Mixed signals: A slew of new legislation is creating confusion among investors

Until recently, Indonesia had been content to give both international and local mining outfits a wide latitude in terms of how to most effectively profit from the extraction of lucrative mineral deposits, as the state took a share via various taxes, licences, royalties and other agreements. This well-established and stable regime was shaken up in 2012 with the implementation of two statutes originally laid out in the 2009 mining law: first, a requirement to refine raw minerals domestically, and second, increased divestment requirements for foreign mining companies, at least 51% after 10 years with the right to maintain a non-controlling stake.

By mandating an increase domestic value-added processing and reclaiming ownership of mining firms, the government clearly meant to improve the potential of the industry to create wealth in the country, but the impact these new rules have on investor interest and confidence may have adverse effects on what is one of Indonesia’s key export sectors.

PLAYING BY NEW RULES: The first of these regulations came in the form of Ministerial Regulation No. 7/2012 and was issued by the Ministry of Energy and Mineral Resources (MEMR) in February 2012 to establish processing requirements for all mining operations in the country. Export of metallic mineral ore (21 products), non-metallic minerals (10 products) and rocks (34 products) are subject to 20% export duty. Mixed mineral ores containing two or more kinds of mineral ores may be subject to 20% export duty.

The new requirements are to be phased in over the next four years, depending on the developmental status of operations with the first deadline for the mining business licence, or izin usaha pertambangan (IUPs), already in production phase and slated for completion by January 12, 2014. Exploration IUP and Contracts of Work (CoW) holders in the exploration/feasibility phase will be required to comply by February 6, 2015, while IUP and CoW holders now undertaking construction of their projects are requested to be fully compliant by February 6, 2016. Officially, the export ban came into effect on May 6, 2012, but transitional provisions have allowed companies holding mining business licences a grace period in which to bring their mineral processing capabilities up the required level before the 2014 deadline. However, these companies will also be subjected to additional export taxes applicable to all unprocessed minerals and ores, which roughly equals a 20% tax. Failure to comply with the new requirements will result in any mining company operating under an IUP licence to forfeit the right to export unprocessed material.

MORE HARM THAN GOOD: The wide-ranging implications of this law have left many in the industry questioning whether the new export requirements go too far too fast, and whether the consequences of compliance could end up damaging the mining sector more than it helps. One of the arguments against the law is that it lumps all minerals together in the same category, while the costs and benefits of refining different metals differ substantially. Processing copper, for instance, produces very thin profit margins, which must take advantage of substantial economies of scale and leave little wiggle room for other considerations such as power, labour and environmental-compliance costs. Conversely, refining materials such as nickel, which Indonesia already has substantial smelting capacity for, offers ample incentive for firms to invest in refining facilities even without export taxes or bans.

“Each of these minerals does not have the same characteristics in terms of the mining and processing stages. Therefore a policy such as a comprehensive ban for all of these minerals seems too blunt an instrument to be very effective at promoting downstream processing,” Tyler Briggs of the USAID programme Support for Economic Analysis Development in Indonesia (SEADI) said during a mineral export processing discussion group held in October 2012 in Jakarta. “Policymakers need to assess whether this whole strategy and export ban within the mineral sector – to have a fully linked industry – is really a good way to do this. It may be better to export and let smelting be done elsewhere where they have excess capacity to do the smelting, particularly in China. It may be cheaper to do the smelting elsewhere, let them take the environmental damage, and then import the raw material of basic products and fabricate products downstream that employ more people at higher-value-added than you would get from simply smelting.”

The general consensus in the industry as of late 2012 is that the 2014 deadline is simply too soon to increase refining capacities to levels required to process domestic output given the time required to secure finances for the multi-billion dollar investments and construction of the smelters. Another SEADI representative, Marian Radetzki, also weighed in with a stern warning at the conference, stating, “If the policy is implemented as is in 2014 it will be a catastrophe for those in the mining sector because they will not have a market either abroad, because of demand, nor domestically, because of the absence of sufficient capacity.”

FURTHER CONSEQUENCES: In addition to the pure profit margin aspects of the processing requirements, a number of other issues have also been raised concerning potential ripple effects. These include social welfare costs, which could come in the form of reduced employment due to unprofitable mines being closed and the relatively low number of workers employed in smelters, as well as environmental costs associated with the smelting process. The Indonesian state could also see its revenues from the sector tail off if mining outfits close up shop or market prices dip as new quantities of concentrate flood the global marketplace.

The World Trade Organisation is also unlikely to view a raw material export ban favourably, and the scheme could funnel more raw product into the black market by creating more incentive for illicit dealings by increasing the gap between international and domestic prices.

Other previously implemented components of the 2009 law could also prove a hindrance to the smelting operations, in particular the size and contract length restrictions. With new IUPs limited to a maximum of 25,000 ha, it could prove more difficult for companies to exploit economies of scale, which are required to make downstream processing economically feasible.

Further adding to the confusion, Indonesia’s Supreme Court ruled in November 2012 that four of the regulation’s 21 articles, including the export ban on raw materials, were unconstitutional. As of January 2013, the government had indicated it would proceed with the ban in 2014 despite the Supreme Court verdict.

DIVESTMENT: The second major policy change affecting the sector this year was the bolstering of divestment requirements for foreign-owned mining firms in Indonesia through the passage of Government Regulation No. 24 of 2012 (GR24) on February 21, 2012. Usurping the short-lived GR23 from 2010, which required only a 20% divestment of foreign ownership, GR24 raises this to a 51% majority after the company’s 10th year of production, limiting foreign stakes to 49%. The process is implemented on a sliding scale over a five-year period, starting with a 20% divestment requirement after the sixth year of production and increasing in each subsequent year to 30%, 37%, 44% and ultimately 51%. With most of Indonesia’s large coal mines are already in the hands of local ownership, this regulation will primarily affect the minerals sector.

The first right of refusal to take on ownership of a divestment is granted to the Indonesian government. If refused, provincial and regional governments get a second crack, followed by state-owned or regionally owned enterprises and finally privately owned Indonesian companies. Although the measure will not be applied retroactively, larger mining projects such as Newmont, Freeport and others with long-term and extendable contracts will need to decide how to go forward upon the expiration of their current CoWs or renegotiate the terms of their licences from a position of greater strength prior to expiration.

QUESTIONS REMAIN: Despite the intention to clarify the investment law via GR24, the implementation of the legislation has left a number of questions unanswered. The 10-year deadline could be a drawback for investors in large-scale mines, which regularly have operational lifetimes in excess of four or five decades. Uncertainty over how the divestment shares will be priced also remains a concern. Other unresolved issues include how to reconcile any outstanding stakes if Indonesian entities prove unwilling or financially unable to purchase shares offered by companies required to divest, the status of companies listed on the Indonesian Stock Exchange, as well as whether the option exists to divest through an initial public offering, and restrictions on subsequent transferring of ownership stakes by Indonesian stakeholders in the future. Because of these issues, mining companies looking to open up new ventures in Indonesia will be forced to consider if it will be economically feasible and whether or not the state will be able or willing to offer additional incentives such as longer IUP terms and tax breaks or even revisit these concerns through future legislation.