The role of the government in developed industrial economies, such as the U.S., the EU and the Middle East countries, is critical where industrial development is concerned. In these countries, the focus is on stimulating the processing industry, increasing exports of products with high added value, instead of raw materials.
Today, the share of goods with low added value in Ukraine’s exports is high. Roughly speaking, raw materials account for 2/3 of Ukraine’s exports. However, the higher the degree of raw materials conversion domestically, the faster the economy will grow, and the less the hryvnia exchange rates will depend on fluctuations in global prices for metal and agricultural products. At the same time, finished products account for more than a half of Ukraine’s imports. The ratio is terrible.
How can the government develop the processing industry?
Firstly, by pursuing a sound trade policy. For example, following the ban on exports of roundwood, the Ukrainian wood processing industry began to quickly recover and develop production of finished products. Such a sensible approach should also prevail in other industries. Thus, it is reasonable to recycle scrap in Ukraine using it to produce wheels for Deutsche Bahn high-speed trains, rather than to export scrap as a raw material. The higher the degree of conversion, the more taxes are paid and jobs created.
Secondly, by promoting the domestic market by investing in infrastructure. There is a great need for renovation in such industries as railway car building, oil and gas extraction, modernization of housing and utility services and their infrastructure. At the same time, Ukraine has production capacities, technologies and engineering schools to meet the demand. Therefore, investments in such industries will initiate the trigger effect — this will create entire production chains of Ukrainian companies, which pay salaries, taxes, attract suppliers, etc. In particular, the launch of large-scale construction projects in the railway industry could contribute additional 2–3% to Ukraine’s GDP.
Thirdly, by establishing mechanisms to support exports, primarily of mechanical engineering products, as this industry actually creates goods with maximum added value. By increasing its share in exports, the government lengthens the value added chain. The lack of mechanisms for funding high-tech exports reduces the industry’s competitiveness and hinders the development of domestic market for steel producers. Mechanical engineering products are sold worldwide through an instrument known as export credit agency. Therefore, the real launch of ECA in Ukraine will give an impetus to the development of mechanical engineering.
Fourthly, by supporting exports through the development of economic diplomacy. Today, all countries apply trade restrictions against imports. Duties against Ukrainian metal products have been introduced all over the world: in the EU, the U.S., Canada, Russia and the Customs Union, Turkey, Egypt, Brazil, Mexico, etc. We seek no preferential treatment in external markets, but we want to compete freely in external markets with local manufacturers. But we are facing trade barriers, which we cannot possibly overcome on our own, without state support.
Despite the EU–Ukraine Association Agreement, duties and quotas apply to the products of domestic steelmakers. Meanwhile, the EU actively opposes the introduction of any trade restrictions in relation to its own producers.
Supercycle — time to invest in technology
When we talk about supercycle, it is important to emphasize the word “cycle”, because a rapid take-off is always inevitably followed by a steep dive. Usually the fall is so sharp and sudden that not all companies survive, and unfortunately, many shut down. Therefore, now, when the supercycle has started, it is very important to invest in the development of production, in new technologies, since there will be no other chance like that.
However, equally important will be the priority areas of investments chosen by steelmakers: creation of additional lines for ore extraction or modernization of mills for producing finished products.
In its own segment, Interpipe faces a constant increase in quality requirements for finished products. Thus, more difficult conditions of production of hard-to-recover hydrocarbons require new-generation pipes with high strength characteristics and premium threads. Higher speed of railway transport and increase in the efficiency of railway transportation require railway wheels with qualitatively different characteristics.
To be competitive in the global market, you need to invest today in what will be in demand tomorrow. Regardless of the phases of decline/growth in the market, Interpipe annually invests about $60 million in modernization of production facilities and creation of new products.
Decarbonization is inevitable
Decarbonization of economy has become a global trend, and the Ukrainian industry will have to decarbonize too. Otherwise, it may lose the European market after the introduction of the so-called “сarbon tax”, a special customs tariff on the imports of products, the production of which does not meet the climate neutrality requirements. In July, the European Commission will publish a package of amendments to the European legislation on climate targets. Regulation on CBAM, a new carbon duty, is among them.
Today, there are only three steelmaking technologies in the world: open-hearth (OH), basic oxygen furnace (BOF) and electric-arc furnace (EAF) routes. The OH route generates the highest volumes of CO2 emissions, an average of 2,500 kg per 1 ton of steel. BOF generates slightly lower, but still significant CO2 emissions during smelting — approximately 1,800–2,000 kg. Meanwhile, emissions in the EAF route average 100–300 kg of CO2. Therefore presently, the EAF route is the most realistic and fastest way to get as close as possible to the Green Deal standards.
Only 5% of Ukrainian steel is produced using the EAF technology, while the same figure reaches 41% in the EU and 70% in the U.S. Why is it so? The main reason is the lack of financial incentives from the government. In the EU, ecological modernization of the steel industry is estimated at €150 billion, and these activities will be funded through concessional loans, special-purpose programs and funds. There are currently no operational financial incentives or other similar instruments in Ukraine that would motivate producers to invest in decarbonization.
Interpipe’s transition to “green” steelmaking technologies cost the company $1 billion. The company gave up the OH route and built a new EAF plant using its own and borrowed funds (attracted, by the way, by an Italian export credit agency). It was long before the Green Deal was adopted. Thus, having reduced our CO2 emissions 10-fold, we have brought ourselves closer to the declared targets of the Green Deal for 2050.
Therefore, the law on “green” steel industry was the only financial incentive in Ukraine. In fact, it completely repeats the toolkit used in the UE, where EAF assets are exempted from the “green” tax on renewable energy, since they are already “green” steelmakers. And the “green” tariff is funded by polluting companies. In our case, it is the other way around: we, as a company that invested $1 billion in decarbonization of production, must pay a tax on “green” electricity as part of Ukrenergo’s transmission tariff.
The government has recently revised approaches to tax policy in the area of subsoil use and iron ore mining. A new version of the draft Law amending the Tax Code provides for reduction of rental rates in case iron ore prices are low, and higher rental rates, compared to today’s benchmark, in case the prices are high and companies can afford such payments.
A logic behind the change in rates is not a bad signal for foreign investors. But what is much more important is stability and predictability of tax climate. Indeed, over the last seven years, the conditions have already changed twice. However, to enable investments of hundreds of millions of US dollars in the mining & metals sector, tax policy should first enable cost planning with a time horizon of at least 8–10 years.
Black Iron is running a greenfield project in the mining & metals sector, which is the first project of the kind in the history of independent Ukraine which is not based on the Soviet industrial heritage. All our estimations, from prospecting to sales markets, are based solely on the current objective market conditions and forecasts of the world’s leading think tanks as regards the future demand for and supply of high-quality iron ore. That is why sustainable tax policy in Ukraine is one of the key factors of successful implementation of the Shymanivske iron ore project.
The current sky-high prices for iron ore at the rate of $200–230 per ton surely afford ground for talks about iron ore producers’ super profits. But three or four years down the road, as analysts forecast, the prices are likely to return to the levels of $70–80/t — typical for the period of 2014–2018. Even so, it remains to be seen whether budget will lose or benefit from such adjustment.
As soon as negotiations started in Ukraine as regards revision of rental rates and the principles of charging those (it is suggested targeting global prices instead of primary costs), we assessed the impact it will have on the implementation of our project. We estimated our possible savings at $170 million, since those negotiations paralleled discussions of a draft Law on support of foreign investment in the media space. The draft Law proposed the prospect for reducing the tax burden (income tax in particular) during the first five years of operations, which are the most critical for investors and during which debts are mainly repaid. But now that the iron ore sector is excluded from the final version of the draft Law, there is no more talk about the savings.
We haven’t revised the final project budget of $1.1 billion so far. We use the same parameters to negotiate our obligations to our partners, particularly Cargill Steel division of Cargill Corporation. We chose it as a financial partner with a contribution of $75 million in exchange of the right to purchase the first 4 million tons of mined raw material within the first 10 years. Another $100 million will be provided as royalty by the family office of one of the richest people in America. Moreover, leading European banks will provide $260–300 million as loans secured by guarantees of a large export credit agency.
As for tax payments, according to conservative estimates, over the 20 years after the launch of the project, Black Iron will pay more than $2.2 billion to Ukraine’s budgets of all levels. Given the expected fluctuations in iron ore prices, the increase in rent payments today will have a negligible impact on the above figure in the long run.
It is not so much the size but predictability of tax changes that is a key factor for us, and also, government policy towards investors in heavy industry in general. We often hear that new approaches to taxation of subsoil use may have political implications. As a foreign investor, we are not a subject of Ukrainian politics and accept the rules established in this country.
But negotiating with the partners or banks, planning our debt obligations would be much easier if we understood that such decisions have an economic justification. Add to this knowing that the change in the political situation next day would not lead to a revision of rent payments or other taxes, or the principles of the permit system or land allocation.
In addition, it is also important for investors to understand that promises to help resolve land issues, facilitate cooperation with local authorities and other signs of interest in obtaining investments worth billions of dollars are also actually fulfilled rather than remain mere promises.
All attempts to increase taxes for companies of the mining & metals sector can be explained by current high prices around the globe. As a rule, prices peak every 10–12 years.
This situation is mainly due to the fact that Brazil’s mining assets are facing problems and cannot supply required volumes of their products to the global market. This relatively small deficit has been a catalyst for a rise in iron ore prices. Yet high prices encourage everyone to mine and export more.
This wave of high prices will pass. No one knows exactly when it will end, but these peaks have never lasted long. It is price holes that are deep and long-lasting.
Needless to say, a company that makes more profit pays more taxes. Even without any price rise. Analysis of this year’s taxes and other payments by ArcelorMittal Kryvyi Rih shows an almost two-fold increase against last year’s payments to budgets of all levels. This increase is solely due to improvement of financial situation.
Moreover, if the enterprise has opportunities to earn more, it will have more opportunities to spend the money earned for the upgrade of its production facilities, including for environmental purposes, and technologies, because modernization requires large investments.
European countries strongly support environmental modernization. Instead of raising taxes, governments offer tranches or financial aid to enterprises for necessary technological modernization of production facilities. We don’t really hope that our government will help the mining & metals sector, but rather expect it not to interfere at least.
There is no need to gear rent payments in Kryvyi Rih to prices in Northern China. In fact, we do not know a single country where taxes are geared to prices for iron ore or products of its processing in China. In the world’s most developed countries, profit from mining activities serves as a tax base. In Australia and Canada, iron ore mining tax is actually a form of corporate income tax. In the United States, iron ore mining tax is levied on revenues from the sale of minerals at the federal level and on taxable profits at the local level.
The overwhelming majority of other countries, including developing economies, use sales revenues or net minerals income as a tax base. Some other countries apply combined taxation systems, where tax can be imposed first as a fixed amount per unit of weight of extracted minerals, and then additionally per unit of area of the mining site (India and China).
Post-Soviet countries engaged in iron ore mining and processing (Russia, Kazakhstan) apply a diversified approach. Sold iron ore is taxed based on indicative prices at the London Metal Exchange (Kazakhstan) or on the actual sales price adjusted for processing and transportation costs (Russia). If iron ore is not sold, but used in economic activities, a tax base is the actual cost of production and primary processing (Russia) increased by the minimum profitability ratio of 20% (Kazakhstan).
For instance, ArcelorMittal Kryvyi Rih consumes 75–80% of mined iron ore and processes it into metal in Ukraine. Iron ore exports are not our core business. We are a steelmaking company. And our primary objective is to provide ourselves with raw materials. We mine a little more iron ore than we can process, and ship the rest to Europe. It is therefore very difficult for us to understand why we should use IODEX 62% Fe CFR China according to Platts to determine a tax base.
A working group has recently been created in the parliament to examine the draft Law No. 5600. We have immediately presented our proposals to it.
Taking stock of the experience of many developed and developing economies, we consider the Brazilian model, where a tax base is net income (revenues from the sale of mineral resources decreased by the amount of indirect taxes, insurance and transportation), in combination with a model used in Kazakhstan for taxing unsold iron ore based on its production cost increased by profitability margin to be the most suitable option for Ukraine.
The use of indicative prices for determining a tax base is not a fair and economically sound approach. This model does not take into account real revenues and income of mining companies (in particular, the quality of iron ore, real conditions and sales markets, transportation costs, etc.).
The application of the mechanism that we propose is quite acceptable both for the government and for mining enterprises that pay rent for subsoil use. The application of the proposed model will considerably increase budget revenues from rent payments. At the same time, this increase will deal no blow to the industry.