Dear Prime Minister, Deputy Prime Minister, Treasurer and Mr Tanner,
Financing major projects
There is a general lack of understanding surrounding the effect that the Rudd government’s proposed Resources Super Profits Tax (“RSPT”) will have on the ability to finance new mining projects or expansions of existing mining projects in particular, but also the difficulty the RSPT may place on relatively new operators who have yet to complete their project repayments and could face default if the RSPT implemented.
The financing of projects generally requires a significant component of both equity funding and debt funding with the majority being by way of debt funding. The former is invested by the project’s owners, the latter generally by financial institutions in particular banks or investors in debt securities.
Implementation of the proposed RSPT will make it harder for project sponsors to raise equity funding because:
Reduced cashflow from operations or proposed operations after tax results in a reduction in the project value. This means investors will pay less for equity. Investors could obtain more equity for the same amount of investment funds, which in turn could result in project sponsors losing control over projects to incoming investors (including foreign investors);
The behaviour of the Rudd government – i.e., lack of prior consultation, making the RSPT retrospective in that it will apply to existing projects where investment was made under different rules, and continuing with the threat of this new tax despite rational reasons given showing this would be against the interests of Australia and its future – has increased Australian sovereign risk. This is the case because the way Australia is viewed by investors (be they domestic or foreign investors) has changed. Australia no longer offers a stable and predictable investment climate. As a result, investors will demand a higher risk weighted return on their investments. The effect of this is that investors will apply a higher Weighted Average Cost of Capital to project future cashflows, a key determinant in determining value. This will lead to a reduction in the Net Present Value of projects, and so investors will pay less for their equity or obtain a larger interest in the project.
Even if project sponsors are prepared to sell down larger equity stakes in projects and lose control of their projects because of the projects’ devaluation resulting from the implementation of the RSPT, they may be prevented from or at risk from doing so by the Foreign Investment Review Board if this entails transferring significant equity interests and/or control to foreign investors.
Mining projects in other countries, previously shunned because of their higher risk (particularly sovereign risk) or lack of infrastructure etc, will become relatively more attractive to well diversified global mining companies who have mobility of capital and are able to divert investment funds to other parts of the world. This will make it more difficult for Australian mining projects to attract equity capital.
Implementation of the proposed RSPT will make it harder for project sponsors to raise debt funding because:
Debt financiers evaluate the credit risk of mining projects by projecting their future cash flows. Since the RSPT will place a significant impost on project cashflows, the funds available for servicing debt (i.e., interest and principal repayments) will be lower. This will have a detrimental effect upon the key financial ratios that financial institutions use to determine debt serviceability of projects, as follows:
Debt/Equity Ratio – this is the ratio of total debt to total equity. The proposed RSPT will potentially result in higher debt being required as lower equity can be raised, due to lower project values. This will negatively impact the Debt/Equity Ratio.
Debt Service Coverage Ratio (“DSCR”) – this is the ratio of project cashflow after tax to debt servicing costs. This ratio generally requires approximately 2 – 3 times project Cashflow after tax which is particularly difficult during early years of projects, and many projects fail on this basis.
The proposed RSPT will reduce after tax project cashflow and potentially increase debt servicing costs because project sponsors are likely to require higher borrowings. This will negatively impact the DSCR. Only the most robust projects in Australia will be able to meet such ratios, meaning many, many current projects in Australia will not be able to proceed.
Project/Loan Life Coverage Ratio (“PLCR” or “LLCR”) – this is the ratio of the present value of future cashflows over the life of the project or loan to total debt. The proposed RSPT will reduce the present value of future cashflows and potentially increase total debt. This will negatively impact the PLCR/LLCR.
Financial institution capital available for debt funding is a finite resource. Further, it is generally true that larger amounts of debt finance are more difficult to raise than smaller amounts. This is particularly the case in the post Global Financial Crisis environment in which the risk appetite and capital availability of financial institutions globally has significantly reduced. Accordingly, projects will find it harder to raise and compete for the greater amounts of debt finance required in an RSPT environment.
The proposed RSPT will reduce project cashflow. As a result, projects will be less economically robust and consequently more risky to financiers. Financial institutions price debt on the basis of risk, and so debt finance for projects will be more expensive under an RSPT. For some projects, this will not only make debt finance prohibitively expensive, but destroy overall project viability, and make many projects unable to be financed.
The Rudd government maintains that the government “guarantee” of 40% project cost will assist in obtaining debt financing. This is incorrect. Financiers will only value a guarantee if it is contractual and is able to be accessed immediately upon default of the borrower. The government “guarantee” is only available at the end of a project’s life if there remains capital that has not been recouped through the RSPT calculation process, or if a project fails. In the first case, project financiers are likely to have been repaid well before the end of the project. In the second case, project financiers will look to exit the failed project by selling it upon taking mortgagee possession well before the trigger for access to the government guarantee has been reached. Further, because the proposed RSPT would take priority over debt servicing costs, any value of the government “guarantee” (i.e., the amount of uplifted capital not yet offset against RSPT liability) is likely to be eroded more quickly than the debt is repaid. This “guarantee” is therefore of no use to financiers, and will not be taken into account by financiers when assessing project risk for debt financing purposes. In any event, given the above, projects that cannot meet banks criteria such as DSCR and LLCR will not be financeable.
In conclusion then:
1. The Rudd government’s proposed RSPT will, if implemented, result in only the most robust Australian mining projects proceeding, albeit more with expensive financing terms. But even those robust projects will see the project sponsor having to sell down more equity at lower project values and raising more debt financing at higher cost on poorer cashflow streams.
2. The opposition to the Rudd’s government proposed RSPT should not be viewed by the Rudd Government as “mining industry bullying tactics” to be dealt with by “divide and conquer” ALP strategies, but the Rudd Government must recognize the immense loss to Australia the loss of these projects will cause and immediately announce it has in Australia’s interests, dropped the RSPT.