By Iain Steel, Research Associate, ODI & Founding Director, Econias
“It’s a high-risk country, there’s no infrastructure, and the resources are low quality.” I have heard these arguments countless times over the years from investors in extractives projects. And in every single negotiation I have advised governments on, across Africa and Asia-Pacific, investors have asked for tax incentives that they claim are necessary for financial viability. But how are governments to judge these claims when investors don’t share the underlying data?
Extractives projects are uncertain and risky. Nobody knows the true geology of the asset before it is developed, the precise amount of investment required, and the operating costs to extract and refine the resources. And the only thing we really know about commodity prices is that they’re volatile and unpredictable. Who would have thought in January 2020 that within four months the price of oil would be negative?
Unbalanced deals are a bad result for all parties
Investors often have better information than governments when negotiating extractives contracts. This is not a criticism of governments, but a function of the work that is usually undertaken by investors. Investors tend to explore for resources and commission studies to determine the technical and financial feasibility of projects. They are also likely to have deeper sectoral expertise and experience than governments, and know the value of their intellectual property.
“Investors often have better information than governments when negotiating extractives contracts.” #DevMatters
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When negotiating contracts for extractives projects, it can be tempting for investors to withhold this information from governments. Knowledge is power, as the old adage goes, and investors may believe that having information that the other side doesn’t have will enable them to get a better deal. However, if this tactic is successful, it can lead to unbalanced deals that fail to deliver benefits to host governments and local communities. Such deals are inherently unstable, as it will eventually become apparent to governments and their citizens that they are not getting their fair share of benefits from the project. And when this happens, the result is bad for all parties – costly renegotiation, legal challenges, or even expropriation.
Access to investor information is necessary, but not enough
There is a better way to negotiate that can lead to durable contracts from which investors, states and local communities can all benefit. As set out in the OECD Development Centre’s new Guiding Principles for Durable Extractive Contracts, rather than withhold information from governments, investors should openly share financial and technical information in negotiations as standard practice. With access to better information, governments are empowered to negotiate more effectively, leading to more balanced and durable contracts that satisfy the aims of host governments, local communities, and investors. However, while sharing information is necessary, it is unlikely to be sufficient. Governments should therefore do three things to make best use of the information.
First, make the quality of information fit for purpose. I have seen investors share “financial models” that are no more than a few lines of cash flow projections typed into Excel without formulas. Finite natural resources belong to the state, and governments can – and should – insist on information of the same detail and quality as is made available to financial lenders and used by extractives companies in their own internal decision making.
Second, recognise the data are estimates. Governments should recognise that the data provided are qualified estimates, and significant uncertainty remains over key assumptions and outcomes. Technical conversations on the assumptions and methods used often take place between investors and governments. They are an opportunity to build trust and a shared understanding of the potential balancing of risks and rewards from the project.
Third, make effective use of the information provided. Financial models should be used to assess outcomes under different scenarios, estimate the costs of any tax incentives requested and their impact on investor returns, and ideally to model broader social and environmental outcomes. Many African governments are already using financial models when negotiating extractives contracts, but have found a substantial gap in access to data that are key inputs for financial models. Modelling capabilities can also be a barrier for governments.
Development partners often provide training on financial modelling. Alternatively, governments can use external experts either procured commercially or provided under development assistance programmes. Indeed, many developed countries use external advisors with financial and technical expertise when negotiating major energy and infrastructure projects. There’s no reason why developing countries shouldn’t do the same, and negotiation support providers such as CONNEX, the African Legal Support Facility, and the Commonwealth Secretariat have all recognised the value of the Guiding Principles and undertaken to utilise them in their support programmes.
“Getting better deals is only part of the challenge for developing countries. The Guiding Principles rightly identify the importance of sharing information continuously over the life cycle of the project.” #DevMatters
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Trust and understanding that go beyond negotiations
Getting better deals is only part of the challenge for developing countries. The Guiding Principles rightly identify the importance of sharing information continuously over the life cycle of the project. Ideally, there should be clear requirements for investors to share specific information with governments on a frequent basis, and these should be codified in legislation. Where legislation does not set requirements, these can be included in contracts. It is unfortunate that those who sit around the negotiating table are usually different from the people who implement and monitor projects after negotiations conclude.
Trust and understanding are often built through negotiations, but these can be lost when negotiations conclude, and new teams move in. Governments and investors should both ensure there is a detailed handover from the negotiating team to those responsible for implementing the contract. And relationships need to be built at different levels, both technical and political, to ensure that any issues are identified and communicated early to reduce the likelihood of economic or political surprises that can derail a project.
So, are those tax incentives really necessary to make a project viable? Investors should share financial and technical data with governments in good faith and prove it.