The good, the bad and the ugly

Sacha Winzenried (Technical Advisor)

Globe Asia - February  2009

 

On 16 December 2008 the Indonesian parliament passed Indonesia's new Law on Mineral and Coal Mining. This Law, which has been under deliberation for well in excess of three years, represents another major regulatory development in Indonesia's investment landscape along with the 2007 Investment Law, and the 2007 and 2008 Tax Laws, and the biggest change in the mining regulatory framework in Indonesia in more than 40 years.

Gaining political consensus on the framework for regulation of this highly strategic industry for Indonesia's economic development was not easy, as illustrated by the long deliberation process.

Clearly the Law has many detractors, but the fact that it was the only framework to gain some form of consensus means the mining industry now faces the challenge of coming to terms with the good, the bad and the ugly in its provisions.

It is unfortunate that the issuance of this Law has coincided with the global economic crisis and the accompanying fall in commodity prices. This undoubtedly impacts the appetite for investment in the mining sector, and it is not clear that the Law provides the necessary encouragement to investors to choose Indonesia over other geologically attractive locations, when allocating scarce investment funds.

 

Farewell to the CoW

The jury is still out on whether this Law will achieve the stated aims of increasing investment in the mining sector, which has suffered from numerous perceived regulatory weaknesses for a number of years.

As expected, the well-regarded Contract of Work (CoW) system will no longer be available under the new Law. This is a disappointment to many investors. Instead both domestic and foreign investors will be able to apply for a form of mining license (referred to in Indonesian as an lzin Usaha Pertambangan or IUP).

The CoW was well regarded as it provided the legal and fiscal certainty which is so important for the mining sector.

Mining investment involves exploration risk, huge upfront capital investment and long payback periods. The start-up costs are compounded by the lack of infrastructure in the remote locations where mining activities are conducted, which often means that mining companies are the largest employers and providers of community development in the areas in which they operate.

The CoW provided investors with the necessary approvals to conduct mining activities for the full life-of-mine from initial survey and exploration activities, through to construction and production.

Under the Law, investors will need to apply for separate exploration and production licenses. The added risks of the new license- and regulation-based structure, as compared to the "one-stop shop" CoW, may deter investors from entering into the large-scale projects which arc desperately needed for the growth of the Indonesian mining sector.

Unfortunately, the hope of many investors that a form of contract would remain available for large projects above a certain investment threshold was not realized in the Law.

 

Investment

The Indonesian mining sector has suffered from lackluster growth for a number of years, due to well-publicized regulatory and other issues. This was beginning to change in 2007 and 2008 on the back of the global mining boom, which saw commodity prices reaching record highs.

PricewaterhouseCoopers' 2007 report on its annual survey of the Indonesian mining sector, mineindonesia 2007* indicated that investment in the Indonesian mining sector grew to $960 million in 2006, with data for the 2008 report showing that investment was above $1 billion in 2007 and likely to be above $1.5 billion in 2008.

The ongoing mining boom also saw major global players such as Rio Tinto and BHP Billiton, who reportedly had submitted applications for CoW to the government, once again looking at major multi-billion dollar investments in Indonesia.

BHP Billiton has already announced that it will not proceed with its planned nickel joint venture with state-owned miner PT Aneka Tambang. The removal of the CoW system, and the added uncertainty of the new licensing system may mean that other large projects on the drawing board may also be cancelled or delayed until there is more certainty on the operation of the Law.

The Law has attempted to remove the uncertainty surrounding the management of the mining sector. With the passing of the Law, whether or not they agree with the content, for the first time in more than three years stakeholders in the mining sector at least know what rules they will be playing under. This is a significant plus.

However, initial thoughts from mining industry observers are that the Law may not provide the level of certainly necessary to encourage the investment in large -scale mining projects, which is so vital to a strong mining sector. In particular, uncertainty around the transitional provisions for existing CoW is causing some concern.

There is also much concern among mining industry players that the Law does not adequately address the needs of investors in large-scale projects, and that it really only serves the interests of small and medium players.

This is partly because of the restriction on exploration areas that can be granted (a maximum of 100,000 hectares for metals and 50,000 hectares for coal) which are further reduced under the production license (25.000 hectares for metals and 15.000 hectares for coal).

 

The challenges

The Law also relies heavily on as yet unseen implementing regulations for its implementation, which are required to be issued within one year. History has shown that such regulations are not always issued on a timely basis (the key implementing regulation for the 2001 oil and gas was not issued until 2004).

This may cause further uncertainty for investors, as the devil will be in the detail for many of the provisions of the Law. It would be best for all concerned if these regulations could be issued as quickly as possible to cover all issues, both good and bad, as uncertainty is the enemy of increased investment.

Some of the key considerations for investors include:

The IUP system replaces both the CoW system, and the former Mining Right (or Kuasa Pertambangan - KP) system which was available only to Indonesian investors under the previous law.

The Law allows IUPs to be held by Indonesian legal entities, which would appear to include both Indonesian companies owned by Indonesian nationals, as well as foreign-owned Indonesian companies, removing any distinction between Indonesian and foreign investors in the mining sector, which is consistent with the current Negative List, which allows for 100% foreign investment in the mining sector.

The Law does however require some form of divestment of foreign interests within five years of production commencing - details of this divestment process are to be set out in a separate regulation.

Foreign investors will be eager to understand the divestment requirements, including the percentage to be divested, given the potentially significant impact on project economics.

The Law's transitional arrangements indicate that all existing CoW will be honored until their expiration date. However, the very next clause of the Law indicates that the terms of these existing contracts must be amended within one year to conform with the provisions of the Law, other than terms related to state income (not defined, but presumably including royalties and taxes).

Further, the Law requires that holders of existing CoW must, within five years of enactment of the Law, comply with the obligation under the Law to conduct onshore processing of their ore.

Onshore processing is also required for new lUPs - although the details are left to the implementing regulation.

In addition, CoW holders which have already commenced some form of activity are required, within one year of enactment of the Law, to submit a mining activity plan for the entire contract area. If this plan is not fulfilled, the contract area will be reduced to that allowed for IUPs under the Law.

The transitional provisions have probably been the most controversial aspects of the Law with debate in parliament continuing on this point right up to the final passage of the law.

Unfortunately the outcome appears to be two possibly conflicting provisions meaning that, state revenue treatment aside, it is not clear how completely existing CoW rights will be honored.

Resolution of this will obviously be of major interest to those investors holding CoW, and is likely to be a continuing disincentive to additional investment by existing contractors until the government's interpretation of these transitional clauses is clearly understood.

There are no provisions dealing with conversion of KPs. It is not clear whether these KPs will be allowed to run until the end of their current terms, or whether they should be converted into IUPs.

If they automatically become lUPs, there may be an argument that foreign investors are able to take direct equity interests in these concessions. If this is the case, this could be a favorable outcome of the Law, allowing immediate direct investment into Indonesia for existing KPs.

The latest comments from the Directorate General of Minerals, Coal and Geothermal seem to indicate that KPs automatically become IUPs - the quest ion therefore remains what provisions of existing KPs will need to be harmonized with the Law.

 

Outlook

In summary, the Law may not have entirely eradicated the uncertainty that has been hanging over the mining industry in Indonesia. The terms of the Law may be adequate to encourage some investors, both foreign and domestic, to take direct equity stakes in IUPs for relatively small-scale projects. This should have an immediate positive impact on investment in the sector.

However, there is likely to be greater uncertainty around proposed large-scale projects as the Law does not offer the long-term protections of the CoW system for large, long-life projects which require significant investment.

Investors will also be relying on the effective operation of the Indonesian legal system to protect their investments, without the specific terms provided in the CoW.

Exacerbating these issues is the onset of the global economic crisis, which has heavily hit even the biggest global mining companies. This means that now, more than ever, investment dollars are scarce, and it is not clear that this new Law provides the necessary impetus for mining investors to choose Indonesia over other resource rich countries.

Only time will tell whether investors will overcome these concerns and invest in these large projects, which are the lifeblood of a strong mining sector.

 

Sacha Winzenried is a Technical Advisor and mining specialist at PricewaterhouseCoopers Indonesia