Alberta 2015 Pre-Budget Submission October 2014

2100, 350 – 7 Avenue S.W. Calgary, Alberta Canada T2P 3N9 Tel 403-267-1100 Fax 403-261-4622

1000, 275 Slater Street Ottawa, Ontario Canada K1P 5H9 Tel 613-288-2126 Fax 613- 236-4280

403, 235 Water Street St. John’s, Newfoundland and Labrador Canada A1C 1B6 Tel 709-724-4200 Fax 709-724-4225

www.capp.ca Ÿ [email protected]

310, 1321 Blanshard Street Victoria, British Columbia Canada V8W 0B5 Tel 778-410-5000 Fax 778-410-5001

Executive Summary The Canadian Association of Petroleum Producers (CAPP) is the voice of Canada’s upstream petroleum industry, representing companies that explore for, develop and produce more than 90 per cent of Canada’s natural gas and crude oil, a national industry with revenues of about $100 billion per year. While our members appreciate and support the province’s efforts to strengthen the competitiveness of Alberta’s energy sector through the royalty and regulatory reforms prioritized in the 2009-10 competitiveness review, more work needs to be done. Industry is increasingly challenged to remain cost competitive in the global market for oil and gas investment. In 2013, non-oil sands operating costs approached 50 per cent of operating revenues – up from approximately 20 per cent in 2008. The increased cost profile of the industry is linked to increased production from unconventional sources, a tight labour market and constrained market access. In addition to rising costs, industry’s challenges are compounded by the recent decline in the price of oil and gas Although most financial firms foresee oil settling into a range between $60 and $65 US a barrel over the course of 2015, right now the price of the North American benchmark is in the high to mid-$40 range. The price of oil has declined by 50 per cent since June 2014, and most analysts do not expect prices to recover substantially before the end of Q2. The implications for the oil and gas industry and the Alberta economy are substantial: according to TD bank, Ontario is now poised to lead Canada in economic growth in 2015 (2.5%), followed by BC (2.4%) and AB (2.3%). With some forecasts suggesting the prospect of a recession for the province. In response to these challenges, CAPP is seeking to work with the provincial government to advance priorities that increase economic competitiveness without imposing additional costs on government. Recommendations Scientific Research and Experimental Development (SR&ED) Tax Credit: • • •

Remove the annual SR&ED expenditure limit in Alberta, similar to the BC approach. Allow corporate partners of a partnership to claim their respective share of the Alberta SR&ED tax credits. Conduct a review of the Alberta SR&ED program as it pertains to competitiveness with other provincial R&D programs, the economic and productivity benefits of the program, and its administrative efficiency.

2100, 350 – 7 Avenue S.W. Calgary, Alberta Canada T2P 3N9 Tel 403-267-1100 Fax 403-261-4622

1000, 275 Slater Street Ottawa, Ontario Canada K1P 5H9 Tel 613-288-2126 Fax 613- 236-4280

403, 235 Water Street St. John’s, Newfoundland and Labrador Canada A1C 1B6 Tel 709-724-4200 Fax 709-724-4225

www.capp.ca Ÿ [email protected]

310, 1321 Blanshard Street Victoria, British Columbia Canada V8W 0B5 Tel 778-410-5000 Fax 778-410-5001

Municipal Competitiveness: • • • • • •

Prioritize economic competitiveness as part of the municipal government act review process Re-introduce a linkage between the residential and non-residential property tax rates in rural and specialized municipalities, and consider 1.33 to 2.00 as the starting range. Freeze rate ratios for rural and specialized municipalities already above the threshold to recognize existing practice and budget constraints. Establish a formal requirement for rural and specialized municipalities to consult with the major non-residential assessment base representatives in the municipality prior to raising non-residential to residential tax rate ratio. Adopt a province-led approach for assessing industrial facilities. This would serve to enhance independence, give assurance that assessments are free of municipal influence, and would promote consistency in the application of provincial legislation. Consider whether Machinery and Equipment (M&E) should continue to be assessed and, if so, review the 77 percent assessment approach for M&E and education tax exemptions in the context of the competitiveness of the overall assessment and tax burden of the oil and gas sector from a benefits perspective, relative to other provinces, and relative to other municipalities and sectors within Alberta.

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Introduction Alberta’s oil and gas sector represents nearly 50 per cent of the provincial economy through direct, indirect and induced economic activity. The province has recognized the importance of the sector to the Alberta economy, and has undertaken significant efforts to ensure its competitiveness.i Core among these initiatives has been Energizing Investment: A Framework to Improve Alberta’s Natural Gas and Conventional Oil Competitiveness, which was launched by the province in 2010. ii This initiative established a framework for enhancing the competitiveness of Alberta’s oil and gas sector, the primary deliverables of which included:iii • •

Royalty reforms that included more competitive front end royalty rates for conventional oil and gas, and new royalty programs such as the natural gas deep drilling program and the Alberta Emerging Resources and Technologies initiative; and Launching the regulatory enhancement project, which led to the 2012 Responsible Energy Development Act, and the creation of a single regulator to better streamline and coordinate the regulatory approval process for oil, gas, oil sands and coal projects in the province.iv

As part of this initiative, the province further indicated that:v Alberta’s broader fiscal regime, including taxes, will also be examined. This will be undertaken with a view of positioning Alberta as one of the most competitive investment locations for upstream oil and gas industry. While our members appreciate and support the province’s efforts to strengthen the competitiveness of Alberta’s energy sector through royalty reforms and regulatory streamlining, more work needs to be done. In particular, it is critical to further support industry in reducing its finding, development and operation costs, and improving the fiscal terms of Alberta’s oil & gas sector from a municipal perspective – both of which were identified as key competitiveness factors confronting the industry in 2009 that need to be addressed.vi Reducing costs and improving competitiveness becomes even more imperative when considering the economic environment the industry and the Alberta government are now facing. In response to low commodity prices, many producers have already announced reduced capital expenditure budgets, with some cutting back as much as 50%. As government imposes cost containment measures of their own, CAPP has increased efforts to advocate for and prioritize revenue/cost neutral, value-adding asks that would reduce costs on industry, improve the business climate, and/or incent investment. To this end, CAPP’s 2015 budget submission focuses on: • •

Removing barriers to innovation and investment by strengthening Alberta’s Scientific Research and Experimental Development tax credit and Strengthening the competitiveness of Alberta’s energy sector at a municipal level.

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1. Alberta’s Competitiveness Context The global oil & gas sector is highly competitive. There are many producers operating in a variety of basins around the world generating comparable products. Alberta (and Canada) need to offer fiscal terms that are competitive with other jurisdictions to ensure industry activity in Canada remains viable. Alberta has one advantage many of its competitors lack: political and social stability. However, this advantage alone is insufficient. Costs are the first area affecting the decision of whether or not to pursue opportunities in Alberta. Recently, costs are rising in Alberta while prices for natural gas and oil declined and then remained stagnant. Figure 1 shows that operating costs for conventional oil and gas production are on the rise, and are now approaching half of operating revenues for conventional oil and natural gas producers in Canada. These costs are strictly operational, and exclude exploration and development costs, royalties and other payments to governments. Figure 1. Non-oil sands operating costs as a percentage of operating revenues.1

This cost escalation is linked to the maturing of the Western Canadian Sedimentary Basin and the evolving nature of oil and gas reserves and extraction methods. In particular, the increased use of deep horizontal drilling and fracking techniques have put upward pressure on development and

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Source: Calculated from Canadian Association of Petroleum Producers Statistical Handbook Tables 04-03B and 0419B.

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operating costs for industry. Figure 2 depicts the increase in Canadian tight oil production by play. The timing of the increased activity corresponds to the timing of increased cost profile of the basin. Figure 2 Canadian Tight Oil Production by Play2

An additional key cost driver for the industry is labour. Figure 3 depicts monthly average weekly earnings in the mining, quarrying, and oil and gas sector in Alberta. As is clear from the graph, the trends are different in Alberta. Every month, real weekly earnings tend to increase by almost $4, which is close to double the approximately $2 a month rate for the same sector in Ontario and British Columbia. Put another way, the average Alberta employee was making over $30,000 a year more in real terms than in January 2001, compared to employees in BC and Ontario, which earned between $10,000-$15,000 over this period. These rising costs affect upstream firms’ economics and investment decisions. For example, Statoil’s recent decision to postpone the Corner oil sands project was based in part on increasing labour and materials costs.3

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Source: NEB “Tight Oil Developments in the Western Canada Sedimentary Basin, Dec 2011 Statoil (2014), “Statoil postpones Corner project,” http://www.statoil.com/en/NewsAndMedia/News/2014/Pages/25Sept_CornerPostponement.aspx accessed October 29, 2014. 3

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Figure 3. Real AB, BC and ON average weekly earnings including overtime for all mining, quarrying, and oil and gas extraction employees, seasonally adjusted.4

Market access is another pressing issue affecting competitiveness in both oil and natural gas. On the oil side, the effects of the market access challenge are primarily felt through prices. Oil prices have declined by approximately 50 per cent since the beginning of 2014, and industry investment could decline by as much as 30 compared to forecast (Figure 4). The outlook for natural gas is also challenging, as Canadian gas continues to be displaced in traditional markets in eastern Canada and the US as new infrastructure is constructed to access US shale gas. The absence of access to new markets–particularly through the development of LNG– could constrain production by as much as 37 per cent by 2030 – the vast majority of the incremental growth will come from unconventional sources.5

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Source: Calculated from CANSIM Table 281-0063 and Table 176-0003. Derived from internal CAPP analysis.

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Figure 4. Crude oil prices.6

2. Strengthening Alberta’s Scientific Research and Experimental Development Tax Credit The increased cost profile of the industry, which is linked to increased production from unconventional sources, emphasizes the importance of investing in research and development (R&D) to bring innovations into mainstream extractive practices in Alberta. However, according to the Alberta Economic Development Authority, Alberta ranks 14 out of 15 in total R&D expenditures, and 13 out of 15 in Business R&D expenditures.7 In fact, in a recently released OECD report, Canada has tumbled out of the top 10 research and development (R&D) spenders since the 2008 recession, and has steadily ceded ground to more aggressive nations on a host of innovation measures. Countries that Canada handily outspent only a decade ago, such as Russia, India, Taiwan and Brazil, have all jumped ahead.8

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Sources: US Energy Information Administration, CME Group, and NGX. Alberta Economic Development Authority. 2013. Report on Competitiveness. Page 6 8 OECD Science, Technology and Industry Outlook 2014. 2014. http://www.keepeek.com/Digital-AssetManagement/oecd/science-and-technology/oecd-science-technology-and-industry-outlook-2014_sti_outlook-2014en#page474 7

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The key challenge with R&D investments in the energy sector is that the knowledge realized by one firm as a result of R&D investments spills over to other firms due to the competitiveness of the market. This applies to the discovery of oil and gas reserves in an area that subsequently draws other firms to the play, as well as innovations in extraction techniques that could be applied more broadly across industry. Horizontal drilling and fracking technologies are two examples of R&D innovations that have been widely adopted by industry and are credited with vastly expanding the reserve potential of the Alberta basin. It is the “non-excludability” of the spillover benefits of R&D investments in the oil and gas sector that justify the existence of programs such as the Scientific Research and Experimental Development (SR&ED) Tax Credit Program, which has been key to encouraging R&D investment in Canada. In 2007, the Federal Department of Finance released a report that found the Federal SR&ED tax credit generated a gross economic gain of $1.11 for every dollar spent on it, and a net economic gain of 11 cents per dollar. Much of this gain is attributable to the knowledge spillovers that accrued to other businesses and industry across the economy.9 The SR&ED is an especially important program for the oil and gas industry. Relative to other industries, oil and gas and mining has only 3.8% of the total distribution of direct R&D expenditure in Canada, which compares to nearly 53 per cent for manufacturing.10 However, at 8 per cent, oil and gas and mining accounts for disproportionately more SR&ED expenditures relative to R&D spending (compared to 45 per cent for manufacturing).11 This suggests that industry relies heavily on the SR&ED program to spur R&D investment. In fact, SR&ED is credited for helping advance the development and commercial viability of horizontal drilling and fracking technologies that are widely in use today. Through developments such as these, the oil & gas industry has evolved to become one of the most varied and technologically sophisticated industries in the world. However, changes to the Federal SR&ED program in 2012 have reduced the value of large company input tax credits by between 25 and 45 per cent.vii This change has substantially limited the ability for CAPP member companies to access the benefits of the program and invest in R&D activities.

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M. Parsons and N. Phillips (2007), “An Evaluation of the Federal Tax Credit for Scientific Research and Experimental Development,” Department of Finance, Working Paper 2007-08. Copies of Department of Finance working papers can be requested at http://www.fin.gc.ca/pub/pdfs/wp2007-08e.pdf 10 Government of Canada. 2011. Innovation Canada: A Call to Action. 2011 Review of Federal Support to Research and Development. Expert Panel Report. 11 Ibid.

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Further to this, Alberta has a number of limitations in its provincial SR&ED program that disproportionately limit access to the program for oil and gas companies. In order to address these challenges and incent R&D investment in the oil and gas sector to encourage much needed innovation in extraction and operational techniques, the Alberta SR&ED program needs to be revised to encourage easier access, be competitive with other industries and jurisdictions, and bread confidence amongst corporations that their decision to invest in innovation within the province of Alberta will result in a timely return on their investment. Tax Credit Limited to $400,000 Alberta provincial legislation limits the value of the refundable SR&ED tax credit to $400,000 per year, and does not permit corporations to claim any non-refundable tax credit for expenditures exceeding the annual limit (as per federal law). Currently, no other province in Canada imposes a similar spending cap on SR&ED. By instituting a spending cap, the government of Alberta is negatively influencing R&D investment decisions within the province, as many oil and gas companies likely spend in excess of $4,000,000 on SR&ED per year due to the large size of companies and capital requirements of the industry. Under the current framework, if a corporation incurs $20 million of SR&ED expenditures in Alberta in 2014, it will earn an Alberta SR&ED tax credit of only $400,000 (based on a maximum of $4 million of expenditures and 10% rate) and federal investment tax credits (ITCs) of $2.94 million (assuming a 15% federal rate) for a total of $3.34 million ITCs. In comparison, the same company in British Columbia would receive $2 million of provincial SR&ED (assuming no provincial cap on expenditures and 11% provincial rate) and $2.7 million in Federal ITCs, for a combined ITC amount of $4.7 million. After taxable portions are removed, for every eligible spend greater than the $4 million cap in Alberta, a company receives a $0.1125 tax credit, vs. a BC company which receives $0.1739. This results in a 54% lower return. The difference is even greater when comparing the Alberta program to its Saskatchewan equivalent, which returns $0.1943 for every dollar spent (or ~75% more). This issue is exacerbated as a result of trends towards increasing company size and capital requirements in Alberta’s oil and gas industry, the net effect is a lower aggregate available SR&ED credit per dollar invested in the oil and gas sector relative to other industries and provinces. Horizontal equity or neutrality of the tax system dictates that those in equal positions should be treated equality. The imposition of a differential SR&ED cap across provinces distorts R&D investment decisions and disproportionately disadvantages Alberta’s oil and gas industry relative to industries in other provinces.

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CAPP recommends that the Alberta government remove the annual SR&ED expenditure limit in Alberta, similar to the BC approach. Non Corporate Tax Structures. All provincial jurisdictions with the exception of Prince Edward Island have provincial SR&ED tax credit programs. With the exception of Quebec, the SR&ED legislation reflects the provisions of the Income Tax Act (ITA). The Alberta legislation, however, has one important exception. Paragraph 26.6(1)(d) of the ACTA does not allow the corporate partners of a general partnership to receive any allocation of Alberta SR&ED tax credits earned in the partnership. No other SR&ED tax credit legislation in the country imposes such limits on a general partnership structure. We believe this legislation continues to create a disparity between Alberta and other provinces, as well as between business structures within Alberta. Many companies house their operations in a partnership form for valid business reasons. This is particularly true in the oil and gas industry. Within the industry, R&D is not only costly but can be a risky endeavor that few corporations are willing to undertake alone. Additionally, the development of new oil & gas technologies often requires multi-disciplinary expertise that is simply not found within a sole corporation. Due to the complexity of these technologies, oil & gas corporations frequently seek to bring that expertise onboard by a partnership arrangement. Until 2007, BC imposed such limitations on general partnerships, but has since amended its Scientific Research and Experimental Development Tax Credit Program to allow for the flow through of BC SR&ED tax credits from a partnership to its non-specified corporate partners. We understand that Alberta Finance and Enterprise is concerned that allowing partnerships to claim the Alberta SR&ED tax credit will result in companies a “doubling up” of the $400,000 tax credit and/or receiving more than the $400,000 per SR&ED project, per year, in a non-associated situation. In the experience of our members, this situation would be highly unlikely since non-associated joint R&D rarely takes place in partnership structures. By making this change and allowing Alberta to treat general partnerships equitably, as they are treated in incentive programs in other provinces and at the federal level, we believe that Alberta will be in a better position to incent innovation while continuing to maintain a fair and competitive tax system. CAPP recommends that Alberta Finance allow corporate partners of a partnership to claim their respective share of the Alberta SR&ED tax credits. Alberta SR&ED Review In order to fully understand the benefits and ensure the program is as effective as possible, CAPP recommends that Alberta Finance conduct a review of the Alberta SR&ED program as it pertains to competitiveness with other provincial R&D programs, the economic and productivity benefits of the program, and its administrative efficiency.

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3. Municipal Competitiveness Strengthening municipal competitiveness is a key priority for our members, and is viewed as an outstanding commitment made by the province as part of the 2010 competitiveness review. To this end, CAPP has undertaken its own municipal competitiveness initiative and research report. A summary of the key findings and recommendations are discussed below. According to the Union of BC Municipalities, at $2,610, Alberta has the second highest municipal spending levels per capita (next to Ontario at $2,854) and the second highest property taxes per capita ($1,328) next to Quebec ($1,566) in Canada. Comparatively, British Columbia municipalities have the lowest per capita property taxes ($893) and among the lowest spending per capita ($1,591). Total real municipal expenditures in Alberta increased by 55 percent from 2006 to 2011. In contrast, Government of Alberta and Government of Canada expenditures increased by less than half this rate (18 percent and 12 percent respectively), and has increased well in excess of changes in population growth (11 percent). Similarly, total municipal taxes in Alberta increased by approximately 46 percent over this period. This translates into a 30 percent increase for each dwelling in the province. From a taxation perspective, between 2004 and 2012: •

Taxes on the non-residential sector have increased by more than the value of the assessment base, while taxes on residential and farmland bases have increased less than their respective assessment bases.

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The average non-residential to residential tax rate ratio for all municipalities increased by 50 per cent from 1.39 to 2.08.

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In rural and specialized municipalities (which is where CAPP members operate), the nonresidential to residential tax rate ratio increased more than 100 per cent (from 1.63 to 3.28).

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Total non-residential taxes increased by 229 per cent in rural and specialized municipalities, while the assessment base increased by 135 per cent. Conversely, total residential and farmland taxes increased by 68 per cent, yet the assessment base increased by 180 per cent.

Sectorally, major oil producing municipalities in Alberta (i.e. Wood Buffalo, Lac La Biche County, Bonnyville, Opportunity) impose average non-residential to residential tax rate ratios that are twice the provincial average for rural and specialized municipalities. These are higher than for all other major industries in Alberta (including forestry (2.6), industrial heartland (3.1) and agriculture (0.5)), and are twice the maximum allowed in BC.

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In addition to the tax rate differential, the municipal tax base for the oil and gas sector in Alberta is broader than for comparable provinces. Alberta is one the last jurisdictions in Canada to assess machinery and equipment (M&E). While M&E is assessed at 77 per cent of its value for tax purposes, this 77 per cent is fully taxable and represents approximately 23 per cent of the assessment base in rural and specialized municipalities. In British Columbia, machinery and equipment is entirely excluded from the municipal tax base, although approximately 25 per cent of what is assessed as machinery and equipment in Alberta is assessed in the BC industrial class. In Saskatchewan, M&E is subject to taxation only when it provides services to adjacent buildings, as such, resource production equipment at battery or gas handling sites is not assessable. These differences illustrate the competitive disadvantage that Alberta oil and gas producers experience relative to neighbouring producer jurisdictions. Applying current municipal assessment and taxation practice in BC and Saskatchewan to Alberta would result in annual competitiveness improvements of at least $386 million and $319 million respectively for the oil and gas sector on an annual basis. The challenges confronting the oil and gas sector from a municipal perspective arise largely as a result of a lack of accountability and transparency to the non-residential base. From a residential perspective, accountability is achieved through municipal elections, stakeholder engagement sessions and publicly accessible meetings on an issue-by-issue basis. From a non-residential perspective, municipal accountability requires more conscious effort. Unlike residents, businesses do not vote, which compromises their ability to influence municipal decisions and, correspondingly, their ability to hold local governments to account. Prior to the 1995 Municipal Government Act reforms, the existence of a 1.33 non-residential to residential rate ratio cap provided an institutional accountability linkage to the non-residential base from a non-residential perspective. Since that time the linkage has been eliminated and, although businesses may possess the ability to influence municipal decisions in other ways (e.g. presentations to council, participating in stakeholder engagement sessions and/or public relations/advocacy campaigns), there is no inherent direct accountability mechanism for non-residential ratepayers in the design and distribution of the property tax burden.

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CAPP recommends the following to alleviate the accountability and transparency deficit, and strengthen Alberta’s economic competitiveness: Municipal Competitiveness: • • • • • •

Prioritize economic competitiveness as part of the municipal government act review process Re-introduce a linkage between the residential and non-residential property tax rates in rural and specialized municipalities, and consider 1.33 to 2.00 as the starting range. Freeze rate ratios for rural and specialized municipalities already above the threshold to recognize existing practice and budget constraints. Establish a formal requirement for rural and specialized municipalities to consult with the major non-residential assessment base representatives in the municipality prior to raising non-residential to residential tax rate ratio. Adopt a province-led approach for assessing industrial facilities. This would serve to enhance independence, give assurance that assessments are free of municipal influence, and would promote consistency in the application of provincial legislation. Consider whether Machinery and Equipment (M&E) should continue to be assessed and, if so, review the 77 percent assessment approach for M&E and education tax exemptions in the context of the competitiveness of the overall assessment and tax burden of the oil and gas sector from a benefits perspective, relative to other provinces, and relative to other municipalities and sectors within Alberta.

CAPP_EDMS-#253663-V1-CAPP-2015AB-Budgetsubmission.DOC i

Government of Alberta. Department of Energy. Competitiveness. Available at http://www.energy.alberta.ca/Initiatives/1869.asp ii Government of Alberta. Department of Energy. Energizing Investment: A Framework to Improve Alberta’s Natural Gas and Conventional Oil Competitiveness. (2010). Available at: http://www.energy.alberta.ca/Org/pdfs/EnergizingInvestment.pdf iii Government of Alberta. Department of Energy. Energizing Investment Phase 2 Royalty Curves and Emerging Resources And Technologies (2010).http://www.energy.alberta.ca/Org/pdfs/RoyaltyMay27.pdf iv Government of Alberta. Department of Energy. Regulatory Enhancement Project. (2013). Available at http://www.energy.alberta.ca/Initiatives/RegulatoryEnhancement.asp v Government of Alberta. Department of Energy. Energizing Investment: A Framework to Improve Alberta’s Natural Gas and Conventional Oil Competitiveness. (2010). p 14. http://www.energy.gov.ab.ca/initiatives/1869.asp vi Government of Alberta. 2009. Alberta Natural Gas and Conventional Oil Investment Competitiveness Study. Stakeholder Briefing. P. 5. Available at http://www.energy.alberta.ca/Initiatives/1755.asp vii TSGI. 2012. TSGI Analysis of the Impact of the 2012 Budget on the SR&ED Program. http://tsgi.ca/news/tsgianalysis-of-the-impact-of-the-2012-budget-on-the-sred-program-posted-march-30-2012/

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