Prodipto Ghosh, Ph.DDistinguished FellowThe Energy & Resources institute September 2011

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The classical texts on economics in referring to the “factors of production” speak of ‘land’, ‘labour’ and ‘capital’. However, in discussing ‘land’ they refer to the various ‘services’ and ‘qualities’ of land, rather than its simple spatial extent.

The third factor of production is thus, conceptually, from the very beginning, ‘natural resources’, rather than a more narrow (dictionary) notion of ‘land’.

Natural Resources

Depletable Non-Depletable

Renewable Non-Renewable

A classification of attributes of natural resources

This classification is largely relevant in the context of depletion paths (sustainability), which I do not address in this presentation 3

Some insights from natural resource economics

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Typically, where a market valuation exists for a given natural resource, there is a positive difference between the (long-run average) cost of its extraction and delivery to the market, and the market valuation.

This is the “resource rent” (also referred to in the economics literature as “royalty”)

The extractor/user and the agent who has property rights over the resource typically compete over this resource rent.

This competition has resulted in colonialism, and explains in large part the continuing civil wars in Africa, and tension in the Middle East. It is also the source of much domestic political controversy. (2-G, Naxalism, Bhatta Parsaul), etc.

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Resource rent arises from two attributes of a resource:

(i) Any property of a resource that gives value to humans: (e.g. soil fertility for agricultural land, location of urban land, carrier of electromagnetic radiation, timber yields for forests, source of energy for wind power locations, etc.). These sources of value arise from markets, technology change, etc. and may vary over time

(ii) Scarcity of the resource: No scarcity, no resource rent (e.g. sea-water).

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In a competitive market (many potential holders (sellers) and users (buyers), no “sunk costs”, no externalities) if the holders resort to competitive bidding to allocate the resource to potential users, the holders extract the entire resource rent (as well as maximize their return and realize economic efficiency).

The market output in this case is at the maximum, and price at the minimum, among all cases.

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Very often, however, the users side is cartelized (few users, numerous holders). (This is typically the case with many internationally traded minerals)

If (all) the holders resort to auction in such cases, there are two cases:

i. “One-off auction”: The holder(s) extract the entire rent between the LRAC of extraction and the (cartelized) market price

ii. “Repeated auction”: The users may collude, and reduce the rent realized by the holders to (their perception of) the minimum expected return of the holders.

The market outcome in these cases is lower output, and higher price than the competitive case (e.g. global carbon market).

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If the holders side of the resource market is cartelized (few holders, numerous users – e.g. petroleum ), no collusion by the bidders is possible, but the holders may collude, and the entire rent may be realized by the holders. (In practice, OPEC pursues several objectives, which somewhat dilute its own yield of the resource rent)

The market outcome in this case is a resource price that is higher than in case of a competitive market, but the level of supply is smaller.

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Uncertainty in future demand for the resource (market conditions, technological substitutes, etc), would result in incentives to both sides to maximize near-term yields of the resource rent

Typically, users would bid less than the case with price certainty (in each alternative market structure), and holders would seek to set higher minimum levels of resource rents for acceptance of any bid.

A typical resolution to the problem is risk sharing – by means of setting shares of the resource extracted, rather than a specified monetary value of the rent (e.g. NELP).

Issues in allocating extraction/user rights to natural

resources

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We consider the implications for sharing of resource rents (R)between relevant agents of different policies for allocations of natural resources to candidate users, the price (P) of the resource (or equivalently, the good (e.g. steel) or service (e.g.mobile telephone) which it enables), and the quantity (Q) of resource extracted (or good/service produced).

The set of agents (A) comprise the resource owners (W), (which may be several, for a given resource); the decision makers (D) who actually make the allocation decisions (distinct from the “owners”), (the owners and decision makers referred to collectively as “holders” (H)); candidate users (C); and the actual users (U) (who are allocated the resource).

For tractability, we do not consider uncertainty (inc. market price, quantum of resource, extraction cost), etc. We also do not consider the regulator of the regulated price (where applicable, see below).

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The set of policy variables comprise: discretionary and non-discretionary (e.g. auctions, “first come first served”) modes of decision-making; unrestricted market pricing or market pricing with a ceiling of regulated tariff.

The candidate users may be numerous or few (or one); and similarly, the actual users may be numerous or few (or one).

Finally, the allocated right to extract/use the resource may be tradeable or refundable; or extinguished without compensation if not used.

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We also adopt the following terminology: Resource rent under competitive conditions, no

uncertainty, R* Resource (or dependant good/service) Price under

competitive conditions no uncertainty, P* = Long-run marginal cost (LRMC), (which must equal or exceed the long-run marginal average cost)

Regulated price or tariff of the resource (or good/service) (where applicable) = T

Regulated resource rent (in Case 2) = Rr Quantity of resource extracted (or good/service

produced) under competitive conditions = Q*

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The effect of specifying whether or not the allocated right to use the resource is (i) tradeable or may be refunded with compensation; or (ii) extinguished if not used without compensation; is simply that it affects the basis of computation of LRMC (and LRAC), and thereby the competitive price, P*. In the former, the resource rent paid to the holder (i.e. resource owner(s) and decision-maker(s) is part of the LRMC or LRAC. In the latter, it counts as a sunk cost, and is excluded from the computation of LRMC or LRAC (and P*).

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The different policy options considered are: non-discretionary (auctions) and discretionary modes of allocation; and market situations where candidate users are many or few; and where actual users are many or few (Note: Where candidate users are few, actual users cannot be many); and price is solely market determined or market determined with a regulated tariff ceiling). (Where there is no regulated tariff, the tariff can be taken as unlimited.

The outcomes are in respect of respective shares of the resource rent (R)to holders (H) and actual users (U), and the resulting price (P) of the resource (or derived good or service).

Table 1: Outcomes in Case 1:

Market structure

Allocation policy options, with/without market pricing with ceiling of regulated tariff

Non-discretionary (inc. auction)

Discretionary)

C=many

U=many

RU = 0

RH = R* if P = P*, else R < R*

P = P*, st P* < T, else P = T

Q = Q* if P = P*, else Q > Q*

RU = 0

RH ≥ R*

P ≥ P*, st P*<T, else P=T

Q ≤ Q*

C=many

U=few

RU = 0

RH = R* if P = P*, else R < R*

P = P*, st P* < T, else P = T

Q= Q* if P = P*,

RU = 0

RH ≥ R*

P ≥ P*, st P*<T, else P=T

Q ≤ Q*

Note: Quantity Q always follows the market demand curve for the resource or good/service, i.e. Q = F(P)

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We consider that the “holders” are now segregated into “owners” (which may be one (e.g. central government) or several (e.g. central, state, and local/(forest) panchayat); that there may be separate decision makers corresponding to each “owner”, and that each decision maker has veto power over the allocation decision.

The policy options/market situations are the same as in Case 1, plus auctioned and regulated (Rr) resource rent, with and without specified shares for each owner.

The outcomes considered are shares of resource rent to each owner/decision-maker, and resulting price and quantity of the resource (or good/service).

Market Situations Allocation Options

Non-discretionary allocation Discretionary allocation

Auction Regulatedresource rent

Discretionaryresource rent

Regulatedresource rent

Single Resource Owner

Single Decision Maker

C =many, U= many

RW = R*RD = 0RU = 0P = P*, st P< T else P =TQ = Q*,unless P = Twhen Q =Q(T)

RW = RrRD = 0RU = (R* - Rr)P = P*, st P*< T, else P=TQ = Q*,unless P = Twhen Q = Q(T)

RW = 0RD > R*RU = 0P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q =Q(T)

RW = Rr[RD > 0RU = 0st (RD+Rr) >R*]P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q = Q(T)

C =many, U= few

Rw = R*RD = 0RU > R*P > P* stP*<T else P= TQ < Q*unless P = Twhen Q =Q(T)

RW = Rr[RD > 0RU > 0st (RD+Rr+ RU) > R*]P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q = Q(T)

RW = 0[RD > 0RU > 0st (RD+ RU) > R*]P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q =Q(T)

RW = Rr[RD > 0RU > 0 st (RD+RU+Rr) > R*]P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q = Q(T)

C= few,U= few

[RW < R*RD = 0RU > 0 st (RW+ RU) > R*]P > P* st P*< T, elseP=TQ < Q*,unless P = Twhen Q =Q(T)

RW = RrRD > 0RU > 0P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q = Q(T)

Rw = 0[RD > 0RU > 0 st(RD+ RU) > R*]P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q =Q(T)

RW = Rr[RD > 0RU > 0 st (RD+RU+Rr) > R*]P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q = Q(T)

Market Situations Allocation Options

Non-discretionary allocation Discretionary allocation

Auction Regulatedresource rent

Discretionaryresource rent

Regulatedresource rent

Multiple Resource Owners

Multiple Decision Makers

C =many, U= many

Sum RW = R*.If pre-agreedshares, eachRW inrespectiveshare, elseeach RW > 0,butindeterminateRD = 0RU = 0P = P* st P <T else P = TQ = Q*,unless P = Twhen Q =Q(T)

Sum RW = RrIf pre-agreedshares, eachRW inrespectiveshare elseeach RW > 0,butindeterminateRD = 0RU = (R*- Rr).P = P* st P <T else P = TQ = Q*,unless P = Twhen Q =Q(T)

Sum RW = 0RD > R*RU = 0P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q =Q(T)

RW = RrRD > 0RU = 0 st RD+Rr) > R*P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q =Q(T)

C=many,U = few

Sum RW= R*.If pre-agreedshares, eachRW inrespectiveshare, elseeach RW > 0,butindeterminateRD = 0RU = 0P = P* st P <T else P = TQ = Q*,unless P = Twhen Q =Q(T)

Sum RW = RrIf pre-agreedshares, eachRW inrespectiveshare, elseeach RW > 0,butindeterminateRD = 0RU > (R* - Rr)P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q =Q(T)

Sum RW = 0RD > 0RU > 0 st(RD+ RU) > R*P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q =Q(T)

Sum RW = Rr.If pre-agreedshares, eachRW inrespectiveshare, elseeach RW > 0,butindeterminate[RD > 0RU > 0, st(RD+ RU) > (R*- Rr)P > P* st P* <T, else P=TQ < Q*,unless P = Twhen Q = Q(P)

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The intuition behind these complex tables is actually quite simple:

Whenever there is discretionary decision making, there is rent accrued to the decision maker(s)

Whenever there are few candidate users, there will be collusion among them

Whenever there are few actual users, there will be cartelized markets

Whenever there are multiple owners of the same resource, there is smooth rent sharing if there are pre-agreed shares, otherwise the result may be indeterminate.

Issues for Policy Making

What are the (legitimate) objectives of policy making? Examples:

Revenue maximization? Mass affordability of a good/service? Process of allocation must be “fair”? Facilitation/promotion of an “infant” sector? In the ultimate analysis, these questions

must be resolved politically, with Parliamentary accountability!

How the policy analyst can help? Identifying policy options that are most likely to

realize the chosen objectives – requires specialized knowledge in the field!

Identifying possible perverse outcomes (e.g. giving scope for rent-seeking) of candidate policy options (e.g. discretionary resource allocations)

Identifying policy options that may avoid deadlock during implementation (e.g. prior agreement on respective shares of resource rent for multiple resource owners)

However, it is not within the mandate of the analyst to choose the policy objectives!

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Prodipto Ghosh, Ph.DDistinguished FellowThe Energy & Resources instituteEmail: prodipto@teri.res.inPhone: 011-24682100

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