By Julian Dierkes
Rio Tinto’s response to the SOMO report claims that the convoluted corporate structure that has been created for Oyu Tolgoi is not aimed at saving taxes, but rather at reducing investment risk.
For as long as Rio Tinto has been involved in Oyu Tolgoi, it has struck me that management is fundamentally not willing to engage Mongolia on Mongolians’ terms to commit to the project in the very long term. Instead management seems to be operating with a remote-controlled spreadsheet constructed by tax lawyers. This continues to raise political risk at Rio Tinto’s peril.
Whether or not the details discussed in the SOMO report suggest tax avoidance or a reduction of investment risk (I can’t tell the difference, to be honest), I see a corporation that seems to have decided that a lack of transparency is an acceptable price to pay for a (seemingly small) reduction in taxes or in investment risk. What that decision seems to disregard is that a lack of transparency on part of the investor is a significant contribution to political risk.
In the past, when Mongolian officials have raised questions about Oyu Tolgoi and Rio Tinto’s management thereof (most recently, with a large tax claim), much of the international response has focused on blaming such questions for destabilizing the relationship and thus hurting the longterm relationship. In those moments, Rio is portrayed as a committed longterm investor.
Rio Tinto’s Longterm Commitment
Yet, the convoluted and seemingly deliberately obscure ownership structures detailed by the SOMO report make me question that longterm commitment, or at least the wisdom of Rio Tinto executives in how they choose to express that commitment.
The size of the OT deposit suggests that it will be in production for many decades. Obviously, this depends on the rate of production and there are some imaginable, but far-fetched scenarios where the project is abandoned (apocalypse, an artificial, cheap substitute for copper, perhaps others). Barring those unlikely developments, this mine will be in production into the late 21st century if not beyond. For a business investment, that is a longterm investment, I would say.
“Mongolia is one of Rio Tinto’s most strategically important markets and we are here to stay” Rio Tinto chief executive J-S Jacques https://t.co/c5SzHQEFxN
— Rio Tinto (@RioTinto) January 22, 2018
Given the substantial up-front cost of developing the underground production at OT, all broad indications suggest that Rio Tinto is in the project for the, er, long haul. So, how are these broad indications translated into specific business decisions that continue to seem to squeeze dollars out of the project by accepting an increased political risk?
There are two classes of political risks that the OT project is facing:
- Catastrophic risk
- Incremental risk
Catastrophic risks means that Rio Tinto’s investment in the project is lost entirely. Generally, the scenario that is considered in bringing this about is a some kind of full-scale nationalization. For OT, it is primarily exogenous (i.e. separate from the project itself) shocks that might represent such a catastrophic risks. Examples would be some kind of authoritarian government in Mongolia that nationalized the project (preferably after completion of construction though the operation of a block caving mine is very cheap, but also very complex in terms of calculating/planning subsistence). Currently, the possibility of such a scenario strikes me as very remote, perhaps <5% over 50 years.
Another example might be a foreign invasion. That also appears very unlikely, unless there were extreme events/changes in either Russia or in China. Both of those are not unimaginable (an even more authoritarian turn in Russia, environmental catastrophe in China that turns into social unrest…), but very unlikely. And it these scenarios unfolded, lost investments in OT might be among the least of the world’s worries.
Of course, the very size of the OT project may inspire a kleptocratic take-over domestically and internationally, i.e. someone (person or country) might actively try to seize the project as a target all on its own, but if that happens, again, it would spell so many problems that this represents catastrophic, but very small risk.
While catastrophic risk would largely stem from dynamics that are not directly related to OT, the project itself does represent some political risks to itself, so to say. But, OT and Rio Tinto do play a very prominent role within Mongolian political deliberations, so they are actors that do contribute to political risk to themselves. To me, the SOMO report strongly suggests that Rio Tinto continues to make decisions that raise the incremental political risks on the project.
Incremental risks stem from changes in the taxation and regulatory environment. Essentially they are the risk that the profitability of the project is reduced, possibly even so far to be no longer economically viable.
Most of the questions that Mongolians and others are asking about the project stem from uncertainty about the information regarding the project.
This is in part because this is only the second mega-project that the Mongolian state is involved in. Erdenet Mine was structured in a very different, post-state socialist context where decisions were made on a very different basis and the “corporation” was in fact part of the state, not a separate entity.
So, Mongolian policy-makers and regulators simply do not have past experience with this kind of project to rely on. Yes, they could hire foreign advice to stand in for their own experience, but that only goes so far. All along in the negotiations, there has thus been a fundamental information asymmetry. There are very many aspects of the project that cannot be known to policy-makers. Are there any aspects that cannot be known to managers, other than those that are subject to the negotiations themselves?
It thus seems to me that in order to minimize the political risk of regulatory uncertainty and also of uncertainty in taxation – the very risk that the Investment Agreement is supposed to mitigate against – it would behoove Rio Tinto to minimize information and experience imbalances wherever is possible without compromising negotiation positions. Overcharging Oyu Tolgoi on management fees (the focus of many discussions between Rio Tinto and the Government in 2013, ultimately reduced from 6% to 3% of capital costs), or the elaborate constructs explored by the SOMO report, do not reduce information imbalances. Other elements of these imbalances have been explored by analysts in the past, see for example the 2015 note by NRGI’s Amir Shafaie.
Rio Tinto Engaging Mongolia
Rio Tinto’s past decisions and an apparent preference for listening to lawyers and accountings over country experts to me suggests that management has made a calculation that higher political risks are small enough a price to pay compared to tax and other savings, that they are willing to pay that price, as they must believe that they will come out on top in the end.
That is unfortunate, as it is a recipe for ongoing turmoil in coming decades. It also undermines Mongolian democracy and attempts (however lamentably feeble they appear at times) to build capacity in Mongolia to address information and experience imbalances. This conclusion does make me rather impatient with oft-repeated claims by voices from the investment community, including financial journalists, that prefer to try to shame the Mongolian government with vacuous terms like “resource nationalist”, rather than examining the decisions that investors like Rio Tinto seem to be making that contribute to political turmoil and uncertainty.
I think that Rio Tinto would be better advised to engage Mongolians more fully by which I don’t mean that management try to lobby or become friends with government officials who are currently mired in a stand-off of mutual accusations of corruption. Instead, Mongolians very real and relevant questions should be taken very seriously rather than being dismissed as money-grabbery (which is absurd given Mongolian ownership resources in any case). There are many more contributions (not even predominantly financial) that Rio Tinto could be making toward building Mongolian capacities and reducing information imbalances than have been undertaken in the past.
Yes, Mongolian employees are rising into management ranks which is important. B Bold’s membership in Rio Tinto’s executive committee is the pinnacle of that approach so far.
Much of the local engagement (Byamba knows much more about this) does seem genuine and community-focused in many aspects.
But I have seen relatively little of that kind of engagement at the national level in areas like mining education, support for Mongolian analytical capacity, etc. To me, some dedication of resources in these areas coupled with greater transparency in all dealings, including corporate structure, would go a long way in reducing political risk that is currently exacerbated by corporate decisions reflected in the SOMO report.