Breaking Down KP’s Suggested Diamond Valuation System

One of the key issues brought up for consideration of the Kimberley Process (KP) this year, was the suggestion to put in place a rough diamond valuation system. At its core, the idea is to find a way to determine if the values stated on rough parcels shipped internationally are reasonable. The suggested methodology proposes that rough diamonds be valuated based on converting known polished diamond prices into rough prices, taking into account manufacturers’ costs and margins.

Much can be said about the pros and cons of having such a system in place. I feel that an important component of this discussion is the “how,” not only because it is an unknown to most, but it can also stimulate a wider discussion on valuation.

Breaking Down Rough Diamond Valuation

A KP certificate includes a number of details, such as the names and addresses of exporter and importer, origin of goods and date of issuance. At the heart of the certificate are details about the exported rough diamonds it accompanies: the number of parcels; the diamonds’ HS code; the total weight in carats of the diamonds by each HS code; and their value in US dollars. The suggested methodology, commonly referred to as price reverse engineering, offers a system to check if the declared is dollar value is reasonable.

To do so, the following underlying calculation was devised:
The fair price per carat of a rough diamond equals the total price of its polished output, divided by its total rough diamond weight in carats less polishing costs and margin. Another way of stating it is:

Total Polished Price/Rough Carat Weight – Costs+Margin = Rough Price P/C

The proposed valuation system starts with tracking polished diamond prices on a regular basis and updating it constantly. The prices are actual transaction prices and not the asking prices found on the B2B trading platforms. This ensures that the price data is as close as possible to the prices manufacturers and polished diamond wholesalers are paid. Therefore, the data collection should ostensibly be what retailers and jewelry makers are paying for polished diamonds.

Together, the cost of manufacturing and margin are suggested to be 15%. Taking the above formula, let’s assume a 0.30-carat polished diamond that is manufactured from a 1-carat rough diamond and sells to retailers for $1,500 p/c or a total of $450: $450 / 1 ct – 15% = $382.50 P/C

The value of a 1-carat rough diamond that a $1,500 p/c 0.30-carat polished diamond is created from thus equals $382.50 p/c.

Another component in this process is understanding yield – the size and type of polished diamond that can be manufactured from a rough diamond. This is a somewhat tricky stage because polishing expertise comes into play here. However, most manufacturers, the largest for sure, know how to polish efficiently and on a grand scale, so variations are limited.

This leaves us with identifying the rough diamonds and sorting them. A valuation system of this kind requires a certain level of uniformity. Those who choose to participate in the system will need to agree, for example, on a certain way of sorting rough diamonds. This starts from identifying rough diamonds by size, model (shape), clarity and color, and then that sorters from all around the world be trained to sort the goods in the same way and according to the same protocol.

To those less familiar with rough diamond sorting, this usually means drawing a grid on a large writing pad, dividing the grid by size, model, clarity and color, and then placing diamonds in the right category. Another way of doing this is by using small, clear plastic dishes and boxes to sort diamonds. Either way, this is an essential part of rough diamond valuation and considered an art, no less. The importance of this stage cannot be undermined because it reveals the value of the rough goods.

Putting It Together

The two components, price discovery with its reverse engineering, and the sorting system, need to connect. To protect the inner algorithm, the reverse engineering calculation will be done centrally. The resulting rough diamond values per carat will then be assigned to each category in the sorting grid.

Local sorters, most likely government employees working at customs offices, will be trained at a diamond center – in Mumbai, Antwerp or Dubai – on the pre-formatted sorting protocol and learn how to sort rough diamonds based on this grid. After completing their training, they will be part of what is currently called LIVA – Local Intelligence Valuation Agency – in their country.

The expected practice would be that someone such as an alluvial diamond digger or a diamond buyer will arrive at the customs or diamond office to get a KP certificate and export his goods. Before issuing the certificate, the trained customs official would sort the rough diamonds and then multiply the value of each sort category by the weight of rough in that category. That outcome will be compared to the value the exporter gave the goods.

Snags & Solutions

The entire system relies on several principles:

• It is independent and objective
• It is applied in the same way everywhere it is used
• Reverse engineering is accepted as a tool to reach proper rough diamond valuation
• It is based on up-to-date polished diamond transaction prices
• It takes into account fluctuations in the market
• It has pre-defined rough diamond sorting protocols

If the idea is to battle undervaluation of rough diamonds when they are exported from producing countries such as Sierra Leone or Angola, the proposed mechanism makes a lot of sense. However, it does not address a number of potential problems. For example, what should a customs official do if a parcel is brought to be exported and the stated value of the parcel is lower than the value the system assigns to it? If the difference is small, should customs ignore the difference?

Conversely, what if the difference is big – how do you define a large difference, more than 5%? More than 15%? More importantly, if the difference in valuation is substantial, what then? Are the goods exported anyway? Is this reported in any way? This is something that needs to be worked out, the Diamond Office in Antwerp has already addressed similar issues, by the way.

Another issue that needs to be worked out is who picks up the tab for this operation. Should producing countries pay for the data collection, system, and training? Or should consumer countries foot the bill?

To be clear, there is a solution for everything, and countries where a meaningful quantity of rough is produced by the informal sector are the countries the proposed valuation system could probably serve best. After all, the KP was formed to prevent the trade in conflict diamonds. As such, it protects the integrity of the rough diamond supply chain. It is in this capacity that the rough diamond valuation system was suggested. Its aim is to help prevent wrongdoings in initial valuations that may shortchange producing countries that rely on royalties and taxes from diamonds. No doubt a noble objective.

Finally, if a wide reaching rough diamond valuation system is on the table, it is worth considering how it can be applied elsewhere, for example as an evaluation tool for manufacturers assessing rough before purchasing. Clearly a boon far reaching in its implications.