Making natural resource extraction an engine for sustainable development

Often, natural resource extraction (such as oil, natural gas or metals) has been a curse more than a blessing.  But it does not have to be always this way.  A number of countries have demonstrated that good management can contribute to sustainable development and well-being of their citizens.  For lessons on good management, study Malaysia (oil and natural gas) and Chile (copper).  For lessons on what to avoid, look at the case of Cameroon (oil).  Of course, there are many examples of in-between cases.

But let's look in more detail at the essentials for success.  Natural resource management should ensure that each of the three links of the decision-making chain is successful:

1.      Discovery and development;

2.      Capturing substantial percentage of the value of the extracted resources by the Government; and

3.      Investment of the captured (by the Government) value on productive assets, especially domestic investments which diversify the economy and contribute to sustainable development and long-term prosperity.

Failure of one of the links, breaks the chain irreparably. 

1. Discovery and development: The most critical aspect of the discovery and development phase is the role of information (knowledge).  Usually, resource extraction companies know more than the governments about the resource, both in terms of the amount of recoverable resource and the economics of development.  This is the case especially before any substantial exploration takes place.  As more exploration is carried out, information is generated not only for the specific location, but neighboring locations too.  For example, discovery of natural gas off-shore by Israel enhanced the likelihood for similar discoveries in Cyprus.  So, governments enhance their knowledge and improve their negotiating position with every new piece of information generated from additional exploration.  This may lead to the false conclusion that the longer a Government waits, the better deal it will strike.

The ideal sequence is for the government to start investing in pubic geological information and if possible exploration.  Then, share the information with all potential bidders.  This reduces the asymmetry of information between government and private companies, but also reduces the risk for the companies, as it provides them with information about the recoverable resource.  Both sides are in a better position to make a commitment (sign a binding contract). 

Of course, the world is not ideal; most often, governments can not invest in early exploration.  So, the appropriate strategy may be to auction plots gradually and sequentially; new discoveries add to the knowledge of the government and enhance the value of future auctions. 

When negotiating a contract, a commitment period of two-three years is typical, within which the private company should carry out the exploration and development.  A relatively short commitment period is important as the private sector may have an incentive to delay exploration too; if a company has the rights to explore an area, it may be best to wait for others to strike first in neighboring lots.  Of course, this is highly inefficient for both sides; reasonable commitments on both sides are needed at a reasonable time.

In general, balancing the rights of the public and the interests of the private companies is always a challenge.  As each case is different, striking the right balance is an art; balancing risks-rewards in a fair manner results in the most equitable solution.  In this process, information and knowledge are the most valuable resources.

Finally, it is important to mention that nearly all deals associated with discovery and development are Public-Private Partnerships (PPP), in the general meaning of the term.  For this reason, it is essential for the Government to have the capacity to design and negotiate PPPs.

2. Revenue capture: The design of an appropriate revenue capture system is complicated and politically sensitive.  Key aspects of revenue capture include: a) knowledge of the geology; b) ability to adopt to changing circumstances over time; c) revenue capture vehicle; and d) level of revenue.  Knowing the geology allows for accurate estimate of both the resource which could be extracted and the associated costs.  The difference between market price and production cost is an essential element for the design of the revenue capture system.  For example, if production cost is substantially lower than market prices, government rents could be substantial and independent of fluctuating market prices.  However, if production costs are high, the government may have to forego revenue collection in periods of low market prices and demand higher revenue when prices are high.

The design of the revenue capture mechanism should take into account that substantial changes are likely to occur in the future; new discoveries and substantial changes in world market prices are the most common changes.  A well-design revenue capture system allows for future adjustments.  Locking into a fixed system imposes undue risks and makes the deal less attractive for both sides in the long term.

Revenue can be captured through direct taxation of profits or a royalty system.  There have been cases, where the government established a national company which participates in ownership of the resource and the extraction business.  The national company could be subject to the same tax regime as private companies, but it can also build the national capacity to develop resources in general.  Most examples of national companies are outright failures, but there are a few cases demonstrating that the concept could be successful and highly beneficial.  Failures are characterized by inefficiency, corruption and inappropriate use of the revenues.  A successful example is Malaysia which staffed the national company with technocrats, who were protected from political and populists pressures by the prime minister; the staff showed commitment to their mission to benefit society in general rather than enrich themselves.  The company kept a smaller percentage of the revenues (compared to world norms) and invested in assets with long term benefits.

It is important for the government to have the capacity to audit the private companies.  When this capacity is not available within the government, it is essential to hire qualified auditors to monitor the performance and avoid the case of un-reported or under-reported revenues.

The level of revenue collection is impacted mainly by the differential between production cost and market price, as well as the government's strategy regarding the development of the resource (short-term vs. long-term focus).

3. Invest into productive assets, especially domestic investments which diversify the economy and contribute to sustainable development and long-term prosperity. Firstly, the balance between savings and spending needs to be settled.  This balance depends on the needs of the country; 30-70% savings rate is common.

Then, the type of investments need to be determined, especially with respect to domestic vs. international.  Domestic investments could have higher rate of return compared to foreign investments (especially in capital-scarce economies) and could transform the economy, if they are properly chosen.  International investments provide more liquidity.  The right balance requires careful evaluation.

In addition to the economic and financial aspects of resource extraction, it is essential to remember that the wealth generated is often a cause of violence both internally (within a country's political or ethnic groups, as well as organized crime) and with neighboring countries.  However, resource extraction has also proven to be a force for national reconciliation and social peace.

Last but not least, environmental damage needs to be kept to a minimum and any damage to society needs to be compensated.  The easy option is to ask the private companies to pay the full social costs, often directly to the affected populations.  However, private companies would tend to compensate the population in the immediate vicinity of the extraction operation and may ignore adverse impacts far beyond the development area.  So, the government needs to develop the compensation approach and possibly participate in its implementation.

In conclusion, natural resource extraction could become an engine for sustainable development and prosperity for a country, if the Government strikes the right balance between the interests of the public and private sector reflective of the risks and uncertainties.  Such balance requires specialized knowledge and a sophisticated organization which is able to determine the right timing for key decisions, design and negotiate appropriate contracts, and manage the wealth generated to foster sustainable economic growth for the benefit of its citizens.

 

P.S. Good reference documenting lessons learned from various countries: "Plundered Nations? Successes and Failures in Natural Resources Extraction" by Paul Collier and Anthony Venables.