Wednesday, October 16, 2013

The challenge with private development of mineral and energy resources

What is the most effective contractual framework for governments to appropriate "fair returns" from the allotment of natural resource exploitation rights to private parties? I think this is a question that deserves much more attention than it has got.

It is critical to effectively address the governance issues in natural resource exploitation contracts. This assumes great relevance for mineral resource rich countries, especially in Africa, whose relationships with mining and energy firms have been mired in allegations of corruption and exploitation. It is equally important for many developing countries seeking to enter development contracts with private firms to exploit their natural resources. 

This is not to say that things will be fine once we have effectively addressed contract governance issues. The effective management of the money generated from the contract would still remain a formidable challenge.

Evidently, the most relevant contract will vary based on context as well as sector. However, there are basically two broad questions. One, what should be the contractual form for sharing of profits between the private developer and the government? Two, should the price of the resource extracted be regulated or determined by a market-based (domestic or international) process of price discovery? If regulated, what should be the principles for the regulated price discovery?

Unfortunately, there exists considerable ambiguity, certainly no consensus, on any of these questions. The commonest form of development contract is different models of production sharing contracts (PSCs). There are broadly two types of PSCs - one where the entire capital investment made by the developer is recovered before revenues or profits are shared and another where the revenue/profit sharing (or royalties) starts as soon as production begins. In the former, the investment risks are borne entirely by the government whereas in the later those risks lie with the developer. In practice, most development contracts reside somewhere between the two extremes. Further, many of these PSCs also have an upfront signing bonus which is transferred by the developer to the government alongside the signing of the agreement.

In case of the least developed resource-rich countries, where developers often hold the upper hand in negotiations, the PSC is more likely to be skewed towards back-loaded sharing of returns. However, governments in larger developing countries prefer to front-load the extraction of their benefits, which in turn often ends up putting off the larger multinational firms.

Both these PSC's suffer from operational problems. The back-loaded revenues sharing PSC raises the question of valuation of the capital investment. Since the firm knows more about its investment decisions and governments have limited expertise to reliably assess investments made, the incentives are aligned towards the private firm gold-plating its investments so as to extend the investment recovery period. The front-loaded revenues sharing PSC often runs into problems of accurate estimation of the production output or its value, as firms try to under-invoice its production either directly or through abusive transfer pricing (under-invoice or charge lower prices in selling the output to its subsidiary) along the upstream of the production chain. Again, a mix of incompetence and corruption enables firms to game the process to its benefit.

Interestingly, in case of the energy sector, the development of oil and gas fields is mostly done or led by state-owned entities. Private participation is through strategic partnerships with the state-owned entity. This eliminates the need to enter into production sharing agreements. Indeed there are just a handful of cases where governments have invited private firms to exclusively develop oil or gas fields. The Government of India's allotment of the KG Basin to Reliance is a very rare example of such PSC with a private developer. It is no surprise that the contract has been mired in controversies.

In the US, where competitive market exists and regulatory and political uncertainty is minimal, most PSC's are front-loaded with a pre-defined revenue/royalty sharing and with a signing bonus as the bid/auction parameter. Much the same is true of other developed market. However, private developers would be reluctant to invest in many developing countries with such a PSC design given the large political and regulatory uncertainties with these countries. But any back-loaded PSC runs the risk of private profiteering and large-scale corruption, with attendant controversies and regulatory and political uncertainties.

This leaves us with the question of pricing. In this there is greater consensus that the price discovery should be left to the market mechanism. However, there are sectors like natural gas, which does not have a globally integrated market. In such cases, a market-based price discovery may not be possible nor be the most efficient option. Once price regulation becomes the most effective option, it begs the question of how the price should be calculated. Again the case of Reliance in India is instructive.

In any case, as the aforementioned challenges highlight, the issue of contracting private firms for the development of natural resources remains a minefield. And it is surprising how little attention is paid to the critical last mile issue of structuring the development contract. 

1 comment:

ashish anshumali said...

can u provide a Save As option to save ur articles