There are two interesting and important developments taking place on international and domestic coal markets. The first is the sharp increase in coal prices on the international market on the back of robust demand from China and India, while the second is the surge in domestic demand as the result of the fast-track program by state-owned electricity utility PLN to build coal-fired power plants with a capacity of 10,000 megawatts by 2010.
Coal prices began to take off at the end of 2003 when the Chinese government decided to ban coal exports in order to meet robust domestic demand.
China's position in the Asia Pacific market has changed from that of a net coal exporter to a net coal importer. Meanwhile, India has been following the same path. The country's thermal coal imports are expected to almost double from 27 million tons in 2006 to 50 million tons in 2010.
The very strong growth on the demand side cannot be fully met because of supply limitations in several coal exporting countries, such as Australia, at one stage the largest thermal coal exporter, and South Africa.
Thus, with strong demand and tight supply, the coal price has risen to some US$57 a ton -- which is much higher than its long-term average of below US$30 per ton.
In the domestic market, PLN's ambitious program to add 10,000 MW of coal-fired capacity by 2010 will create huge additional coal demand at home.
Answers are, however, needed to two important questions. First of all, how is PLN going to finance its expansion program? And second, where will the coal come from? The answer to the first question is probably more straightforward as PLN has already offered bonds to investors, the proceeds of which will be partially used to finance the crash program.
But the answer to the second question is less clear in our view. Traditionally, Indonesia has allocated 70 percent of production for export and 30 percent for the domestic market.
With high coal prices on the global market, we expect that coal companies will prefer to sell there rather than on the domestic market. And if this trend continues in the future, we are potentially going to see a market deficit in 2010.
There are already some concerns among Indonesian players that the government will impose some sort of export restrictions in order to meet the domestic demand.
Even if PLN intends to use low-rank coal (coal with low calorific content), which is available in abundance in Indonesia, but is not suitable for export, a question mark hangs over its economic justification given that low quality coal has a high moisture content, and therefore involves high transportation costs. The government's initiative in lowering the royalty rate to encourage exploration for low-rank coal will probably not be sufficient to cover the high transportation costs.
In our opinion, major investments will be required in order to be able to take advantage of the increasing demand from both the overseas and domestic markets.
But if we look at investment conditions in the coal sector, we will see that there have been no major new investments there for almost 10 years. The problem here, as usual, is the unsupportive investment climate.
There are several reasons why Indonesia's coal sector is unattractive: the royalty system, export taxes, the Value Added Tax problem and lack of legal uncertainty.
The royalty rate in Indonesia is higher than in other countries. This serves to reduce the country's competitiveness on the global market. For example, in Indonesia coal companies operating under Coal Contract of Work (CCoW) agreements are subject to a 13.5 percent royalty, while in Australia, China, and South Africa royalty rates are only 7 percent, 2 percent, and 0 percent, respectively.
The export tax, which was original intended to be imposed on the coal mining firms, has given rise to controversy as the coal miners operating under first and second generation CCOWs are not supposed to be subject to fiscal regulations other than those stated in the CCoWs.
Although the government revised the coal export tax before its implementation at the end of 2005, and totally revoked it in September 2006, we believe there are still some concerns regarding the government's seriousness about honoring contracts with the miners.
The taxation issue clearly reduces Indonesia's competitiveness in the coal export market.
Probably the most controversial move was the issuance of Government Regulation No. 144/2000, which states that unprocessed coal is a "non-tax subject". This regulation prompted a negative response from the Indonesian coal industry as it meant that firms could no longer claim VAT refunds after the implementation of the regulation, which means additional costs for the CCoW companies.
The Indonesian Supreme Court finally struck down the regulation in March 2004, but, again, the government's attitude towards first and second generation contract holders was called into question as these companies are not supposed to be subject to any other fiscal regulations other than those stated in their contracts.
Another issue that has become of major significance for the mining sector in general relates to forestry regulations. What is putting pressure on the mining sector is not only the technical aspects of the regulations, but also the present inconsistency in law enforcement.
It is not, however, fair to say that the government has done nothing to try to attract new investments to the sector. Indeed, the government has even started issuing third generation CoWs, which are, in our view, the most investor-friendly coal agreements issued to date as a result of lower tax rates, a better ownership structure and less stringent divestment requirements.
The government's initiative to lower royalty rates, while not overly encouraging, are a good starting point. But these efforts may be rendered ineffective should the government continue to adopt policies that confuse investors.
The government has to pay attention to the coal sector and adopt a comprehensive, long-term approach to dealing with the various shortcomings. After all, the industry has great potential given the high international coal price and strong domestic demand. These are good reasons indeed for the government to improve the investment climate in the coal sector.
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