Petroleum policy issues in developing countries

Petroleum policy issues in developing countries Alexander G. Kemp

Petroleum is of vital importance to most developing countries either in their capacity as producers or consumers. On both counts they are heavily exposed to the impact of the large oil price fluctuations which have characterized the last 20 years and are likely to be prevalent in the foreseeable future. To optimize their benefits in government take and investment producing countries should place emphasis on profitrelated fiscal instruments. Consuming countries should ensure that oil prices reflect their opportunity costs. The design of consumption taxes on petroleum products should take into account: a) their revenue-raisingpotential," b)their distributional effects; c) the need to correct for externalities in the use of petroleum; and, d) the energy security~price vulnerability aspects, Keywords: Petroleum; Policy; Developing countries

The petroleum industry plays a major role in the great majority of developing countries. In virtually all developing countries oil is an important source of energy. Frequently supplies have to be imported and the oil import bill is often one of the most important items in the balance of payments. In a number of developing countries oil production constitutes an important source of income, foreign exchange and budgetary revenue. In other countries petroleum production is either only small or potential rather than actual, In the overwhelming number of developing countries oil activity looms large and policies towards the industry have a significant impact on the whole community. Oil producing countries have to determine licensing and taxation terms towards exploration and production. More fundamentally depletion policies have to be established. For major producers Alexander G. Kemp is with the Department of Economics, Edward Wright Building, Dunbar Street, Old Aberdeen, AB9 2TY, UK. 1 04

the appropriate treatment of the fiscal revenues has also to be determined. In consuming countries policy decisions have to be made regarding pricing. Where there is domestic production the appropriate pricing of crude oil is an issue. (The issue often arises more acutely regarding natural gas.) At the consumption stage the question of the appropriate pricing and taxation of product sales emerges. Sales of petroleum products constitute a significant potential tax base in developing countries. The issues of the appropriate level and structure both need resolution. Many developing countries suffer from serious pollution. A significant amount of atmospheric pollution is caused by the consumption of petroleum products. Appropriate policies to mitigate the problem have to be developed. A main choice is between the use of regulations and associated penalties and emphasis on the fiscal instrument. This paper surveys the issues involved in making rational decisions in the above main policy areas. Other possibly less central issues, such as the appropriate action to very high import dependency are also discussed.

CONTEXT FOR PETROLEUM EXPLOITATION AND CONSUMPTION For the last 20 years the exploitation and consumption of petroleum has taken place in an environment personified by oil price volatility and much uncertainty regarding its future behaviour. It has also been an era when new petroleum exploitation technologies have developed at a rapid pace, particularly for offshore environments. These developments have created both investment opportunities and problems which host governments have had to acknowledge. Consuming country governments have also had to develop responsive policies to the large fluctuations in oil prices over the last 20 years. The likelihood is that oil price volatility and continuing uncertainty regarding future trends will 0301-4215/92/020104-12 © 1992 Butterworth-Heinemann Ltd

Petroleum policy issues in developing countries

continue to be a feature of the environment within which investment and consumption take place. Currently the oil market suffers from considerable uncertainty on both the supply and demand sides. On the demand side, while a considerable amount of information and understanding of market behaviour has been obtained from the experience of the 1970s and 1980s, much uncertainty remains about future trends, A major question is whether the significant improvements in energy efficiency which were experienced in the 1980s in response to the massive price increases in 1973-74 and 1979-80 are likely to be sustained in the 1990s. In the first half of the 1980s oil consumption in OECD countries fell by around 20%. Some forecasts of demand assume that the expenditures on energy conservation which took place in the 1980s will not be repeated, and that the previous pattern of behaviour of consumption in relation to oil prices will be re-established, Others take the view that energy conservation will continue more or less irrespective of oil price trends. While widely differing views are current on future oil consumption prospects there is agreement that the prospects for increases (in proportionate terms at least) are greatest in the Asian countries which are in the process of successful industrialization. 1 This differentiation in the pattern of consumption growth has led to another policy issue coming to the forefront, namely the optimal expansion of refining capacity in that region, In Eastern Europe on the other hand there are currently serious recessions in most countries. Demand for petroleum products is falling on that account. Most of this bloc (including the USSR) are in the process of raising prices of petroleum products from extremely low values to levels approaching free market equivalents. These developments are likely to cause a stagnation of demand for some time ahead, The 1990s have commenced with expressions of major concern for the environment. In this context the polluting effects of hydrocarbon emissions have been highlighted. Discussions of appropriate policy responses have been held in many fora. While some action has already been taken it is currently by no means clear either how widespread or how determined action will b e . If policies were implemented with the vigour necessary to achieve some of the targets suggested by environmentalists the result would certainly be a significant reduction in the demand for petroleum products otherwise attainable. Currently it is very unclear how vigorously such measures will be implemented. The result is

ENERGY POLICY February 1992

that the uncertainty over future oil demand is further increased. On the supply side there are several major uncertainties likely to be experienced for several years. While output prospects in any producing province are always subject to some uncertainty there are larger question marks over the USSR and some of the bigger producers within OPEC. The USSR is currently the largest oil producer in the world. It has been experiencing major production difficulties for some time due principally to serious equipment failure and shortages and pipeline problems. Production has fallen from around 12.5 million bbl/day in 1988 to around 10.5 million bbl/day in the autumn of 1991. Further reductions can confidently be predicted in the short term. If the Soviet economy continues to stagnate and Western investment in oil-producing facilities is insubstantial oil production could fall for several years. The effect on the world price could be significant. On the other hand if a large amount of Western investment were enticed into the Soviet oil industry the production decrease could be arrested possibly within a few years. Proven reserves are enormous. There are many extremely large discoveries not developed due to lack of appropriate technologies. Similarly there is great scope for enhancing recovery from existing fields through the employment of Western technologies. Whether these possibilities will be translated into practice is currently the subject of much uncertainty. Because the potential is so great the effect is to increase oil price uncertainty. Within OPEC there are also several features which combine to leave the medium-term price outlook very uncertain. Over the past decade the most obvious immediate cause of world oil price uncertainty was the excess producing capacity within the Organization. With the Gulf war and its immediate aftermath this excess capacity disappeared. The removal of Kuwait and Iraq production from the world market ensured this result. Future prospects have to incorporate the likelihood that production from these countries will enter the world market at a substantial level. The main uncertainty concerns the timing of the re-entry of these two countries on a significant scale. Other OPEC members are currently in the process of effecting increases in their producing capacity. Major projects are in progress in Saudi Arabia, Iran, Venezuela, and Nigeria for example. To what extent capacity will be increased is currently unclear. All of these countries have internal budgetary difficulties which could limit plans. On the other hand invest-

105

Petroleum policy issues in developing countries

120 i ~ 100

80

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60 --'k-- Petroleum X ~ Total X

40 20

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o

197

I 1972

I I I I I I I I I 1974 1976 1978 1980 1982 1984 1986 1988 1990 Years (1970-1990)

Figure 1 Nigerian petroleum exports as % of total exports. Source:

IFS.

ment in production facilities could be greatly enhanced if Western companies were allowed to participate in a major way. This possibility exists, and in some countries where nationalization took place in the 1970s foreign company investment has already restarted. The extent to which OPEC capacity expands over the next few years thus depends upon both internal budgetary constraints and the political will of some key host governments to allow direct participation by foreign companies. There can be little doubt about the willingness of oil companies to invest given the prospect of large low-cost reserves. The likelihood is that significant excess producing capacity will re-emerge within OPEC as a group, Some members will have difficulty in expanding their capacity because of a relatively unfavourable resource base, but others, such as the key Middle East countries and Venezuela, can be expected to substantially increase their capacity. Even with further falls in production from the USSR the net result is likely to be a substantial increase in world productive capacity. The ability of OPEC to regulate its output is likely to re-emerge as a major influence on price prospects. This was the major factor contributing to price volatility in the 1980s and there must be a high chance of its reappearance in the 1990s. The conclusion from this brief survey of world supply and demand prospects is that price uncertainty can be expected to remain high for a considerable number of years. There is also strong potential for major volatility in actual prices. It is against this background that producing and consuming country governments in the developing countries have to determine their optimal strategies and policies, 106

POLICIES FOR PRODUCING COUNTRIES Significant producers A considerable number of developing countries are major oil producers. They are extremely dependent on oil revenues for both balance of payments and budgetary purposes. Nigeria is an example of a country which has large non-oil sectors but where oil revenues are still of overwhelming importance. In Figure 1 the share of petroleum in total exports is shown for the period since 1970. The dominance of oil revenues is extremely marked. It is noteworthy that the relative importance of these revenues did not change dramatically after the oil price collapse in 1986. Physical production in 1986 and 1987 was in fact lower than in both the preceding and subsequent years which significantly contributed to the lower revenues. The lower output figures were related to commitments to OPEC quotas. Oil has also been the dominant source of budgetary revenues, accounting for 82% of total government revenues in 1990. The dominant reliance of the main Middle East producing countries on oil exports needs no elaboration, but there are also cases of heavy reliance on this source in other less important producers. Exampies are: Gabon (83%-85% of total exports in recent years); Ecuador (43%-46%); Egypt (around 30%); Mexico (34%-36%); and, Oman (around 99%). In these countries the proven reserve base remains significant. For all such countries appropriate policies in an era of expected uncertain and volatile prices will be ENERGY

POLICY

February

1992

Petroleum policy issues in developing countries

/

P

\ \ Economic \ \ ~ \\ rents >-3y

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xz MCD+P d .~ &

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o

Output Figure 2 Supply price of petroleum, those which can collect economic rents to the state while sustaining production development and exploration incentives. 2 Some governments have for a long time been zealous in their pursuit of the objective of rent collection, and the large price rises of the 1970s intensified these efforts. 3 The chosen policy instruments have not always been appropriate for an era of pronounced price volatility. The result has been disincentive effects becoming apparent, and discretionary fiscal changes have had to be made. All this increases the uncertainty of the investment environment and can have a negative effect on risk taking. Investors may well build a risk premium into their required expected returns. This is unfortunate for developing countries which are suffering from a shortage of the appropriate skills and capital, Economic rents from petroleum exploitation in a province may, in brief, be defined as the returns in excess of those required to sustain production, new field developments and exploration. The position is shown in schematic form in Figure 2. A certain return OMCp is required to cover the production costs (including a normal profits element) from existing fields. A total return OMCd+p is required to compensate for the costs and risks involved in developing new fields. A return of OMCT is required to sustain exploration as well as new development and production. The shaded area indicates the economic rents which may be collected by a host government. (The area between MCa+p and MCt is sometimes referred to as the quasi-rents from exploration. They may be appropriated by a host government in the short run but only at the long-run cost of reduced exploration and discoveries.) Economic rents may be collected by a system of auctioning of exploration rights, by a scheme of taxation or by some combination of the two. In a freely working market competitive bidding for

ENERGYPOLICYFebruary1992

mineral rights should lead to the host government being able to collect anticipated economic rents in a lump sum payment. The front-end payment should reflect the expected net monetary value (EMV) from the proposed exploration and development programme. There are well known advantages of the system, principally that the lump sum payments are made voluntarily, no subsequent distorting effects are produced, and no requirements for government to estimate the investor's discount rate are present. Despite these apparent advantages the bonusbidding system is generally not employed in developing countries. Lack of exclusive reliance on the scheme is understandable. Even with lively competition among bidders only ex ante or anticipated economic rents can be collected. In an environment of highly uncertain and volatile oil prices ex post or realized economic rents may well be very different from those anticipated at the time the licences were awarded. From the host government's viewpoint the optimal reaction to this situation is to include a scheme of taxation in addition to the bonus bidding system. The investor should, of course, be fully informed of this before the rights are awarded. He will then adjust his cash bid accordingly. The tax system will be used as a back-up to ensure that the host government receives an acceptable share of the realized economic rent. In developing countries where petroleum exploitation has been taking place for some time on a substantial scale, where knowledge of the reserve base is already extensive and where competition for rights is keen, there is a strong case for incorporating a bonus-bidding scheme into the licensing arrangements. The promise of early lump sum revenues is attractive, especially in countries where the discount rate of the host government is high. If all the above features are present substantial revenue may be expected from the bids. The more the above features are absent, other things being equal, the less will be the revenues from the bidding systems. To date host governments in all developing countries have relied exclusively on taxation and quasifiscal instruments (state participation in particular) to collect economic rents. In the 1970s these terms were generally tightened and in the second half of the 1980s frequently relaxed. In some cases several changes were made. In most cases the types of fiscal instruments employed have not been sufficiently flexible to react appropriately to the major fluctuations in oil prices and, thus, economic rents, which have taken place in the last 20 years. The traditional devices under the concession system include a royalty and income tax. Royalties are conventionally

107

Petroleum policy issues in developing countries

flat-rate and based on gross we-held values. They have been the traditional reward to landlords. They have some obvious advantages from the viewpoint of host governments, such as: 1) early revenues; 2) relatively easy estimation (compared to other taxes); and, 3) a relatively low level of risk-sharing by government. (The oil price risk is shared but cost risks are borne by investors.) The disadvantages of the conventional royalty are many. It is not well-related to economic rents, and this can cause serious problems in an environment of fluctuating oil prices. Thus a flat-rate scheme at a conventional level (say 10%-15%) could leave a high share of the rents with investors when oil prices and profits are high. Host governments are then liable to be dissatisfied and tempted to take unilateral action to increase their share. On the other hand when oil prices and profits are low a high flat-rate royalty could render marginal fields uneconomic to investors, and cause premature field abandonment of existing ones. Some countries have introduced sliding-scale royalties followingthe major priceincreasesin 197374. Under this scheme the rate of royalty increases with field production. To the extent that rents are a function of field size this system is more flexible. But the size of the rents is also a function of oil prices and exploitation costs, and a sliding-scale royalty is obviously not sensitive to these variables. All the above arguments also apply to production and severance taxes, Optimally, conventional royalties or production taxes should not be employed as rent collecting devices. Where the realistic political economy of a major producing country demands early revenues, moderate use of the device will generally be tolerable and not cause serious distortion to investment and production decisions. If reserve prospectivity and well productivity are high the dangers of the deterring effects becoming operative will be low. Nevertheless the device should not be employed as a main rent-collecting device. Concession systems include a corporate income tax. Being profit-related this imposition is much less likely to cause disincentives to field developments, The effective rate is a function of: 1) the nominal tax rate; and, 2) the pace of write-off of development and other costs. There is no provision for a normal return on capital. Ignoring the issue of the employment of loan finance and the deductibility of debt interest, only immediate write-off of costs ensures that the rate of return on investment is not reduced by the tax. In practice in developing countries immediate write-off of costs is generally not available,

108

Exploration costs are sometimes allowed this facility, but development costs are normally recoverable over a period of several years. The effect is to put a wedge between pre-tax and post-tax rates of return. With five-year straight line depreciation (perhaps a representative a v e r a g e ) t h e present value of the tax relief on an expenditure of £100 is £83.4 at a real discount rate of 10%. This is when the depreciation commences as soon as the expenditure is incurred. In some countries depreciation may not commence until the asset in question has been placed in service. This in effect means when production from the related field has commenced. If first production did not take place until three years after the investment the present value of the tax depreciation allowance is reduced to £62.7 with a 10% real discount rate. The depreciation provisions are just as important as the nominal tax rate in determining the effective burden and the share of the rents which accrues to the host government. While corporate income tax can ensure that the host government receives some share of the rents it is not the optimal instrument for achieving this objective. Corporate income taxes are generally flat-rate and are not directly targeted on economic rents. A given scheme could leave a high share of the rents with investors when oil prices are also high, but cause development disencentives when oil prices are low. In many developing countries production-sharing contracts are employed rather than concessions. The private investor becomes a contractor but incurs the investment costs and risks. The oil produced is divided into cost oil and profit oil. From an economic viewpoint the cost recovery terms correspond to the depreciation arrangements under an income tax. Frequently a ceiling is placed on the share of production available for cost recovery purposes. (Figures of 40%-50% are not u n c o m m o n . ) T h i s e n s u r e s that the state receives early revenues from its share of the profit oil. In more recent years profit oil splits have frequently been on a progressive basis with the state's share increasing with annual production. This arrangement produces a desirable degree of flexibility to the extent that economic rents are a function of the size of field. This is not always the case, however, as large fields may also have high unit costs. The system also does not cater well for the fact that economic rents are a function of oil prices. Schemes which were implemented in the 1970s when oil prices were on a rising trend in real terms may not be appropriate later. Though the system is apparently fully profit-related the ceiling on cost recovery can

ENERGY POLICY February 1992

Petroleum policy issues in developing countries

impact in a manner similar to a royalty. When oil prices are low it could mean that cost recovery is postponed for a very long time. The viability of projects may be put in jeopardy and there could be incentives to prematurely abandon fields, In the last 15 years a number of developing countries have introduced into legislation a resource rent tax as a fiscal device which meets the main objections to the more conventional instruments, Examples are Papua New Guinea, Tanzania, Namibia and the Seychelles. In brief this device permits investors to recover their investment and earn a threshold rate of return before they are subject to the tax. 4 Project cash flows are accumulated forward at the threshold rate and only when the accumulated total becomes positive is taxation payable. The initial tax base is this accumulated sum and in subsequent years any positive net annual cash flow. The scheme has several potential attractions. It should ensure stability of the contractual framework within which petroleum exploitation takes place. No discretionary changes in tax rates or threshold should be necessary in the face of fluctuating oil prices and variations in costs. If no economic rents are realized there will automatically be no government take. If large rents are achieved the state will obtain its due share. From the investor's viewpoint the main advantages are the high degree of risksharing by the government and the absence of an early fiscal burden, This last factor will generally constitute a disadvantage for host governments, and so they are very likely to incorporate some other instrument such as a conventional royalty as well. Where prospectively and well productivity are high moderate levels of royalty are likely to be tolerable, Some investors are unhappy with this type of tax. They appreciate the downside protection which the rent tax provides and also the contribution to contract stability. They are unhappy about the limited upside potential which this instrument may leave, This is n o t a problem of the concept but of the specific rates employed. If the tax rate is extremely high the upside potential is clearly restricted. (Tanzania is an example of this phenomenon.) Moderate tax rates can ensure that sufficient upside potential is left to the investor, The conclusion is that the exclusive use of conventional fiscal instruments such as royalties, income tax and production sharing arrangements by major producers as devices to collect economic rents is not optimal. At least some of the major producers could employ bonus bidding schemes to procure worth-

ENERGY POLICY February 1992

while early revenues. In areas where proven reserves are significant and geographical knowledge is substantial the use of this device is likely to be particularly beneficial as there will be keen competition among investors. In an era of fluctuating oil prices bonus bidding schemes need to be backed up by conditional taxation. Conventional royalties, income tax and presentation sharing arrangements are insufficiently flexible. The changes in terms required in most countries in the 1970s and 1980s provide evidence for this claim. A resource rent tax scheme is superior, and can make a major contribution to long-term contract stability and thus improve the investment environment. Minor and potential producers In the developing world a large number of countries are either minor or potential petroleum producers. As an example of the possibilities, in Table 1, estimates are shown of the potential in oil-importing countries in Africa. The remarkable feature is the widespread potential across the continent. Even low levels of production could make a significant contribution to some of the very small economies in question. To achieve exploration and production from countries where little or no activity is currently taking place may require some shift in the policy emphasis. Thus, there may not be sufficient competition for acreage among investors to ensure that bonus bids attract high revenues. There may even be just one company interested in any individual block. In countries where little or no exploration has been undertaken the most important priority may be to stimulate some seismic and drilling work. A discretionary licensing system which puts emphasis on this is then preferable. In countries where little petroleum activity has taken place exploration risks are likely to seen as high, and bonus bids may be ineffectual as the following example shows: Exploration costs (E) = $50 million Net present value from discovery ( N P V ) million

= $500

Perceived chance of discovery in known producing province (P) = 1 in 5 Expected monetary value ( E M V ) = P ( N P V ) - E = + $50 million Perceived chance of discovery in largely unknown province = 1 in 15 E M V = - $16.67 million Reflecting the exploration risks the bonus bidding system would produce no revenues in the relatively

109

Petroleum policy issues in developing countries T a b l e 1. Ultimate resource potential of m a j o r African oil-importing developing countries (billion barrels).

Country Benin Cape Verde Central African Republic Chad Equatorial Guinea Ethiopia Gambia Ghana Guinea Guinea Bissau Ivory Coast Kenya Liberia Madagascar Mali Mauritania Mauritius Mozambique Namibia Niger Senegal Seychelles Sierra Leone Somalia South Africa Sudan Tanzania Togo Uganda Western Sahara Total

Estimated land and shallow water resources High Low 0.1 0.08 0.6 2.4 0.3 0.9 0,3 2.0 0.1 0.2 0,3 0.5 0.5 1,1 1.9 2,2 0.2 1.1 0.08 0.7 1.0 0.03 0.3 0.9 0.3 1.5 0.4 0,02 0.2 0.6 20.8

0.05 0,04 0.3 1.2 0.1 0.5 0,1 1.0 0,07 0. l 0.1 0,3 0.3 0.4 1.0 1.1 0.1 0.6 0.03 0.3 0,6 0.04 0,1 0.6 0.1 0,8 0,2 0,01 0,1 0,4 10,7

Estimated deep water resources High Low 0. l 0.2

0.1

0.04 0.1 0,07 1.2 0.05 1.3 0.04 0.04 0.4 0.7 0,3 0.4 0.6 0,5 0.2 1.0 0.04 1.3 0.5 0.9 0.2 0.02 0.1

17.8

9.3

0.2 2.4 0.07 2,0 0,08 0.08 0,7 1,4 0.6 0.7 0.8 1.1 0,3 1.5 0.1 2.6 0.8 1.7 0.3 0.02 -

Estimated total resources High 0.2 0.3 0.6 2,4 0,5 3.3 0.4 4,0 0.2 0.3 1.0 1.9 1,1 1.8 1.9 3.0 0.2 2.2 0.3 0,7 2,5 0.03 0.4 3.6 1.1 3.2 0,7 0.04 0,2 0.7 38.6

Low 0.1 0.1 0.3 1.2 0,2 1.7 0.2 2.3 0.1 0.2 0,5 1.0 0,5 0.8 1.0 1,6 1.2 0.1 0.2 0.3 1.6 0.04 0.1 1.9 0,6 1.7 0.3 0.(/2 0. l 0.5 20.5

Source: US Department of the Treasury, Office of the Assistant Secretary for International Affairs, An Examination of the World Bank Energy Lending Program, 1981.

unknown province despite the comparatively large net present value expected from a discovery, The case for profit-related fiscal terms is even stronger in largely unproven provinces. These provide downside protection which is more important to investors when the chance of losses is high. Where income tax is levied the early write-off of exploration expenditure plus the ability to carry forward losses for a considerable time provide some downside protection. For a multinational company the ability to employ a branch of an existing company (rather than a subsidiary) for exploration is important. The investor will then be able to obtain tax relief for the exploration costs against other income of the company. If a subsidiary had to be employed this would obviously not be possible. From the host country's viewpoint it is advantageous to permit a branch operation. In effect the government of the investor's parent country is sharing in the exploration costs in the developing country, The example given above highlights a fiscal problem. At the exploration stage there is no expected economic rent. It could thus be argued that there should be no taxation in prospect on the discovery,

110

On the other hand if a discovery is made a substantial positive NPV is in prospect. Host governments in the developing world will certainly see this as legitimate taxable capacity even though the presence of taxation may reduce exploration incentives. In these circumstances it is particularly important to ensure that taxation has the minimum adverse effect on incentives. In many of the developing countries noted in Table 1 there is a further reason for taking particular care in the design of the fiscal terms. The expected size of discovery is comparatively small. This means that the expected NPV is unlikely to be large, and, given the high exploration risks, in at least some of these countries, the EMV will often be quite small. In the design of an income tax it would be important to take into account the factors discussed above. They provide some downside protection. Host governments will generally require a fiscal device which gives them a share of any realized economic rents. Conventional instruments are not well-designed to procure revenues from modest discoveries without causing distortions. Conventional royalties, for example, impact harshly on marginally

ENERGY POLICY February 1992

Petroleum policy issues in developing countries Table 2. Timing of tax payments with resource rent tax and resource rent tax plus advance resource rent tax in petroleum field ($ million). Resource rent tax (75%) 1990 1 9 9 1 1992 RRT

0

0

0

1993 0

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

0

0

46.1

162.9

170.1

177.9

106.2

76.1

52.1

32.7

17.1

4.4

Resource rent tax with advance RRT a

ARRT RRT

5.7 0

14.7 0

25.0 0

26.3 0

27.6 0

29.0 0

30.4 0

31.9 0

33.5 93.2

0 177.9

0 106.2

0 76.1

0 52.1

0 32.7

0 17.1

0 4.4

Total

5.7

14.7

25.0

26.3

27.6

29.0

30.4

31.9

126.7

177.9

106.2

76.1

52.1

32.7

17.1

4.4

Note: a R R T 75%, A R R T 10%, interest rate for A R R T 5% in real terms

attractive fields. The resource rent tax (RRT) is the most suitable fiscal instrument. Early revenues are not procured by this tax which is likely to cause difficulties for an impoverished host government. A solution to this problem may be found by introducing an advance

In developing countries direct state participation in petroleum production is common. This can certainly increase the state's take, but where prospectivity is not very high exploration incentives can be impaired. The effect depends upon the precise form of the participation as the following example shows:

resource rent tax ( A R R T ) payable from first production. It could be based on revenues minus operating costs, and the rate would be modest. A R R T payments would be creditable against the normal R R T payable later. They would be carried forward with interest and set off against RRT. If there were insufficient R R T available against which to credit the A R R T , cash refunds would be made at the end of the life of the project. The rate of interest payable

Exploration cost (E) = $10 million

on A R R T payments would be less than that likely to be employed by the investor to assess the project as the risks involved are very considerably less.

The private investor carries the state's share of

An example of the scheme of A R R T plus R R T compared to R R T alone is shown for a high cost petroleum project in Table 2. The rate of A R R T is 10%, the R R T rate is 75% and the interest rate on A R R T payments 5% in real terms. The scheme is seen to accelerate payments to the host government quite successfully. The chances of the scheme deterring marginal projects is very low, and certainly less than other more conventional schemes, Investors are always anxious to procure fiscal stability for themselves. Where there is a conventional income tax it is often difficult for the host government to provide assurances regarding the stability of income tax to investors in any one sector. Changes may be required unrelated to any petroleum sector activity, but there will be an impact on that sector. It is possible to provide for this eventuality where there is a general income tax and a special fiscal instrument applied only to the petroleum sector. For example, where there is an R R T applied to post-tax returns a formula can be devised which automatically reduces the rate of R R T if income tax is raised and increases R R T if income tax is reduced, This concept is incorporated in the new Petroleum (Taxation) Act 1991, in Namibia.

cry:

ENERGY POLICY February 1992

N P V from discovery = $100 million

Chance of discovery = 1 in 5 EMV = P(NPV) - E

= $10 million

Let government participation (SS) at the rate of 65% be introduced. Three forms are common and their effects are as follows:

exploration costs and is not reimbursed after discovE (1) = - $ 3 million The state company is a full risk-sharing partner: EMV = P(NPV)(1-SS)-

E M V = P ( N P V ) (1-SS) - E ( 1 - S S )

(2) = $3.5 million The private company carries the state's share of exploration costs and is paid back only where cornmercial discovery is made: (1-P)E (3) = - $ 1 . 7 million In cases (1) and (3) the participation terms make the exploration unattractive to the investor. If the rate of participation were lower the result could be different. For example if it were 25% the EMVs in the three cases would be (1) + $5 million, (2) +$7.5 million, and, ( 3 ) + $ 5 . 5 million. The developing countries are very often short of capital and foreign exchange. It is not obvious that employing the limited funds in high-risk exploration represents a sound use of such funds. In such cases direct participation at low or zero levels is probably preferable. State oil companies do have a useful EMV = P(NPV-E)(1-SS)-

111

Petroleum policy issues in developing countries 70 60 - -

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I

01

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I

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1972

1974

1976

1978

1980

1982

1984

1986

1988

Years { 1970-I 988)

Figure 3. Kenyan petroleum imports as % of total exports. Source:

IFS.

role, however. They can be employed to facilitate the transfer of skills and technology to the host country. There are several cases (for example Mozambique) where the state company has no direct stake in the exploration venture, but where it is actively involved in decisionmaking and the transfer of skills and technology from the private oil company.

POLICIES F O R CONSUMING COUNTRIES Very many developing countries are heavily dependent on petroleum imports. Kenya is an example of a country having some success in achieving economic growth, with a notable amount of industrial activity already in existence. In Figure 3 Kenya's imports of petroleum expressed as a proportion of total exports are shown over the period 1970-88. (The import bill is shown in this way to take full account of the significant exports of petroleum products from Kenya.) The striking features are: first, the overall major dependence since 1973; and, second, the marked fluctuations in the degree of dependency over the period. The latter phenomenon largely reflects the behaviour of real oil prices over the period, This pattern is broadly found in many other developing countries. In the period since 1973 there can be no doubt that the result was a major disruption to the development process in these countries, The optimal response covers several areas of economic policy. Within the petroleum sector itself the most important policy issues are those of pricing and taxation of consumers, In the 1970s and 1980s many countries adopted a

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policy of keeping petroleum prices below free market levels. The underlying thinking was usually: first, to restrain inflation in the economy generally; and, second, to contribute to income redistribution policies. While understandable this policy produces serious distortions to economic behaviour and can exacerbate national problems. 5 As consumers individual developing countries cannot affect world prices for petroleum products. Their foreign trade possibilities are therefore defined by the relative border prices of exports and imports. The opportunity cost of consuming such a product is either the cif value if the product is being imported or the fob value if the product would otherwise be exported. This measures the scarcity value of the products. When prices of petroleum products diverge from border values (excluding the effects of indirect taxes) there is a general welfare loss. The pricing of petroleum products significantly below their opportunity costs causes major problems. Consumption of the products is artifically increased. Imports are increased further or exports are reduced. The subsidization of importsrepresents not only an inefficient allocation of resources but entails a budgetary problem if the scale of such imports is substantial. Where the products are employed as inputs (for example fuel oil for power generation) rather than final consumption, there is reduced encouragement to energy efficiency. There may even be substitution in processes towards more intensive use of the subsidized products. Where the consuming country also produces petroleum these inefficiencies have sometimes been compounded. In contractual arrangements in several countries there are domestic market obligations on investors at prices well below market levels. 6 Apart

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Petroleum policy issues in developing countries

from the possible disincentive effects on new field developments this diverts a share of the potential economic rents away from the general taxpayer to the consumer of petroleum. In some countries the national oil company produces and supplies petroleum at prices well below their opportunity cost levels. The effect is to adversely affect the financial position of such companies, to reduce their capacity to invest, and to make them more dependent on the government, There are many examples of inefficiencies of the types noted above. In Egypt for many years the prices of LPG and fuel oil in particular have been kept well below border levels. The intention was to keep down the price of the fuels used, respectively, for heating water and cooking and for generating electricity, given that these were very important to the poorer sections of Egyptian society. The result was a major import bill for LPG, a reduced capability to export fuel oil, and an inefficient use of that fuel in electricity generation. Because of its low price the generating company had little incentive to increase the efficiency of its generating and distribution activities. The consequences were that the Egyptian balance of payments suffered and the public sector's financial position significantly deteriorated, While the distributional effects in this case were highly understandable the devices chosen were not very well targetted. Thus all domestic consumers, both poor and rich, benefitted from the subsidies, The deterioration in the balance of payments and the public sector budgetary position restricted the pace of economic growth and the capability of the government to improve the position of its poorest citizens, Both final consumers and intermediate purchasers adjust the pattern of their expenditures to relatively low fuel prices. Energy intensive methods of production and consumption are encouraged. This is dangerous, especially where the petroleum is being imported and its price could increase in an unpredictable manner, Consuming-country governments have to determine both appropriate pricing and taxation policies towards petroleum products. 7 It has been argued that opportunity cost pricing is generally appropriate. This of course means that subsidies on the consumption of the products should generally be removed. It is recognized that this may have significant distributional consequences, but only in rare cases will the subsidization of petroleum products be the most appropriate way to help the poorest members of society. Generally the device is too blunt and

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the benefits are dissipated too widely. The appropriate taxation of petroleum products can be considered under a number of headlines and may be classified as: revenue raising; distributional; environmental; and, energy policy. In virtually all countries some petroleum products, especially motor gasoline, are regarded as a suitable tax base for pure revenue raising purposes. The revenue base is likely to be buoyant over time. The income elasticity of demand is typically thought to be fairly high and the price elasticity comparatively low. The case for excise duties is strong on these grounds alone. There is a presumption in favour of equal taxation of all products. The wedge between the marginal cost and price then becomes equal across different products. In the case of petroleum other considerations also come into play. Distributional ones would militate against the employment of equal taxes over all products. Motor gasoline is frequently thought to be a worthy subject of heavy taxation because it is generally consumed by the higher income groups in developing countries. Diesel fuel consumed in vehicles poses some problems from a distributional viewpoint.It is consumed in motor cars and thus deserves equal tax treatment with motor gasoline. It is also consumed by buses and trains where services are used by poorer people. Diesel fuel is also consumed on farms, though in developing countries it is fiequently only comparatively well-off farmers who can afford to employ tractors. In some countries (such as the UK) there is a tax concession for certain purposes (such as agriculture), and otherwise the tax on diesel fuel approximates to that on motor gasoline. Whether enforcement mechanisms can be put in place in developing countries to handle differential taxation of the same product is doubtful. The conclusion is that unless distributional considerations are important the tax on diesel fuel should approximate to that on motor gasoline. In developing countries kerosene is widely employed for lighting, heating and cooking, frequently by the poorer sections of society. On distributional grounds any excise tax should not be nearly as large as that on motor gasoline. The size of the tax could have substitution consequences. In many countries k e r o s e n e and f u e l w o o d are near substitutes. Kerosene will generally become the preferred fuel as incomes rise, but if the tax on kerosene is substantial there could be substitution back to fuelwood. Whether this is a desirable outcome will at least in part depend on the environmental consequence of further use of fuelwood and the depletion of forests. To some extent kerosene is a substitute for LPG.

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Petroleum policy issues in developing countries

The relative duties will thus have an influence on relative consumption. A further complication in some countries (such as Thailand) is that LPG is also employed as a fuel in vehicles. As a motor fuel LPG would be eligible for a relatively high tax rate, but for cooking and water heating purposes a comparatively low rate (on distributional grounds). One solution to the problem (acknowledged by the Thai government) is to have a differential tax depending on its use. This demands an enforcement mechanism which can be difficult in practice, Energy policy suggests that conservation, energy efficiency and substitution possibilities be brought into consideration. 8 In many developing counties heavy reliance on imported petroleum, whose price is expected to be volatile, raises questions of energy security. It is arguable that consumers should be required to pay a premium to reflect this cost. This would raise the cost of petroleum in relation to other domestic sources of energy. The most efficient method of implementing this concept is to levy an excise duty on the use of all petroleum products. In practice this means not only a tax on final sales to consumers but also a duty levied on purchases of gas oil and fuel oil by industry and power generators, Levying a duty in the manner described should reduce the consumption of the products whose supply and price is subject to some insecurity, and favour the use of other sources of energy and conservation, The idea is controversial, but acknowledges a problem which is likely to be present for the foreseeable future. Energy policy considerations could also suggest that diesel fuel be taxed at a lower rate than motor gasoline. Diesel engines are generally more fuel efficient than those employing motor gasoline, The consumption of petroleum products causes considerable air pollution in developing countries, Traffic congestion is also a horrific problem in many cities such as Bangkok and Lagos. The pollution problem needs urgent attention in many countries, The two relevant policy approaches are: first, taxation; and, second, standards and regulations backed up by penalties. Taxation schemes can be devised related to the emissions from vehicles, power stations, factories and households. Sophisticated schemes would be clearly linked to the pollution and would clearly encourage the pollutor to take steps to reduce the undesirable emissions. Crude schemes (such as excise duties) would be less directly linked to the amount of pollution, but could still result in less emissions, Sophisticated pollution taxes have not been properly developed for use in Western countries. In developing countries in the meantime it may be

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more practicable to proceed through the use of regulations and penalties for the more obvious sources of pollution. A differentiation of the duty on motor gasoline to favour unleaded would be an exception as it is relatively easy to introduce. Regulations on the necessary conversion of cars may also be necessary to make the scheme effective. The problems of traffic congestion are more efficiently dealt with directly such as by a simple system of road pricing such as exists in Singapore. Putting extra taxes on petroleum products is not accurate targetting for this problem. CONCLUSIONS The context in which petroleum exploitation and consumption are likely to take place is one of continuing price uncertainty and possible volatility. In these circumstances producers of petroleum should adopt licensing and taxation policies which reflect this environment. Major producers owning acreage of high prospectivity and relatively high well productivity could with advantage employ bonus bidding schemes to award exploitation rights. Conditional taxation is still required to collect a share of realized economic rents. Such taxation should be profit-related for the most part, and be flexible in response to fluctuations in the size of the economic rents. The resource rent tax is more suitable than conventional royalty and income tax schemes and production sharing arrangements. In countries which are minor producers or where no discoveries have been made bonus bidding schemes are unlikely to produce significant revenues. It is more important to have a fiscal system well-targetted on economic rents in such countries. The terms need to reflect the possibly high exploration risk. State participation terms can introduce disincentives in situations of high exploration risk. In some developing countries there is not a strong case for direct state participation in oil exploration. In consuming countries pricing of petroleum should reflect the opportunity costs of the consumption. Balance of payments and budgetary difficulties can readily be exacerbated when the consumption of these products is subsidized. Petroleum products are generally a suitable base for taxation on revenueraising grounds. While there is a case on welfare grounds for an equal rate of tax on all petroleum products distributional considerations point to higher rates on some, especially motor gasoline. Diesel fuel may obtain a rather lower rate on energy efficiency and possibly distributional grounds.

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Petroleum policy issues in developing countries

Kerosene would receive a much lower rate of tax for distributional reasons. G r e a t care needs to be taken not to

produce undesired substitution between pet-

roleum products (or other energy sources) by differential taxation. There is a case for having some positive taxation in the case of all p e t r o l e u m products to reflect the energy/security problem when the price of a m a j o r

import is subject to marked fluctuations. T h e r e is a clear need for action to be taken to deal with air pollution from the use of p e t r o l e u m products. A taxation scheme could be devised related to the pollution caused which would give incentives to polluters to reduce the environmental damage. For practical reasons it m a y be easier to deal with this

problem in the m e a n t i m e by regulations and fines on the worst forms of pollution. An exception could be the introduction of a tax differential in favour of unleaded gasoline backed up by regulations in the necessary conversion of cars. The problems of traffic congestion are best dealt with by direct measures

such as road pricing schemes.

1Robert McRae, 'Energy demand in developing Asian countries', paper presented to 1991 International Conference of International Association of Energy Economics, Honolulu, HI, July 1991. 2K.I.F. Kahn, ed, Petroleum Resources and Development, Belhaven Press, London and New York, 1987. 3A.G. Kemp, Petroleum Rent Collection Around the World, Institute for Research on Public Policy, Nova Scotia, Canada, 1988. 4R. Garnaut and A. Clunies Ross, The Taxation of Mineral Rocks, Oxford University Press, Oxford, UK, 1983. K.F. Palmer, 'Mineral taxation policies in developing countries: an application of resource rent tax', 1MF Staff Papers, International Monetry Fund, Washington, DC, USA, 1985. 5M.S. Kumar, Energy Pricing Policies in Developing Countries, UNDP/ESCAP/ILO/ARTEP, 1987. M. Munasinghe, 'Energy pricing policy framework and experience in developing countries', in C. Siddayao, ed, Criteria for Energy Pricing Policy, Graham and Trotman, London, UK, 1985. World Bank, Energy Options

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and Policy Issues in Developing Countries, Staff Working Paper No 350, Washington, DC, USA, 1979. World Bank, Energy in the Developing Countries, Washington, DC, USA, 1980. World Bank, Energy Pricing in Developing Countries: a Review of the Literature, Energy Department Paper No 1, Washington, DC,

USA, 1980.

°J.M. Gillis, Energy Demand in Indonesia, Projections and Policies, Development, Discussion Paper No 92, Harvard Institute for International Development, Cambridge, MA, USA, 1980. 7G.A. Hughes, Options and Impacts of Energy Pricing Strategies in Thailand Asian Employment Programme/ILO, New Delhi, India, 1980. G.H. Hughes, 'The impact of fuel prices on Thai-

land', in D. Newbery and N. Stern, eds, The Theory of Taxation for Developing Countries, The World Bank, Washington, DC, USA, 1985. M. Munasinghe, 'An integrated framework for energy pricing in developing countries', Energy Journal, Vol 1, No 3, pp 1-31. D. Newbery, in Siddayao, ed, op cit, Ref 5. SD.F. Barnes and Liu Qian, 'Urban interfuel substitution, energy use and equity in developing countries: some preliminary results', paper presented to the 1991 International Conferences of the International Association for Energy Economics, East-West Centre, Honolulu, HI, USA, July 1991. R. Bhatia, 'Energy pricing

and household energy consumption in India', Energy Journal, Vol 9, Special South and South-East Asia Pricing Issue, 1988. E. Cecelskij, J. Dunkerley and W. Ramsay, Household Energy and the Poor in the Third World, Resources for the Future, Washington, DC, USA, 1979. A. Desai, 'Interfuel substitution in the Indian economy', Discussion Paper D-73D, Resources for the Future, Washington, DC, USA, 1989. W. Elkan et al, Transitions Between Traditional and Commercial Energy in the Third World, Surrey Energy Economics Centre Discussion Paper Series, SEED No 35, 1987. E.L. Hughes-Cromwick, 'Nairobi households and their energy use - an economic analysis of consumption patterns', Energy Economics, Butterworths, Guildford UK, 1985. S.N. Sharma, in Siddayao, op cit, Ref 5. World Bank, Pakistan Issues and Options in the Energy Sector, Washington DC, USA, 1980. World Bank, Mauritania: Household Energy Strategy, Report of the Joint UNDP/World Bank Energy Sector Management Assistance Program, Washington, DC, USA, 1988. World Bank, Senegal:Urban Household Energy Strategy, Report of the Joint UNDP/World Bank Energy Sector Management Assistance Program, Washington, DC, USA, 1988. World Bank, Niger: Household Energy Conservation and Substitution, Report of the Joint UNDP/World Bank Energy Sector Management Assistance Program, Washington, DC, USA, 1988. World Bank, Zambia: Urban Household Energy Strategy, Report of the Joint UNDP/World Bank Energy Sector Management Assistance Program, Washington, DC, USA, 1990. World Bank, Haitii: Urban Household EnergyStrategy, Report of the Joint UNDP/World Bank Energy Sector Management Assistance Program, Washington, DC, USA, 1991.

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