The Role of Royalties in Resource Extraction Contracts

The manner in which governments charge mineral resource producers has been the subject of considerable debate. Income-based charges such as resource rent taxes have been advocated on the theory that royalties and other output-based charges create inefficiency by distorting production decisions. Using a principal-agent approach to resource contracts, separating asset ownership from asset use, we demonstrate that royalties can be efficient under conditions of certainty and also when there is uncertainty and asymmetric information. Royalties serve a key pricing purpose, signaling the marginal impact of extraction on the residual value of reserves and surrounding land or sea.