How royalties are related to homemade pasta

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Before digging into the detail of royalties, it helps to understand what royalties are, and their purpose. An important starting point is that royalties are different than taxes , and they serve a different purpose.

Governments levy different kinds of taxes on different things — such as land (property taxes), the purchase of goods and services (sales taxes), and liquor and cigarettes (sometimes called “sin taxes”). When governments set these taxes, they generally do it based on how much money they need to pay for things like health, education and other public services. The taxes don’t have anything to do with ownership. (Government doesn’t own the cigarettes, but it taxes them.)

Royalties, on the other hand, are about getting value from selling something we own. On behalf of Albertans, the Government of Alberta uses royalties as one of two key mechanisms to collect the value of the oil, natural gas and oil sands resources that Albertans own. The other mechanism is how it sells the right to explore for and produce oil, natural gas and oil sands (known as “land sales”.)

Imagine this. You own a very special pasta-making machine. It makes some of the best pasta the world has tasted. Your plan is to start selling your pasta at the local market but ultimately sell it around the world and you plan to do this for 10 years.

There’s a couple of approaches you could take to do this. You could do it all yourself, assume all the risk, raise all the capital and take all the profits (or losses). Or you could licence your pasta-making machine to many business operators who specialize in food distribution, and negotiate a share the profits.

If you take the first approach and decide to operate on your own, you’ll receive a price for the homemade pasta you sell, which will be based on what people are willing to pay for it. If there are lots of other people also selling homemade pasta, this price might be lower at times. If there’s a homemade pasta shortage in the land, the price you receive might be higher than other times.

As owner of the pasta-making machine, you’ll realize value from the homemade pasta you produce and sell, which is different than price. The value is the price you receive for the homemade pasta, minus:

…over the entire 10 years you plan to operate.

If you take the second approach, and decide to licence the rights to a pasta company, you will still own the pasta-making machine but the pasta company will produce and sell homemade pasta on your behalf. The pasta company will be the one raising the capital to produce the pasta, incurring the day-to-day costs and risks, and receiving the price for the homemade pasta that is produced and sold on a day-to-day basis. However, as the owner of the pasta-making machine, you’ll still want to get the value of the homemade pasta your machine has produced.

Under this approach, you’ll need to determine the value of your machine and the homemade pasta that is produced and sold from it. You’ll also need to decide how you’re going to collect that value. That would likely include an upfront cash payment from the pasta company, and then some money based on how much profit the pasta company makes or a monthly payment based on how much you think the pasta company can afford or is willing to pay you before they’d decide to find another pasta-machine owner that charges less.

When it comes to energy production, Alberta uses the second approach. The Government of Alberta doesn’t directly explore for and produce Alberta’s oil, natural gas and oil sands resources. Energy companies do all of that on Alberta’s behalf. They drill for the oil and gas, they operate the wells and projects, they transport and sell the resources, and they aim to make money doing it. But the resources they are producing and selling are owned by Albertans, and these resources have value. Albertans receive a share of that value when the resources are produced and sold.

When the government sets royalty rates and holds land sales, the objective is to receive good value for Alberta’s resources while, at the same time, encouraging energy companies to invest in producing and selling those resources on Alberta’s behalf.

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