Policy and regulatory framework to enhance local content : yardsticks and best practice

The focus of this paper is on how to design a policy to enhance national participation in the local oil and gas industry in a way that actually turns out the benefit the host country of these resources. The underlying idea of the policy approach we recommend is to create a sound business climate, to encourage oil companies to compete in involving domestic value generating activities and firms, and to let their track record in this respect influence their rights to future oil and gas. Doing so on a competitive basis, which also allows for preferential treatment of efforts to develop local firms and local labour, should contribute positively to the development of local industrial capacity in relation to the domestic oil and gas industry. This will, in turn, most likely spin off positively to industrial development in other areas of the host country economy as well, which means that also industrial sectors other than oil and gas related industry should benefit. Altogether, this means that the chances for the host country to expand and realize its industrial potential ought to become significantly strengthened. SNF Working Paper No 02/11 1 POLICY AND REGULATORY FRAMEWORK TO ENHANCE LOCAL CONTENT Yardsticks and Best Practice OIL AND GAS – A BLESSING OR CURSE? Huge expectations quite naturally arise when a country discovers a great potential of valuable natural resources as oil and gas. It is easily assumed that this will provide the country with revenues which will ease financial constraints on public budgets, and that the efforts to extract these resources will allow national entrepreneurs and business enterprises to prosper and the domestic economy to grow. These expectations arise despite the fact that several studies indicate that countries with an abundance of national resources on average seem to experience less economic growth and worse development of outcomes than countries with fewer natural resources. When controlling for the income level of the country, countries that are highly dependent on revenues from natural resources, generally score lower on the UN Human Development Index and on economic growth, exhibit greater corruption, have a greater probability of internal violent conflicts, and have a larger share of the population in poverty than countries with diverse sources of wealth (Sachs and Warner, 1995; Leite and Weidmann, 1999; Papyrakis and Gerlagh, 2004). This is what is referred to as the resource curse (Sachs and Warner, 2001), or the paradox of plenty. It may be explained in many different ways. Extraction of non-renewable natural resources with a significant resource rent often represents a windfall gain of great magnitude for the host country. Huge and sudden revenues of this kind are likely to cause the real exchange rate of the national currency to appreciate, which will weaken the competitiveness of non-resource based sectors of the economy. They furthermore tend to bring high volatility in government revenues due to oil price fluctuations, which easily implies disastrous stop and go policies. Thus, revenues and economic activities related to oil and gas poses specific challenges to policy that generally are demanding to deal with, and in some cases may lead to poorer performance than if the natural resources had not been discovered. When empirical studies as referred to document that huge exports of natural resources seem to correlate with poor social and economic performance, causation is not really analyzed. In fact, there is no convincing theoretical argument that huge endowments of natural resources are bound to lead to poor social and economic performance. This is not supported by empirical evidence either. Some countries with large natural resources perform well; others do not. Thus, it is more likely to be the other way around. Bad policies 1 This paper is written as part of an ongoing project focusing on how to enhance local content in Uganda’s oil and gas. This project will be concluded in April 2011. Hence, views and conclusions in this paper represent work in progress and may be revised and improved as part of the process to finalize the project. SNF Working Paper No 02/11 2 and obstructing social conflicts easily result in heavy dependence on exports of the natural resources, and in turn the poor performance of the society and the national economy. Thus, rich endowments of natural resources is not necessarily a curse to the social and economic development of a country, neither does it have to be a blessing. That will depend on how the country deals with the challenges and opportunities which follows from possessing such resources (Gylfason, 2001; Iimi, 2007). It is how institutions, regulations and politics are constructed and operated, that will decide. Thus, countries that are in the planning stages of the petroleum development before production starts, have the opportunity to address and handle these challenges in a sensible way. In this paper we will discuss and describe what it is essential to focus on and to be aware of in order to turn the endowment of natural resources to a blessing for a country. This discussion is based on lessons that may be drawn from the experience of resource rich countries internationally, and on the literature addressing the issue of industrial development and economic growth. It is argued that a viable policy has to build on a comprehensive approach to the drivers of national wealth, and on the creation of industrial linkages between domestic resources and leading international companies that invest to undertake business activities in the country. Politics ought to be concerned with industrial capacity building and private sector development. Ambitions with regard to national participation in the oil industry and efforts that are taken to achieve them, may serve as a means in this respect. In the oil industry, the key is to create a division of labor between government and oil companies, where oil companies adhere to and are held accountable for expanding industrial capacity in the host country, while the government stay dedicated to the task of industrial capacity building. GOVERNMENT TAKE, INDUSTRIAL CAPACITY BUILDING AND ECONOMIC GROWTH When oil and gas are discovered in a country, the country is not likely to have the industrial capacity that is needed to generate the market value of these resources. The oil industry is an old industry with more than a century of industrial experience. US based firms have traditionally dominated core activities within the industry all around the world, supplemented with firms from some of the other major industrial countries, as UK and France. Today there are more actors on the scene, of which some also originate in smaller industrialized countries and emerging economies. This nevertheless means that a new host country for oil and gas will depend heavily on the competence of foreign firms. Oil and gas are natural resources of high value, and a significant resource rent may be expected in the industry. A resource rent means that oil may be sold at a price that allows the industry to generate profits which exceed the yield that may be expected from industrial activities in general. The size of this oil rent will, of course, vary with the oil price and the costs to extract and market the resources. It nevertheless raises the question as to how the SNF Working Paper No 02/11 3 oil rent ought to be distributed between the companies extracting the resources and the society in the country where the resources are located. The government of a country is the institution to act on behalf of the society in this respect, and the share of the resource rent that the country is able to capture and channel through government budgets, is referred to as government take. Government take represents taxation of the oil industry that exceeds taxes put on industrial activity in general, and is the source of additional revenue for government budgets. Thus, one way of maximizing host country benefits from oil and gas, is to get as high government revenues from the industry as possible, and to use these revenues sensibly to enhance value generation in the nation. This obviously does not mean that extremely high tax rates will maximize government revenues from the industry. Taxation of the oil industry has to take into consideration that relatively high tax rates tend to attract less efficient firms. Less efficient firms generate a smaller oil rent than more efficient firms. Thus, the size of government take does not have to increase with higher tax rates. Besides the resource rent aspect of the oil industry oil and gas activities in a country also attract leading international companies in many different industries related to oil and gas. This offers an additional opportunity that frequently is referred to as local content. Local content is a concept drawing attention to the share of goods and services that are needed to explore for oil and gas, and later to develop and extract these resources, that is produced in the host country by firms with an infrastructure in the country, and by using host country labour. It means value generation in the host country instead of imports. In this sense, national content is a synonym term to local content. The industrial justification for considering local content is based on the fact that discoveries of oil and gas will attract the interest of leading companies in the petroleum industry worldwide. This offers a unique opportunity for the host country of such resources to enforce policies to enhance industrial development domestically. Industrial development is a learning process, where capacity and capabilities expand through a process of solving challenging tasks in collaboration with internationally leading competence. Thus, countries with large endowments of oil and gas are in a position to outline a policy that may benefit the country at large. This is in accordance with the recommendation