The Guide, which is a companion document to the IMF’s Code of Good Practices on Fiscal Transparency (2007), has been revised to reflect the new Code and to provide more recent examples of good practice by individual countries The Guide applies the good practices of the Code to the unique set of transparency issues faced by countries that derive a significant share of revenues from natural resources. It addresses issues arising both from the sheer size and volatility of such resources and the technical complexity of the transaction flows. The Guide supplements the Manual on Fiscal Transparency (2007).
The Guide, which is a companion document to the IMF’s Code of Good Practices on Fiscal Transparency (2007), has been revised to reflect the new Code and to provide more recent examples of good practice by individual countries The Guide applies the good practices of the Code to the unique set of transparency issues faced by countries that derive a significant share of revenues from natural resources. It addresses issues arising both from the sheer size and volatility of such resources and the technical complexity of the transaction flows. The Guide supplements the Manual on Fiscal Transparency (2007).
I. Clarity of Roles and Responsibilities
1. Much of resource revenue management hinges on the relationships between the government, national resource companies (NRCs), and international companies. These relationships must be clearly defined for all stages of resource development. Extractive industries can impact the economy or environment at any stage from exploration through to abandonment. Exploration is usually the highest risk element of any extractive industry project, though there is a difference in this respect between mining and petroleum,22 and substantial expenditure is generally required before a discovery is confirmed. Any government policies intended to encourage investment by international companies or using NRCs at various stages of development should be clear. In the petroleum industry, particular emphasis needs to be placed on clarifying the role of the national oil companies (NOCs). These still produce much of the world’s oil and often play a strong policy role relative to the rest of government. This chapter of the Guide examines the legal framework governing these relationships, the special nature of the fiscal regime for resource companies, the broad role of NRCs, including their noncommercial activities, and clarity of revenue sharing arrangements with lower levels of government.
A. Legal Framework for Resource Revenues 1.2.4/1.2.5
The government’s ownership of resources in the ground should be clearly established in law and the power to grant rights to explore, produce, and sell these resources should be well established in laws, regulations, and procedures that cover all stages of resource development.
The Basic Legal Framework
2. Legal title to the nation’s resources in the ground is established through the constitution and national laws, as well as subnational laws in some cases. The power to grant rights to explore, produce, and sell these resources should also be clearly established in laws, regulations, and procedures covering all stages of resource development. The legal framework needs to establish a basis for reconciling the divergent interests of key stakeholder groups, including the state; private investors; owners of surface land rights; parties that can be affected by the social and environmental impact of extractive industries; and civil society. In terms of fiscal transparency, particular emphasis needs to be given to the clarity of the framework for relationships between the government and (private) investors, since many transactions arising from these relationships have fiscal implications. Also, transparency of the legal framework provides an important safeguard for foreign investors and should help ensure effective use of the resources for public benefit. An increasingly important part of the legal framework is the establishment of laws and regulations that give assurance that revenues and accumulated assets are managed transparently through the budget process to achieve national objectives.
3. The constitutional foundation is an important factor, but constitutions differ significantly in the degree to which they:
recognize or guarantee private property rights or prohibit private parties or foreigners from acquiring property rights in general and mineral rights in particular;
vest the authority to grant mineral or hydrocarbon rights in subnational governments or agencies rather than the national government; and
vest the authority to regulate specific matters in special agencies in the executive branch (for example, taxation, foreign exchange, employment, environmental protection) or in the judiciary (settlement of disputes).
4. The legal framework should define which political entity and official has the authority to grant mineral or hydrocarbon rights and regulate their use. In most countries, the sovereign state is the owner of the resource and can grant rights to private parties. Often, this authority is exercised through a sector ministry, which is likely to have power over the application of relevant laws and policies, and the implementation of the government’s decisions on the pace of, say, petroleum sector development by making available areas for exploration, and granting licenses. In some countries (such as Azerbaijan, and Egypt), licenses are ratified by the legislative branch of the government,23 although this does not necessarily mean the contracts, or summaries thereof, are disseminated to the public. Given the typically significant macroeconomic impact of hydrocarbons in particular, national policy-makers normally prefer to retain authority at the national level (see discussion of subnational government authority further below).
5. Modern legal frameworks for resource industries tend to emphasize an environment that is open to domestic and foreign investors, while establishing clear state authority over all stages of development from access to blocks for exploration to production and site abandonment. Two central features of the framework in terms of transparency are: (i) avoidance of excessive complexity and opportunities for official discretion in implementation; and (ii) encouragement of disclosure of all fiscal and quasi-fiscal arrangements. Best practices for such legislation in this respect are: (i) standard agreements and terms for exploration, development and production, with minimum discretion for officials, though these terms may vary over time; (ii) licensing procedures are clear and open; (iii) disputes are open to (international) arbitration; and (iv) individual agreements and contracts regarding production from a license or contract area are disclosed. These practices are relatively standard in the advanced economies, and are increasingly an area of focus for resource-rich developing and emerging market economies. Application of these principles of transparency will be examined further, first with respect to licensing procedures, and then in relation to the fiscal regime.
6. Clarity and openness of licensing procedures are fundamental to achieving transparency during subsequent stages of development. Taking the petroleum industry as an example, licensing practices vary both in the complexity of terms and disclosure practices.24 They can be grouped in three broad categories in line with these criteria:
Open bid—fixed terms
7. Open tendering with clearly defined procedures and sealed bids constitutes best practice. A sealed bid license round with fixed terms is used in the United Kingdom, New Zealand, Ireland, Norway, and Australia. The royalties and taxes are not biddable, but set by law. Licenses are awarded on the basis of work program (or sometimes expenditure) bids.25 Timor-Leste, a new petroleum and gas producing country, has aimed at establishing open bidding internationally competitive processes at the outset (based on the offered work program). Bids received and final contract awards are disclosed publicly.26 Ultimately the seismic data and drilling data from the successful bidder will also become public.27 The United States uses open bidding for offshore projects, with relatively fixed terms, and publishes the bids and license awards, but allocates licenses on the basis of signature bonus bidding (that is, a variable term, as discussed below).
Open bid—variable terms
8. Some countries have significant variation in their terms. Licenses may be allocated in a sealed bid process based upon various bid parameters which might include such elements as work programs, bonuses, royalty rates, profit oil splits, cost recovery limits, and possibly even tax rates. As a general rule, corporate income tax is legislated and not a bid item. Disclosure of winning bids and contracts is an important element of transparency, although interpretation becomes increasingly complex with the number of bid parameters. Bidding rounds should be open to scrutiny by international observers.
9. Negotiated deals are characterized by the lack of sealed bids and a firm bid deadline, and, most often, considerable discretion on the part of the government agent (e.g., the Ministry of Energy or the NOC). Disclosure of winning bids is also not generally part of the process. Though some terms may be fixed, generally a wide range are subject to negotiation. Companies will make proposals to the government authority, which will ultimately award the licenses to those companies submitting the most competitive proposals. This approach can be fairly efficient but carries a greater risk of corruption. Good practice as far as disclosure is concerned would at least include ex post publication of contract awards and terms. Egypt provides an example of good practice in this respect: all contracts are made public, although licenses may be awarded either through negotiated deals or bid rounds.
10. In the current petroleum industry environment, many situations do not lend themselves to open tendering and competitive bidding. Most of the world’s geological basins have matured to the point that significant new discovery expectations are much lower than in earlier eras. International companies, particularly the smaller ones, are not in a position to invest in exploration or release ideas about prospects to either licensing authorities or competitors. An ordinary tender for bids in the early stages of exploration of frontier or gas-prone regions (see discussion of natural gas in Box 1 below), for instance, is thus likely to fail because of the high risks and up-front costs. Negotiated deals are thus common in these situations. Good practice for transparency, however, would require publication of all signed contracts.
Natural gas has become an increasingly important global energy source. It is attractive from an environmental point of view, demand is foreseen to grow rapidly, and supply appears adequate to meet the demand for several decades. Nonetheless, its development faces some unique difficulties, quite distinct from crude oil projects, largely because of its heavy dependence on costly transport infrastructure and the absence of a broad-based market price. Aside from the economic consequences of the nature of gas supply, these features pose particular difficulties for the establishment of a transparent fiscal regime.
Natural gas, which may or may not be associated with crude oil in a reservoir, is transported by pipeline or, as liquefied natural gas (LNG), by tanker. The application of gas-to-liquid (GTL) technology is increasingly seen as a viable alternative to LNG for processing of remote gas. LNG contracts raise different considerations than do pipeline gas contracts, which often involve multilateral negotiations over transit rights. Moreover, the LNG contract chain (production and liquefaction, transportation, and receiving terminal) can be broken down into independent segments, allowing financing to proceed on a modular basis. In the context of developed market economies in North America and Europe, deregulation aimed at encouraging competition in each segment of the gas contract chain, combined with increased trade of gas, appears to have been relatively successful, resulting in generally lower but also more volatile gas prices.
Much of the world’s natural gas reserves are considered “stranded” because remote locations, high transportation costs, and often high political risks make their exploitation commercially not viable. However, prospects of commercial exploitation of these “stranded” resources improve if gas prices rise and with technological progress progressively lowers the costs of LNG and GTL plants.
Location, combined with the lumpiness of investments and the interdependence of segments of the contract chain (for instance, except for the very largest companies, a production contract cannot be securely completed until the tanker transportation has been arranged), have tended to lead to an environment favoring negotiated deals rather than open bidding for contracts.
Where domestic consumption is an important element of natural gas projects, gas consumer prices should be based at least on full cost recovery—and preferably linked to international prices. Otherwise, quasi-fiscal subsidies of domestic use of natural gas will understate government activity, distort energy demand, and limit the attractiveness of the resource to private sector investors.
11. An often expressed concern with regard to open tendering processes is that both government and companies may lose their competitive advantage by public disclosure of winning contracts. For reasons of commercial confidentiality, therefore, negotiated contracts with nondisclosure clauses are the practice in a number of countries. The reason usually advanced by governments (and to some extent by companies) is that disclosure would erode their bargaining power for future contracts. In practice, however, the contract terms are likely to be widely known within the industry soon after signing. Little by way of strategic advantage thus seems to be lost through publication of contracts. Indeed, it could be argued that the obligation to publish contracts should in fact strengthen the hand of the government in negotiations, since the obligation to disclose the outcome to the legislature and the general public increases pressure on the government to negotiate a good deal.
B. Fiscal Regime 1.2.2/1.2.4
The government’s policy framework and legal basis for taxation or production sharing agreements with resource companies should be presented to the public clearly and comprehensively.
12. The high risks, high returns, and prolonged development of extractive industries mean that the fiscal regime for these sectors has many unique features, is generally complex, and, as indicated above, often has significant scope for discretionary arrangements in individual agreements. Ideally, a government will wish to establish a regime that is both attractive to potential investors and gains a fair share of resource rent. The fiscal regime should be clearly and comprehensively set out in government policy statements and incorporated in the resource and tax laws.
13. In the petroleum industry, apart from the substantial amount of production under direct state ownership,28 there are two broad types of fiscal systems used to determine shares of resource rent between the government and investors: (i) tax/royalty systems, in which companies are licensed to explore, exploit, and sell the oil, and are subject to a range of tax (as well as non tax) instruments; and (ii) production sharing contract (PSC) arrangements, whereby companies are contracted to extract and develop the resource in return for a share of the production.29 A number of other fiscal arrangements may apply to either regime. The PSCs may also embody some tax or royalty elements.30 And even under a PSC system, it is common for the contractor to pay corporate income tax under general tax legislation, either directly, or indirectly through a mechanism involving the state partner (usually the NOC). This practice has evolved largely in response to companies’ desire to receive foreign tax credits in their home jurisdictions. Either system can be designed to achieve identical ends with regard to revenue shares and risk-reward mix, and a fiscal regime may incorporate aspects of both systems. Although the greatest part of world oil production does not occur under PSCs, these have become the main system of choice for many developing countries, particularly those opening up new areas or remodeling their arrangements.31
14. Industrialized countries have tended to rely more on tax/royalty systems. As a rule, these countries build on the basic corporation tax regime, and so have a solid basis in general taxation law. Each type of system, however, poses transparency challenges, and the nature of the investment makes resource taxation complex. The main elements of tax/royalty regimes are described below. Practical approaches to assessing government/industry “take,” which aim at providing a summary indicator encompassing many aspects of the fiscal regime in the petroleum industry, are described in Box 2.
The Fiscal Regime and Government “Take”
Because of the complexity of country-specific fiscal regimes, a common approach to analyzing PSCs and other arrangements is to prepare a summary estimate of the projected overall division of rents between company and government resulting from all instruments. This is often referred to as the government “take” (see Johnston 2004 and Kumar 1995). Effectively, the estimation collapses all of the rent extraction mechanisms into the equivalent of a single cashflow-based tax taken over the life of the project.
Particularly for frontier regions following an initial discovery, very little information is generally available, and both government and company negotiators will necessarily build a variety of risk assumptions into the projections. After a contract is signed, however, provided that risks are clearly stated, an overall summary of the projections and relative take could be an important element of disclosure. Indeed, without a summary overview, disclosure of contract terms is likely to be quite difficult to interpret. Data on government take across countries and projects are relatively readily available in the industry, but their potential significance for transparency has been underemphasized.
A summary at this level does, however, have obvious limitations, as stressed by Johnston (2004). Among other things, a single statistic cannot capture the differing share of risks that may emerge from any particular fiscal regime, and coverage may not be comprehensive (e.g., quasi-fiscal activities (QFAs) such as the provision of social services through resource companies are often not included). Moreover, such data do not reveal differences due to the structure of the fiscal regime (such as presence or absence of ring-fencing) and the availability of home-country tax credits to foreign investors.
Better standardization of methodology would seem necessary to improve transparency. In this regard, the following should be considered:
Assumptions underlying the projections and estimates should be clearly stated.
Sensitivity of results to changes in key variables (e.g., oil price) should be shown.
Take should be shown in terms of discounted as well as undiscounted cash flow.
The effective royalty rate (or the minimum share the government may expect in any given accounting period) should be estimated.
Ex-post take estimates as well as ex-ante take projections should be made available to the general public.
Disclosure of take analysis results by company or field will encounter various legal barriers at the company level. Thus, for both technical and administrative reasons, implementation of such reforms may be slow. However, where take projections and estimates can be easily prepared, their disclosure could be a good prima facie indicator of transparency. Take projections and estimates, it should nonetheless be emphasized, say nothing about the relative profitability of fields and should not be interpreted as setting a negotiating standard. Rather, making such data available to the general public could form one useful element of overall disclosure, which, along with other measures, should help improve transparency of the fiscal regime.
15. The normal range of tax instruments can be applied to resource industries—and it is vital that the definition of the industry fiscal regime cover all instruments actually applied. Profitability and risk considerations will likely lead to special rates and an industry-specific, multi-instrument regime designed to meet the needs of government and the industry. In principle, the policies underlying such a regime should be stated openly to the public and the tax treatment of the industry should be subject to normal budgetary and public scrutiny. In practice, regimes lie on a wide spectrum. At one end, as envisaged by Cordes (1995), resource companies are subject to the same regime as other industries except for some form of additional profits tax (such as a “resource rent tax,”) geared to high profitability, and some form of royalty equivalent to ensure a minimum revenue flow. At the other extreme, various instruments and rates may be used in a case-by-case approach that attempts to optimize government returns relative to risks. The more complex and discretionary the system, the more difficult will it be to define the basic fiscal regime and achieve better transparency.32
16. At the best practice end of the spectrum, it should be possible to define the resource industry tax baseline regime as those normal taxes applied to all corporations, plus a few policy variations (royalties, additional profit tax) that form an integral part of the regime.33 Any special concessions beyond these should be identified and reported as tax expenditures34 For many countries, however, the regime itself is inherently complex and discretionary. The overriding transparency objective in such systems should be to move toward a clear definition of the fiscal regime, as well as reducing discretionary options.
17. In principle, and by definition, PSCs are individually designed and the general underlying policies may be less clearly described in government policy statements or laws. As a practical matter, however, governments (or NOCs) usually make contracts under powers granted by general petroleum legislation and frequently negotiate and base their contracts on some form of model contract.35 It is possible for parameters in such contracts to remain undefined and thus open for bidding or negotiation, and many important elements of contract language are subject to case-by-case adjustment. Publication of model contracts may thus be of limited value in defining the fiscal regime, unless governed by clear policy statements or limitations in legislation regarding the variability of contracts. Publication of actual contracts will provide more definitive information, subject to the constraints outlined under licensing procedures above.
18. The main parameters of PSCs are the cost oil retained by the contractor to cover cost, profit oil, which covers the remaining production, and an agreed formula for dividing profit oil between the government (and/or NOC) and the contractor. The latter may be fixed, or may be progressive according to production, price, or profitability criteria. Policy transparency would require that, where PSCs are the central instrument of the fiscal regime, all of the key PSC parameters should be available to the public in the same way as tax rates, exemptions, and deductions.
Other Elements of the Regime
19. Other elements that may be part of the overall policy framework include ring-fencing, indirect taxes, various forms of bonus and other nontax payments, fiscal stability clauses, and equity participation. These elements are discussed below.
20. Ring-fencing (a limitation on taxpayers’ ability to consolidate income or deductions for tax purposes across different activities, projects, or license areas) has important implications for revenue flows and investor incentives. Its absence can postpone government revenue flows, since deductions from new projects can be offset against earnings from current production. But ring-fencing, in appropriate circumstances, can also help level the playing field for new entrants to a maturing resource project. In the longer-term, absence of ring-fencing may yield higher government revenue by encouraging more exploration and development, at the cost of some additional risk to government revenue and some possible postponement of early revenues. From a transparency point of view, it is important that the government policies in this regard are clearly stated and that the system is applied in a uniform and open way.
21. Indirect taxes may also play an important role in the fiscal regime. Resource sectors are often treated differently from other economic activities either because of their special nature, or as a fiscal incentive to attract investors. Indirect taxes provide an important source of early revenue to the government, but are also used as an investment incentive. For fiscal transparency purposes, the costs of any incentives provided through indirect tax exemptions (including import tariffs on intermediate inputs) should be clearly recognized, whether as part of the overall fiscal regime or separately calculated as tax expenditures.
22. VAT refunds present special problems. As Sunley, Baunsgaard, and Simard (2003) point out, zero-rating exports under a destination-based VAT will lead to continuous net refunding to exporters, which puts pressure on weak tax administrations, particularly in periods of high investment. VAT exemptions for imported capital goods and other inputs to the industry are therefore used by a number of countries to avoid the administrative burden of refunding, although it is difficult, especially for weak tax administrations, to separate inputs used by the resource industry from those used in other sectors of the economy.36
Bonuses and Nontax Payments
23. Various types of bonus payment are used by many countries to collect early revenue from a project with little administrative effort. As indicated earlier, signature bonuses can be a key element of the fiscal regime at the licensing stage, and are an effective tool for generating revenue early on. Where projects are high-risk and license deals are primarily negotiated, however, such payments are likely to be implicitly offset by concessions elsewhere (a trade-off that may well be justified in terms of government risk management). Bonuses paid prior to project development thus may have some of the characteristics of oil-backed loans, with an implicit repayment through future favorable tax treatment. Disclosure of contract terms in some form is therefore a necessary part of transparency. Various other forms of nontax instruments, such as license, rental, or lease fees are also used, but generally these appear to be relatively minor components of the overall fiscal regime.
Fiscal Stability Clauses
24. Investors naturally want to get as much assurance as possible that they will not be subject to unfavorable changes in the fiscal regime. To meet this requirement, many project agreements include fiscal stability clauses. There are various forms of such clauses, such as “freezing” the tax system at the time of the agreement or guaranteeing the investor take by compensatory adjustments to tax changes (in production shares, for example.) On the one hand, such clauses can be administratively cumbersome and limit tax policy flexibility, although fiscal stability provisions can be designed to minimize the general tax policy impact. They also impair the parliament’s normal authority to pass fiscal legislation. On the other hand, they may be necessary in high-risk environments, and may increase the overall government take if they reduce investor risk premium. They may also make tougher policies elsewhere in the regime more acceptable than otherwise. At any rate, both the existence of such clauses and their potential implications should be clearly explained to the public.
C. Authority Over Revenue Flows and Borrowing 1.2.2
Fiscal authority over resource-related revenue and borrowing should be clearly specified in the law. Legislation should include a requirement for full disclosure of all resource-related revenue, loan receipts and liabilities, and asset holdings.
25. The budget process should handle resource-related revenues similarly to other government revenues, and any law governing the receipt of such revenues and appropriation for spending should be consistent with the law governing the government budget. In practice, it is often the case that laws governing company payments are first executed outside the finance ministry. For example, a royalty is usually imposed by petroleum or mining legislation and collected by the ministry or agency responsible for the legislation; similarly, an oil PSC is most often made either with the petroleum ministry or with the NOC. The ministry responsible for fiscal policy, however, should have a guiding influence on the level of such payments and the design of the overall fiscal regime. Moreover, resource industry laws should be consistent with general budget and tax laws.
26. To the extent that resource revenue payments are received by an NRC, a resource-related fund, or local governments, the rationale for such arrangements should be made clear. Good practice is that all such revenues should flow to the government budget before being appropriated for spending purposes.
27. Rights to borrow for public purposes should be under the authority of the finance ministry on behalf of the government. Receipt of such borrowings should be credited to a bank account under the control of the finance ministry or its treasury, with the balances credited, liabilities incurred, and terms of loans being fully disclosed to the public. The basis for transparency in this regard is, first, an adequate legal framework that specifies authority to borrow clearly and requires adequate disclosure and oversight mechanisms. Second, the legal framework must be adequately observed and oversight bodies should have adequate authority and capacity to administer the law. Borrowing or collateralization by an NRC should be similarly transparent, given the likely significant fiscal implications of such borrowings. However, in a number of developing resource-rich countries, practice often departs substantially from such standards: loans may be made on the basis of future production collateral, generally on a negotiated rather than open tender basis; the terms of loans are often not fully available to the public; and the authority for such borrowing may not be subject to the usual rules of financial management and oversight by the finance ministry and the national audit office.
28. Resource-related asset holdings should also be subject to clear rules for disclosure, regardless of whether they are held by the finance ministry, a separate resource fund (see below), or any other entity. Equally importantly, these assets should be considered as part of government’s overall financial assets, with changes considered as part of the overall fiscal balance (see Chapter III). To the extent that a full government balance sheet is maintained, the assets should be reported as part of the consolidated government balance sheet.37
D. Equity Participation 1.1.5/1.2.4
Government involvement in the resource sector through equity participation should be fully disclosed and the implications explained to the public.
29. As indicated above, direct government equity participation in projects to develop resource sectors is an important element of the fiscal regime in a number of resource-rich countries. Sunley, Baunsgaard, and Simard (2003) indicate that 18 of the 40 emerging or developing countries covered by their survey participated, or had the right to participate, directly in resource ventures. Maximum equity stakes in these countries ranged from 5 to 50 percent. Governments can acquire equity under normal commercial terms or through various forms of concessionary purchase, including tax swapped for equity, and so-called “free” equity. A common way is through what is called a “carry”—where the government “carried” equity interest is financed by private investors, but, after commerciality has been established, the government contributes to sunk project costs to a varying extent from its share of the profits or profit oil.38 In addition, some systems allow the government an option to buy into a project at the time of discovery. Generally, however, favorable terms for the government’s participation involve some form of offsetting reduction elsewhere in the fiscal regime. All such concessions and their costs should be disclosed as completely as possible.
30. If, as is commonly the case, the government has the right to take up a working interest through the NRC (in some cases paid by the NRC share of profit oil) or the resource ministry there should be full disclosure of the form of payment and ownership arrangement.39
31. Where the bulk of production is under direct state control, payments to the budget would occur as taxes and dividends or as other forms of income, including the proceeds from direct domestic and external sales of oil or any other resource products. Good corporate governance practice would require that NRC accounts statements should be available to the public and the policy on dividends should be disclosed. As discussed further below, however, few NRCs currently meet these standards. Compliance with EITI would require considerably more effort to apply these.
E. National Resource Companies 1.1.4/1.1.5
Ownership structures of national resource companies and their fiscal role vis-à-vis the resource sector ministry and the finance ministry should be clearly defined.
Commercial responsibilities should be clearly distinguished from policy, regulatory, and social obligations.
32. NRCs have become increasingly important players, especially in the oil sector.40 Government ownership and control of resources gained increasing importance in the 1970s, with an initial focus on nationalization and control of upstream activities. Subsequently, governments of both oil-exporting and oil-importing countries began creating national companies to promote downstream activity; one key aim of this was to gain control over petroleum retail pricing. This led to a rapid expansion of national companies’ role in setting petroleum policy, including the adoption of a variety of noncommercial policies usually associated with the government. The ability of these companies to attract available local (as well as international) expertise, and the greater flexibility of company structures, led in many countries to a corresponding decline in the quality and authority of traditional general government. Although in more recent years there has been a critical re-evaluation of the role of NOCs in recognition of their manifold weaknesses, they continue to have a powerful influence on policy in many developing and transition countries.41 As discussed under practice III C, there may be a case in some countries for considering a broad public sector balance including the NRC as a key indicator of fiscal policy.
33. Two issues that have a direct bearing on fiscal transparency for all NRCs are discussed in McPherson (2003):
Commercial and noncommercial activities should be clearly separated. Poor commercial performance may in part be attributed to poor governance and lack of competition, but the companies’ substantial role in promoting a variety of noncommercial/quasi-fiscal activities reduces managerial accountability for both types of activity. Provision of noncommercial services is primarily a government responsibility, and clarity of fiscal policy requires that the extent of such activities should be overseen by the finance ministry.42
Policy and regulatory roles vis-à-vis the sectoral ministry and the finance ministry should be clearly defined. These problems are minimized where these companies focus primarily on commercial activities.
34. Substantial reform of management of NRCs is needed to address these issues adequately. At the same time, better disclosure of the ownership structures of these companies and their subsidiaries is a central element of corporate governance.43 Such disclosures should include, if applicable, share participation of government officials and more general governance issues (e.g., composition of board, audit practices). The government’s policy and administrative roles usually need to be more clearly defined as well. Addressing capacity and institutional constraints in these areas is critical for reforming resource transparency and management in developing countries. The “Norwegian Trinity Model” provides one model of a clear definition of roles.44 In many ways, policy and administrative reforms are a necessary precursor to implementing improvements to many other elements of transparency and resource management, since most such improvements rely on establishing clear lines of accountability.
F. Quasi-Fiscal Activities (QFAs) of Resource Companies 1.1.4/1.1.5
Arrangements whereby international or national resource companies undertake social or environmental expenditure or provide subsidies to producers or consumers without explicit budget support should be clearly defined and described in the budget documents.
Economic and Social QFAs
35. State-owned enterprises and government institutions, as well as the central bank can undertake quasi-fiscal activities (QFAs).45 The existence of QFAs means that the budget gives a misleading picture of the actual extent of fiscal activity, and, as discussed above, leads to a confusion of responsibility between the government and state-owned enterprises. These issues are discussed extensively in the Manual but they are particularly relevant for resource-rich countries in which government responsibilities are transferred to sector agencies where both financial and managerial resources are concentrated.46 With respect to resource sectors, the main types of QFAs include:
Energy QFAs: requirements for NRCs to provide products (particularly energy) at less than cost recovery or market price for domestic consumption;
Public expenditure QFAs: requirements for NRCs or international companies to provide social services or other public goods normally provided by general government;
Employment QFAs: provision of employment in NRCs or related activities that go beyond what would be done if companies were run on a purely commercial basis; and
Borrowing QFAs: use of company leverage to borrow on behalf of government.
36. Energy QFAs cause market distortions and understate the size of government activity and the size of the budget deficit. In particular, providing energy at low prices represents an implicit, untargeted subsidy that invites over consumption and waste by households, enterprises, and other users, with a potentially large adverse environmental impact. Maintaining such subsidies leads to a misallocation of resources and risks the creation of an unsustainable dependence on continuing low energy prices. Such QFAs are prevalent in many energy-rich countries. The previous section has noted additional consequences in terms of reducing managerial accountability for both commercial and noncommercial activities.
37. Energy QFAs come in various forms and may involve international companies as well as NRCs. Generally, most important among these is, as indicated above, the provision of petroleum or other energy products through state-owned enterprises at nonmarket prices that, in some cases, do not cover even operating costs.47 Sometimes, de facto subsidies to consumers are even higher if energy parastatals tolerate the accrual of arrears by consumers.48 In the oil sector, a particular type of QFAs are what is called “Domestic Market Obligations (DMOs).” These often require (foreign) oil companies to sell a certain share of crude oil production domestically at below market price. Such arrangements should be disclosed as part of the government’s energy policy, which often also include administrative pricing rules for petroleum and other products. Energy QFAs due to low prices and the toleration of arrears can be very large. For example, implicit subsidies of petroleum products because of unduly low prices were estimated at 3.5 percent of GDP on average in 1999 for a group of 15 oil-exporting countries, with wide variations across countries. Some of the highest oil-related implicit subsidies were measured for Iran (17 percent of GDP in 1999-2001) and over 20 percent of GDP in Azerbaijan in 2000.49
38. Public expenditure QFAs involve national resource companies or international companies taking responsibility for services or public goods that are normally provided by general government. This may have been justified by government on the grounds that these activities represent a desirable partnership between companies and government to serve the needs of communities. In some cases, it is argued that a company is better placed to provide services to, say, remote communities than is the government.50 Moreover, companies themselves may feel that they enjoy benefits through better reception by the communities affected by the resource development.51 Such activities, however, are rarely reported clearly or comprehensively. The extent of government fiscal activity is thereby understated, which may also generate inefficiencies.
39. The main transparency point is that the extent of such type of activities and their justification should be clearly explained in the budget process. Budget documents should explain clearly the nature of the expenditures and how costs are shared between the government and companies—including through the tax treatment of such expenses.52 Coverage and explanations of QFAs in budget documents should be nondiscriminatory, i.e., relevant activities should be covered regardless of company ownership (private or state-owned).
40. The financing and provision of social services (e.g., local schools or health clinics), infrastructure, or other services for local communities may or may not be fixed in contracts between the government and individual companies. Such spending may be beneficial from a development perspective as it helps fight poverty and improve infrastructure, especially in regions and sectors where government implementation capacities are weak. However, it may also result in direct costs for the government (e.g., recurrent costs after the end of the mining project) and could distort overall public spending priorities.
41. To the extent that spending for such programs is cost recoverable or tax deductible by resource companies, the government is burdened with part of the costs for these activities. For instance, if 40 percent of all spending on social and community programs by a resource company project is tax deductible, the government effectively and implicitly subsidizes these activities to this extent through foregone revenue.53 A case in point is the “Infrastructure Tax Credit Scheme” for mining companies in Papua New Guinea. In recognition of limited implementation capacity of local governments to implement social service and infrastructure projects, it was agreed that licensed mining companies would finance and implement development projects (e.g., schools, health facilities, roads) up to a maximum amount (0.75 percent of the value of gross sales) and receive in exchange an income tax credit for these expenses.
42. Employment QFAs are similar in principle, but involve less easily defined costs and social aims. A fairly common example is the provision of employment opportunities in NRCs over and above what would seem required for commercially run enterprises. The requirement for national or international companies to provide training to local counterparts, hiring quotas as well as local content requirements can also be considered quasi-fiscal activities since they result in higher costs and hidden taxes for companies than under a pure market environment.54
43. Borrowing QFAs55 are equally an extension of NRC fiscal authority outside normal channels. The costs, however, are in terms of diffusion of financial management authority and hard to quantify. Such arrangements signify a need to clarify the relative roles of the national resource company and the finance ministry.
Environmental and Site Abandonment Issues
44. Extractive industries invariably have a significant impact on the environment. Environmental expenses differ from QFAs in that they are seen as a partial obligation of the resource companies because they are fundamentally linked to the production process. Nonetheless, at least part of these expenses will be tax deductible and hence the costs partially borne by the state; it is important that the level of expenditure on environmental protection be captured in fiscal documents and publicly reported alongside other public spending. Increasingly, these concerns are being built into general and industry-specific legislation as well as individual contracts. While, a decade ago, oil PSCs often did not include proper site restoration and cleanup provisions, these are becoming standard features.
45. In many respects, however, such issues are but one facet of the overall negotiations between governments and companies. Ownership of the resource ultimately generally rests with the government, and from a purely commercial company perspective, the cost of protecting the environment or restoring the site is both a government responsibility and part of the overall cost structure. For any company, this component must therefore be included in overall project costs and thus taken into account in profit calculations. The question is how such costs are shared between the company and the government, through cost recovery or tax deduction, and over what period of time. Socially, and environmentally, it is, of course, essential that such costs be clearly recognized and reported, and that steps to address the issues be built systematically into individual project design—with appropriate and efficient sharing of costs between the government and companies. In advanced countries, these factors are reflected in the legislation and applied through the general tax system and specific project agreements.56 though even in such countries, there is often scope to improve reporting on implicit state support of environmental spending through the tax system.57
G. Subnational Government and Resource Revenues 1.1.3
Arrangements to assign or share resource revenues between central and subnational levels of government should be well defined and explicitly reflect national fiscal policy and macroeconomic objectives.
46. The assignment of taxation powers and expenditure responsibilities to central and subnational governments should be based on stable principles and agreed formulae, which should be clearly and transparently formulated, and implemented as legally prescribed, in an open and consistent manner. These general requirements are particularly important in large, diverse, decentralized countries that have sizable oil or other natural resource revenues. At the same time, however, when subnational jurisdictions are fiscally important and enjoy a large degree of independence from the central government, it is a considerable challenge to establish a sound and transparent subnational revenue sharing system. This challenge is much greater in such countries when state and local government fiscal operations do not provide good fiscal data regularly and in a timely manner.58
Economic and Fiscal Policy Considerations
47. Economic theory suggests a number of reservations with regard to giving oil or other large natural resource revenue to local governments, in particular if combined with resource-related taxation powers. In practice, however, resource revenues are playing an increasing role in financing subnational governments worldwide. Assigning revenue to subnational governments is generally considered likely to improve accountability and the quality of spending because local governments can determine better than central governments the needs and requirements of their populations. However, the “resource curse” arguments advanced at a national level (see Overview) are likely to apply equally, if not more strongly, to weak subnational governments. From a macroeconomic and sustainability perspective, the most important argument is that a central government will be able to exercise the needed authority to strictly control spending and save windfall revenue.59 Another argument in support of natural resource revenue accrual at the central government level is the need for policy coherence; since energy sector policies are usually under the jurisdiction of the central government, government tax and expenditure policies related to natural resources should also be determined at this level.
48. However, despite such arguments, controls over resource revenue are often decentralized. In some countries, subnational governments own the natural resources.60 In others, constitutions or basic legislation require that natural resource revenue is shared with subnational governments, often reflecting political economy considerations.61 Measures other than direct revenue-sharing can be taken to balance centralization of resource revenue collection. For example, non-resource taxes can be assigned to subnational governments to provide them with some autonomy. Fiscal management and equity factors also generally require that a transfer system be put in place to address vertical imbalances between the central and local governments as well as horizontal imbalances across local governments (Ahmad and Mottu 2003).
49. Since natural resources tend to be distributed highly unevenly across regions, it is difficult to base horizontal revenue allocation on the “origin principle” as this would intensify regional imbalances. The following examples illustrate these difficulties. In Indonesia, implementing this principle would imply that five provinces would likely receive 80 percent of the local share in oil and gas revenue, while those in the remaining 25 provinces would each receive very little.62 In Argentina, three provinces (with only 3 percent of the population) produce nearly three-fourths of total oil output. Some similar factors apply in Russia, where the five oil-richest regions have only six percent of the population, but collect over 50 percent of all subnational government revenue related to natural resources63. In this last case in 2006, however, about 96 percent of oil revenues was assigned to the federal government. The case for equalization transfers into non-resource producing regions needs to be examined in the context of the overall assignment of oil revenues in each country.64
50. Existing revenue sharing systems can be categorized within a spectrum ranging from full centralization to full decentralization, with a variety of tax and revenue sharing arrangements in between.65 Also, revenue sharing can be applied (i) across taxes (e.g., assignment of all royalties to provinces in Papua New Guinea), (ii) on the basis of providing a share of all resource-related revenue, or (iii) on the basis of expenditure needs of local governments. While smaller countries tend to fully centralize oil revenue, larger countries, especially those with a federal structure, typically adopt some form of subnational revenue sharing arrangement (e.g., Colombia, Ecuador, Indonesia, Kazakhstan, Mexico, Nigeria, Russia, and Venezuela).66 Mexico has established a revenue sharing formula that has a broader revenue base, i.e., it includes not only natural resource revenue sources but also indirect taxes.
51. Generally, there appears to be a trend towards an intensified use of subnational revenue sharing, as is demonstrated for example in Indonesia, which changed from a centralized model to a decentralized revenue-sharing model in 2001. Other countries, including Papua New Guinea, the Philippines, and Nigeria also have subnational revenue sharing systems. In Bolivia, there is pressure to reverse changes to the hydrocarbon revenue allocation system, which were designed to give a higher revenue allocation to subnational governments, especially provinces that produce oil and gas.
Fiscal Transparency Guidelines
52. Clear rules and principles should guide whatever subnational revenue sharing arrangement is chosen. Moreover, tax powers, revenue sharing arrangements, and expenditure responsibilities should be based on stable principles and agreed formulae that should be developed and exercised in an open and consistent manner. These principles should not only include understandings between the various levels of government on the original arrangement, but also rules and procedures for modifying it. As regards the latter, Brosio (2003) has suggested the sound rule that as long as renegotiations of the subnational revenue sharing system take place, the original system continues to be in place and no party holding a stake should have a veto power to stop the existing system from functioning.
II. Open Budget Processes
53. Similar principles of transparency to those recommended for other parts of the government budget should apply to the processes for planning, allocating, spending, and reporting of resource revenues. The special features of resource revenue, however, require that governments give particular emphasis to policy clarity with regard to explicit treatment of risks arising from the resource base, transparency of accounting, and control of receipts and spending. In particular, the government should clearly explain to the public its policies toward smoothing the impact of volatile revenue flows and ensuring long-term fiscal sustainability. If savings or stabilization funds have been established, they should be fully integrated into the overall fiscal policy framework. All resource-related asset holdings should be fully disclosed and asset management policies open. This section covers these and other good transparency practices that will lead toward an effective application of fiscal policy in resource-rich countries.
A. Fiscal Policy and Resource Revenues 2.1.2/2.1.4/3.1.7
The budget framework should incorporate a clear policy statement on the rate of exploitation of natural resources and the management of resource revenues, referring to the government’s overall fiscal and economic objectives, including long-term fiscal sustainability.
54. Governments benefiting from large flows of revenue from exploitation of natural resources face a range of issues that need to be explicitly considered for fiscal transparency. First, revenues are subject to high and unpredictable price volatility, with potentially destabilizing budgetary and liquidity effects. Second, since the resources are finite, it is important to take into account alternative options concerning possible exploitation rates and the intergenerational distribution of income flows, as well as the distribution of spending and the immediate social impact of resource industries. Third, the economic impact of large inflows of resource revenues needs to be carefully considered in the light of possible “Dutch disease” effects, characterized by an appreciating real exchange rate and the associated adverse impact on the nonresource tradable sector of the economy.
55. A clear framework for government policy that recognizes all of these issues is an essential basis for design of an effective and transparent fiscal management system in resource-rich countries. The requirements in the Code for budgeting to be conducted in a medium-term macroeconomic and fiscal policy framework (practice 2.1.2) and for governments to publish a periodic report on long-term finances (practice 3.1.7) are therefore particularly compelling for resource-rich countries as they clarify the range of fiscal policy options arising from prospective resource revenues. Fiscal sustainability issues (practice 2.1.4) also need to be directly addressed, with a clear account of the sensitivity of the sustainability analysis to different assumptions about exploitation rates, export prices and other economic variables.
56. Development of a medium-term framework and long-term fiscal sustainability analysis should be within the capacity of all countries, although the depth of detail may be constrained initially by the capacity of the public financial management system. 67 For some countries, they may need to be implemented gradually.68 Elements that are particularly important for resource rich countries are:69
Establishment of a medium-term fiscal framework (MTFF), with a comprehensive statement of fiscal policy objectives, broad medium-term macro-economic projections (based on clearly stated and realistic assumptions), and aggregate fiscal targets;
Identification and regular analysis of major fiscal risks to the fiscal position and budget policy (including macro-economic risks, control risks, and contingent liabilities);
Regular reviews of long-term fiscal sustainability, focusing on resource production and price expectations;
An open process for setting budget spending priorities.
57. To ensure that the sustainability of fiscal policies is comprehensively addressed, the medium-term framework needs to incorporate all extrabudgetary funds, quasi-fiscal activities and tax expenditures. Such a framework is most effective in the context of a unified budget and the use of risk management strategies. Publication of the medium-term projections, including the policy and economic assumptions used in the framework, is crucial in helping the public to understand the future implications of current fiscal policies.
58. A medium-term fiscal policy framework and long-term assessments of public finances should assist in evaluating the implications of planned expenditures for future expenditure priorities and assessing the associated risks for sustainability. For example, both social entitlement and investment programs, which newly resource-rich countries might want to expand substantially, involve multi-year spending commitments and can increase budget rigidity. Also, while investment programs carry substantial implications for future recurrent costs, many resource-rich countries maintain capital budgets that are separate from recurrent budgets. Under such “dual budgeting” conditions, the planning and execution of each budget is separate, and the implications for later recurrent spending are not part of the decision making process. Linking annual budgets transparently to medium-term plans and priorities helps ensure that resources for capital and recurrent expenditure are not over-committed in the short term, allowing greater flexibility subsequently in responding to variations in resource revenues and other shocks. It can also encourage realistic appraisals of the impact of investment programs on economic growth.
59. OECD best practice guidelines suggest that a long-term report (10-40 year projections) assessing the sustainability of current fiscal policies be published every five years, with more frequent publication if there are major expenditure or revenue policy changes.70 For resource-rich countries, long-term reports should contain scenarios that allow for the return of commodity prices from transitory swings to longer-term trends. Because the longer-term horizon is subject to greater uncertainty, it is also important to provide appropriate sensitivity analysis showing the impact of different assumptions about economic variables, including the relative prices of commodities and alternative exploitation and taxation policies.
B. Fiscal Policy, Resource-related Funds and the Budget 2.1.5
Mechanisms for coordinating the operations of any funds established for resource revenue management with other fiscal activities should be clearly specified.
60. Many countries have established separate funds for resource revenues, either to channel resources for development investment or to promote saving to help address the stabilization and sustainability issues of large, volatile, and exhaustible revenue flows. Such funds need to be closely integrated with the budget, so that they clearly operate in a manner that supports the government’s overall fiscal policy and resource allocation. This requires that projections of transactions, and accounts giving details of actual spending by the funds, and their assets and liabilities, are presented to parliament as part of the budget process, along with standard budget reports and accounts. Funds should ideally not undertake domestic expenditure directly because of the dangers of generating a “dual budget” and reducing fiscal transparency. Resource-related funds are best managed as an integral part of the medium-term fiscal policy framework to help ensure that expenditure plans are set within a sustainable path. Stringent mechanisms should also be in place to ensure efficiency and integrity in the management of assets and use of resources and to provide assurances of transparency, good governance and accountability.71
61. Experience to date with stabilization and savings funds has been mixed. Two examples of countries with successful and transparent national funds are Botswana (for diamonds - see Box 3) and Norway (for oil). 72 The operation of the Norwegian Pension Fund - Global (NPFG, formerly known as the Norwegian Petroleum Fund) can be considered as best practice for a resource-related fund, as it forms part of a coherent fiscal policy strategy. The strategy has two central pillars: first, it aims at smoothing public spending over time and decoupling it from volatile oil revenue; second, it seeks to replace oil wealth with financial assets, which are expected to grow in value over time, so as to be able to deal with the expected increase in public spending associated with an aging population (Scancke (2003)). Importantly, Norway’s fiscal policy drives the operation of NPFG rather than vice versa. NPFG accumulates all oil revenue and returns on financial investments, and makes transfers to the budget only to the extent necessary to finance the non-oil deficit, which is determined by annual, medium-term and long-term fiscal policy objectives. NPFG is thus characterized as a financing fund; stabilization and sustainability objectives are achieved by fiscal policy, not by NPFG.
Botswana’s Prudent Management of Mineral Wealth
Diamond mining in Botswana started in the early 1970s, and the country has been a key player in the world diamond market since the 1980s. Diamonds are Botswana’s major natural resource, accounting for around a third of GDP, three-fourths of exports and over half of government revenue. Diamond mining is carried out by the private sector, but with significant government shareholdings in mining ventures, with foreign investors the other major shareholders. Mining agreements typically last for 25 years, and sales marketing arrangements for 5 years, providing a stable and reliable framework for investors and the government. By some estimates, Botswana’s government takes about 75 percent of diamond mining profits through taxes, royalties, and dividends. The tax legislation is considered transparent, relatively simple, and characterized by low tax rates (e.g., the corporate tax rate has been reduced to 15 percent).
Botswana has achieved strong real GDP growth over a prolonged period of time (on average, almost 9 percent since the 1970s), reaching a per capita income of $3,500 in 2000. Inflation has generally been low, and large fiscal and current account surpluses have been recorded in many years. Foreign exchange reserves have been rising to over $5 billion and despite some decline in recent years still amount to about 2 years of imports, while external debt is below 10 percent of GDP. Botswana has been awarded investment-grade sovereign debt ratings. Political and economic stability has helped greatly to attract substantial foreign direct investment across major economic sectors (Basu and Srinivasan 2002). Prudent policies have also helped in recent years to master external shocks such as a regional drought, a decline in diamond demand, and a significant depreciation of the South African rand, the currency of Botswana’s biggest trading partner.
Within a stable political system, Botswana has pursued broadly coherent and prudent economic policies over long periods of time, dealing effectively with large, variable diamond revenues, thereby avoiding the “resource curse” (Acemoglu and others, 2003). Mostly appropriate monetary policies have contained inflation and stabilized the exchange rate, helping avoid real appreciation and a loss in competitiveness (“Dutch Disease”). Fiscal policy has been the main tool for macroeconomic management. Public spending has increased strongly in many years, but these increases have not generally been excessive. Significant shares of diamond revenues have been saved over many years, adding to the country’s foreign exchange reserves and effectively sterilizing the liquidity impact of large external diamond revenue inflows. The government’s external reserves are managed prudently and transparently by the central bank and invested through the Pula Fund (80 percent) in long-term assets and the Liquidity Fund (20 percent) in the money market and short-term bonds.
Medium-term National Development Plans (NDPs) have been a key fiscal policy instrument for channeling diamond revenues into capital investments. The NDPs have some features of medium-term expenditure frameworks (MTEFs). They have generally been implemented in a disciplined fashion. Through public and private investments the country has significantly expanded its physical infrastructure. (e.g., roads, energy, health facilities, schools), although public investments have not always been good quality. Before the HIV/AIDS pandemic began to spread, remarkable progress in social development had been made. NDPs have generally been formulated with a view to maintaining a sustainable fiscal position, as measured by the “sustainability ratio” (Modise 2000, IMF 2004), defined as the ratio of non-investment current spending (excluding health and education, which are considered as investment in human capital) to non-mineral revenue.
62. While part of the explanation for Norway’s success with NPFG lies in the country’s historical strengths (a well established institutional framework, a long tradition of fiscal and central banking transparency, and a broad revenue base), other countries are setting up funds precisely because they lack such advantages.73 For example, Wakeman-Linn and others (2003) outline the political economy case that appears to have been behind the establishment of funds in Azerbaijan and Kazakhstan (and likely more generally) which quarantine resource revenues, to a greater or lesser extent, from the rest of the budget. Essentially, the argument is that a separate fund with clearly defined policy objectives can protect some portion of resource revenue more effectively from political pressure and potential waste and corruption than the government budget.74 Where the budget environment is nontransparent and administration is weak, such an argument has some merit, but such funds should still be integrated within a consistent fiscal policy framework—along the lines of the Norwegian model. This requires explicit procedural and operational rules, as discussed in the following section.75
C. Operations of Resource-related Funds 2.1.2
Operational rules applied to resource-related funds should be clearly stated as part of an overall fiscal policy framework.
63. Operational rules for resource funds should facilitate the process of meeting basic fiscal policy objectives through the budget. Aligning resource funds with general budgetary practices will reduce the risks of creating a dual budget through direct spending from a resource-related fund or undermining the transparency or efficiency of budgetary spending by earmarking revenues for specific purposes.76 Rigid operational rules - such as a requirement that a pre-determined share of specified resource revenues be deposited in the fund or that deposits or withdrawals be linked to the level of prices or revenues - can complicate, or at times conflict with fiscal policy.77 In all cases, the law governing fund spending should clearly specify the purpose and encourage parliamentary scrutiny.
64. Key procedural rules that should apply to resource fund operations include:
There should be a clear specification of operational rules and responsibilities over spending and borrowing by resource funds.78
The fund revenues, expenses, and balance sheet should be presented to the legislature and the public together with the annual budget, including a consolidated account.79
No monies should be spent directly from such funds; any use of such funds should be through the government budget and subject to normal budget appropriation processes.
Fund activities should be regularly reported to parliament and the public and externally audited by an independent auditor; and reports and audit results should be published.
An independent supervisory board should be appointed to give assurance of good governance.80
D. Fiscal Policy and Asset Management 2.1.2/1.2.5
The investment policies for assets accumulated through resource revenue savings should be clearly stated, including through a statement in the annual budget documents.
65. For resource-rich countries that are accumulating financial assets from savings of resource revenue, establishing a sound asset management strategy becomes an important element of fiscal policy. The strategy should reflect ultimate objectives, such as the relative importance of savings and stabilization, and macroeconomic considerations, such as the desire to avoid exchange rate appreciation.81 Clear investment guidelines that are available to the public should govern the separate asset management function, and fund managers should be accountable for investment performance. The guidelines should provide clear direction on risks versus returns, types of assets allowed for investment, and geographical and currency composition of assets. Asset management formulation should be in the hands of the finance ministry to ensure coordination with overall fiscal policies; and changes to asset management policies should be clearly and publicly stated. The operational management could be delegated to the central bank or tendered to professional investment companies. Norway again provides a best practice example in asset management of an oil fund (Box 4).
Norway’s Pension Fund-Global: Best Practice Asset Management
Norway has a well-formulated and transparent asset management strategy for its Government Pension Fund-Global. The Ministry of Finance bears overall responsibility for the Fund’s asset management, but has delegated the task of the operational asset management to the central bank (Norges Bank) based on a management agreement. The Ministry of Finance defines the strategy for investment by identifying a benchmark portfolio against which Norges Bank seeks to achieve the highest possible return. However, the Ministry of Finance also controls exposure to risk so that the actual return should remain within a range around the return on the benchmark portfolio. (http://www.norges-bank.no/english/petroleum_fund/management/strategy.html)
The benchmark portfolio is composed of stocks in the FTSE equity indices in 27 countries and of the bonds in the Lehman Global Aggregate bond indices in the currencies of 21 countries. Equities account for 40 percent of the benchmark portfolio as follows: 50 percent equities listed in European exchanges, and 50 percent equities listed in the Americas, Africa, and Asia/Oceania. The remaining 60 percent of the portfolio consists of fixed income instruments issued in European currencies (55 percent), American currencies (35 percent) and Asian currencies (10 percent).
Norges Bank has set up a separate wing for investment management (Norges Bank Investment Management, NBIM) which has separate business lines for the two asset classes. At the end of 2004 the NBIM relied on 19 professional investment companies to manage the equity portfolio of the Fund with 44 different mandates, while the fixed income portfolio of the Fund was managed by 16 investment managing companies with 21 mandates.
Annual and quarterly reports are published in a timely fashion, including on the central bank’s website (http://www.norges-bank.no/english/petroleum_fund). These reports provide detailed information about recent changes in the management of the Fund, transfers from/to the budget, market trends, returns on investments and income, trends regarding risk exposure, and administrative costs. In addition, the central bank regularly issues press releases, summarizing the fund’s quarterly financial performance. The Fund is audited by the Office of the Auditor General based on the work performed by Norges Bank’s Auditing Department.
66. The Norwegian example demonstrates how such best practices can be applied. In some other countries, political economy arguments have been used to limit public access to information on resource-related asset holdings.82 Such prohibitions are likely to limit transparency and governance. However, even where applied, they should not preclude giving adequate assurance to the public regarding overall asset performance, including comparisons of actual performance against pre-identified benchmarks.
E. Accounting for Resource Revenues 2.2.1
The government accounting system or special fund arrangements should clearly identify all government resource revenue receipts and enable issuance of timely, comprehensive, and regular reports to the public, ideally as part of a comprehensive budget execution report. The reports should be based on a clear statement of the accounting basis (cash or accrual) and policies.
67. Resource revenues should be accounted for under the same system and rules as other revenue and expenditure, with the accounting system based on a well-established internal control system. Best practice is provided by an accounting system that allows accounting and reporting both on an accrual and cash basis.83 This requirement is not easy to implement, considering that various types of resource revenues (e.g., signature bonuses, royalties, profit shares, corporate profit tax payments, indirect tax revenue) and recipient institutions (e.g., resource ministry, NRC, tax administration) may be involved. As a result, there may be a need for specific verification and reconciliation mechanisms and institutions.
68. In resource sectors such as oil, however, it may not be sufficient to use the existing accounting and internal control framework. It may be necessary to establish specific verification and reconciliation mechanisms and institutions to improve transparency in the flows of resource-related revenue. For example, as discussed in Chapter III, the EITI encourages governments and companies to use reporting templates that would ensure consistency and transparency in resource revenue flows between companies and host governments.
III. Public Availability of Information
69. The public availability of information on all resource-related transactions is central to fiscal transparency. Failure in this respect has been a continuing source of concern and has given rise to a number of international initiatives aimed at promoting greater public availability of these data. The EITI is a significant new initiative that promotes, on a voluntary basis, the publication of company payments to the government as well as resource revenue receipts by the government. Beyond current revenue transactions, however, it is important that the government reports adequately on spending of such receipts, on any debt or contingent liabilities contracted against resource collateral, on its resource reserves, and on QFAs incurred in association with resource developments.84
A. Budget Documentation of Resource Revenues and Spending 3.1.1/3.1.4
All resource revenue-related transactions, including through resource funds, should be clearly identified, described, and reported in the budget process and final accounts documents.
70. Governments may receive resource revenues through a variety of tax or equivalent instruments. Budget documentation should clearly classify resource revenue related receipts under the appropriate instrument. In some cases, some or all of those receipts may be directly placed in a resource fund. In other cases, such as the Norwegian Pension Fund-Global, all petroleum revenues and expenditures are recorded in the budget, and net proceeds are transferred to the fund. Thereafter, the necessary funds to finance the non-oil budget deficit are transferred back from the Fund to the budget.85 In other countries, such as the United Kingdom, the government receives all payments directly through the revenue authorities, and these are recorded against each type of revenue instrument. In the aggregate budget documents, such receipts are not separately identified, but detailed reports on such resource revenues by type of tax or other levy are regularly produced (in the case of the United Kingdom, by National Statistics.86) A basic principle in each case is that the tax payments are under the supervision of the relevant tax authorities, and all transactions are included in the budget (or related) analytical presentations. In advanced countries, well-established government tax administration and reporting and auditing procedures give credibility to reported data. Some developing countries also publish basic data on oil revenues in their budget documents. However, systematic monitoring and verification of data are often not adequately in place.87
B. Reporting on Company Resource Revenue Payments 3.1.4
Reports on government receipts of company resource revenue payments should be made publicly available as part of the government budget and accounting process.
71. Many countries rely on established government accounting and reporting procedures to provide reliable information to the public on resource revenue receipts—as well as spending. In principle, governments in all countries should move toward compliance with the relevant reporting standards defined in the Code, Manual, and this Guide, as well as the OECD Principles of Corporate Governance with reference to NRCs. However, the lack of capacity in many developing countries to move rapidly toward such standards is recognized. The EITI has initiated a model of standard reporting procedures to be agreed by a multi-stakeholder group in each reporting country that will help give assurance that revenue receipts from natural resources are fully accounted for.88 This initiative is aimed particularly at developing resource-rich countries where general revenue and budget administration controls do not currently reach good practice levels. For such countries, compliance with the principles for establishing reporting procedures set under the EITI for governments and extraction companies should represent a substantial step forward. Governments should also lift any confidentiality provisions that would impede reporting of resource revenue payments. It is important, in this context, to emphasize that there must also be adequate assurance of data quality, as discussed further in Chapter IV.
72. Under EITI provisions, the basic standards and procedures for companies and governments to follow in reporting resource production and revenue flows are as follows:
Regular reporting by host governments in line with a government reporting template agreed by a multi-stakeholder group;
Regular reporting by companies, including NRCs, in line with a company reporting template agreed by a multi-stakeholder group;
Wide dissemination of comprehensive and comprehensible material on payments and revenues.
Validation and publication of reports of aggregated data, and reconciliation and analysis, by an independent third party; and
Active participation by civil society.
73. The EITI reporting requirements are applied only to upstream activities (that is, all activities up to the first point of marketable production—wellhead or mine gate) and are designed only for extractive industries, such as metal ores, gemstones, crude oil, and natural gas. Reporting covers a set of benefit streams defined by the multi-stockholder group, which may not include QFAs. To accommodate government accounting practices, and to promote reconciliation among the parties to EITI reporting, all benefit streams are reported on a consolidated cash basis.
74. Although the EITI criteria and reporting requirements cover only a narrow range of resource-related fiscal activity, they provide an important framework around which governments and companies can build a credible reporting base. Establishing a government commitment at this level and agreeing with companies on compliance with EITI reporting requirements is an important first step towards the broader goal of transparent resource revenue management.89
75. Significant efforts are required, however, to apply the EITI mechanisms. By end-2006, although some two dozen countries had either made formal commitments to participate in the EITI, or indicated their intention to do so, some had not moved beyond an expression of interest. In future, a validation mechanism approved at the 2006 EITI Conference in Oslo will be used to determine which countries can be formally designated as EITI candidate countries (those who provide evidence of meeting four basic indicators of commitment), and which of these countries qualify as EITI compliant countries, having fully implemented EITI by meeting a series of indicators including the publication and distribution of a validated EITI report reconciling aggregated resource-related payments reported by companies with resource-related receipts reported by the government.
76. The four basic indicators required under the sign up phase of the EITI validation process (which designates a country to be of “candidate” status) are: an unequivocal public statement of commitment; an undertaking to work with civil society; appointment of a senior official responsible for EITI; and publication of a costed work plan. The second or preparation phase of the EITI requires, inter alia, that government removes obstacles to EITI implementation, agrees on reporting templates, ensures all companies will report, and ensures that both company reports and government reports are based on audited accounts to international standards. The disclosure phase requirements include submission of an EITI report to the validator (the independent organization contracted to confirm that the process has been properly conducted) showing all material oil, gas and mining payments by companies to government, and all material oil, gas and mining revenues received by government. The final or dissemination phase requires that the EITI report be made publicly available in a way that is “publicly accessible, comprehensive, and comprehensible.” Any discrepancies would be highlighted and appropriate follow-up action encouraged.90
77. A number of countries have taken steps towards full implementation of the EITI in advance of establishment of the validation process. Ghana and Guinea produced early reports on mining revenue collection and reconcilation. Nigeria and Azerbaijan were pilot countries for testing and evaluating the verification process and are now producing regular EITI reports. Cameroon, Gabon, the Kyrgyz Republic, and Mauritania have also produced EITI reports. 91
C. Fiscal Balance 3.2.3
The (primary) non-resource fiscal balance should be presented in budget documents as an indicator of the macroeconomic impact and sustainability of fiscal policy, in addition to the overall balance and other relevant fiscal indicators.
78. A central issue for countries rich in nonrenewable resources is how best to use revenue derived from the resource to promote a diversified economy and share the benefits with future generations. One approach is to treat resource riches as wealth, and only to consume the part of current revenue which is consistent with permanent income expectations (Barnett and Ossowski, 2003). To achieve such an objective, and therefore maintain a constant overall level of wealth (whether in untapped resources or financial assets) the non-resource primary fiscal deficit would need to be set equal to an estimate of permanent income from the government’s wealth (although this estimate may of course need to be adjusted periodically because of the difficulty of assessing the value of natural resource assets).92 In practice, the government might allow the actual level of the non-resource primary deficit to deviate for a period from the estimate of permanent income for macroeconomic reasons or because it decides to draw on some of its resource or financial wealth, perhaps to increase investment (human or physical). While technically difficult, this analytical framework can play an important role in better informing the public and politicians on the policy choices that impact on current and future generations and should be summarized in budget documentation.93
79. In resource-rich countries with widespread poverty, a decision to target a higher non-resource fiscal deficit for a period may in part reflect a wish to permit additional investment in schools, health clinics, and other basic infrastructure.94 The expectation would be that the resulting increase in human and physical capital would offset the decline in resource or financial wealth. However, the actual contribution of the new investment to improved growth prospects, and the timing with which any benefits are realized, are difficult to predict. They will depend on a range of issues including the quality and relevance of the investment, competitiveness, market structure, and economies of scale. Moreover, consideration must be given to the macroeconomic consequences in the short term. The accumulation of financial assets to ensure medium and long term sustainability therefore merits explicit consideration as an integral part of fiscal policy for resource-rich countries. If these assets are invested abroad, this approach can also help mitigate problems related to real exchange rate appreciation and Dutch disease.
80. Uncertainties notwithstanding, these considerations lead to the conclusion that the primary non-resource fiscal balance is an important indicator for measuring the direction and sustainability of fiscal policy in resource-rich countries.95 Estimates should therefore be prepared from resource revenue projections of an appropriate level for this balance and used as a basis for determining fiscal policy and spending levels. As Barnett and Ossowski (p 51) point out with respect to oil-producing countries, however, few highlight the non-oil balance in their budgets—and it is likely that a similar observation would apply to mineral-rich countries. With respect to oil-producing countries, the IMF increasingly includes measures of the primary non-oil balance in country documents, and advises country authorities to focus on such measures in budget and other fiscal policy documents.
81. Broader concepts of the fiscal balance may also be appropriate in countries where the NRC plays a large fiscal role. To the extent that NRCs have a dominant role in fiscal policy and carry out QFAs, there is a reasonable case for including them in a broad public sector balance or an indicator that consolidates with the general government all public corporations presenting fiscal risks for purposes of fiscal policy management. The general case for applying such a balance is recommended under practice 3.2.3 of the Code and described in the Manual. These considerations are particularly relevant for fiscal management in a number of resource-rich countries.
D. Reporting on Resource-Related Debt 3.1.5
The government’s published debt reports should identify any direct or indirect collateralization of future resource production, for instance through pre-commitment of production to lenders. All government contractual risks and obligations arising from such debt should be disclosed.
82. Open and timely disclosure of all contracted debt and contingent obligations is another essential element of public information.96 Such a disclosure provides an added assurance of transaction flow data—deficit/surplus data should fully reconcile with accumulated debt. Full disclosure of all liabilities and contingent liabilities is essential to assessing fiscal sustainability and setting medium- and long-term fiscal policy.
83. The extensive abuse in several resource-rich countries of borrowing by collateralizing future production is documented in Global Witness (2004). As noted in Chapter I, the legal framework should carefully define proper authority to contract such loans and require public disclosure of loan terms. But this framework needs to be supported by strong requirements for reporting by both borrowers and lenders. Clear standards for reporting debt are applied in many countries and this aspect is covered in the Manual. Governance and capacity issues must be addressed in those countries that do not at present comply with basic requirements in this regard. Measures are also needed to improve disclosure by the lenders who are involved in these transactions.
E. Reporting on Assets 3.1.5
All financial assets held by government domestically or abroad, including those arising from resource-related activities, should be fully disclosed in government financial statements.
84. The standard requirements outlined in the Manual apply to questions of disclosure of government financial assets. Two specific issues arise in connection with assets related to resource revenues in developing countries. First, such assets are often held in a separate fund with disclosure requirements that may differ from those of general government. Second, in many developing countries, and indeed a number of emerging markets and some advanced countries, requirements for disclosure of financial assets are not in compliance with the Code’s good practices.
85. Where assets are held in a separate fund, best practice (as in the case of Norway, see Box 4) is to set clear published guidelines for asset management and report on assets and asset management performance. Attainment of the basic elements of disclosure along these lines should be the goal of all countries—although the technical standards applied in advanced countries may not be achievable for developing countries in the near term. If assets are held simply as part of overall government assets, as is the case in the U.K., reporting on financial assets becomes part of the government’s overall financial reporting to the extent that reporting on financial assets has been established.97
86. Priority should be given by resource-rich countries to implementing appropriate practices for asset disclosure as soon as practicable. Tracking asset worth is a central element of a savings policy for long-term sustainability of fiscal policy. Some capacity building may be needed in this regard, but the benefits should greatly outweigh the costs.
F. Estimating Resource Asset Worth 3.1.5
Estimates of resource asset worth based on probable production streams and assumptions, should be disclosed.
87. If net worth of public assets is a central fiscal policy concern, an estimate of resource asset worth is a key input. As of yet, however, countries do not systematically include clear statements of estimated value of natural resources in their budget or accounting statements, reflecting measurement difficulties, uncertainty over physical volumes and prices, and the lack of current standards even for advanced countries.98 The practice suggested above, therefore, sets a very high standard, which will be difficult to implement even for industrial countries. This Guide therefore recommends a pragmatic approach toward implementing a basic standard for low and middle income countries with significant new resource discoveries—essentially building on effective revenue forecasting methodology and focusing on the government’s share of asset value (Box 5). An explicit calculation of resource asset worth will be an important step toward transparency, and will provide an important basis for long-term policy. Ideally, such calculations should be published in the budget documents. The high level of uncertainty associated with such estimates, however, suggests caution in publishing quantitative estimates, given possibilities of misinterpretation. Published documents should give assurance that fiscal policy is based on sound evaluation methodology, and progressively move to more detailed quantification as production becomes established.
Elements of Asset Worth Estimation for Developing Countries
Considerable uncertainties underlie medium-to long-term revenue projections of resource revenues, particularly for countries at an early stage of development of oil or mineral resources. Technical advice to countries in these situations has largely emphasized conservative approaches to forecasting prices and revenue,1 and building a detailed analysis of field-by-field production estimates and the applicable fiscal regime, while also explaining how the baseline price assumption has been determined. Such an approach can be extended over the lifetime of mines or fields and flows discounted to present value to give a working estimate of resource wealth that can be used as a basis for fiscal policy formulation.2 Fiscal transparency principles would require that these estimates and the underlying model and assumptions be published in the policy analysis document supporting the budget. Key elements of such an approach would include:
A clear statement of the principle of “asset recognition” (for instance, a conservative policy could be to include only those projects that have approved development plans and where a lease has been granted. As new developments proceed, these would be added to the economic asset inventory).
Technical production characteristics separately specified for each field or mine (these would be government estimates that would need to be periodically calibrated against actual company production).
Specification of the fiscal regime parameters and any exemptions applicable to each field or mine.
A sensitivity analysis to show likely changes in asset worth as a result of changes in key parameters, such as the baseline oil or mineral price.
1 Increasingly the focus has shifted towards using realistic price forecasts (i.e., central estimates).2 This methodology is suggested as a practical starting point. In commenting on the draft Guide, however, the International Valuation Standards Committee (IVSC) noted the importance of specifying the basis for valuing asset worth and strongly recommended the use of market value or at least fair value rather than investment value. IVSC Guidance Notes 14 and 9 provides detailed instructions for the derivation and use of market inputs for such discounted cash flow estimates. (See www.ivsc.org for further details in the context of the broad work on IVS)
88. In the longer-term, international standards for reserve estimates could establish relevant standards for country estimates of resource asset worth. As described in Box 6, however, development of comprehensive international standards for estimating reserves poses a host of complex technical and collective action problems. Individual country action should not, however, be delayed because of the absence of a fully agreed standard. On the contrary, positive action by individual countries will help provide a basis for standards of wider applicability. Moreover, the basic elements of such practices should be applied irrespective of the level of economic development—a concern with asset worth is at least as important for developing as for advanced countries.
International Resource Reserves Reporting—Emerging Standards
With respect to hydrocarbons, reports on reserves are required for listed companies by the U.S. Securities Exchange Commission and by the relevant stock exchange authority in other countries. While the technical definitions of reserves (promulgated by the Society of Petroleum Engineers, the World Petroleum Congresses, and the American Association of Petroleum Geologists)1 are generally accepted, financial reporting standards still vary somewhat. The key standard for booking of oil reserves by companies is set by the US Securities and Exchange Commission. The U.S. Financial Accounting Standards Board Statement No. 69, which applies to companies listed on the U.S. stock exchange, applies similar standards, placing emphasis on disclosure of proved reserves. Currently, there is no requirement for reserves disclosure to be audited. There have been frequent suggestions of a need to review these standards to take greater account of changing technology (such as allowing estimates based on seismic imaging techniques).2 A greater emphasis on third party review of reserves estimates, for example through specialized companies, could also help enhance reliability of reserves reporting.
Very similar concerns of technical and economic uncertainty apply to estimates of mineral resources and reserves. The Australian mining industry Joint Ore Reserves Committee Code, developed in 1989 partly in response to the preceding mining booms and busts of the 1960s in that country, has become the foundation for most recent national codes.3 The Combined Reserves International Reporting Standards Committee (CRIRSCO), initially set up in 1994, has developed a fairly standard set of definitions of resources and reserves.
The United Nations Framework Classification (UNFC)4 for energy and mineral resources has been developed as a generally applicable system harmonized with the technical standards listed above. It classifies resources in terms of three criteria: economic and commercial viability; field project status and feasibility; and geological knowledge. Reserves can then be classified in each of these dimensions in a three digit code: 1.1.1 would signify a resource that is commercially recoverable, has been justified by a feasibility study, and is based on reasonably assured geology. In principle, the UNFC classification provides a more uniform basis for both accounting and budget statements of reserves.
89. In developing such standards, an important distinction must be drawn between the use of asset worth statements for accounting or financial reports and that for budget and long-term policy purposes. Most work at the international level to date has been oriented toward the former purpose, a trend possibly driven primarily by company stock exchange listing requirements. For this purpose, while uncertainty is acknowledged, accounting reports99 are obliged to set strict (and generally conservative) criteria for asset recognition. As Box 6 indicates.100
90. Reserves estimates based on IFRS or another national reporting standard, however, are of limited utility for purposes of setting national budget policy. Rather than determining an agreed point value for resource assets to construct a balance sheet summary, long-term policy-making should be primarily concerned with potential responses to changing economic circumstances. Budget documents and other fiscal policy statements should thus clearly state the assumptions on which projections and estimates are based, and they should show the sensitivity of projections and estimates to changes in key parameters (with the resource price obviously being key, particularly in the case of oil).101 Similar technical and economic assumptions will underlie projections and estimates included in government or company financial statements and budget statements of reserves. It is essential, however, that the differing uses of these data be clearly recognized in the respective statements. More work seems required in both areas.
G. Reporting Contingent Liabilities and Quasi-fiscal Activities 3.1.3
Government contingent liabilities and the cost of resource company quasi-fiscal activities arising from resource-related contracts should be reported in budget accounts or other relevant documents in a form that helps assess fiscal risks and the full extent of fiscal activity.
91. Any contingent liabilities arising from resource contracts should be disclosed in budget and accounts documents. A budget annex dealing with fiscal risk (see below) could be an appropriate form of disclosure for these and other forms of contingent liability. Government guarantees should be listed in government reports on debt (but separately identified as contingent debt).
92. As described in Chapter I, energy QFAs can be very large. These QFAs deserve more analytical attention than they have received in the past, since failure to report them masks the true extent of government activity in the resource sector and the economy as a whole. As far as public expenditure QFAs are concerned, governments of low-income countries should have a particular interest in presenting social service spending to parliament and the public as they could demonstrate that pro-poor spending is actually higher than reported in government budgets and accounts. Companies should also benefit from comprehensive and detailed disclosure of data and information on such spending as evidence for their corporate social responsibility. At any rate, the various mechanisms and types of QFAs outlined in Chapter I should be explained and disclosed in government budgets (e.g., as an annex to the budget) and other documents. In countries with very active NRCs and large QFAs, the fiscal reports of the government should be consolidated with that of the NRC and published.
93. Further assurance of reporting quality could be achieved if resource company reports also reported such activities clearly and in detail—particularly if these elements are subject to audit. Governments and energy companies should, as far as possible, analyze, quantitatively estimate, and regularly report the size of such activities. In the first instance, such data is likely to be most readily available through international and national company reports. Companies should be encouraged to disclose this information comprehensively and regularly through their annual reports, and should make the basis of estimation clear and available to the government and the public. Government budget documents should derive information from these sources and regularly and systematically report on all such QFAs. These reports could be supported by analytical comments on the impact of such activities and future policies toward them.
H. Fiscal Risks 3.1.3
Risks associated with resource revenue, particularly price risks and contingent liabilities, should be explicitly considered in annual budget documents and measures taken to address them explained and their performance monitored.
94. Resource-rich countries are prone to large, sudden, and unexpected changes in output prices, especially in the case of oil. Such price changes give rise to potentially large forecasting risks for revenue and other variables, both directly and indirectly. For example, a large change in the oil price would not only affect oil revenue directly, but could also trigger changes in other key variables such as the exchange rate and interest rates, which in turn could affect expenditure and financing projections, both in the short and medium term. Annual budget documents should transparently show the baseline price assumption and how it was determined. Moreover, sensitivity analyses should be carried out to address forecasting risks, especially for the oil price assumption, and their results should be disclosed to the general public and external experts for scrutiny.
95. The Manual advises against the practice of multiple supplementary budgets within a budget year since this reduces the transparency of the budget process and is testimony to poor budget preparation, especially if it is a chronic practice. However, this may sometimes be justifiable in resource-rich countries in the case of consecutive large shocks, providing these are properly considered in the context of their medium- and long-term impact.
96. The Manual advocates publication of a statement as part of the budget (e.g., an annex) that systematically describes risks to the fiscal position associated with the budget estimates of revenue, expenditure, and the deficit. For resource-rich countries, risks that should be addressed in such a statement could include guarantees on loans or commitments (explicit or implicit) for environmental cleanup operations, other contingent liabilities, the holding of inventories, unforeseen shocks to costs and output variations (for example in the case of oil mandated through OPEC), unclear expenditure commitments or otherwise imprecisely defined fiscal policies.102 There may be implicit as well as explicit contingent liabilities. For instance, NRCs or other state-owned enterprises involved in resource exploitation or trading may have incurred liabilities (including labor-related expenditures and contingencies) that ultimately are likely to be served by the government. Risks from unclear expenditure commitments or imprecisely defined fiscal policies could include budgetary contingency clauses that allow higher than budgeted spending if the oil price exceeds a certain trigger level.103
97. Measures to manage such risks should also be clearly explained. These measures could include provisions in government budgets or financial plans of NRCs. Governments should, at a minimum, appropriate the expected cash costs of payments on called guarantees in the next budget year. If an oil price contingency rule exists, the trigger price should be clearly established ex ante, and procedures should also be established ex ante that set possible limitations of the contingency spending and determine the budget formulation and decision processes to be used prior to authorizing any contingency spending.
98. Governments may use market-based hedging strategies to help manage their oil price risk.104 Such strategies involve locking in the price of future production now or insuring against large price falls, or both.105 In this way, rather than trying to cope with a volatile and unpredictable revenue stream, the revenue stream itself is made more stable and predictable. Hedging, however, may be constrained by political concerns, lack of implementation capacity and creditworthiness. Full transparency in implementing such strategies also presents difficulties for major exporters because of market sensitivity to such information.
99. The development of a hedging strategy and individual hedging decisions should be based on the general principle of conservatism, and a clear set of rules and institutional responsibilities. For example, hedging by NRCs beyond that of short-term (1-2 months) commercial purposes and hedging of the government should be based on the same rules as far as accountability is concerned.106 Governments that are using hedging strategies to mitigate against price risk should inform the general public about the advantages (e.g., price and revenue stability, reduced risk of revenue shortfalls) as well as the costs (e.g., premia, margin requirements) and risks (including the risks of not hedging). An explicit budget provision indicating broad estimates of these costs and benefits—but without revealing market-sensitive information—may be an appropriate method for governments to use transparently to insure against price risks over the budget year. Governments should also report ex post, publicly and regularly, any hedging activities of NRCs that go beyond short-term hedging and are not undertaken for the purpose of hedging the government budget price and revenue risk.
100. Hedging generally involves complex strategies and transactions, requiring a certain level of institutional capacity to ensure adequate management and administration, including recording, reporting, internal control, and evaluation and audit mechanisms to protect against speculative transactions or mistakes. Countries that do not have adequate capacity in these respects should seek support to strengthen the key institutions before engaging in hedging strategies.
IV. Assurances of Integrity
101. The need for effective mechanisms to provide assurances of integrity is especially important in the case of resource revenue flows. The magnitude of these transactions and their technical complexity provide a high exposure to risks of malpractice. In developing countries, this situation is often combined with a lack of technical capacity and political failure to address risks adequately. The inherent risks107 associated with resource sectors require that governments place special emphasis on data quality, internal controls, and independent external audit. This chapter of the Guide examines some key requirements for establishing good practice in this area of the Code. The role of the EITI validation process is highlighted again in this context.
A. Internal Control and Audit of Resource Revenues 4.2.5
Internal control and audit procedures for handling resource revenue receipts through government accounts or special fund arrangements and any spending of such receipts through special funds should be clearly described and disclosed to the public.
102. The special risks and complexity of resource transactions require that procedures of internal control and audit of resource revenue flows go beyond standard government rules and procedures in a number of respects. As noted above, tax administration for resource revenue flows is complex and requires specialist skills, generally in short supply in developing country administrations. Internal controls should be clearly defined and subject to periodic external review that is accessible to the public. In advanced countries, the national audit office can provide adequate assurance that such controls are in place. In the United Kingdom, for instance, the National Audit Office periodically reviews high-risk government processes to establish that internal controls are adequate. Its 2000 report on the petroleum revenue tax examined key areas of risk (such as misstated production volume or value, misstated claims for allowable expenditure, or non-settlement of tax liabilities) and gave assurance that the Inland Revenue is adequately managing the risks associated with this tax.108 For developing countries, weakness in both government internal audit and the national audit office may require that an independent external source provide the necessary assurance. Nigeria, as a pilot exercise under the Nigerian EITI, has recently followed this path and engaged an independent company to carry out a comprehensive, financial, physical, and process audit of its oil and gas revenue administration. The report, completed in April 2006, is available on the internet. It reveals significant weaknesses in revenue administration, but represents an important step toward transparency and the establishment of effective internal controls.109
103. Standard control and audit procedures should be applied to spending of resource-related revenue (including through resource stabilization and savings funds) in the same manner as they apply to ministries and other government bodies.
B. Tax Administration Openness 4.2.6/1.2.1
Tax administration should be conducted in a way to ensure that resource companies understand their obligations, entitlements, and rights. The scope for discretionary action by tax officials clearly defined in law and regulations, and the adequacy of sector skills and standard or sector-specific procedures, should be open to review.
104. General transparency considerations suggest the need for a tax administration framework that is clear and understandable and covers all procedures related to taxpayers’ rights and obligations, revenue administration powers, and adequate dispute resolution processes. Within this general framework, tax administration for resource companies is often best centralized in a large taxpayer unit; specialized sectors within such a unit would usually be organized along clear functional lines and with a sector-based audit program emphasizing field audits.
105. Staff working in such specialized units should be well qualified to deal with complex sector-specific issues, including, for example, transfer pricing and petroleum cost accounting, and should work closely with industry representatives to identify and resolve uncertainties in the application of relevant tax laws, which may also involve explaining the administration’s views through public rulings or education programs. While some scope for discretionary action by tax administrators is necessary given the complex environment of major resource development,110 this should be clearly defined in law and regulations to avoid corruption initiated by companies or government on the one hand and unduly aggressive assessments of resource companies by tax officials on the other. Strengthening dispute resolution mechanisms, both at the administrative level and through the courts, is necessary to address the latter problem. Finally, tax administration staff should be able to offer professional service, advice, and assistance to help taxpayers understand their rights, obligations, and entitlements under the tax laws. Service and other standards that taxpayers can expect the administration to meet should be published.
106. Tax information systems need to be in place and maintained centrally to allow tax officials and others (for example, under EITI) to reconcile tax office data on company resource revenue and costs with data from other sources111. Moreover, it is important to ensure a regular flow of relevant data and information on resource revenue from other organizations to the tax office (and vice versa) to keep all relevant government offices promptly and comprehensively informed about recent developments. At the same time, tax administrations should keep information it holds about a taxpayer confidential in accordance with the law, although under certain limited circumstances the law may permit the tax administration to disclose taxpayer information to other government agencies (e.g., for law enforcement or statistical purposes).
107. The tax administrations’ work plans and performance indicators, including those for the specialized unit dealing with resource revenue companies, should be published ex ante, and ex post annual reports should be provided to the legislature on performance during the year. Both ex ante and ex post reports should be available to the public. Tax administration and other agencies receiving resource revenue payments also need to be made subject to the standard external auditing requirements and these audit reports should be published.
108. The standard requirements for assurance of integrity described in the Manual apply to resource-related transactions: data should meet accepted quality criteria and there should be adequate oversight mechanisms in place. The need for adequate oversight of accounts of NRCs and other relevant companies, as well as government accounts, is of specific importance to resource-related transactions. Oversight of these transactions is particularly emphasized under the EITI.
C. Oversight of Companies 4.3.1/1.1.5
International and national resource companies should comply fully with internationally accepted standards for accounting, auditing, and publication of accounts.
109. International companies can be expected to observe the audit-related transparency and disclosure requirements under the OECD’s Principles of Corporate Governance. These suggest that annual audits should be conducted by an independent, competent and qualified auditor to provide an external and objective assurance to the board and shareholders that the financial statements fairly represent the financial position and performance of the company in all material respects.112 Also, these companies are obliged to comply with internationally accepted accounting and audit standards, including, for example, the recommendations of the Statement of Recommended Practice of the Oil Industry Accounting Committee (2001). While these requirements are outside the scope of the Code, adherence to relevant company and auditing standards by both international and domestic private sector companies in the resource sectors is a critical element of effective resource revenue management. Application of such standards is therefore supported by the Guide. While international resource companies generally do comply with International Financial Reporting Standards (IFRS), this is often not the case for NRCs in low and middle income countries.113 Therefore, one of the first requirements for NRCs is that they need to apply IFRS, including to the consolidated accounts that cover all of their subsidiaries.
110. The international dimension of company operations, however, requires coordinated action to ensure that internal and national oversight mechanisms are effective. Increasing concern with corruption in international business dealings has led to the development of national laws and international agreements to help oversee and control such practices. The U.S. Foreign Corrupt Practices Act, (US Code 15, 78 dd et seq.) passed by the U.S. Congress in 1977, was the first major piece of legislation of this kind. The 1997 OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions represents a widely supported effort (with 35 signatories) to establish similar legislation as a standard feature for developed countries. The 2004 Transparency International global corruption report, however, notes that while all of the signatories have passed laws making foreign bribery a crime, few national governments have enforced the new laws, with the U.S. being a notable exception.114 The OECD Working Group on Bribery monitors implementation of the convention, and, since 2001, phase II monitoring has been concerned with effectiveness of national enforcement.115
111. NRCs, as well as any domestic private sector companies involved in the resource sectors, should be made subject to standard company audit requirements, and there may also be a case for oversight by the national audit office (the government external auditor), particularly where the national audit office has a mandate and capacity to audit state-owned enterprises. There may be cases that require special audits of NRCs. Auditing of NRCs, however, is often a critical weakness, which in a number of countries has led IMF-supported programs to require that such audits be undertaken.116 In this context, the selection of independent auditing companies should be based on a transparent tendering and selection process. Audit reports should be published. Tax administration and other agencies receiving resource revenue payments also need to be made subject to the standard external auditing requirements. External audit of government agencies and state-owned enterprises is often found to be a particularly weak area of fiscal transparency in developing countries. Special efforts to improve resource revenue transparency could usefully be combined with training and technical assistance.
D. Oversight of Company/Government Revenue Flows 4.3.1
A national audit office or other independent organization should report regularly to the parliament on the revenue flows between international and national companies and the government and on any discrepancies between different sets of data on these flows.
112. It normally falls within the mandate of the national audit office to provide assurance of the integrity of government revenue flows. The general provisions of the Code should apply equally to resource revenues. However, in many cases, the national audit office lacks the mandate or expertise to audit such revenues, particularly where a significant portion of revenues flow through NRCs/NOCs. Establishing effective internal management and control systems ( following practices outlined elsewhere in this Guide) will facilitate the task of the national audit office. The traditional transactions-based audit practiced in most developed countries often fails to address the key systemic issues that are prevalent in resource-rich countries. Risk-based approaches (as illustrated by the United Kingdom and Nigerian examples cited above) need to be applied more widely and given full political support for the underlying problems to be addressed and credible assurance of integrity given. 117
113. The validation mechanism under the EITI represents an important step toward establishing credible assurance of revenue flows, which in turn should help promote longer-term institutional change. The mechanism requires an independent validator to verify the procedures adopted to assess, compare and report on both the aggregate payments to government reported by companies (including state-owned resource companies) and the aggregate payments received by government from companies. The validation process is not a financial audit, and it does not remove the need to establish effective government audit process. Commercial auditors and national audit offices would continue to carry out these functions. However, the validation report can comment on the adequacy of such processes in relation to EITI validation principles. This approach is of central importance to EITI implementation. It also provides a starting point for national agencies to build their own capacity and participate effectively in the assurance process. Country development partners can help to augment the capacity of national audit bodies, possibly by supporting systemic recommendations made by EITI validators.
114. Local CSOs can also play a vital role in providing independent assurance of integrity of processes and data. At a general level, the Manual advocates independent scrutiny of macroeconomic forecasts, and in some countries CSOs have taken on such a role (for instance in Ukraine). The EITI has given much more emphasis to the potential role of CSOs in providing assurance of integrity of resource revenue data. Active participation of CSOs is seen as one of the key criteria by which effective implementation of the EITI is to be judged. One promising example of effective engagement of CSOs in promoting transparency is provided by the Memorandum of Understanding (see http://www.eitransparency.org/section/countries/_azerbaijan/_mou) signed by Azerbaijan’s State Commission and aimed at guaranteeing a fundamental role for local CSOs in the design and monitoring of EITI implementation.