Durable extractive contracts are underpinned by a fiscal system that is consistent with the governments’ overall economic and fiscal objectives and provides a fair sharing of financial benefits between the investor and the host government, taking into consideration the potential risks, rewards, and country circumstances. As there is no one ideal fiscal regime, each host government needs to identify the optimal mix of fiscal instruments and terms to meet its objectives.
A predictable fiscal regime that includes responsive terms defined in legislation and/or the contract to adjust the allocation of overall financial benefits between host governments and investors to variables that affect project profitability (such as variance in commodity prices, costs, production volume, or resource quality) contributes to the long-term sustainability of extractive contracts and reduces the incentives for either party to seek renegotiation of terms.
Host governments need to generate financial benefits from the extraction of their resources. Durable extractive contracts avoid sustained periods of commercial production with little or no revenue flows to the government.
46. In the extractive sector, the fiscal system refers to the combination of general tax law, a sector-specific law, and project-specific contractual agreements, such as: (1) concession agreements, common to both mining and petroleum with the primary instruments being royalty and taxes; (2) production sharing contracts, characteristic of petroleum regimes which share the production between the state and the investor (in some instances, there may also be royalty and taxes imposed); or (3) risk service agreements, sometimes used for petroleum resources, where the host government pays the investor a service fee. When using multiple legislative and contractual instruments, host governments should consider how they interact with each other and with the general tax legislation. Recognising that the specificities of the extractive sector and the need to attract investment result in some variation between the standard tax regime and the extractive fiscal regime, limiting such variations can help to avoid fragmentation and minimise the burden of administration and ensure overall coherence of the fiscal system.
47. Governments decide what combination of fiscal instruments and terms will be appropriate for their individual circumstances. These circumstances include how much the government wants to raise and spend, but also how competitive the government wishes to be to attract investment and encourage resource exploration, development, and production for optimal resource recovery. It is important to devise an optimal mix of fiscal instruments and terms for the given set of country circumstances, knowing that each instrument has its own trade-offs and there is no one ideal fiscal regime.
48. The choice of fiscal instruments and terms may be influenced by the capacity of a particular country to implement them. Close, ongoing co-ordination among different governmental agencies, including Ministries of Energy and Mining, Environment, Finance, Tax Policy and Administration, is important to achieve the right policy balance and successful implementation.
49. Without prejudice to the applicable revenue-sharing arrangements between federal and sub-national governments, extractive contracts that are underpinned by a responsive fiscal regime that provides for the fair sharing of value through all stages of the project life-cycle and across a range of outcomes and ongoing market conditions are more likely to be durable. Extractive projects are likely to operate through several economic cycles and they are likely to experience booms, but also periods of economic stress and loss. Host governments should aim to structure a credible fiscal system that minimises distortions to production decisions, is responsive to price changes, and allows both governments and investors to reduce risk and adequately deal with incomplete information at the time of the negotiation and signature of the contract.
50. Responsive fiscal terms defined in legislation and/or the contract, anticipate multiple profitability scenarios (whether influenced by price, cost, volume, quality, etc.) and equitably rebalance the sharing of financial benefits, foster fiscal stability and contribute to the durability of the contract. The meaning of responsive in this context is that the government share of financial benefits automatically increases when profitability is high, and conversely decreases when profitability is low.
51. This structure can also help governments deal with political pressures which could minimise the likelihood to renegotiate or introduce changes while maintaining the predictability of the contract. Chasing the price of commodities through repeated renegotiation is neither efficient (given that price volatility tends to be a structural characteristic of the industry), nor it is productive as experience shows that this results in strained relationships between host governments and investors.
52. Without responsive fiscal instruments and terms defined in legislation and/or the contract, pressures for changes in fiscal terms may arise from governments and investors for different reasons. For example, without responsive fiscal instruments and terms, when commodity prices rise, there is often the presumption of a perceived windfall wherein all upside accrues to investors. This creates an incentive for governments to modify fiscal instruments and terms in an attempt to address this imbalance – whether real or perceived. For investors, when prices fall and there are not responsive fiscal instruments and terms it may result in projects becoming uneconomic. This creates an incentive for investors to approach host governments to seek more favourable terms to enable continued activity and production.
53. Fiscal instability is one of the key risks considered by investors, in addition to geologic, political, technical and non-technical risks, which influence an investor’s view of the overall investment climate and their assessment of the attractiveness of the investment opportunity. For example, if governments frequently change fiscal instruments and terms when prices rise, this creates additional fiscal risk for investors. In response, investors may require higher project returns to compensate for that risk, or simply not undertake projects. The result is likely to be a consequential reduction of investment and revenues for host governments, if the government fiscal framework is deemed by investors to be unstable.
54. In cases where investors perceive there to be high fiscal or political instability, they may seek the inclusion of fiscal stabilisation clauses to reduce these risks. Host governments may not need to offer or accept to include stabilisation clauses, as they could still attract the required investment through strong constructive negotiations and open competitive bidding involving technically and financially capable investors. Where governments decide they are necessary, fiscal stabilisation provisions can be designed to minimise the general tax policy impact, by limiting its scope to specific key fiscal terms (not all fiscal terms), such as agreed rates, for a specific period of time (not indefinitely), and possibly by applying a stability premium on tax rates. Commensurately, for extractive contracts to be durable, they should contain clear obligations on investors to pay their full share of taxes under the contract and applicable law and the clear rights of the host governments to enforce those obligations. The adoption of bona fide anti-avoidance measures or the interpretation of existing laws by host governments to protect the revenue base against tax base erosion and profit-shifting (e.g. on interest deduction limitations and transfer pricing) and consistent with internationally recognised tax practices should not be considered a change in law constrained by stabilisation clauses.
55. There are various mechanisms available to governments to design responsive regimes. It is worth considering that responsive regimes may increase the burden of administration. The government’s limited administrative capacity and performance in managing variable revenues, may point to heavier reliance on less responsive instruments and terms that are easier to administer.
56. The overall government benefits from the development of its natural resources are broader than the fiscal take and can include the development of new infrastructure, employment creation, training, local procurement of goods and services, and community projects. However, if there are sustained periods of production with little or no revenue flows, the contract may not be sustainable as host governments need to demonstrate that the country is benefitting financially from the development of its finite resources.
57. Depending on context, it may be appropriate to ensure a minimum share of revenues to the host government for each year of commercial production. Governments that have a diversified economy and/or wide revenue base may not necessarily need nor desire to receive a payment in every year of production from every single project. For host governments with limited revenue, access to capital markets and project portfolio, the assurance of a minimum level of revenue is important. In addition, for governments with newly developing extractive industries, early revenue flows are important to bolster budgets in light of the population’s expectation of realising some immediate benefits from its resource development.
58. Ensuring a minimum share of government revenue can be achieved through a royalty and/or cost recovery ceilings in a production-sharing contract. It should also be noted that these fiscal instruments are regressive and may discourage incremental investments in marginal projects.
59. A fiscal system that includes both regressive and progressive instruments, and that is progressive overall will help to align the interests of the host government and the investor.