Download Method and Results - Austrian Association for Energy Economics

Cost Valuation and Tax Design
Magne Emhjellen, Petoro AS, Postboks 300 Sentrum
4002 Stavanger , Norway, Email: [email protected]
and
Petter Osmundsen, University of Stavanger, Department for Industrial Economics and Risk Management, 4036 Stavanger.
Email:[email protected].
Overview
In research related to oil project valuation and separate cashflow valuation one often makes the assumption that the
present value of the cost cashflow may be calculated using the risk free rate (Laughton and Jacoby, 1993, Laughton, 1998 and
Emhjellen, 1999). From a Capital Asset Pricing Model (CAPM) (Sharpe, 1964, Lintner, 1965) point of view this is only
permissible when the uncertain changes in the cost cashflow is not correlated with the rate of change in the market portfolio.
To examine this we test whether two important cost factors for oil projects, labour costs and steel prices, are
systematic cost factors (i.e. correlated with the value of the market portfolio). In addition, we examine whether oil prices
represent a systematic revenue factor, and thus whether the CAPM beta obtained for oil prices support using a higher required
rate of return when discounting revenues than when discounting costs. After identifying the main cost variables for an example
project, historical data on the cost variables, as well as historical data on a proxy for the market portfolio (The Total Index,
Oslo Stock Exchange) are presented. The betas of these cost variables are then calculated.
Method and Results
The results for the period examined show that the oil price beta is higher than the cost betas and that risk free
discounting of the cost cashflow may be a reasonable first approximation until more reasherch is undertaken. The results of the
paper therefore support the idea that revenues should be discounted at a higher rate than costs when calculating the present
value of oil exploration projects.
The issues of distinct required rates of return for discounting individual cashflow streams of oil projects have been
raised by the Tax Commission in Norway. In a tax evaluation study they implicitely propose that the oil companies should
change their valuation method from discounting the aggregate net cashflow stream to a method where one specific partial
cashflow is valued separately, namely the tax reduction cash flow from tax depreciation (Government Report NOU 2000:18). 1
The companies’ actual investment evaluation methods is essential to evaluate the implications of the suggested tax changes.
The Commission recommended a slower pace of tax depreciation. Tax depreciation time should expand from the current 6
years (linear depreciation) to a time frame more accurately reflecting the economic life of extraction and transportation
installations
The companies argued that, with their global practise of using average discount rates, this would cause considerable
tax increases and lead to a non-neutral tax system that would generate underinvestment. At any rate, they said, tax reduction
cash flows are by experience not certain, as verified for example by the Commission’s own report of proposed tax increases.
The Tax Commission, on the other hand, argued that the revised tax system would be neutral if the companies correctly
discounted tax reductions by a risk free rate.
Conclusions
This debate raises important questions. Present tax theory usually presumes average discount rates. In the event of the
adoption of separate cashflow discounting, how should the tax reductions of depreciations be valued. Clearly the tax reductions
from investments are not riskless since the use is linked to the fact that the companies have to be in a tax position. The tax
position is most closely linked to product prices. Therefore, above certain prices the companies will be in a positive tax
position while they will be out of tax position at product prices below a certain level. Therfore there is a probability factor of
reduced value of tax deductions from investments in adition to the uncertainty of the correct systematic risk on these tax
deductions when calculating present value. This probability factor related to the time when tax reductions can be used to reduce
tax and the uncertainty related to the correct size of the individual cost cashflow betas indicate that further research should be
undertaken on the required rate of return of individual cashflow streams.
References
Confederation of Norwegian Business and Industry, 1986-1995. Wages and attendance statistics, quarterly.
Copeland, T.E. and Weston, J.F. 1992. Financial Theory and Corporate Policy: Third Edition, Addison - Wesley.
Emhjellen, M. and Alaouze, C. M. 2002 “Project Valuation when There are Two Cashflow Streams”, Energy Economics, Vol. 24, September, pp. 455-467.
Ibbotson Associates Inc. 1989. Stocks, Bonds, Bills and Inflation 1989 yearbook, Ibbotson Associates, Inc., Chicago Illinois.
Emhjellen, K., Emhjellen, M., Osmundsen, P. 2002. "Investment Cost Estimates and Investment Decisions", Energy Policy, vol. 30, pp. 91-96.
Jacoby, H. and Laughton, D. 1992. "Project Evaluation: a Practical Modern Asset Pricing Method", The Energy Journal, Vol. 13, pp. 19-47.
Lewellen, W.G. 1977. "Some Observations on Risk-Adjusted Discount Rates", Journal of Finance, Vol. 32, pp. 1331-1337.
Lintner, J. 1965. "Security Prices, Risk and Maximal Gains from Diversification", Journal of Finance, Vol. 20, pp. 587-615.
Laughton, D. and Jacoby, H. 1993. "Reversion, Timing Options, and Long-Term Decision Making", Financial Management, Vol. 22, pp. 225-240.
Laughton, D. 1998 (1). "The Management of Flexibility in the Upstream Petroleum Industry", The Energy Journal, Vol. 19, pp. 83-114.
Laughton, D. 1998 (2). "The Potential for Use of Modern Asset Pricing Methods for Upstream Petroleum Project Evaluation: Concluding Remarks", The
Energy Journal, Vol. 19, pp. 149-153.
Lund, D. 1992. "Petroleum taxation under uncertainty - contingent claims analysis with an application to Norway", Energy Economics, 14, 23-31.
McMillan, J. 1992. Games, Strategies & Managers, Oxford University Press.
Metal Bulletin, 1986-1995. Prices and Data: Iron and Steel, Steel Reinforcing Bars, Brussels Bourse, Metal Bulletin Books Ltd.
NOU 2000: 18, Skattlegging av petroleumsvirksomhet (Taxation of the Petroleum Industry), Report by the Petroleum Tax Commission, delivered to the
Ministry of Finance, 20 June 2000.
Osmundsen, P. 1999. "Risk Sharing and Incentives in Norwegian Petroleum Extraction", Energy Policy 27, 549-555.
Osmundsen, P. 1999a. ”Effektivitet, Insentiver og Proveny” (Efficiency, Incentives and Revenue), Report for the Norwegian Ministry of Oil and Energy,
scientific attachement to the annual government report on the Norwegian oil industry, Oljemeldingen, St.meld. nr. 39 (1999-2000), 9. June 2000.
Osmundsen, P. 1999b. “Norsok og kostnadsoverskridelser sett ut i fra økonomisk kontrakts- og insentivteori” (Norsok and Cost Overruns, Seen from the
Perspective of Economic Contract- and Incentive Theory), scientific attachement to the Government Report by the Investment Commission NOU 1999:11,
appointed by The Norwegian Ministry of Oil and Energy on 28 August 1998.
Schall, L.D. 1972. "Asset Valuation, Firm Investment, and Firm Diversification", Journal of Business, Vol. 45, pp. 11-28.
Sharpe, W. 1964. "Capital Asset Prices: A Theory of Capital Market Equilibrium under Conditions of Risk", Journal of Finance, Vol. 19, pp. 425-442.
Siew, Wei-Hun. 2001."The investment appraisal techniques used to assess risk in the oil industry" Conference Proceedings, 24th IAEE International
Conference. April 25-27, 2001.
Standard & Poors. Platt's Prices and Data, 1986-1984, McGraw-Hill.