Opinion: Conversion of CCoWs to IUPKs – unresolved Issues Introduction

INTRODUCTION

It continues to be unclear when and in what circumstances Indonesia’s major coal producers will be able to convert their Coal Contracts of Work into Special Mining Business Licenses.

The long and unexplained delay in issuing the necessary enabling regulations may well indicate that the Government and major coal producers have been unable to reach consensus, as yet, on what would be minimally acceptable conversion conditions as far as both parties are concerned.

In this article, the writer will review some of the issues surrounding conversion of Coal Contracts of Work into Special Mining Business Licenses and why Indonesia’s major coal producers may be in a difficult position.

BACKGROUND

The Government has made clear that there will be no extensions or renewals of existing Coal Contracts of Work (“CCoWs”) once they come to the endof their current terms.

It has been reported that numerous CCoWs will expire in the next few years. According to the on-line news portal Bisnis.com, the expiring CCoWs include the CCoWs of PT Tanito Harum in 2019, PT Arutmin Indonesia in 2020, PT Kendilo Coal Indonesia in 2020, PT Kaltim Prima Coal in 2021, PT Multi Harapan Utama in 2022, PT Adaro Indonesia in 2022, PT Kideco Jaya Agung in 2023 and PT Berau Coal in 2025.

CCoW holders need to quickly establish their future legal right to produce coal from their existing contract areas once their CCoWs expire. Any continuing uncertainty in this regard will make it difficult for CCoW holders to raise new equity capital or obtain third party financing for their operations. Likewise, prospective buyers may be unwilling to enter into new long-term coal offtake and supply contracts if there is a “question mark” over the legal right of CCoW holders to continue producing and supplying the coal required to fulfill those long-term coal offtake and supply contracts.

As the only continuing legal right to produce coal, on a large scale, is going to be a Special Mining Business License for Coal Production and Operation (“IUPK”), CCoW holders are understandably very interested in converting their CCoWs into IUPKs and sooner rather than later.

The problems that CCoW holders face, in terms of converting their CCoWs into IUPKs, are twofold. First, there is the present lack of any clear legal basis for converting CCoWs into IUPKs. Second, there is the concern that the Government may seek to impose conditions on the conversion of CCoWs into IUPKs, compliance with which conditions may not be commercially realistic according to many CCoW holders.

The Government has repeatedly said that it will “soon” issue two new Government Regulations setting out (i) how, when and subject to what conditions CCoW holders may convert their CCoWs into IUPKs and (ii) the tax treatment that will apply to former CCoW holders once they convert their CCoWs into IUPKs (“New GRs”). The New GRs were supposedly in near final form and almost ready to be signed in the first week of January 2019. As of 15 March 2019, however, the New GRs had still not been issued.

It is only once the New GRs are issued that CCoW holders will have any assurance that (i) they can convert their CCoWs into IUPKs well in advance of the expiry dates of their CCoWs and (ii) the conditions for conversion of their CCoWs into IUPKs (including the tax treatment they will be subject to once they receive their IUPKs) are commercially realistic.

COMMENTARY

1.  CCoW Holders Presently Lack a Clear Legal Right to Receive IUPKs Now

1.1  CCoWs versus CoWs: Questions have been raised, including by former senior officials of the Ministry of Energy & Mineral Resources (“ESDM”), as to whether CCoW holders should receive IUPKs over their contract areas at all or if, instead, contract areas should be granted to State-owned enterprises (“BUMNs”) once CCoWs expire. The genesis of this public questioning of the entitlement of CCoW holders to IUPKs is undoubtedly to be found in the relative legal weakness of CCoWs, compared to metal mineral CoWs, when it comes to extensions/ renewals.

An early generation CCoW provides that: “Contractor may request BATUBARA at the appropriate time for an extended Operating Period for any Mining Area, if considered necessary in view of long-term marketing requirements and in view of the requirements for appropriation of Coal from any such Mining Area economic recovery. BATUBARA will give sympathetic consideration to such request and if it is agreeable thereto endeavor to obtain a commensurate extension of its Mining Authorities relative to the said Mining Area.”

By contrast, an early generation CoW provides that: “… this Agreement shall have an initial term of 30 years from the date of the signing of this Agreement [i.e., until 2021]; provided that the Company shall be entitled to apply for two successive ten year extensions of such term, subject to Government approval. The Government will not unreasonably withhold or delay such approval.”

The most that CCoW holders can really say is that (i) they have a contractual right to “sympathetic consideration” from the Government to any request for extension of their CCoW Operating Period and (ii) if they can otherwise make out the required economic case for an extended Operating Period but (iii) any extension is subject to the agreement of the Government. Further, the length of any Government agreed CCoW Operating Period extension is left wholly unspecified, thereby making it effectively a matter for the discretion of the Government. A CCoW holder would be very hard-pressed to make out a credible claim of breach of its CcoW rights if the Government was to either refuse an Operating Period extension application altogether or only grant a nominal Operating Period extension of, say, one to two years. Put simply, a right to “sympathetic consideration” from the Government is not worth very much in this day and age.

By contrast, CoW holders can say (and, indeed, have said with considerable justification) they are “entitled to two ten year extensions of their CoWs” and the Government is obliged to “not unreasonably withhold approval” of any extension application.

While the Government would have to think very carefully about the likely consequences, in terms of international arbitration, of refusing a CoW holder’s extension application, the risk to the Government of refusing a CCoW holder’s extension application is much less serious.

1.2  2009 Mining Law: Unfortunately for CCoW holders, their very limited contractual right to Operating Period extensions is not improved or strengthened in any way by Law No. 4 of 2009 re Mineral & Coal Mining Law (“2009 Mining Law”).

Article 169 of the 2009 Mining Law merely provides that (i) CCoWs (and CoWs) remain in effect until they expire and (ii) must be adjusted, other than with respect to State revenue, not later than twelve months after the 2009 Mining Law came into effect.

While it is generally understood that the drafters of the 2009 Mining Law always intended that CCoWs (and CoWs) would be replaced by IUPKs, the “uncomfortable” fact remains that the 2009 Mining Law does not say anything specific about CCoW holders (or CoW holders) being entitled to IUPKs.

The rights of CCoW holders to IUPKs have subsequently been dealt with, in a confusing, inconsistent and piecemeal fashion, in various government and ministerial regulations that are briefly summarized in Parts 1.3 to 1.5 below.

1.3  GR 77/2014: The first attempt to deal with the conversion of CCoWs into IUPKs was made in Government Regulation No. 77 of 2014 (“GR 77/2014”) re Third Amendment to Government regulation No. 23 of 2010 re Implementation of Coal and Mineral Mining Business Activity (“GR 23/2010”). Article 112(2) of GR 77/2014 provides that the holders of CCoWs, which have not been extended, may receive (without any auction requirement) IUPKs after their CCoWs expire. This, self-evidently, provides no comfort whatsoever to CCoW holders looking for legal certainty now, by way of converting their CCoWs into IUPKs and years before their CCoWs expire.

Article 112B of GR 77/2014 goes on to provide that IUPK extensions of CCoWs (and CoWs) may be applied for not more than two years and not later than six months before the relevant CCoW (or CoW) expires.

There is obvious inconsistency between Article 112(2) and Article 112B(2) of GR 77/2014 which is not at all helpful in terms of delivering the legal certainty sought by CCoW holders. In addition, Article 112B of GR 77/2014 does not seem to have been subsequently amended or revoked and, as a consequence, is now inconsistent with Article 72 of Government Regulation No. 1 of 2017 (“GR 1/2017”) re Fourth Amendment to GR 23/2010 (“GR 1/2017”).

1.4  GR 1/2017: GR 1/2017 deals with, among other things, extensions of IUPKs for coal (and metal minerals). To this end, Article 72 of GR 2017 provides that IUPK extensions may be applied for not earlier than five years and not later than one year prior to expiry of the relevant IUPK.

Unfortunately, however, for CCoW holders, GR 1/2017 is silent as to if and when the holders of CCoWs (and CoWs) may apply to initially convert their CCoWs into IUPKs.

Notwithstanding that GR 1/2017 does not expressly deal with conversion of CCoWs (and CoWs) into IUPKs, ESDM (which both supervises CCoW/CoW holders and administers the application of GR 1/2017) has previously been willing to interpret and apply Article 72 of GR 2017 (read in conjunction with Minister of Energy & Mineral Resources (“MoEMR”) Regulation No. 11 of 2018 re Procedures for Granting of Areas, Licensing & Reporting in Mineral and Coal Mining Business Activities (“MoEMRR 11/2018”) – see Part 1.5 below) as providing implied authority for the conversion of CoWs into IUPKs up to five years prior to the expiry date of the relevant CoW. ESDM has, however,apparently not been willing to adopt an equally generous interpretation of Article 72 of GR 2017 when it comes to the conversion of CCoWs into IUPKs. ESDM’s much more favorable treatment of CoW holders, when it comes to conversion of CoWs into IUPKs, is most likely attributable to (i) the urgent need, in 2018, to finally resolve the Freeport Indonesia CoW situation which was dependent upon Freeport Indonesia receiving an IUPK four years before the expiry of its CoW and (ii) de facto recognition of the much stronger contractual right of CoW holders, compared with CCoW holders, to extensions of their CoWs as outlined in Part 1.1 above.

1.5  MoEMRR 11/2018: At first sight,CCoW holders might seem to be able to derive some considerable comfort from MoEMRR 11/2018. Article 105 of MoEMRR 11/2018 provides that holders of CCoWs (as well as holders of CoWs) may apply for conversion of their CCoWs into IUPKs not earlier than two years and not later than six months prior to expiry of the relevant CCoW.

There are, however, various problems with MoEMRR 11/2018 and with Article 105 of MoEMRR 11/2018 in particular. First, MoEMRR 11/2018 is only a ministerial regulation that ranks quite low in the Indonesian legal hierarchy and may be amended or revoked at any time by MoEMR, thereby providing very little legal certainty for CCoW holders about their right, on a long-term basis, to convert their CCoWs into IUPKs. Second, Article 105 of MoEMRR 11/2018 is not consistent with the treatment accorded by ESDM to CoW holders which may convert their CoWs into IUPKs up to five years (not two years) prior to expiry of the relevant CoW. Third, Article 105 of MoEMRR 11/2018 does not provide any detail as to the conditions that CCoW holders must fulfill if and when they want to convert their CCoWs into IUPKs.

1.6  Assessment & Evaluation: Lacking the contractual “clout” of CoW holders and no longer automatically favored by ESDM in preference to CoW holders, CCoW holders need legal certainty, in the form of a Government Regulation at least, to assure them of their right to convert their CCoWs into IUPKs on terms no less favorable than those ESDM has recognized CoW holders as having to convert their CoWs into IUPKs. However, none of the 2009 Mining Law, GR 77/2014, GR 1/2017 or MoEMRR 11/2018 currently provides CCoW holders with the required legal certainty.

One of the New GRs, promised by the Government since late 2018, is meant to provide the legal certainty needed by CCoW holders in the form of a sixth amendment to GR 23/2010.

2.  Much Reduced Preferential Treatment for CCoW Holders

The contractual and regulatory difficulties that CCoW holders currently face, in terms of a clearly established right to convert their CCoWs into IUPKs well in advance of the expiry date of their CCoWs, could well be compounded by an increasingly ambivalent attitude, on the part of the Government, to the coal industry in general and to CCoW holders in particular.

As the writer has recently pointed out in another article, the Government may no longer see any very good reason to automatically favor the coal industry and CCoW holders over the metal minerals industry and CoW holders. Mainly locally-owned and politically well-connected, CCoW holders traditionally enjoyed a much closer relationship with and received commensurably better treatment from the Government than did CoW holders which used to be largely (although not exclusively) foreign-owned and often (but not always) without strong local political connections. This, however, is rapidly changing  with BUMNs, Regional Government-owned enterprises (“BUMDs”) and whollylocally-owned companies (“Local Companies”) becoming the majority shareholders in some of the largest former CoW holders including Freeport Indonesia. With BUMNs, BUMDs and Local Companies now dominating not only the coal mining industry but also increasingly the metal mining industry as well, the previously obvious distinction between CCoW holders and CoW holders, in terms of which were the more loyal supporters of the Government and, therefore, the more deserving of preferential Government treatment, is likely to be becoming increasingly blurred as far as the Government is concerned. The writer would suggest that the Government’s changing attitude to the coal industry in general and to CCoW holders in particular is evident from numerous recent developments including:

(a)  more rigorous collection of taxes and non-tax State revenue from coal producers compared to the previous situation in which coal producers often received surprising latitude from the Government in terms of payment of the taxes and non-tax State revenue due from them;

 (b)  the cancellation/revocation of the CCoW of a party which granted a security interest over its mining rights in breach of the applicable laws and regulations, something that had not previously happened to any CCoW holder;

(c)  the 2018 introduction of a hugely preferential and what was then well below market ceiling price for coal supplied to the State electricity company in satisfaction of the domestic market obligation (“DMO”);

(d)  increasing the DMO quota for 2019;

(e)  the early 2019 increase in the non-tax State revenue rate for coal; and

(f)  growing Government insistence upon coal producers carrying out local value activity.

The apparently changing attitude of the Government to the coal industry in general and to CCoW holders in particular is, however, an ongoing and somewhat uncertain process at best. Accordingly, it remains to be seen what will be the end result.

3.  Possible Conditions to CCoW Conversion

3.1  Preliminary Remarks: One of the implications of much reduced preferential Government treatment for CCoW holders is that CCoW holders should expect the Government will want to impose conditions on theconversion of CCoWs to IUPKs that are substantially the same as or at least similar to the conditions the Government has imposed on the conversion of CoWs to IUPKs.

PT Freeport Indonesia (“Freeport Indonesia”) is the most high-profile example of a former CoW holder which has converted its CoW into an IUPK. Accordingly, CCoW holders should be looking very closely at the conditions imposed on Freeport Indonesia as, arguably, providing the best presently available guidance to what the New GRs may well provide for in terms of the applicable conditions that must be accepted by CCoW holders before they can receive IUPKs.

3.2 Limited Fiscal Certainty: It is already clear, from the Government’s remarks as to what the New GRs will contain, that CCoW holders (which convert their CCoWs into IUPKs) can only expect very limited fiscal certainty or so-called “nailed down tax treatment” which will be essentially the same as what Freeport Indonesia and the other CoW holders have received. The likely scope of this limited fiscal certainty is something that the writer has already discussed, at length, in his earlier article “Greater Fiscal Certainty for Coal Miners? – Maybe for Some”, which appeared in the February – March 2019 edition of Coal Asia Magazine.

3.3  Commitment to Local Value- Added Activity: In December 2018, Freeport Indonesia was obliged to commit to building a copper smelter within five years as a condition of receiving its IUPK.

There is nothing particularly surprising about Freeport Indonesia having to commit to build a copper smelter as the Government has, for a long time now, insisted upon most metal mineral producers carrying out full domestic processing and refining of their production before being able to export the same. It is important to bear in mind, however, that Article 102 of the 2009 Mining Law (“ML Article 102”) obliges coal producers, as well as metal mineral producers, to carry out local value-added activity.

To date, coal producers have been largely exempted from strict compliance with ML Article 102 in what may be seen as a good example of the Government’s traditional favoritism of the coal industry over the metal mineral industry. While some CCoW holders have (i) undertaken studies of coal gasification, coal briquetting and/ or other value-added initiatives and (ii) in some cases, even formed consortia with a view to building coal gasification plants etc., these initiatives have been essentially voluntary activities motivated by potential commercial opportunities rather than by Government insistence regardless of any associated commercial opportunities.

There are increasing signs though that, going forward, the Government will insist that coal producers in general and CCoW holders in particular carry out local value-added activity. To this end, both MoEMR and the Minister of Industry (“MoI”) have recently highlighted the importance of Indonesia’s coal producers carrying out local value-added activity whether in the form of coal gasification, coal briquetting or otherwise. Although MoEMR and MoI seemed primarily concerned with the contribution that increased local value-added activity in the coal industry could make to improving Indonesia’s economic growth rate, it is not hard to see ESDM soon insisting upon coal producers undertaking local value-added activity because this is what is required by ML Article 102 and whether or not there is any associated positive impact on Indonesia’s economic growth rate.

The writer noticed with particular interest the presence, at a recent coal industry conference, of well-known figures in the local coal mining industry actively promoting coal gasification as the “next big thing” for the coal mining industry. It may well be that Indonesia’s more astute coal producers have already “seen the writing on the wall” and realize that the local coal mining industry will no longer be allowed to avoid compliance with ML Article 102.

Having regard to the above, it would not be surprising to the writer if the New GRs make commitment to carrying out local value activity a precondition to CCoW holders converting their CCoWs into IUPKs. This would be entirely consistent with both (i) the Government’s insistence that Freeport.

Indonesia commit to building a smelter within five years as a pre-condition to receiving its IUPK in late December 2018 and (ii) the increasing difficulty the Government apparently has in seeing any good reason to distinguish between CoW holders and CCoW holders when it comes to favorable policy treatment.

3.4  Divestiture of Shares to BUMNs and BUMDs: More interesting still is the possibility that the Government might insist upon CCoW holders divesting or agreeing to divest, within a specified period of time, some percentage of their shares to BUMNs and/or BUMDs as a pre-condition to converting their CCoWs into IUPKs, just as was the case with Freeport Indonesia.

Given the CCoW holders are largely owned by Local Companies already, any Government move, in the direction of giving BUMNs/BUMDs shares in CCoW holders once they obtain IUPKs, would not be about enforcing the 49% foreign ownership limitation on production operation IUP/IUPK holders that have been in commercial operation for more than ten years. Instead, obliging CCoW holders to divest some percentage of their shares to BUMNs/ BUMDs would be all about giving effect to Article 33(3) of the Indonesian Constitution (“IC Article 33(3)”). IC Article 33(3) provides that:

“The land and water and all the natural resources contained therein shall be controlled by the State and shall be used for the greatest prosperity of the people.”

It is important to note very carefully that IC Article 33(3) refers to control  of Indonesia’s natural resources by the State, not to control of Indonesia’s natural resources by Indonesian Companies. In other words, merely because most CCoW holders are Indonesian Companies, rather than foreign investment companies, this does not mean that the contract areas or the coal resources/reserves in those contract areas, operated by Indonesian Companies as CCoW holders, are “controlled by the State” as a literal interpretation of IC Article 33(3) suggests is required.

“Control by the State” essentially means control by BUMNs/BUMDs. More importantly, Indonesia’s resource nationalists have increasingly equated“control by the State” with “ownership by the State”.

The Government’s growing commitment to control/ownership of the mining industry by BUMNs/BUMDs is very evident in the designation of PT Indonesia Asahan Aluminum (“Inalum”), a BUMN, as the party to acquire 51% of the issued shares of Freeport Indonesia in December 2018. It is, likewise, notable that Inalum will transfer 10% of Freeport Indonesia shares to a special purpose vehicle, PT Indonesia Papua Metal and Mineral, to be owned as to 60% by Inalum and as to 40% by a Papua BUMD. The Government has subsequently indicated that Inalum will now acquire a substantial shareholding in PT Vale Indonesia Tbk as well.

At a time of increasing resource nationalism in Indonesia and with Commission VII of the House of Representative pushing forcefully for full effect to be given to IC Article 33(3), it is not beyond the bounds of possibility that the Government might insist upon CCoW holders beginning the process of divesting at least some shares to BUMNs and/or BUMDs. The fact that CCoW holders are in a very weak contractual position, compared to CoW holders and with regard to the right to claim an extension or renewal of their CCoWs (see Part 1.1 above), might provide the leverage the Government needs to force CCoW holders to accept some divestiture of shares to BUMNs and/or BUMDs. This could be presented by the Government as just the “price” CCoW holders have to “pay” for IUPKs given they, very arguably, are not entitled to IUPKs as a matter of right and unlike CoW holders.

3.5 Reason for Delay in Issuing New GRs: It could well be that CCoW holder unhappiness with the IUPK conversion conditions proposed by the Government is what is delaying the issuance of the New GRs. To the extent advanced drafts of the New GRs may contain conversion conditions along the lines of those possible conditions outlined in Parts 3.3 and 3.4 above, CCoW unhappiness would not be hard to understand. At the same time, however, the Government may have determined it is unwise, so close to the April Presidential Election, for it to be seen to not be rigorously  enforcing ML Article 102 and IC Article 33(3) in the case of CCoW holders.

Increased political sensitivities around the April Presidential Election may mean that both CCoW holders and the Government have decided it is preferable to wait until after the April Presidential Election to settle the conditions for the conversion of CCoWs into IUPKs and then issue the New GRs. Once the April Presidential Election is behind us, CCoW holders could stand a better chance of using whatever residual influence they have with the Government to secure revisions to the New GRs before they are issued. At the same time, the Government will be more easily able to make an informed decision as to whether or not the continuing support of CCoW holders remains sufficiently important to justify at least some lastminute special treatment for CCoW holders and even if the overall influence of the CCoW holders is in decline.

CONCLUSIONS & SUMMARY

As CCoW holders wait to see how, when on what conditions they will be able to obtain IUPKs, they should be looking very closely at what the Government has given CoW holders in general and Freeport Indonesia in particular in terms of conversion to IUPKs.

Just as with their likely future tax treatment, it may be unrealistic for CCoW holders to expect any less onerous conditions on their right to obtain IUPKs than those conditions that Freeport Indonesia has had to accept in converting its CoW to an IUPK.

For better or for worse, the Government seems to be moving towards a “one size fits all” approachwhen it comes to large scale mining industry activity and regardless of whether that activity is in respect of metal mineral mining or coal mining. In the case of CCoW holders, it will be most interesting to see to what extent, if at all, they are obliged to accept any (i) firm commitment to carrying out local value added activity within a specific time frame and/or (ii) obligation to divest at least some shares, now or within a specific time frame, to BUMNs and/or BUMDs.

While the importance of the CCoW holders to the Government may be much less than it used to be, it would be unwise to assume that the CCoW holders do not still retain some influence with the Government. The ultimate form of the New GRs will, therefore, bea key “litmus test” of how significant or otherwise the residual influence of CCoW holders continues to be.

 

This article has been contributed by Bill Sullivan, Senior Foreign Counsel with Christian Teo & Partners and Senior Adviser to Stephenson Harwood LLP. Christian Teo & Partners is a Jakarta based, Indonesian law firm and a leader in Indonesian energy, infrastructure and mining law and regulatory practice. Christian Teo & Partners operates in association with international law firm Stephenson Harwood LLP which has ten offices across Asia, Europe and the Middle East: Beijing, Dubai, Hong Kong, London, Paris, Piraeus, Seoul, Shanghai, Singapore and Yangon. Readers may contact the author at email: bsullivan@cteolaw.com; office: 62 21 5150280; mobile: 62 815 85060978