Dear Secretary Jewell:

Taxpayers for Common Sense (TCS) is submitting the following comments for consideration in the scoping process of the Programmatic Environmental Impact Statement (EIS) for the federal coal program. TCS is a national non-partisan budget watchdog that has been working on behalf of the nation’s taxpayers since 1995.

Revenues received from royalties collected from natural resource extraction on public lands and waters represent an important source of non-tax income for the federal government. Fair assessment and accurate collection of royalties to ensure taxpayers are receiving a fair return has been a guiding principle for TCS for more than 20 years.

For this reason, TCS has tracked, monitored, and scrutinized actions at the federal coal program, sounding the alarm in testimony, reports, policy briefs, and in other communications with the Department of the Interior, Congress, and the public. The bottom line: In the existing system, our nation’s coal has been substantially undervalued, costing taxpayers billions of dollars of revenue.

The Bureau of Land Management (BLM) has given the coal industry effective control over much of the current federal leasing process, allowing practices that do not establish fair market value. The federal coal program lacks transparency, which only perpetuates the status quo. As a consequence, taxpayers have sustained decades of revenue losses from the sale of federal coal.

The BLM has the fiduciary responsibility to manage all natural assets, including federal coal, on behalf of nation’s taxpayers. The time for reform is now. Federal coal mining may increase with expanded demand for coal exports; if reforms are not adopted, the well documented problems of the federal coal program will cost billions more in lost revenue.

TCS welcomes the BLM’s review of the federal coal program. The review should ensure that leasing problems are identified and addressed so that taxpayers receive the fair return they are due.

Our comments focus on the following issues:

1.Leasing Process

2.Fair Market Value

3.Royalty Rates

4.Royalty Valuation

5.Royalty Rate Reductions

6.Reclamation and Bonding Requirements

1.Leasing Process

• The BLM must use the Programmatic EIS process to design a system of coal leasing that promotes competition among coal companies for federal coal leases. Competition is an essential part of any functioning market; without it, the program must compensate in various ways to achieve fair coal pricing. The lack of competition also leads to public skepticism that the federal coal program is not ensuring a fair return for these resources.

The leasing process generally used by the BLM does not obtain fair market value for taxpayers. Competitive bids are seldom generated, and studies indicate that the resulting losses for taxpayers are substantial. Congress enacted the Federal Coal Leasing Amendments Act of 1976 (FCLAA)[1] to require competitive bids and to specify that no bid may be accepted that does not represent fair market value. The act also established diligent development requirements to reduce speculation and to institute minimum royalty rates. BLM’s FCLAA implementing regulations[2] require the Secretary to delineate tracts for leasing from among those lands classified for coal leasing. Tracts are to be of a size the Secretary “finds appropriate and in the public interest and which will permit the mining of all coal which can be economically extracted…”[3] Tracts are then offered for lease at sales held either on the motion of the Secretary or upon the request of any qualified applicant. The Secretary must award leases by competitive bidding, except for certain sales expressly authorized to be negotiated sales.

Coal Production Regions. Federal coal lease sales have little resemblance to the process described in the BLM’s own regulations. A principal reason current practices fail to follow the rules is the BLM’s decertification of coal producing regions that form the cornerstone of the regulatory structure.[4]  Since the BLM concluded that there were no coal production regions in America, it has lost control of the coal leasing process. Decertification of coal producing regions short-circuited the full competitive system envisioned by Congress, eliminating the first step on which all other regulations depend.

Lease-by-Application (“LBA”). The LBA system eliminates the formal process by which the regulations anticipate BLM would set leasing levels — a process that involved extensive public participation and directed the consideration of many facets of the coal resource, uses of the public lands, and current and future market factors. Under the LBA system, the BLM allows coal companies to play a large role in delineating tracts for leasing — a process that typically results in tracts that do not generate competitive bids. The reason: The location and configuration of a given tract limit its appeal only to the one company that applied for the tract to be sold.

The BLM asserts that it does not simply accept a tract for leasing as described in an application, but rather uses: “… a wide variety of information, including geologic data that delineates the location, quality, and quantity of coal within a given area, to determine the most appropriate tract configuration that would encourage competition and help achieve maximum economic recovery of the resource.”[5]  Yet, most lease sales in the Powder River Basin (PRB) are for tracts adjacent to deposits already leased by a company.[6] Moreover, the tracts are often of a size or design that precludes another company from economically mining them and bidding on them. The evidence is clear: The BLM, instead of deciding whether there is sufficient demand for coal and designing tracts to maximize competition and economic value, defers to industry, which, in turn, avoids competition and designs tracts to maximize company share value and strategic positioning in the market. This assessment is confirmed in a market analysis report prepared for XCEL Energy by the John T. Boyd Company, a mining and geological consultant:

As a practical matter, most companies will attempt to define LBA tracts that, because of location or geometry, are of interest only to the nominating company. This minimizes competitive bidding on the tract, and may result in a lower cost lease. Where competition has existed for coal leases (mostly in the southern Gillette area but recently in the central portion of the coalfield) relatively high bonus bids in the range of $0.90 – $1.10/ton have resulted. BLM has, even in non-competitive cases, required “Fair Market Value” bids in this range, particularly in the Southern PRB.[7]

Relying on industry to “nominate” tracts for lease appears to conflict with the Mineral Leasing Act of 1920 (MLA), which provides applicants the opportunity to request a lease sale, not to delineate tracts.  Even though there may be little competition for a tract because of the limited number of mining companies, the BLM should be able to design competitive tracts attractive to at least two bidders if the agency exercised its own judgment.

Allowing coal companies to take the lead on delineating tracts sets up a vicious cycle: Offering tracts of limited interest results in sales with few bidders, which, in turn, justifies the avoidance of the competitive system.

Lease Modifications. The MLA allows the Secretary to modify an existing lease to avoid “bypass” coal – stranded coal formations that don’t offer sufficient quantity to be sold competitively on their own. The Energy Policy Act of 2005 expanded the amount of acreage that can be added to an existing lease by a lease modification from 160 acres to 960 acres – a size that might represent significant value to a company with equipment already in the area.

The Inspector General (IG) examined 45 lease sale modifications since 2000 and concluded that $60 million had been lost by those adjustments.[8] The BLM faulted that conclusion because the IG had valued the coal in the additional lease areas at the same rate as the main leases to which additional deposits were added. This conflict highlights the need for further review and guidance on valuing coal deposits, both for lease modifications and for maintenance tracts. The BLM argued that the coal should be valued at a lower rate because there was no competitive interest – one choice for valuation.  If coal is being added to an existing lease because it is by definition coal for which there is no competitive interest, determining its value to the company requesting it might be appropriate – a second valuation alternative.  The IG proposed yet a third alternative– valuing the coal at the same rate as the lease being modified.

2.Fair Market Value

• During the Programmatic EIS, the BLM should look for mechanisms that will introduce more transparency into the process of determining FMV for lease sales. The BLM should review the process in the State of Montana, which releases its FMV calculations for public review and comment before lease sales.

Because lease modifications and most LBA lease sales are not competitive, it is imperative that the BLM establish the correct Fair Market Value (“FMV”) for federal coal. The process of determining the FMV for a lease tract is shrouded in secrecy. The data and methodology the BLM uses to determine FMV are not publicly available. Bids are sealed. The public has no idea what the coal is worth or how it was valued.

In the absence of a competitive system, accurate determinations of coal values are critical to the revenues realized by the government. “Value” or “fair market value” enters into the lease sale and management processes at several points, and serves as the basis for evaluating lease sale bids and lease prices paid, which, in turn, influence coal prices and calculations of royalty revenues. Final lease sale values can then be used as comparable for estimating values of new tracts. Thus, when value estimates are low, it is possible to lock in a system of continuing undervalued leases.

The process of developing fair valuations for tracts, especially in a noncompetitive system, can be both difficult and controversial. Regulations, agency guidance, and state office practices affect how value and FMV are determined. Appraisals involve subjective valuations of the elements that comprise the value of a property. There are legitimate problems with attempting to apply the same valuation processes used for competitively bid leases to lease tracts that genuinely lack competitive appeal.

In the case of Montana’s 2010 lease sale of the state-owned Otter Creek tracts, the Montana Department of Natural Resource Conservation (DNRC) contracted with Norwest Corporation to prepare an appraisal of the FMV of the tracts.[9] Norwest used BLM’s Handbook H-3070-1, Economic Evaluation of Coal Properties, to calculate the value of the coal as $0.0539 per ton, or $30.8, million using the Comparable Lease Sales Approach. Using the Income Approach, Norwest placed the value at $0.0652 per ton, or $37.3 million. Norwest noted that these values were lower than similar federal lease sales because of the lack of existing mining equipment and rail service at Otter Creek. The DNRC released the Norwest valuation to the public and requested public comment in advance of the lease sale. The DNRC then used the appraisal and public comments to design a minimum bid package to secure fair market value for the coal leases. The winning bid by Ark Land Company, a subsidiary of Arch Coal, approved on March 18, 2010, was $85,845,110 – significantly higher than the initial appraised FMV. [10] Exposing all of this information to public review contributed to the higher bid the state received and certainly provided a more transparent process that could be used as a model for federal lease sales.

3.Royalty Rates

• During the Programmatic EIS, the BLM should consider increasing the royalty rate to 18.75 percent for federal coal production, as this royalty rate would ensure that the taxpayers are recovering a fair share of the market value of the resource and not favor one energy source over another. The federal government currently charges a royalty rate of 18.75 percent for offshore oil and gas production, and many states charge similar or higher rates for state-owned oil and gas.

The industry has argued at times that the taxes that coal companies pay to local, state, and federal governments should offset the royalties they pay for the right to mine and sell federal coal. Just because the coal industry pays taxes, like every other industry, does not mean it should not pay fair market value for federal coal. Private landowners charge royalties on the market value of private coal, in addition to whatever taxes the companies might pay.  Taxpayers, the owners of federal resources, should also charge market-based royalties.

4.Royalty Valuation

• The Programmatic EIS should consider a regulatory framework that gives the BLM and ONRR a more proactive role in determining the value of federal coal for the purpose of royalty calculation and the value of applicable deductions, rather than relying so heavily on industry-reported data. Transparency should be a priority in this process.

The process used to determine the value of federal coal for calculating a royalty is also done in secret, and is largely controlled by industry. The Office of Natural Resource Revenue (ONRR) released its final rule governing the valuation of federal coal on June 30.[11] The updated rule is certainly an improvement, but TCS is disappointed that well documented problems with coal valuation were not eliminated.  Numerous studies, including a recent report by the Council of Economic Advisers (CEA),[12] have demonstrated how coal companies manipulate the current valuation system to reduce royalty payments.  Valuation of the minerals is a key component of the leasing process.

ONRR will now use the gross proceeds from the first independent, or “arm’s-length” sale, of the coal to calculate royalties owed to the federal government. The changes will improve the system by ensuring that the value for royalty recovery in a non-arm’s-length transaction is established through the price set in sales between unrelated parties – the economic gold standard for establishing value in the market. However, ONRR made no changes to the valuation of arm’s-length coal sales–a significant oversight in the proposed rule.

Existing rules generally assume coal companies will sell coal at the mouth of the mine, technically a sale to an independent broker that transports it to consumers for resale. Especially in the Powder River Basin in remote parts of Wyoming, the “market price” is significantly higher than the price of the coal at the mouth of the mine, which may be located a great distance from the market. Calculating the value of the coal at the mouth of the mine instead of the market price leads to significantly lower royalties for taxpayers. By paying royalties at the mine mouth, instead of market value, it’s clear coal companies are paying royalties at a rate well below the royalty rate set in regulations or in the terms of individual agreements.

In its report, the CEA suggests coal valuation could be considered ‘’under a framework analogous to property taxes,’’ in which “the market value for coal should be based on sale prices of coal with similar characteristics, from both Federal lands and non-Federal lands.”[13] This concept was proposed at a congressional hearing by Dan Bucks, the former Director of the Montana Department of Revenue: “Interior can address these root causes if it returns to the plain language of the federal Mineral Leasing Act that calls upon Interior to directly value coal—just as a property tax assessor directly values homes and businesses. Instead of following the property tax model called for in the law, Interior has instead delegated initial valuation to companies through an income tax approach that opens the door to abuse and underreporting.”[14]

The final ONRR rule does not change any of the existing transportation or washing allowances for federal coal. This decision is problematic because existing rules discount the transportation and processing costs borne by coal companies, a system that artificially creates a disincentive for companies to reduce costs. In addition to removing the incentive for efficiency, deducting these costs is a complex endeavor requiring ONRR to review detailed cost information on complicated industry processing.

Here again, more transparency is the answer. TCS recommended ONRR consider an index price system for coal similar to the one used for oil and gas valuation.[15] The CEA suggested possible models using average coal prices, regionally or nationally, to set the value of federal coal. Similarly, transportation deductions, “can be based on easily observable indices of coal transportation costs per rail mile, rather than on self-reported cost numbers according to the CEA report.”[16] TCS also believes the deduction for washing coal should be eliminated. The deduction has proven susceptible to abuse and is generally a cost of doing business that should be borne by industry.

5.Reclamation and Bonding Requirements

• The BLM must review its bonding regulations and practices to determine whether current arrangements will adequately cover reclamation costs in the event of default.  Reclamation costs must be reviewed to keep pace with current development costs. And BLM must change self-bonding practices to ensure that companies have assets adequate to cover all unreclaimed leases.

The Surface Mining Control and Reclamation Act of 1977 (SMCRA) requires coal mining operators to restore all land affected by their operations and to post a bond to cover reclamation costs if they fail to restore the land.[17] With many coal companies financially stressed, the ability of BLM to implement the law’s bonding requirements, particularly in allowing “self-bonding,’’ is questionable.

In recent years, coal companies have qualified for self-bonding in ways that were not anticipated by the original self-bonding rules promulgated in 1983[18] by the Office of Surface Mining Reclamation and Enforcement (OSMRE), the regulatory authority created by SMCRA. Specifically, large coal companies have used the financial statements of subsidiaries to prove they have the assets available to cover reclamation costs.[19] The practice evolved from a provision in the original rule that allowed operators to post self-bonds using the financial statements of their parent companies. The idea was that a parent company’s financials would support any reclamation liabilities if a producer abandoned a mine. But the same analysis cannot be applied to subsidiaries.

SMCRA’s self-bonding option has proven inadequate to protect taxpayers for three reasons:

1.When a reclamation liability is bonded – whether by surety, collateral bond or self-bond — Generally Accepted Accounting Principles allow the related liability to be carried “off balance sheet.”  The reclamation liability is not shown on the balance sheet and does not increase total liabilities and the debt-to-equity ratio of the company.  As a result, the company appears financially stronger than if these reclamation liabilities were carried on the balance sheet. Off-balance sheet accounting is not a great concern when an independent surety company has analyzed the permittee’s ability to pay and put its own assets at risk or when the permittee has pledged specific, identifiable assets to secure its performance. In both cases, the liability can be satisfied even if other assets carried on the balance sheet become unavailable.  When a self-bond is used, the permittee avoids recording a balance sheet liability simply by making a self-serving promise and nothing more.  In effect, the permittee distorts the reporting of its financial position by eliminating a liability without affecting the asset side of its balance sheet or shifting potential liability to an unrelated third party.

2.The value on which regulators rely when companies self-bond is always subject to the volatility of the coal market. The circumstances most likely to lead to an inability of the permittee to pay reclamation cost – a drop in the value of mining properties and assets and a drop in profitability – generally render a self-bond inadequate. In addition, current regulatory requirements depend on financial statements to assess the financial health of companies. The assets are not market-to-market, which means that the balance sheet may reflect value that does not exist under prevailing market conditions.

3.Regulators, in theory, can require surety or collateral when a company’s financial performance deteriorates. But that remedy often is not practical because the company’s ability to secure third-party surety bonds or letters of credit evaporates rapidly. Similarly, liquid assets that might be pledged as collateral can be exhausted as the company experiences negative cash flow.  Moreover, the value of illiquid mining assets (the mineral properties and mining equipment) also declines.  In effect, in a coal market collapse, regulators depending on self-bonding will be unable to force a substitution of third-party guarantees or rely on company-owned assets to meet the liability.  Taxpayers are left to pay for the reclamation costs.

Finally, in the event of a bankruptcy, there is no requirement that a company’s promise to pay for reclamation costs through a self-bond will get any higher priority than other creditor claims. Frequently, the same assets used to signify the health of a subsidiary for self-bonding purposes are also posted as collateral to cover debt carried by its parent company. They are, in a sense, “double-pledged.” The difference between the pledges, however, is that the parent company’s creditors have claim to the assets in a bankruptcy while the regulatory agency does not.

Peabody Energy Bankruptcy. Peabody’s ability to increase its reliance on self-bonding as its financial health deteriorated represents a colossal regulatory failure. When Peabody filed for Chapter 11 bankruptcy on April 13 after years of losses ($2 billion in 2015 alone), the company held $2 billion in outstanding mine clean-up or reclamation liabilities, including $1.4 billion in unsecured “self-bonds.”[20] Between 2009 and 2015, Peabody’s off-balance-sheet reclamation liabilities increased from $1.6 billion to $2 billion.  At the same time, the portion of these liabilities secured by third parties decreased from $807 million to $592 million. Peabody’s self-bonded promises increased by more than $500 million.  As a result, Peabody went from self-bonding half of its reclamation liabilities to self-bonding two-thirds of them. Meanwhile, while these off balance sheet liabilities were rising, every indicator suggested that Peabody was a poor credit risk:

• Peabody’s already poor bond rating was further downgraded by both Moody’s and S&P in August 2013.[21]
• Peabody’s stock price dropped from $687 at the end of 2009 to $8 at the end of 2015.
• Long-term debt increased and shareholder equity declined. Peabody’s financial statement debt-to-equity ratio, which ignores the off-balance sheet liabilities for reclamation, rose from 165 percent in 2009 to 1100 percent at the end of 2015.[22]
• If self-bonded reclamation liabilities were taken into account, then Peabody’s debt to equity ratio for 2009 would have been 187 percent and for 2015 a staggering 1,256 percent.[23]

Peabody’s bankruptcy came after a string of other high-profile bankruptcy filings by companies such as Arch Coal and Alpha Natural Resources. In Arch’s bankruptcy proceedings, only $75 million of its $485 million in self-bonded reclamation liabilities were secured. Alpha Natural Resources was similarly approved to guarantee only $61 million of its $411 million in self-bonding obligations in bankruptcy proceedings.[24] Both companies’ remaining unsecured self-bonding liabilities, combined with Peabody’s $1.4 billion in unsecured self-bonds, means taxpayers could be forced to pay a whopping total of more than $2 billion in reclamation costs..

These bankruptcies did not come as a surprise, and it is obvious that these companies should not have qualified to self-bond their reclamation costs in the first place. With Peabody now bankrupt, it is clear that self-bonding practices should be reformed to protect taxpayers. For the last decade, Peabody Energy’s bond ratings have been “non-investment grade.”  Even as rating agencies were cautioning would-be bondholders that Peabody’s long-term ability to meet its obligations was “speculative,” the company avoiding setting aside assets for its reclamation liabilities by relying on its self-professed creditworthiness.

6.Royalty Rate Reductions

• The BLM should review its guidance and application of standards for the approval of royalty rate reductions during the Programmatic EIS. Reductions in royalty rates should be the exception, not the rule. According to ONRR data, almost half of the federal coal lease sales in the last 25 years received a royalty rate reduction.

The major amendments to coal leasing enacted in 1976 authorize the Secretary to, “waive, suspend, or reduce a rental, or minimum royalty, or reduce the royalty on an entire leasehold or on any tract or portion thereof … whenever in his judgment it is necessary to do so in order to promote development, or whenever in his judgment the leases cannot be successfully operated under the terms provide therein…”[25] Two essential MLA elements must both be met to qualify for a rate reduction:  1) the royalty rate reduction must encourage the greatest ultimate recovery of coal; and 2) the royalty rate reduction must be in the interest of conservation of natural resources.  Even if these elements are demonstrated, a rate reduction may be granted only when it is necessary to promote development or if the lease cannot be successfully operated under the lease terms. Royalty rates may be reduced to as low as two percent.

In practice, the BLM often grants royalty rate reductions. According to data obtained from ONRR, the BLM has often reduced the royalty rates on federal coal leases during the last 25 years. Of 80 federal leases in 9 states, 35 of them (44 percent) recorded royalty rates less than the minimum of 12.5 percent for surface mines and 8 percent for underground mines. More than half (16 of 28) of the royalty rate reductions occurred between 2001 and 2007. Some examples include:

• North Dakota: All 11 federal leases in ND of different durations, beginning in 1992 through 2013, received a royalty rate reduction. The average royalty rate for all 11 leases was 2.33 percent.
• Oklahoma: All six federal coal leases in OK of different durations received a royalty rate reduction, paying an average royalty rate of 3.39 percent on federal coal beginning in 1995 through 2013. One OK lease received a rate reduction of 10.5 percent (from 12.5 percent to 2.0 percent) in 1995, remaining at 2.00 percent through 2013.
• Colorado: Of the 19 federal coal leases in CO, 11 received at least one reduction in royalty rate during the period from 1992 through 2013.

The loss in federal revenue from these royalty rate reductions cannot be calculated from this data because the volume of coal extracted from the individual leases or the relative amount of coal produced on leases with reduced royalty rates has not been publicly disclosed. In a separate analysis of BLM data, Headwaters Economics estimated that royalty rate reductions have reduced total royalty payments by roughly $294 million on all leases sold between 1990 and 2013. Their report notes that these leases only accounted for roughly one-third of the amount of coal produced during this period, and that the remainder is from leases sold prior to 1990. If losses from royalty rate reductions are consistent with older leases, the total cost of reduced royalty rates is “closer to $860 million from 1990 to 2013, or about $37 million annually (in 2013 dollars).”[26]

The discretion to reduce royalty rates was granted as part of the Federal Coal Leasing Amendments Act of 1976 (FCLAA) because the legislation represented a significant increase in royalties at the time. Decades later, the justification for the royalty rate reductions no longer exists – the baseline rates have been in effect for almost 40 years and apply to many existing leases. Fairness to both taxpayers and industry competitors requires that the royalty rate be made consistent for all lessees.

At a minimum, the BLM could improve transparency by collecting data from the field on a monthly basis. Each month, each state office should report the number of royalty rate reduction requests it has received, the number of requests granted and the justifications, and the volume anticipated to be valued at the reduced rate.  In the past, the BLM has been reluctant to disclose any data because of lessees’ concerns about trade secrets. But these aggregate numbers would not disclose any confidential data about individual mines and should be made publicly available on BLM’s website. The data would provide an essential baseline for understanding the impact of royalty rate reductions upon taxpayer revenue, and would be consistent with the Department of the Interior’s Extractive Industries Transparency Initiative. The impact of policy decisions regarding rate reductions could then be evaluated based on publicly available data.

Conclusion

From the designation of lease tracts to the reclamation of abandoned mines, the federal coal program has long been the source of controversy for failing to ensure a fair return to taxpayers. Given that backdrop, itis appropriate for the Interior Department to reevaluate the process and to update policies that have not kept pace with today’s energy markets. The goal of this review should be to create a program that strives for transparency and fulfills the department’s fiduciary responsibility to wisely manage public resources on behalf of taxpayers.

Sincerely,

Ryan Alexander

President