting to border measures.

Chile’s progressive profits-based mining tax implies that risk is shared between the government and private firms. Implementing this type of tax is beneficial in many ways but demands a high level of institutional capacity. In particular, it is necessary to be able to ascertain potential operating margins and provide oversight for payment of appropriate amounts of tax.

One characteristic of the mining sector is that it is made up of large firms with sizable market power, many of which are multinationals based outside the producing country. Their investment decisions are made by weighing all potential costs against the potential benefit of extraction. In this way, governments need to be mindful of tax liabilities facing firms in third countries that they will be paying, but also that they will be considering with respect to future investment. Chile continues to attract significant investment – more than other countries in the region – including to the mining sector, yet a significant proportion of its tax revenue comes from copper mining.

In order to benefit the country as a whole, the management and investment of tax revenue must be sound and counter-cyclical. The Chilean fiscal expenditure policy is based on long-term copper revenues and growth forecasts, and the tax revenue is invested in sovereign wealth funds. This policy has been so successful that the two sovereign wealth funds sustained from tax revenue run to billions of US dollars and exceed the national debt. The fact that the counter-cyclical and formula-based approach is embedded in the Fiscal Responsibility Law provides maximum insurance against mismanagement of funds. Spending of the ESSF requires Congressional approval. This also ensures against potential spending of the funds for short-term gain, which has been a downfall of such funds in some other cases.

The counter-cyclical investment in SWFs and expenditure from them also helps to dampen the adverse effects of changes in the prices of copper and molybdenum on the exchange rate. Tax revenue is invested in dollar-, euro- or yen-denominated securities, thereby offsetting the pressure on the Chilean peso when mineral prices are high. When they are low, the foreign-invested funds are drawn upon, thereby lessening exchange volatility. This is a major issue for countries such as



Chile that are heavily dependent on export earnings from their minerals sector and are, at the same time, mindful of “crowding out” other sectors by a strong or volatile exchange rate.

The Chilean government is aware of the importance of fostering linkages between mining and mining-related sectors that create employment in knowledge-intensive industries with strong future potential. The proximity to mines gives Chilean small and medium-sized firms supplying equipment and services to the mining industry a strong comparative advantage in developing and exporting. The need for technological solutions to challenges posed to the sector by environmental regulations, the need to drill deeper for deposits and increasingly complex mineralogy can potentially be filled by Chilean firms. Partnerships between large mining firms and smaller suppliers are key to responding to these challenges.

Development of the mining and mining-related sectors means appropriate investment in people. Lack of qualified engineers and, in particular skilled technicians, is a bottleneck found in the mining sector in many countries. The Chilean education system provides a labour force of sufficient quality but insufficient number. Educational programmes to prepare students for employment in the mining sector have been expanded although coordination has not been fully adequate to propel such programs to the level of international renown.

In conclusion, there is much to be learned from the Chilean policy experience vis-à-vis its mining sector. This study has shown that Chile is able to achieve policy objectives through targeted domestic policies without recourse to export restrictions. Equally, however, some things remain to be done: one example is the management of information on potentially exploitable mineral deposits which could be consolidated. Another area that warrants reform is the unpublished Ley Reservada del Cobre. The purpose of this paper is to identify best policy practice in mining, however, and there is much on which to expound in the case of Chile.

Policy lessons from Botswana

It has been seen that Botswana’s strong economic growth in the past four decades, and formidable advances in terms of education, access to clean water, infrastructure and well-being of its people, are in large part due to effective management of its mineral resources. Although the economic situation in Botswana has its specificities (e.g. small population, low population density, substantial mineral reserves), many of the policy priorities and their implementation can be regarded as models for other minerals-rich countries. In particular, Botswana has achieved a strong but balanced system of mineral taxation, effective management of revenue, strong investment in its people and its infrastructure and policies to encourage the creation of a diamond hub, in a climate of stability with limited corruption.

The Government of Botswana has managed extraction of its main mineral resource, diamonds, through a joint venture with De Beers, the largest private firm in the industry. The GRB receives 80-82% of the revenue minus costs from its joint venture. It has conducted its relationship with De Beers strategically. In the early days of Botswana’s diamond production, the 1970s and 1980s, negotiations concentrated on obtaining a greater share of the revenue from its natural resource. In the late 1980s and 1990s, the GRB took advantage of its leverage in the joint venture to increase its management capacity, including by obtaining a share in De Beers and two seats on the Board of Directors of the global firm. It thereby obtained access to the highest levels of experience and strategic business acumen in the industry. Since the late 1990s, the GRB has used its leverage to advance its priority of creating a diamond hub in its capital, Gaborone.

In this way, the Government of Botswana has invested heavily in its relationship with De Beers and has managed that relationship well, using its leverage to obtain important advances for its population. Given its low levels of capacity at the start of this relationship, this is all the more commendable. It suggests that it may be easier for a country with low levels of capacity to manage one or a small number of relationships rather than putting into place the governance structures that are necessary to regulate many small firms. It also suggests that the capacity-building aspects of the joint management structure have been substantial.



Through its relationship with the private sector, the GRB has aligned its interests in terms of production levels and rates of extraction, and management policies of its largest joint venture. This may have had a restraining effect on any inclination to over-tax or over-regulate the industry, which has been observed in some other mineral-rich countries. A greater understanding of the constraints and the enormous potential of the mining sector has served the GRB well.

The Government of Botswana has, through its relationship with De Beers and its development policy over past decades, emphasised the need to build internal capacity within the country in order to undertake contract negotiations with foreign investors on an equal footing, and implement its minerals policy. The internal capacity building in the diamond industry has been an important element of Botswana’s success in obtaining and managing the revenue from the minerals sector.

Not only has the GRB successfully leveraged its position as the global leader in diamond reserves to extract substantial revenue from its resources, but even more crucially it has generally been quite exemplary concerning the way in which its revenue is spent. One of the main problems mineral exporters face is the tendency for public expenditure to follow the cyclical patterns of revenue generated from mineral resources. The GRB has overall resisted the impulse to spend the entirety of its revenue from the mining sector and has generally avoided both overheating the economy and investing in unsound projects. As was seen in the Chilean case, Botswana’s expenditure of mineral revenues has generally been counter-cyclical or acyclical.

Botswana’s overriding development strategy and its main expenditure projects are decided in a very inclusive process every six years that results in a national development plan. The content of each six-year plan is generated by a consultative process that touches all levels of state and local government, interest groups, traditional chiefs and business owners; this procedure is derived from traditional practices but has been refined in the current context. All development projects that are undertaken are retained through this consultative process. Projects are selected largely according to technical criteria and in line with established priorities, and not according to political considerations.

One of the cornerstones of Botswana’s revenue management strategy has been that revenues from its mineral assets are invested in their entirety in other assets – health and education of its citizens or its infrastructure. Recurrent expenses have been financed entirely from non-mineral revenues. The substantial advances in social indicators are probably largely due to this policy. Currently, this breakdown of revenue use has not been actively targeted, and is not enshrined in any constitutional or legal framework. Investment expenditure over the last three decades, largely financed from minerals revenues, has been largely on infrastructure and education and training, with health spending in third place. Today, virtually all Batswana have access to clean water, and virtually all Batswana children attend junior secondary school.

At the same time, the GRB has not felt compelled to spend all the tax revenue it collects, and has built up a substantial sovereign wealth fund. The Pula (“Rain”) Fund was established in the mid-1990s. It has been described both as an inter-generational fund and a stabilisation mechanism. The Pula Fund is invested offshore in foreign currencies which furthermore avoids putting pressure on the national currency.

Although Botswana’s mining sector provides a substantial share of government revenue, it continues to draw investors. The mining sector accounts for a large share of FDI stocks. Botswana has made concerted efforts to attract FDI into export-oriented manufacturing and services, so as to reduce reliance on diamond exports and to diversify its supply-side capacities. The Ministry of Trade and Investment of Botswana has partnered with the OECD in undertaking a comprehensive review of its investment policies to identify areas that need further reform in order to attract more diversified and sustainable investment, both domestic and foreign.

Particularly important to potential investors in the mining sector is Botswana’s political and regulatory stability.

62 Because mining is a highly capital-intensive industry that demands long-term

investments, potential investors value such stability very highly. Botswana’s tax system, in particular, can be qualified as very stable. Countries like Botswana that have achieved high levels of



perceived governance overall are in a much better position, if changes are needed, to mitigate their impact on investment.

Botswana’s minerals sector has been the engine of its development strategy and efforts have been made to ensure its continued development and presence in the country. Early on, with the help of development assistance funds, good quality, detailed geological information was collected to obtain a comprehensive view of the country’s resources. Such information is of prime importance for minerals-rich countries wishing to attract investment. The geological information has been refined and more detailed data collected over time. Information collected by prospectors complements existing sources and is, in principle, made available when a prospector releases his right to explore or retain the concession. Evidence from surveys confirms that this information increases a jurisdiction’s attractiveness to overseas investment.

In an effort to retain diamond activity in the country, and aware of the non-renewability of its main mineral resource, Botswana has made sustained efforts to become involved in other stages of the diamond value-chain. The first step was investing in capacity to sort and value the country’s diamonds in Botswana itself, creating local jobs and increasing the level of local expertise. At the beginning of 2013, aggregation, a further step in the value-chain, was commenced locally. Since November 2013, the entire selling operation of the De Beers group, i.e. the largest market for diamonds worldwide, takes place in Gaborone. This seems unprecedented and is the result of the GRB using its leverage within the De Beers group to further its aim of creating a Southern African diamond hub in its capital. Further down the value-chain, the GRB has leveraged its relationship with potential rough diamond purchasers to encourage a diamond cutting and processing industry that has created 3 500 jobs.

With the aim of obtaining as much value from its natural resource as possible, while retaining incentives for investment and leaving open space for competing enterprises, the GRB now sells a share of its diamonds on an alternative auction-based platform. This initiative will provide additional information about the value of its diamonds moving forward, and may provide insights into the trade-off in diamond revenue between volatility and price levels. Correctly valuing diamonds is of primary importance to the GRB, not least of all in order to calculate the royalties due from diamond extraction. This represents a clear understanding and good use of market mechanisms to extract maximum gain from its resource.

Challenges to Botswana’s regulatory model

Botswana has been very successful in bringing itself to the level of an upper-middle income country. Further advances, however, may prove more challenging, particularly faced with falling diamond revenues. Consensus may break down somewhat as priorities in terms of access to electricity, basic and secondary education, clean water, basic health services and transportation have largely been met. It will be increasingly difficult to choose between competing priorities if more sophisticated systems for undertaking cost-benefit analysis and monitoring and evaluation are not in place.

Botswana’s expenditure of its mineral sector revenues on health, education and infrastructure may have been the single most important factor in its phenomenal performance. In the past few years, however, these expenses have grown substantially and will likely be unsustainable in the face of falling mineral revenues. The Pula Fund has been used in recent years to top up such expenditure: investments in human and infrastructure capital have continued to be heavily funded as opposed to financial investments for future generations, despite the fact that basic infrastructure investments have been accomplished. It has been suggested that the returns to some of these investments have fallen.

The rules that have governed the allocation and expenditure of Botswana’s revenue have worked well until now but they have no statutory basis. This implies that it would be possible to spend accumulated assets indiscriminately. Although there is no history of this in Botswana, a more structured legal framework for the different budget and fiscal rules would make it even less likely.

63

In addition, there are no explicit rules regarding the accumulation of financial savings from minerals.



Agreement on certain rules or targets for public asset accumulation would add to Botswana’s policy portfolio as would more transparency in management of public assets.

64 Greater transparency in

public expenditure is also more appropriate as Botswana’s labour force has accessed higher education. Greater oversight, including that of outside, independent bodies, will be increasingly desirable.

Furthermore

Examination of the policy environment in Chile and Botswana underlines many areas of good practice in the regulation of their minerals sectors without resorting to distortive trade policies. There are many instances of other minerals-rich countries using export restrictions to try to regulate their minerals sectors. Users of export restrictions indicate that they do so in an attempt to foster spillovers to other sectors, particularly in order to promote the development of downstream or upstream industries; to increase government revenue coming from the extractive industries; to offset exchange rate impacts; to control illegal exports or other activities; and to protect the environment or citizens’ health, among others.

The cases of Chile and Botswana suggest alternatives to export restrictions that have been successful in responding to many of these policy objectives in varied, and often innovative, ways. One area that has not been covered in the two case studies is controlling illegal export of mining products and illegal mining activities. This is a substantial problem in some minerals-exporting countries. Different types of activity can be distinguished: informal activity, where small-scale, traditional miners carry out their occupation; illegal mining which is larger-scale and involves heavy machinery; and criminal mining which includes the worst forms of extortion, threats, violence and money-laundering. These are particularly difficult problems but some policies are being put into place in minerals-rich countries such as Peru and Colombia.

One of the over-riding and most generalizable lessons from the natural resource curse debate is that “institutions matter”. This is well illustrated by the case studies presented in this chapter. Strong institutions enable resource-rich countries to reap the benefits of exploiting their mineral resources while fostering sustainable rates of extraction. As with other economic activities, it is important to develop and maintain a governance framework based on the rule of law and supporting institutions that provide an environment in which firms have incentives to invest in productive activities (UNCTAD, 2007).

Notes

1. Jane Korinek is a Trade Policy Analyst in the OECD’s Directorate of Agriculture and Trade. This research was undertaken in the Policies for Trade and Agriculture Division of OECD’s Trade and Agriculture Directorate under the management of Frank van Tongeren. Research on the current economic situation was provided by Tarja Mård, statistician at OECD. The chapter on “Creating spillover effects: Development of mining-related activities in Chile” was prepared by consultant José Pablo Arellano of the Corporation of Studies for Latin America (CIEPLAN), formerly CEO of Chile’s state-owned copper mining firm. The author wishes to thank the Chilean Delegation to the OECD and the Directorate for International Economic Relations in the Ministry of Foreign Affairs of Chile for their help in facilitating this research. The author is grateful for comments on earlier drafts received by staff from the following Chilean bodies: Ministry of Mining; Ministry of Finance; COCHILCO, the copper advisory body; and the following OECD colleagues: Mario Marcel, Deputy Director of Public Governance and Territorial Development; Aida Caldera Sanchez of the Economics Department; James Green from the Center for Tax Policy; Kathryn Gordon of the Investment Division of the Directorate for Financial and Enterprise Affairs; Yunhee Kim of the Trade and Agriculture Directorate as well as many OECD Delegations.

The chapter on management of mineral revenues in Botswana was provided by Keith Jefferis, Managing Director of econsult Botswana, former Deputy Governor of the Bank of Botswana. The author wishes to thank individuals in the following Botswana administrations and OECD Directorates who provided comments on earlier drafts: Ministry of Minerals, Energy and Water Resources; Ministry of Finance and Development Planning; Jean-Philippe Stijns of the OECD Development Centre; Lee Corrick of the Centre for Tax Policy and Carole Biau of the Investment Division of the Directorate for Financial and Enterprise



Affairs, as well as many OECD Member country delegations. This report benefitted from discussions in the OECD Working Party of the Trade Committee, which agreed to make the study more widely available through declassification on its responsibility.

2. This chapter draws heavily on Korinek (2013) and Korinek (2014).

3. See Chapter 1, Table 1.6 for an exhaustive list.

4. The policies discussed in this chapter respond to the first three of the objectives listed here. Other policies to address issues such as controlling illegal exports, environmental protection and the protection of citizens’ health, and managing mineral extraction rates will be covered by additional OECD case studies in the future.

5. See, in addition, Korinek and Kim (2010) or the WTO World Trade Report 2010, p. 123-130.

6. For example, Peru has partially modelled its regulation of the mining sector on that of Chile. Some West African countries are re-working their Mining Codes and have called on the West African Economic and Monetary Union (WAEMU) to help in this task and to harmonise their treatment of foreign mining interests.

7. This section draws substantially on the work of Boadway and Keen (2010).

8. In practice, few OECD countries have signed on to the initiative. At present, among OECD countries, only Norway is EITI compliant.

9. In recent years, however, the Chilean government has authorised Codelco to capitalise profits in order to finance new projects.

10. In September 2012, Congress approved a permanent increase in the corporate tax to 20% in order to finance the education system, supporting pre-schools and providing better funding for university students.

11. The Decree Law 600 regulating investment has been in force since the 1970s and ensures non-discriminatory treatment and tax invariability, through a contract between the foreign investor and the State of Chile. The investment regime has been seen as a guarantee of stability for foreign investors and one of the reasons Chile has been a leader in attracting foreign investment, including in the mining sector.

12. See http://www.camara.cl/prensa/noticias_detalle.aspx?prmid=100806.

13 This is a very pertinent issue for the mining industry in Chile since energy inputs in the sector are extensive.

14 For more details, see Korinek (2013), pp.26-27.

15. Although De Beers only receives 18-20% of before tax profit, the company makes more profit in Botswana than anywhere else in the world. This reflects the very large scale and very high profitability of diamond mining in Botswana (Jefferis, 2009).

16. The tax policy vis-à-vis diamond mining firms is, in principle, subject to negotiation. In practice, however,

according to industry executives, a similar rate and tax base is used in that industry as in other mining industries.

17. Fraser Institute Survey of Mining Companies 2013, http://www.fraserinstitute.org/uploadedFiles/fraser-ca/Content/research-news/research/publications/mining-survey-2013.pdf.

18. There is some debate over whether or not tax revenue from natural resources should be invested abroad or within the country of extraction. The Natural Resource Charter, a set of principles for governments and societies on how to best harness the opportunities created by extractive resources for development, suggest that wealth created from taxation of mineral rents should be invested in the country, not in sovereign wealth funds (www.naturalresourcecharter.org).

19. See http://www.swfinstitute.org/statistics-research/linaburg-maduell-transparency-index/. Also Korinek (2014), footnote 29.

20. There are 24 GAPPs, grouped into three broad categories: i) Legal Framework, Objectives, and Coordination with Macroeconomic Policies; ii) Institutional Framework and Governance Structure; iii) Investment and Risk Management Framework. See http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf for details.

21. Detailed information about the Chilean SWFs can be found at www.hacienda.cl/fondos-soberanos.html.

http://www.camara.cl/prensa/noticias_detalle.aspx?prmid=100806

http://www.fraserinstitute.org/uploadedFiles/fraser-ca/Content/research-news/research/publications/mining-survey-2013.pdf


http://www.naturalresourcecharter.org/

http://www.swfinstitute.org/statistics-research/linaburg-maduell-transparency-index/

http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf

http://www.iwg-swf.org/pubs/eng/santiagoprinciples.pdf

http://www.hacienda.cl/fondos-soberanos.html



22. For a detailed overview of the conceptual issues underlying the structural balance policy and the formula used to determine the structural balance indicator, see Arellano (2006), Marcel and Vega (2010) and Rodríguez et al. (2007).

23. Fiscal policy is continually open to debate and review in Chile. A report has been released by the Corbo Commission that assisted the current government in reviewing the fiscal rule. A discussion of some of the possible refinements can be found in Corbo Commission’s Report: Towards a Better Fiscal Policy (Libertad y Desarrollo, www.lyd.org, 8 July 2011). The review was commissioned in part because the counter-cyclical nature of the current fiscal rule was found to be insufficient in the face of a large crisis such as that in 2008 and 2009.

24. As of December 2012, the market value of the PRF was USD 5.1 billion.

25. See Ministry of Finance, www.hacienda.cl/english/sovereign-wealth-funds/economic-and-social-stabilization-fund.html

26. Ministry of Finance, www.hacienda.cl/english/sovereign-wealth-funds/investment-policy.html.

27. http://www.swfinstitute.org/statistics-research/linaburg-maduell-transparency-index/.

28. It is not possible to shield the economy entirely from commodity export volatility. The commodity boom brought higher costs, particularly in wages, and strong investment inflows. The economy showed signs of overheating in 2008. When world trade and commodity prices collapsed, the investment boom came to a halt (OECD, 2010). The OECD Economic Survey of Chile 2010 (pp.44-50) includes further suggestions for further insulating the economy from such shocks while introducing additional flexibility.

29 Given Chile’s decision to invest PRF funds abroad, another option would be for the fund to invest in fixed-income securities denominated in currencies that evolve with the peso, such as those of other natural resource exporters (IMF, 2008).

30 This section draws heavily on work prepared by Keith Jefferis, Managing Director of econsult Botswawa, formerly Deputy Governor of the Bank of Botswana.

31. The percentage non-mineral primary balance is computed as the difference between non-mineral revenue and expenditure (excluding interest receipts and interest payments), expressed as a percentage of non-mineral GDP.

32. This difference is substantial and has hence motivated the GRB to adopt policies in a number of areas, including the prioritised accelerated development of its vast coal reserves for export.

33. Some examples include a levy on alcoholic drinks to fund alcohol awareness and various youth empowerment schemes; a levy on electricity bills to fund rural electrification; and a fuel levy to finance the Motor Vehicle Accident Fund. The expenditures from these funds are not subject to the normal parliamentary scrutiny for budget expenditures.

34. The limits are set out in Section 20 of the Stocks, Bonds and Treasury Bills Act, 2005 (Chapter 56:07).

35. http://www.resourcegovernance.org/.

36. http://collections.europarchive.org/tna/20070701080507/; http://www.dfid.gov.uk/pubs/files/eitidraftreportbotswana.pdf

37. More details can be found in Korinek (2014).

38. See a full account of this debate in Chile in Meller (2002) "Dilemas y Debates en torno al Cobre" in particular the article by the same author, "El cobre chileno y la política minera".

39. This section was authored by José Pablo Arellano, former CEO of Codelco, presently at the Corporation of Studies for Latin America (CIEPLAN).

40. Porter's definition of a cluster is a group of geographically concentrated, interconnected companies, universities and other related entities, arising as a result of externalities in the industry. Ramos (1999) discusses the advantages of clusters around natural resources.

41. From the 1950s until the mid-1970s, when the economy opened to imports, international trade policies sought to promote this substitution, with varying results. See the account by Ffrench-Davis, “Integración de la gran minería a la economía nacional: el rol de las políticas públicas” in Ffrench-Davis and Tironi (1974).

42. See Ramos (1999), Lagos and Blanco (2010).

http://www.lyd.org/

http://www.hacienda.cl/english/sovereign-wealth-funds/economic-and-social-stabilization-fund.html

http://www.hacienda.cl/english/sovereign-wealth-funds/economic-and-social-stabilization-fund.html

http://www.hacienda.cl/english/sovereign-wealth-funds/investment-policy.html

http://www.swfinstitute.org/statistics-research/linaburg-maduell-transparency-index/

http://www.resourcegovernance.org/

http://collections.europarchive.org/tna/20070701080507/

http://www.dfid.gov.uk/pubs/files/eitidraftreportbotswana.pdf



43. This is based on the Activity index of the engineering consulting sector 2011, constructed by the Association of Engineering Services from a sample of mining firms.

44. This is the trend elsewhere; an example is the programme of six university schools for mining in Europe (Federation of European Mining Programs, FEMP), which offers a joint Master’s from these schools in four other European countries, the European Mining, Minerals and Environmental Program (EMMEP).

45. This is the case in many emerging markets. BRIC countries, for example, produce highly educated researchers but do not generally have sufficiently large and satisfactory research structures in order to generate major new innovations. They too are concentrating on incremental, as opposed to radical, innovation (Les Rencontres Économiques conference, session on innovation, 6-8 July 2012).

46. This policy has been recognised in Chile for some time: Eyzaguirre et al. (2005) suggested that too much of Chile’s research and innovation funding was going to basic research, and that the innovation effort in Chile should rather concentrate on adopting and adapting foreign technologies, which is a strategy that comes at a lower cost.

47. CORFO, the Chilean Economic Development Agency that manages Start Up Chile has financed several SME projects with applications for the mining industry. It has also promoted, jointly with the Ministry of Mining, several programmes to enhance innovation in the mining industry, including by attracting foreign research centres.

48. The 2011 Law of Mine Security establishes some standards in this area.

49. The last substantial diamond deposit discovery dates from 1973 and, as has been seen in a previous section, geological information available in the country is quite comprehensive.

50. http://www.cso.gov.bw/index.php/summary-statistics/53-key-indicators2/116-unemployment-rate-is-17-8-percent-as-per-the-botswana-core-welfare-indicators-survey-2009-10.

51. Statistics Botswana (2014), Vision 2016 and Millenium Development Goals Indicators Report,

http://www.cso.gov.bw/attachments/article/113/Vision_2016_Millenium_Development_Goals_Indicators.pdf

52. http://www.afdb.org/en/countries/southern-africa/botswana/botswana-economic-outlook/

53. As an example, in addition to salary, DTC Botswana covers 60% of employees’ mortgages.

54. In order to undertake further aggregation, De Beers opened 26 part-time Gaborone-based positions requiring a University degree. Applications were received from 11 000 applicants.

55. The majority of gem diamonds are purchased as engagement rings. De Beers’ early advertising was very successful in securing the engagement ring market for its product. Its advertising slogan “A Diamond is Forever” was given the Advertising Age award for “slogan of the century”.

56. http://www.dtcbotswana.com/about_us.php.

57. Similar studies to Chile and Botswana are underway in OECD looking into the minerals policy practices in Colombia and Peru. Colombia and Peru have revised their system of taxation of extractive industries and both countries have reformed their systems of distribution of the tax revenue. A close examination of those policies will complement the practices outlined in this chapter in the areas of taxation of the mining sector and distribution of extractive tax revenue.

58. http://www.irc.gov.co/irc/en/fiscalinformation/National%20Development%20Plan%202011-2014.pdf, p.13.

59. http://www.ceplan.gob.pe/sites/default/files/Documentos/mipyme_productividad_e_informalidad-fredy.pdf.

60. Two upcoming studies will examine the policies undertaken by Colombia and Peru in the area of formalization of informal-sector mining, including administrative, environmental, economic and security initiatives in the area.

61. Investment policy is an area that was not covered in detail in the two studies from which the material in this chapter is drawn (Korinek, 2013, 2014). One reason for this is so as not to overlap with similar studies such as one by UNCTAD (UNCTAD, 2011). There is much good practice in this area in Chile as well, in particular as regards the implementation of Decree-Law 600 for attracting foreign capital, as can be gleaned from UNCTAD (2011).

62. Success in attracting FDI is partly due to the favourable perceptions of the country’s good level of governance. Botswana’s policies and regulation in the mining sector were ranked 25th best out of

http://www.cso.gov.bw/index.php/summary-statistics/53-key-indicators2/116-unemployment-rate-is-17-8-percent-as-per-the-botswana-core-welfare-indicators-survey-2009-10

http://www.cso.gov.bw/index.php/summary-statistics/53-key-indicators2/116-unemployment-rate-is-17-8-percent-as-per-the-botswana-core-welfare-indicators-survey-2009-10



http://www.afdb.org/en/countries/southern-africa/botswana/botswana-economic-outlook/

http://www.dtcbotswana.com/about_us.php

http://www.irc.gov.co/irc/en/fiscalinformation/National%20Development%20Plan%202011-2014.pdf

http://www.ceplan.gob.pe/sites/default/files/Documentos/mipyme_productividad_e_informalidad-fredy.pdf



112 jurisdictions by managers and executives in the mining industries in 2013, higher than Chile (in 30th position), and ahead of various North American states and provinces, some Australian states, Turkey, Portugal and Spain (Fraser Institute Survey of Mining Companies, 2013).

63. See the policy lesson from Chile on this point, discussed earlier in this chapter.

64. A certain lack of transparency in the management of the Pula Fund has resulted in relatively low ratings according to SWF management indicators.



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Annex 7.A.

Institutions framing the mining sector in Chile

Beyond the overall governance framework and sound macroeconomic policies and institutions, countries need institutions and policies geared specifically to the extractive industries. Key elements of a specific policy mix for extractive industries should include (UNCTAD, 2007; Otto et al., 2006):

A knowledge base of a country’s mineral endowments through geological surveys.

A legal framework governing the exploration and exploitation of mineral resources that establishes mineral ownership rights.

An administrative framework for the extraction of mineral resources. This involves the issuing of licenses, defining under what conditions exploration or extraction may take place and developing mining-right cadastres (i.e. compilations of current exploration and mining activities in the country and their ownership).

Policies relating to the production of minerals that regulate the activities of industrial and artisanal mining.

A system of revenue management. This concerns the sharing and distribution of the rents from mineral extraction.

Policies related to the health and safety of workers, protection of the environment and the rights of local communities.

The frameworks described above are administered, regulated, managed, and subject to oversight by a number of different entities from various arms of government, regulatory agencies, industry associations and public and private sector firms. There is no single way of doing this. The allocation of responsibilities between entities and the complex web of relationships between them is often in part a function of historical evolution. The resulting institutional context, however, often determines whether the necessary frameworks are in place to provide oversight without stifling the enterprise of productive actors. A view of the different institutions with a decision-making role in the mining sector in Chile, and an overview of their interactions, is shown in the following chart.

A large share of Chile’s copper production (82% in 2010) is carried out by the five largest enterprises: Codelco (state-owned), BHP-Billiton, Anglo-American, Antofagasta Minerals and Collahuasi (a joint venture between Xstrata, Anglo-American and Mitsui Corp). All these firms, except Codelco, are incorporated outside Chile. Antofagasta Minerals, a Chilean-based company, is listed on the London Stock Exchange. This is typical even among smaller firms: only three out of over 200 companies involved in mining in Chile are listed in the country. One reason for this is the small number of Chilean firms that incorporate: most exist under limited liability or natural persons status.

The smallest firms are supported by the Empresa Nacional de Minería (ENAMI). ENAMI´s mission is to promote small and medium-sized private sector mining in Chile, and to correct for market failures affecting its performance, by providing a range of services that firms require in order to be competitive.

1 ENAMI’s Board of Directors consists of the Minister of Mining, a representative

of the Minister of Finance, a representative of the President, a representative of COCHILCO, the copper advisory agency, and SONAMI, an industry association comprising small, medium-sized and



large copper producers (Figure 7.A1). Its efforts are concentrated on 2000 small private-sector firms. ENAMI buys unprocessed copper from small mining firms at a rate negotiated with SONAMI. Small firms thereby profit from ENAMI’s buying and selling on a larger scale. ENAMI buys unprocessed copper and refines it for sale on the international market. It is the sixth largest copper exporter in Chile. ENAMI also provides financing to small mining firms and provides technical assistance.

An important element in the framework of mining operations is the ownership of resources and the permission to prospect and exploit them. In Chile as in many countries, mineral resources are owned by the state and this ownership is established in the Chilean Constitution. Concessions for exploration and exploitation are granted by the court rather than a government agency which is thought to limit potential administrative discretion. Exploration permits are granted for a period of two years, renewable for another two years. Holders of exploration permits are given priority in transforming to an exploitation concession (UNCTAD, 2011). Once a permit has been granted for exploitation, the owner can keep it as long as a small annual fee is paid, regardless of whether exploitation is actually undertaken. Exploitation can be sub-contracted by the permit holder. It has been suggested that this situation may induce rent-seeking behaviour or sub-optimal extraction levels since a permit holder has no incentive to relinquish the permit. It is commonly thought that almost all potential areas have been staked.

2

Figure 7.A1. Decision-making institutions in the Chilean mining sector and their interactions



Mining development is best managed when it is supported by substantial and reliable geological information regarding the size and quality of potential deposits. In some resource-rich countries, there is a wealth of publicly available information.

3 Chile’s geological service,

Sernageomin, holds information on the claims that have been staked for exploration and exploitation. Sernageomin does not, however, consolidate detailed information on the size and quality of deposits. Since Sernageomin has no obligation to provide such information, a comprehensive picture of the size, location and grade of deposits is not available in the public domain. This is one area where the institutional structure of Chile’s mining sector could be improved. Indeed, a survey by the Fraser Institute of 690 mining companies ranked Chile 32

nd out of

112 countries in terms of the quality of and access to geological data. Three per cent of respondents indicated that the lack of such data was a strong deterrent to investment in the sector, and 11% indicated that it was a mild deterrent.

4 There have been some recent moves to strengthen

the public availability of information. In particular, a law on mine closure financing, the Ley de Cierre de Faenas (Mine Closure Act), published in November 2011, includes some provisions for sharing information on exploitation plans.

Notes to Annex 7.A.

1. See www.enami.cl/english-overview/english-overview.html.

2. The lack of publicly-available information regarding the concessions granted means that there are different views concerning the distribution of these concessions, although there seems to be consensus that most potentially viable claims have been staked either by Codelco or BHP-Billiton. Certainly, Codelco holds more claims than it has the capacity to exploit and has signed agreements with several companies (including Antofagasta Minerals and Rio Tinto) to exploit some of its concessions.

3. An excellent example is the United States Geological Service (USGS).

4. http://www.fraserinstitute.org/uploadedFiles/fraser-ca/Content/research-news/research/publications/mining-survey-2013.pdf.

http://www.enami.cl/english-overview/english-overview.html





Annex 7.B.

Institutions framing the mining sector in Botswana

Diamond production in Botswana started in 1971. Botswana has since become the world’s largest producer of diamonds from the most profitable diamond mines in existence, producing 25-30% of the world’s gem-quality diamonds. Diamonds mined in 2011 represented about USD 4.5-5 billion and 23 million carats.

1 In Botswana, as is generally the case globally, all minerals belong to

the State.

From the outset, the Government of the Republic of Botswana (GRB) has been involved in a joint venture with the world’s largest private diamond-producing firm, De Beers. In 1969, the De Beers Botswana Mining Co. was established to develop the country’s diamond deposits. At the time, the Botswana government held a 15% share in the company (Evan-Zohar, 2002). This was increased to 50% in 1975 once production was underway and the joint venture firm was named Debswana. Production originally took place in Botswana’s Orapa location. A few smaller diamond deposits were discovered at a second location near Letlhakane, and production was started there in 1977. The world’s most profitable diamond mine, Jwaneng, started production in 1982. Botswana’s diamonds currently represent about 72% of De Beers’ total production in value, and about 42% in volume.

2,3

Botswana has established a number of institutional structures for the management of mineral revenues. The high-level Minerals Policy Committee sets the framework for taxation and revenue-raising in the mining sector, and takes a lead role in negotiations with mining firms.

4 This group has

been particularly important in the context of negotiations with De Beers over the distribution of revenues from Debswana. Botswana has negotiated astutely, using its leverage to win concessions that have resulted in a favourable revenue-sharing formula. This leverage was first used in the 1970s during negotiations for additional mining licences, which were used to increase the GRB’s share in Debswana from 15% to 50%. It was used again to increase the GRB’s overall revenue share when the original mining licences came up for renewal in the 2000s. In 2011, negotiations for the renewal of the Debswana marketing contract were used to win concessions regarding the building of downstream diamond industry activities and the establishment of an independent marketing channel outside the De Beers Diamond Trading Company (DTC) marketing structure. (This issue is examined more closely in a later section of this chapter). Botswana’s leverage arises from its role as the world’s largest producer of rough diamonds, and its dominant position as the largest single contributor to De Beers’ sales and profits. The GRB has invested substantially in its relationship with De Beers in this regard.

Debswana, the firm licensed to extract the vast majority of Botswana’s diamonds, is therefore a 50-50 joint venture between the GRB (GRB) and De Beers S.A., the largest diamond-producing firm worldwide. Debswana’s Board of Directors is comprised of six members appointed by the GRB and six by De Beers S.A, as well as one ex-officio member, its Managing Director.

In addition, through Debswana the GRB has owned a 15% share in the De Beers global group since the late 1980s. During the 1980s, when diamond prices were low, Debswana stockpiled a substantial quantity of rough diamonds. When the market recovered in 1986, this stockpile was sold to De Beers and Debswana was paid partly in cash and partly in shares in De Beers. The GRB also obtained the right to appoint two directors to the global De Beers firm’s board.

5 In this way, the

GRB obtained access to high-level information regarding the operation of the global diamond industry (Jefferis, 2009).



At present, De Beers is owned jointly by Anglo-American (85%) and the GRB through Debswana (15%). Debswana also holds shares in Anglo-American which equalled 2% of Anglo-American’s value in the early 2000s although half its shares were sold in 2004 (Evan-Zohar, 2002).

Responsibility for regulating the diamond-mining industry, and for minerals policies generally, lies with the Ministry for Mineral, Energy and Water Resources (MMEWR). The MMEWR regulates all mining, prospecting and exploration activities as well as mineral processing activities; collects and disseminates geological information; and is responsible for all financial, commercial and administrative issues arising in those mineral sector companies in which the GRB is a shareholder. The Permanent Secretary of the MMEWR sits on the Board of Debswana, the Botswana Diamond Trading Company (DTCB), the selling arm of the De Beers network, and De Beers S.A. The Ministry of Finance and Development Planning oversees revenue collection including that of the minerals sector among other responsibilities. The Permanent Secretary sits on the Board of Debswana and of De Beers S.A. Other Debswana Board Members appointed by the GRB are the Governor of the Bank of Botswana, Attorney General, and the Permanent Secretary of the Office of the President.

Availability of geological information

The quality of geological information available in Botswana is generally good. Three-quarters of investors said the quality of geological information available encourages investment (21%) or does not deter investment (52%). Six per cent of respondents indicated that geological information was a strong deterrent to mining investment in Botswana while for 24 per cent it was a mild deterrent (Fraser Institute, 2013). In terms of the quality of geological information, Botswana ranks 48 out of 112 mining jurisdictions surveyed. It is ranked third-highest among non-OECD jurisdictions (after South Africa and Namibia) according to this criterion.

A good, consolidated database of all available geological information is a strong public good, providing vital information to potential investors and to policymakers. An aero-magnetic study of the entire country was completed in the late 1970s and early 1980s supported by development assistance. In 1993, a study was undertaken to provide more information at a higher level of resolution (1:125 000). Geochemical maps are also used.

Best practice, according to MMEWR officials, would involve the updating of geological databases regularly with information that is obtained quarterly from prospectors once their licences lapse. Although there is a substantial effort in this area, it is still incomplete. Nonetheless, the availability of up-to-date and easily accessible geological information from the Geological Survey department has made it quicker, easier and less costly for exploration firms to get started (Matshediso, 2005).

Legal framework for mining operations: Licensing

The legal framework for mining operations is based on the Mines and Minerals Act of 1999 which determines, inter alia, the process by which licences are granted. Firms wishing to undertake mineral exploration in Botswana must obtain a prospecting licence, which is valid for three years, renewable for two two-year periods (i.e. potentially seven years in total). The granting of a prospecting licence involves a commitment to a minimum level of expenditure over the licence period. When applying for renewal, prospecting firms must submit reports regarding their exploration activities and information on existing deposits to the Geological Survey of the MMEWR. If the prospecting licence does not lead to an application for a retention or mining license, the information submitted to the MMEWR can be made available to other companies that apply for a prospecting licence in the same area.

When prospectors find significant deposits that are not economically viable to mine under present conditions, they can apply for a retention licence. The retention licence is granted for a period of three years, renewable for three years, whose cost is substantially higher than that of the prospecting licence, and increases annually. The relatively high cost of the retention licence and its



increase over time aims to give an incentive to firms to release concessions that they do not intend to mine.

When a mineral deposit is found to be economically viable during the prospecting phase, the holder of the prospecting licence has a preferential right to apply for a mining licence. Mining licences are granted for up to 25 years and are issued only to firms registered in Botswana. Mining licences can be automatically renewed subject to the fulfilment of certain conditions that are specified in the Mines and Minerals Act. Licence applicants must show proof of technical competence and access to adequate financial resources. A mining licence costs 100 Pula (USD 12) per square km. The granting of a mining licence automatically gives the investor a lease on the land covered by the licence (Jefferis, 2009).

All applicants for a mining or retention licence must carry out an Environmental Impact Assessment (EIA) as part of the feasibility study that accompanies the licence application. At the end of the mining operation, the holder of the mineral concession has to restore the topsoil of affected areas and restore the land to a substantial degree to its former condition (Jefferis, 2009). The environmental impact of diamond mining activity in Botswana is relatively small compared to other kinds of mining operation, as the diamond mines are open cast and processing generally involves washing and sorting rather than chemical processes. The main environmental impact comes from extracting underground water.

Debswana’s 25-year licence for mining diamonds was renewed in September 2004 (Iimi, 2007). There are no legislated restrictions prohibiting other companies from mining and marketing diamonds (WTO, 2009). A number of firms are presently prospecting and mining diamonds in Botswana. According to Botswana legislation, diamond mining licences are subject to negotiated settlement regarding terms and conditions, including taxes and royalties. For all other minerals, however, the terms are not subject to negotiation and the tax and royalty regimes are fixed in the legislation.

6 Korinek (2014) reports that, based on the author’s personal contacts, all new diamond

mining firms appear in practice to be subject to the same terms as other mining firms and there is scarce potential for negotiation. That all firms are subject to similar terms contributes to good practice. It would be more transparent, however, if this were clearly stated in appropriate legislation.

At the moment of issuing a mining licence, the GRB has the option of acquiring up to 15% working interest participation in any mining company (Matshediso, 2005). This practice, however, has not been exercised recently, for several reasons. First, recently licensed mining operations have been relatively small, which affects the balance of costs and benefits from the GRB exercising a shareholder function. Second, the GRB considers that the existing tax system is quite efficient at capturing mineral rents and there would be little additional revenue to be gained. Third, the 15% shareholding has to be paid for (at cost), but perhaps more importantly, the GRB as shareholder would be obliged to provide the relevant share of future capital expenditure requirements for mine development.

An amendment has been proposed to the Mines and Minerals Act whereby the 15% working interest participation, in particular in foreign entities, is opened to Botswana citizens, if the GRB does not exercise its right to minority participation. The idea is to facilitate the participation of Batswana in such ventures. As the details of such a policy are important to its outcome, it will be important to follow the evolution of such an amendment.

Institutions surrounding the processing and selling of diamonds7

After extraction, diamonds are sorted and valued according to four basic criteria, called the “four C’s”: carat, colour, clarity and cut.

8 Diamond valuation is complex, and no two diamond experts

will give the same value to a given diamond. Hence, diamonds are not a “commodity” since each one is different and valuation is a complex and imperfect process. This is one of the major differences between diamonds and most other products of the extractive industries. Rough (uncut) diamonds (i.e. those sold by Debswana) are valued according to their carat, clarity, colour and the cut that can be made most efficiently and the amount of the stone that will potentially be lost in the cutting process. Rough (uncut and unpolished) diamonds are not sold on the retail market and it is



against the law to hold rough diamonds without a licence under strict penalty (Mines and Minerals Act, 1999).

Once diamonds are sorted and valued according to the characteristics outlined above, they are “aggregated”. “Aggregation” is the process by which stones are combined in order to be sold as a package to licensed buyers of rough diamonds, who then cut and polish them. Polished stones are sold to jewellery manufacturers who supply design and production of jewellery. The end of the value-chain is the retail sellers who specialise in commercial operations and marketing.

The sorting and valuation stages in the diamond value-chain in Botswana are done exclusively by the Diamond Trading Company Botswana (DTCB). The DTCB is a 50-50 joint venture between the GRB and De Beers. Its Board of Directors is made up of ten people, in equal measure nominated by the GRB and by De Beers. The DTCB puts together “packages” of diamonds to be sold to licensed Botswana Sightholders in sales held ten times per year. The diamonds that are not sold to Botswana Sightholders are sold to Diamond Trading Company International (DTCI).

9 DTCI is a subsidiary of De Beers, and handles the aggregation of rough

stones, combining diamonds from Botswana with those from other mines in the De Beers group, specifically Namibia, South Africa and Canada.

The creation of the DTCB was a major step in Botswana’s push to increase its value addition in the diamond industry and increase the number and skill level of the industry participants. DTCB is the largest diamond sorting and valuing facility in the world, and uses state of the art technology. It employs 400 people and includes an in-house diamond academy to train new recruits in sorting and valuing techniques.

Until 2013, Debswana was under contract to sell all its output to DTCI and DTCB. DTCI and DTCB, however, are not obliged to buy all of Debswana’s production. This particular contractual agreement arose in part due to competition policies in final goods markets. In accordance with US antitrust legislation and EU competition directives, DTCI cannot hold excess inventory.

10 So as not

to allow the price of diamonds to fall, and as diamond sales are based on a three-year contract, DTCI does not buy diamonds it cannot sell in a reasonable amount of time. Since Debswana’s contractual agreement with De Beers does not allow it to sell its production elsewhere, it halts production when demand falls sharply or for an extended period. This happened in 2009 when global demand for diamonds fell: Debswana, the largest private sector employer in Botswana, halted all production of diamonds for several months, sending several thousand of its 5 510 permanent employees home on extended leave with full pay while cutting 580 jobs.

11

De Beers agreed, in its last contractual discussions with the GRB to move all its aggregation and rough diamond sales operations for all diamonds sold within the De Beers network to Botswana’s capital, Gaborone. This is part of the GRB’s and De Beers’ local “beneficiation” strategy to generate more benefits in diamond-producing countries through the development of downstream activities in the diamond industry, ranging from sorting and valuing diamonds, to cutting and polishing, to the manufacture of jewellery.

Notes to Annex 7.B.

1. The exact figure in value is not published in a transparent fashion. This was calculated by combining De Beers company totals with shares for Botswana’s production that were communicated by in-country regulators and executives.

2. www.debeersgroup.com/ImageVaultFiles/id_2067/cf_5/2012_OFR_Performance_Statistics.PDF.

3. De Beers also has mining operations in South Africa, Namibia and Canada.

4. The Minerals Policy Committee is comprised of the Permanent Secretary, Ministry of Minerals, Energy and Water Resources (MMEWR); the Permanent Secretary, Ministry of Finance and Development Planning (MFDP); the Permanent Secretary to the President; the Governor of the Bank of Botswana; and the Attorney General.

http://www.debeersgroup.com/ImageVaultFiles/id_2067/cf_5/2012_OFR_Performance_Statistics.PDF



5. www.debeersgroup.com/en/About-Us/Governance/Board-Of-Directors/.

6. Mines and Minerals Act and the Income Tax Act.

7. For more details of the processes in downstream in the diamond value-chain, see Korinek (2014).

8. The carat refers to the weight of the diamond. Diamonds are found in a range of colours, the rarest being colourless or fancy colours such as red, blue or green. Clarity is graded according to the visibility of inclusions or blemishes under tenfold magnification. The cut of a diamond is the only element that is determined by human intervention. No two diamonds are the same. The value of a particular diamond takes all these characteristics into account, some of which have a subjective element.

9. DTCI has recently been renamed De Beers Global Sightholder Services.

10. In 2001, several law suits were filed in US courts alleging that De Beers “unlawfully monopolised the supply of diamonds, conspired to fix, raise, and control diamond prices, and issued false and misleading advertising”. After multiple appeals, in 2012 the US Supreme Court denied final petition for review, and a settlement in the amount of USD 295 million with an agreement to “refrain from engaging in certain conduct that violates federal and state antitrust laws” was finalised.

11. The Telegraph, “De Beers to suspend work at Botswana diamond mine as sales slide, 23 February 2009, www.telegraph.co.uk/finance/financialcrisis/4789233/De-Beers-to-suspend-work-at-Botswana-diamond-mines-as-sales-slide.html

http://www.debeersgroup.com/en/About-Us/Governance/Board-Of-Directors/

http://www.telegraph.co.uk/finance/financialcrisis/4789233/De-Beers-to-suspend-work-at-Botswana-diamond-mines-as-sales-slide.html

http://www.telegraph.co.uk/finance/financialcrisis/4789233/De-Beers-to-suspend-work-at-Botswana-diamond-mines-as-sales-slide.html

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