The Art and Science of Benefit Sharing in the Natural Resource Sector DISCUSSION PAPER INTERNATIONAL FINANCE CORPORATION RIGHTS AND PERMISSIONS 2121 Pennsylvania Avenue, NW The material in this publication is copyrighted. IFC Washington, D.C. 20433 U.S.A. encourages use and distribution of its publications. Content Telephone: 202 473-1000 from this document may be used without prior permission Facsimile: 202 974-4384 provided that clear attribution is given to the original source and that content is not used for commercial purposes. www.ifc.org PHOTO CREDITS All rights reserved. February 2015 Cover, p. 44, 56, Adriana Eftimie; p. 6, 10, and 50, iStock; p. 2, 8, 15, 23, 24, 29, 30, 36, 39, 44, 47, 49, 60, 62, 64, 83, The findings, interpretations, views, and conclusions Ted Pollett; p. 14 Cairn India; p. 54, Reidar Kvam and expressed herein are those of the authors and do not World Bank Group Photo Collection necessarily reflect the views of the Executive Directors of the International Finance Corporation or of the DESIGNER AND TYPESETTER International Bank for Reconstruction and Development (the World Bank) or the governments they represent. Station 10 Creative, Columbia, MD Some information in the publication comes from publicly available sources such as company websites. IFC has not verified the accuracy of such information nor the companies’ practices. Contents 5 The International Finance Corporation: Development Institution and Investor in the Natural Resource Sector 7 About this Discussion Paper 8 Acknowledgments 10 Abbreviations 11 Chapter 1: Overview of IFC Approach and Experiences 11 IFC Approach 17 IFC Experiences and Lessons Learned 21 Chapter 2: Sharing Financial Benefits at the National Level 21 Sharing the Financial Benefits at the National Level 25 Drivers of Project Outcome and Fiscal Benefit Sharing 31 Judging Overall Reasonableness of Fiscal Benefit Sharing 31 Critical Areas for Review 33 Chapter 3: Sharing Financial Benefits at the Local Level 33 Sharing at Lower Levels of Government: State, District, Municipality 38 IFC Advisory Services—Revenue Management 40 IFC Revenue Management—Observations and Lessons Learned 41 Critical Areas for Review 43 Chapter 4: Linkages to the Local Economy 43 Enhancing Local Procurement 45 Processing and Using Natural Resources 45 Providing and Sharing Infrastructure 51 Critical Areas for Review 3 53 Chapter 5: Environmental and Social Benefits and Costs 53 Meeting IFC Environmental and Social Performance Standards 58 Rights Impact Benefit Sharing with Communities 61 Helping Communities Benefit More from Projects: Process Is Key 62 What Is Reasonable Community Benefit Sharing? 63 Critical Areas for Review 64 Continuing a Dialogue 65 Appendixes 65 Appendix A: Resource Development and Taxation 73  Appendix B: IFC Measures to Assess Natural Resource Projects 76 Appendix C: Introduction to Simple Model and Scenarios 78 Glossary 80 Bibliography Boxes 24 Box 2.1: Adjusting Cash Flows for the Cost of Time and Uncertainty 40 Box 3.1: Lessons Learned from IFC Revenue Management Programs 48 Box 4.1: IFC Local Supplier Development Program—Rio Tinto Simandou Iron Ore Project in Guinea 56 Box 5.1: Broad Community Support 59 Box 5.2: Gender Impacts of Projects Figures 14 Figure 1.1: IFC Stakeholder Framework and Areas of Project Impact 16 Figure 1.2: Schematic IFC Investment Cycle 47 Figure 4.1: IFC’s Experience in Strengthening Local Businesses’ Linkages to Natural Resource Projects 54 Figure 5.1: IFC Performance Standards Tables 22 Table 2.1: Comparison of Selected Mining Tax Terms across Selected Countries 74 Table A.B.1: Share of Net Project Benefits Going to Government (hypothetical project) (%) 77 Table A.C.1: Hypothetical Mine Model Assumptions 77 Table A.C.2: Hypothetical Mine Model Outcomes by Scenario 4 The International Finance Corporation: Development Institution and Investor in the Natural Resource Sector The International Finance Corporation (IFC), IFC has been engaged in the natural resources sector— a member of the World Bank Group (WBG), is the largest oil, gas, and mining—since its inception. As part of the global development institution focused exclusively on WBG, IFC shares the objective that its engagement in the the private sector in developing countries. Established in natural resource sector supports a positive contribution 1956, IFC is owned by 184 member countries, a group of a country’s natural resources to sustainable economic that collectively determines our policies. Our work in development. As such, priorities for the WBG1 in the more than 100 developing countries includes a network sector include the strengthening of governance and of nearly 1,000 financial institutions and more than transparency, mitigating environmental and social 2,000 company clients and helps create opportunities in risks, ensuring that the poor benefit and that the rights emerging markets where they are needed most. IFC uses of affected people are protected. IFC is also concerned its capital, expertise, and influence to help end extreme with balancing the need to combat climate change with poverty and boost shared prosperity by harnessing the ensuring that the poor have access to affordable energy. private sector. The exploitation and extraction of oil and minerals has IFC blends investment with advice and become ever more important for many of the world’s resource mobilization to help the private sector poorest countries, and is promising to remain vital in advancedevelopment. In the most recent financial year, the foreseeable future given world demand for minerals IFC invested more than US$22 billion, including about and energy. The sector is a key source of jobs, energy, US$5 billion marshaled from other sources across various government revenues, and a wide array of additional industry sectors, including agribusiness and forestry, benefits for local economies. IFC’s mission in the oil, gas, financial institutions, infrastructure, telecommunications and mining sector is to help developing countries realize and information technology, oil, gas, and mining, these benefits and promote adequate benefit-sharing manufacturing, and consumer and social services. between all stakeholders. In addition to investments, IFC provides advisory services and supports its clients to adopt important standards in areas such as environmental and social performance and corporate governance. Because of its convening power, IFC can bring important parties together for project development and the sharing of technical, industrial, and financial knowledge and innovation. 1 These priorities emerged as commitments from the WBG in response to the Extractive Industries Review (EIR)—an extensive review of the WBG’s activities and future role in the sector. For more information: http://www.ifc.org/wps/ wcm/connect/industry_ext_content/ifc_external_corporate_site/industries/ oil%2C+gas+and+mining/development_impact/development_impact_extractive_ industries_review 5 6 About this Discussion Paper If developed and managed appropriately, a country’s For communities, projects are likely to bring a mix oil, gas, and mineral resources can make a major of economic benefits and environmental and social contribution to economic development and poverty costs, particularly for local communities who live close alleviation. The revenues generated by the production of to the asset. Oil, gas, and mineral development can oil, gas, and minerals can fund government programs and bring benefits, such as jobs and skills development, transform natural assets into human, social, and physical opportunities for small and large business development, capital, helping to drive sustainable development and and investment in infrastructure and related services long-term poverty reduction. The sector encompasses a (roads, water, and power). At the same time, projects diverse group of stakeholders who have strong interests can bring negative impacts that, if not properly in the decision to develop an oil, gas or mineral resource, addressed, can result in environmental degradation, the timing, and how the development of the asset is social disarticulation and impoverishment, among managed, including how the costs and benefits of natural others. Ideally, projects should improve people’s lives resource development1 are shared. overall. Well-managed projects will create opportunities for affected communities to participate in decision- For governments, natural resources are part of making and design. the national wealth that they have a responsibility to manage for the long-term good of the country. Oil, gas, For investors, projects offer opportunities to invest and mining sectors are often a vital source of taxes and capital and deploy their expertise and technical skill. revenues to fund government budgets. Governments Companies will choose to invest in the exploration face competing priorities when designing policies that and development of oil, gas, and mineral resources determine when, how, and by whom the resource will if the potential return is attractive and the risks are be developed. From a benefit-sharing perspective, such acceptable. Investors require clear and transparent policies need to embrace the interests of current and fiscal frameworks and regulatory regimes, and stable future generations and the rights, interests, and needs contracts. Companies are increasingly aware that their of different levels of government, communities, and interest in the natural resources sector is closely linked other stakeholders. Also critical is the development to the interests of other stakeholders. Deals that are of government policies and capacities to manage seen to be reasonable and to benefit host communities and monitor the performance of the sector and the and countries are more likely to be durable and their appropriate use of revenues for the national good. operations less likely to be interrupted. PURPOSE OF THIS DISCUSSION PAPER The purpose of this paper is to contribute to the understanding and discussion of how the costs and benefits of natural resource development are shared across society. This paper presents how IFC, as both an 1 The paper only considers the commercial exploration, development and investor and a development organization, determines exploitation of oil, gas, and mineral assets. whether benefits and costs are shared reasonably, and 7 ACKNOWLEDGMENTS This document was prepared by Liane Asta Lohde with support from Clive Armstrong (consultant) and Veronica Nyhan Jones (IFC). We appreciate the many invaluable contributions to this paper that we have received from concept stage to final product. Key informants and peer reviewers include Edward Bickham (World Gold Council), Kate Carmichael (ICMM), Nick Cotts (Newmont), Philip Daniel (IMF), Emily Greenspan (Oxfam America), Patrick Heller (Natural Resource Governance Institute), Michael Jarvis (World Bank), Jaakko Kooroshy (Chatham House), Bryan Christopher Land (World Bank), Thomas Lassourd (Natural Resource Governance Institute), Denise Leung (World Resource Institute), Anita Malhotra (Rio Tinto), Gary Joseph Raymond McMahon (World Bank), Raghavan Narayanan (Independent Evaluation Group), Hege Marie Norheim (Statoil), Ted Pollett (consultant), Malan Rietveld (Columbia Center on Sustainable Investment), Christopher Sheldon (World Bank), Paul Stevens (Chatham House), Larry Suskind (MIT), Perrine Toledo (Columbia Center on Sustainable Investment), Luc Zandvliet (Triple R Alliance). Excellent feedback and input was also received from the following IFC colleagues: Arjun Bhalla, Pierre A. Pozzo di Borgo, Tom Butler, Lance Crist, Rodrigue Djahlin, Adriana Eftimie, Richard English, Brian McNamara, John Nicholas Middleton, Olivier Mussat, Walid Nasr, Knut Olsen, Fernando Ruiz- Mier, Gosia Nowakowska-Miller, Sunrita Sarkar, Stephanie Sines, Robin Weisman, Shaza Zeinelabdin. We have also benefited greatly from sharing our work and road testing it in various fora over the past year, including the Mining Indaba in South Africa, the IFC Sustainability Exchange, Annual Meetings of the Intergovernmental Forum, IPIECA Working Group on Social Responsibility. Special thanks go to Gillian Davidson (World Economic Forum) for a successful collaboration. We would also like to acknowledge Benjamin Aryee (Ministry of Lands and Natural Resources, Ghana), Andrew Dawe (Department of Foreign Affairs, Trade and Development Canada), Fundi Dlamini (Richards Bay, Rio Tinto), Gabriella Rigg Herzog (Hess Corporation), Daniel Kaufmann (Natural Resource Governance Institute), Helen Murphy (IPIECA), Jon Samuel (Anglo American), Honorable Minister of Land, Mines and Energy Patrick Sendolo (Liberia), Gordon Thorpe (Newmont Ghana Gold), Sahr Wonday (National Minerals Agency, Sierra Leone). The publication was edited by Alicia Hetzler, Deborah Horan, and Diane Stamm, with design and layout by Station 10 Creative. Special thanks go to Sharon Flynn (consultant) for her invaluable assistance for getting us through the finish line and to Anna Vorotniak (IFC) for her administrative support throughout. 8 how this assessment influences IFC’s decision to invest in At the close of each chapter, some examples are a particular natural resource project.2 highlighted when further review of a particular aspect of benefit sharing may be warranted. Determining whether Through its long experience in the sector, IFC has a project will generate reasonable benefits is a dynamic learned that investments likely will run into problems process that reflects diversity of national context, at some point in their life cycles if there are imbalances changing nature of markets, government priority, in the sharing of fiscal, economic, environmental, and human behavior and project realities. As a result, there social costs and benefits. By describing IFC’s thinking is a spectrum of what can be considered reasonable and lessons learned, the goal of the paper is to promote overall. However, there may be particular features of a broad, constructive dialogue across stakeholders— a benefit-sharing arrangement that stand out and can governments, investors, civil society, and others— signal a risk to its legitimacy. around benefit sharing. Our aspiration is that this paper will complement as well The paper draws on IFC’s experience and presents an as stimulate work by others that can enhance the collective overarching framework for multi-stakeholder benefit knowledge and encourage dialogue. Many other actors— sharing, providing analysis and guidance for a range of from civil society, academia, private sector companies, complex topics. The paper is intended to provide entry industry associations, multilateral organizations—have points for stakeholders of varying levels of familiarity made contributions to enrich our understanding of how with the issues to benefit-sharing assessment. The paper natural resource development can contribute to sustainable is not a definitive manual for all the issues covered development and what is required for a fair sharing of for which more detailed, high-quality and excellent benefits among all affected stakeholders. Recognizing that references and literature exists.3 the agenda is large and with many different perspectives, IFC hopes that other actors will add to this effort and share their own experiences and practice to create a STRUCTURE OF THIS PAPER common database. This paper is organized along these broad areas of impact that IFC considers in the benefit sharing assessment: IFC is eager to receive feedback from stakeholders. fiscal, economic, environmental, and social. The You can send your comments to Liane Asta Lohde, approaches IFC uses to evaluate benefit sharing are Senior Economist, Infrastructure and Natural Resources presented in each area, along with some lessons learned. at llohde@ifc.org. This is complemented by a discussion of key issues that are topical in the field. The paper is available on the following website: www.commdev.org Each chapter opens with a list of questions that can be used as a guide to assess the potential benefits and costs of an investment. The questions are not exhaustive, but are thought to be a useful starting point for review, or for initiating dialogue about net impacts and risks across constituencies. 2 This paper focuses on benefit sharing in the context of a project’s development phase (and beyond) once an economic resource has been identified. 3 As a starting point, please see www.eisourcebook.org 9 ABBREVIATIONS BCS Broad Community Support IFC PS International Finance Corporation Performance Standards EFR Effective Royalty Rate IMF International Monetary Fund EIR Extractive Industries Review IRR Internal Rate of Return EITI Extractive Industries Initiative NGO Non-Governmental Organization EP Equator Principles NPV Net Present Value ERR Economic Rate of Return—used OECD Organisation for Economic Co-operation ESP PS Environmental and Social Policy and and Development Performance Standards MIGA Multilateral Investment Guarantee Agency ETR Effective Tax Rate RM Revenue Management FPIC Free Prior and Informed Consent SEP Stakeholder Engagement Plan FRR Financial Rate of Return SME Small and Medium Enterprise GIIP Good International Industry Practice SNG Subnational Governments ICMM International Council of Metals and Mining UN United Nations ICP Informed Consultation and Participation VAT Value-Added Tax IFC International Finance Corporation WBG World Bank Group 10 CHAPTER 1: Overview of IFC Approach and Experiences Nonrenewable natural resource projects—that IFC recognizes the important technical and economic is oil, gas, and minerals—are usually seen as part of differences between the oil, gas, and mining industry, a nation’s wealth. Accordingly, their use for the long- and understanding project and country specifics is term sustainable development of a country is a prime crucial. Nonetheless, the three sectors share certain objective of any legitimate government. The role of characteristics that distinguish them from any other government in establishing a framework to manage industry, including high degrees of uncertainty and risk and invest revenues derived from oil, gas, and mining (geological, exploration, technical), price volatility, long projects is crucial to ensure that the sector contributes project lead times with significant capital expenditures positively to sustainable development. up front, and often a large footprint with environmental social effects. These factors profoundly influence how, The fair sharing1 of the net benefits of natural resource when and to whom benefits and costs accrue and the developments, i.e. benefits in excess of costs, between process by which a durable benefit sharing agreement government, investors, and other stakeholders, is across stakeholders can be reached. In this light, an important to ensuring that projects and their positive overall approach to assessing benefit sharing that covers impacts are durable and resilient to change over time. oil, gas, and mining is proposed. Investors, governments, communities, and other stakeholders share a strong interest in a reasonable IFC APPROACH distribution of benefits. Guided by its development mandate, IFC looks carefully Most private-sector investors realize that projects that at an extractive project’s potential to contribute to a are good for the host country and communities, and country’s economic and social development, and how whose benefits are perceived to be shared reasonably, project costs and benefits will be distributed when are less likely to face disruption, renegotiation, or even considering a potential investment. IFC also reviews expropriation. Terms and conditions that deliver shared the profitability of the proposed investment and the benefits are more likely to survive changes in societal underlying economics of the project to make a financial expectations, political regimes or market disruptions and decision on whether or not to put its own capital at risk. reward investors over the long run for the capital and These factors are considered throughout the life cycle skills deployed and the risks taken. As developers better of an IFC investment along with other key criteria that understand this connection and experience stakeholder determine IFC’s engagement, including IFC’s prospective challenges and even social conflict, their interest in a role and value addition, strategic fit with World Bank dialogue to create shared benefits and value is growing. Group country engagement and institutional priorities as well as general compliance with policies. A full investment cycle from early review to investment and eventual exit from a project consists of many steps and can unfold over many years, especially in the natural 1 The sharing and distribution of a project’s costs and benefits can be considered fair if the development aspirations of all stakeholders are adequately met and net resource sector, where projects have long lead times and benefits are commensurate with stakeholder expectations over time. face high levels of uncertainty. 11 An assessment of prospective project development Poor country and sector governance often poses an impacts and benefit sharing is an integral part of IFC’s impediment to the transformation of resource wealth into investment appraisal approach. A benefit-sharing sustainable development. The engagement of the World assessment typically considers: Bank (WB), the International Monetary Fund (IMF) and other development actors in a country will help judge i. the country and community context, the processes by the risks along the value chain and verify a country which sharing was determined and how proceeds are government’s commitment to reform and change. managed and used; IFC reviews ex ante the risks weak governance poses to ii. environmental and social issues and risks, mitigation key project development benefits. In general, IFC makes measures and opportunities to enhance outcomes careful judgments about whether it should support beyond mitigation as well as stakeholder expectations natural resource projects where governance is weak but and concerns; development pay-off may be significant, such as supply chain development, shared infrastructure, investment in iii. the overall distribution of diverse, uncertain and local communities. IFC also considers project-specific sometimes unquantifiable benefits and costs across arrangements that can help reduce governance risks, such affected stakeholders, using IFC’s stakeholder as technical assistance to build local capacity in revenue framework (Lysy, Bouton, Karmokolias, Somensatto management, enhance transparency and accountability. and Miller 2000). The timing of these, which are IFC supports the global transparency agenda and grouped by financial, economic, environmental and initiatives like the Extractive Industries Initiative (EITI). social impacts, is also reviewed. Also, IFC has taken the lead among other development finance institutions by championing full revenue and IFC will assess the broader context, starting with the role contract disclosure in its projects. of the natural resource sector in the country, its economic contribution to date, its prospects, and government Understanding who the key stakeholders are, what vision for its future. Understanding country and sector their aspirations, concerns and expectations of a project governance issues and capacity, as well as expectations and are, and what drives these is important for judging the concerns by host governments can help determine whether reasonableness of a benefit sharing settlement and its a project will likely contribute to sustainable development. legitimacy and durability over time. If project realities are not commensurate with stakeholder perceptions—be The assessment includes a review of ‘traditional they informed or not—a project may be at risk. Typically, corruption’, as it may occur during the acquisition key stakeholders include the government (federal and of mineral rights.2 IFC looks carefully at the private sometimes subnational), citizens at large, affected investors in projects it is asked to support.3 This is done communities, and investors. both to satisfy IFC of their integrity and the possible presence of political insiders whose presence may be an As part of its due diligence before investing and part indication of a sweetheart deal. Where corruption is a and parcel of project supervision, IFC through its factor, IFC will not invest. Performance Standards requires a stakeholder analysis and engagement plan for the range of stakeholders that are interested in the project. Stakeholder engagement plans must be scaled to the risks and impacts, the development stage of the project and tailored to the 2 Due diligence will focus on how access to resources was obtained, especially in characteristics and interests of affected communities. countries where sector regulation is weak and procedures are characterized by inconsistency and lack transparency. Grandfathered contracts will be analyzed for their consistency with prevailing laws/codes, gross aberration of key terms, Stakes in project may go much beyond the immediate the history of license acquisition etc. project boundaries and the directly affected communities, 3 IFC closely investigates board composition, shareholding, investor background and that of other potential beneficiaries. Anti-corruption representations and and they can be high. Especially, projects that are big covenants are required. in scale and are transformational for an entire country 12 Stakeholder Benefit Sharing: Expectations and Concerns HOST COUNTRY CITIZENS: Expect that natural resource wealth May be concerned that (i) natural resources are will be used to develop the country being exploited and depleted mainly to benefit foreign and to benefit its citizens broadly. investors or wealthy locals, or (ii) that the revenues are mismanaged, wasted, misappropriated, or not distributed equitably. HOST COUNTRY GOVERNMENTS: Expect that their framework of laws May be concerned about (i) signing a bad and standards for accessing the country’s deal because of a lack of expertise or leverage in resources is respected, that they receive negotiations, (ii) delays in receiving benefits, or a reasonable share of taxes and profits, (iii) loss of benefits as a result of inappropriately and that the project has positive linkages high costs or transfer prices. with the rest of the economy, helping to develop local skills and expertise. AFFECTED COMMUNITIES: Expect engagement and respect for May be concerned about (i) environmental providing access to “their” resources, impacts that threaten their health or livelihoods, protection from negative impacts, (ii) social impacts or changes brought on by preservation of culture, and tangible boomtown effects and rapid urban development, benefits from project development. influxes of newcomers competing for jobs, (iii) lack of access to project opportunities, and not benefiting from project taxes paid to governments. INVESTORS: Expect to build and operate (or May be concerned about (i) dynamic politics and sell) their project and earn profits for their freedom to operate, (ii) unreasonable changes providing risk capital and management to terms and conditions, and even expropriation, skills, in addition to paying known (iii) communities interfering with operations, taxes and charges. (iv) being held accountable for a perceived failure of the resources sector to generate sustainable national or local benefits. 13 FIGURE 1.1: IFC Stakeholder Framework and Areas of Project Impact Who are the key stakeholders? ts Co en m m m rn un ve itie What are their main expectations, concerns, Go s Fiscal Economic motivations, perceptions? impacts impacts What do key stakeholders need to PROJECT understand about each other’s context? E&S impacts What are stakeholder responsibilities? s En nie ga em pa g en m t Co Are functional engagement processes in place? 14 or even region, national expectations and concerns will inform project-level dynamics and vice-versa. At the core, IFC assesses a project’s costs and benefits and their distribution across stakeholders, in three broad, overlapping areas of impact. IFC considers a The development variety of questions as part of its due diligence and decision-making process: aspirations of all 1. Fiscal impacts: How are the net financial benefits of projects shared through profit sharing, stakeholders must taxation, and in other ways—at both the national and subnational levels of government and with be met and the communities and others? distribution of 2. Economic impacts: What additional economic costs and benefits are generated and shared, such as net benefits should jobs and training, the introduction of technologies, spending with local suppliers, investment in be commensurate infrastructure, the supply of energy, such as oil, gas, coal and electricity, or the supply of other raw with stakeholder materials at competitive prices to local industry and households? expectations 3. Environmental and social impacts: What are the positive and negative environmental impacts and over time. risks that the project brings and who bears them? How do impacted communities, including vulnerable groups within communities, gain or lose from the development in other ways? 15 FIGURE 1.2: Schematic IFC Investment Life Cycle Lessons Learned IFC INVESTMENT LIFE CYCLE PUBLIC DISCLOSURE APPRAISAL & & BOARD INVESTMENT EARLY REVIEW INVESTMENT REVIEW APPROVAL SUPERVISION EVALUATION IFC EXIT Initial screening against Detailed and comprehensive Public disclosure Once invested, Annual tracking of IFC loans may be IFC sector and country review by multi-disciplinary of Summary IFC supervises project results of prepaid or IFC strategy, policies and IFC team (finance, technical, of Investment investment over portfolio projects may exit equity role in project environmental, social, Information (SII), life of project, (Development investment before economic and country, Environmental monitoring Outcome Tracking end of project life Review of possible legal, corporate governance, and Social Review performance and System); environmental and social advisory) with distillation of Summary (ESRS), working with risks and potential for terms and conditions of and Environmental client to ensure Periodic, development impact IFC investment Action Plan (ESAP) compliance with IFC independent required prior to requirements and evaluation of Preliminary review of Discussions with investors presentation to agreements in all investment’s investment thesis and on needs and gaps across Board for approval areas of development and broad due diligence on all aspects of project; the project other contributions company and sponsors identification of opportunities Review and to enhance development approval of impact investment by IFC Board Decision to invest subject to agreement of prospective client with IFC terms and conditions SELECT BENEFIT SHARING CONSIDERATIONS Does the project appear to How was the deal obtained, how does it compare Has the project generated net positive offer positive development with others? What are host government and citizen development impact? benefits? expectations? What is the prospective sharing of benefits and costs, Are potential environmental and how can this change with project circumstance Who has benefited from the project and how? and social risks significant? (price, cost, etc.)? Can they be mitigated? What are expected development outcomes overall, and the risks to these? Was the deal sustained? Do the prospective net impacts on and relationships Can risks to development impact be mitigated and with communities seem enhanced? reasonable? How will this be achieved? Is the community better off? How did the company How will affected communities be impacted? obtain access to the license? Are engagement processes effective, inclusive, Does initial review of key participatory? Do communities support Were special initiatives to enhance project terms raise any red flags? the project? development impact successful? 16 IFC EXPERIENCES AND LESSONS LEARNED taxes did not increase in parallel—partly because tax structures and agreements were not designed to cope As both a development institution and an investor, with these changes. IFC is in a unique position to simultaneously share the perspectives of investors, host countries, and other The considerable deterioration in prices for various stakeholders. As a result of balancing these dual roles commodities in the recent past, as well as the notable over many years, through commodity price cycles and price volatility generally seen during the last years, has industry change, a number of lessons have emerged that changed the conversation again, bringing into relief the have a bearing on how to assess and secure a durable uncertainty that medium- to long-term investors and benefit-sharing arrangement. governments face in this sector. UNCERTAINTY IS A KEY FEATURE 1 THROUGHOUT THE PROJECT LIFE CYCLE 2 EVERY PROJECT IS UNIQUE A project’s expected business outcomes and performance Individual projects vary greatly in their size and life over time are exposed to many uncertainties. The cycles, the richness of the resource, ease of access, cost future values of key drivers of project performance, of extraction, profitability, and impacts on people and such as costs of production and commodity prices, the environment. Oil and gas is a different business from are uncertain and can be volatile. Even the scale and mining. However, gas is also very different from oil,5 and quality of a resource may not be fully known until late mining projects vary greatly from one another. in the development and its extraction. And there may be substantial technical and production challenges that In regulating the natural resource sector, governments need to be addressed. Projects may require many billions must strike a balance between accommodating the special of dollars, may take years to come to fruition and many circumstances of projects and maintaining a transparent, more to generate a financial return once operational. standard and manageable regulatory framework and Against this backdrop, the planning of programs intended a bureaucracy that supports it. The way a project is to benefit communities may be difficult, given business treated and perceived depends on its host country and and other uncertainties. community context, the present and future economic role of the natural resource sector and the government’s vision Government policies and regulations can change for it as an engine for sustainable development. and other political events may have major impacts on a project’s success and commercial viability. Tax Investors seek acknowledgement for the uncertainty and frameworks and agreements and their impacts on unique project circumstances they face and value stability projected benefit sharing that seemed reasonable at the of the arrangements that govern their obligations to the outset of a project may look very different in the future.4 government and other stakeholders. Especially for mega- For example, much-higher-than-expected commodity projects, investors and governments may enter negotiations prices over the last decade boosted the profitability of natural resource projects and companies. A number of governments came to believe they were not receiving a fair share of project benefits because their incomes from 5 “Oil and gas” is used often to refer to one industry, but differences can be great, especially in the area of pricing. Oil project prices are usually set by international markets. Gas prices may be set by reference to international prices (with a cost- to-market adjustment that is likely to be greater than in the case of oil). When access to international markets is difficult or expensive, gas prices are set by local negotiation at prices far from the prevailing oil price equivalent. As a result, 4 Terms and conditions always reflect the relative bargaining strengths of investors gas projects are less profitable than oil projects and may be taxed differently. and governments. Once projects are built and operating, the balance of power Moreover, without easy access to international markets, gas developments also usually shifts in favor of governments, and investors fear the risks of an depend on specific supplier-to-off-taker long-term contracts. “obsolescing bargain” where new terms can be unreasonably imposed on them. 17 about specific aspects as regards project development and benefit sharing. While deal-by-deal negotiation allows for greater tailoring to project specifics, legitimacy rests 4 PERCEPTIONS AND EXPECTATIONS MATTER heavily on transparency of process, symmetry in the access Diverse stakeholder groups have different perceptions to information and technical know-how and capacity. This and expectations about natural resource projects and may not be achieved in many weak governance countries. their potential impacts. In particular, countries and communities with little experience developing natural resource projects may have difficulties to fully understand 3 GOVERNMENT POLICY IMPACTS BENEFIT SHARING all of the issues, including the scale and nature of future impacts. Even when projects have been constructed and in operation for some time, it can be difficult to Governments face multiple competing demands and fully capture the economic and social impacts that have the policy objectives they set impact benefit sharing— accrued over decades. Many older projects lack baseline including whether, when, and how to develop their data which can further impede tracking and may breed natural resources. Although the overriding objective of distrust of company practices and government policies. most governments is to ensure their country benefits to the greatest extent from their natural resources, Expectations and perceptions by host communities there are many different ways they may try to ensure and other affected stakeholders will have a bearing on this. Government commitment to transparency and project success. Stakeholders are unlikely to share equal accountability, due process and prudent public financial access to information or understanding of a project’s management are key. fiscal, economic, social, and environmental effects and impacts. Transparency and access to information are Good policy does not necessarily require governments to essential to manage misperceptions and enforce mutual maximize the net revenue they receive from every project. accountability among stakeholders. In IFC’s experience, The benefits of offering standard terms and conditions imbalance of information coupled with poor stakeholder may outweigh the costs and complexity of trying to engagement can derail an otherwise healthy project. implement a more sophisticated tax system or setting terms Proactive management of diverse local expectations and conditions project by project. New, emerging countries via honest dialogue about benefits, costs, risks, and may be best served by setting relatively attractive terms to mitigation measures can help build trust. Ideally, this encourage a steady flow of new investment. It may also be creates a platform to cooperatively plan strategies to an appropriate long-term strategy for building a robust, smooth costs and benefits across constituencies. lasting industry, as some of the most important, resource- producing countries, such as Australia, Canada, Chile, and Peru demonstrate. Governments may accept less tax income in return 5 PROCESSES ARE IMPORTANT for investors helping them achieve other development The processes by which benefit sharing is determined objectives. For example, investors may be expected to directly influences public perceptions about the increase local procurement and skills development, build, reasonableness of the distribution of costs and benefits. manage, and provide affordable access to infrastructure This starts with how contracts were awarded, how (power, rail, roads) for use by others, or process environmental and social impacts are monitored, how production locally rather than export raw materials. affected communities are consulted to the collection and use of fiscal revenues for the economic development of Governments play an important role in providing an the country. Transparency of processes along the value enabling environment for private-sector actors so that chain is important for creating accountability of key natural resource projects can link into the local economy actors by enabling access to information and a better and generate benefits for as long as resources are understanding of the project benefits and costs. A process economically recoverable. 18 that is perceived as opaque and not inclusive can generate suspicion and negatively impact a project, as stakeholders may persistently challenge the arrangement, including any 7 THE ART AND SCIENCE OF BENEFIT-SHARING proclamations about net benefits. Even if company and For IFC, determining whether a project has a reasonable government agree on what they view as a reasonable split balance of benefits and costs depends on an informed, over time, an uninformed, excluded electorate may at some overall judgment based on expert, multi-disciplinary point decide to change the government and the project input and review. From a development and commercial terms as a result. perspective, IFC tests for a range of outcomes, and thresholds exist with respect to financial, economic, There has been a welcome trend of greater transparency environmental, and social considerations. For a project about natural resource projects—including revenue flows, to be supported, it must demonstrate, at minimum, that contract terms, and reporting to communities. But for it is profitable, that its economic benefit to society and benefit-sharing arrangements to be durable, the process economic return on investment is positive and greater must be consultative and participatory. Consultation than its financial return, that it is compliant with IFC with affected communities should start early—even Performance Standards (IFC PS), and that affected during the exploration phase—and should be iterative communities are broadly supportive. throughout a project’s life, taking into account dynamic, environmental, and social risks. Communities must be However, given the diversity of national contexts, able to register their grievances and see them addressed. geographical potential, and business arrangements, IFC Resilient agreements are those that are supported has found that there is no single blueprint that can be by affected stakeholders who have meaningfully used to determine what equitable sharing looks like. In participated and can influence decisions about project practice, investigation and professional judgment from aspects that affect them. This may relate to land access, a diverse team of experts, representing specialty areas water management, in-migration, and infrastructure such as finance, engineering, environmental and social, development. Broad community support is central to economics, and law, to name a few, is required. managing project risks over time. Often precise measures or cut-offs between what FISCAL BENEFITS ARE ONLY is acceptable, for example with respect to the fiscal 6 ONE PART OF A PROJECT’S COSTS AND BENEFITS sharing between the public and private sector, and what is not are at best imperfect and at worst misleading. Rather, it is important to contextualize and assess fiscal Benefit-sharing discussions usually focus on the sharing against other project characteristics and drivers, distribution of the financial (fiscal) benefits and costs stakeholder expectations and concerns (see Box 1.1), and of the project between private investors and the central potential impacts. Even when the overall judgment is that government. However, there is a broader range of other there is a balance of costs and benefits at a particular non-fiscal costs and benefits that need to be considered to moment in time, circumstances can change and present understand the full range of impacts and opportunities of risks that need to be addressed and managed carefully. natural resource development. For example, communities are immediately—and sometimes negatively—impacted by projects near them. Their lives will be impacted in varying ways, and different groups within these communities will fare differently. In addition to tax revenue, projects may bring jobs, infrastructure, local sourcing, and competitive supplies of energy and other materials that may benefit the country as a whole or particular regions and sectors. Projects will also have environmental impacts that need to be assessed and tracked. 19 IFC Guiding Questions on Financial Benefit Sharing How do the project’s fiscal terms and conditions (royalty rates, profit tax holiday etc.) compare with those in other countries? How does the project’s benefit-sharing compare to common industry measures, such as the Effective Tax Rate (ETR) used in the mining sector? How is the project’s net present value (NPV) shared, using a base case set of assumptions of the factors that determine project results? How does the distribution of benefits change with variations in project costs, prices, and volumes? What is the investor’s expected real rate of return after tax? What are investors’ risks, and are returns commensurate? Did the project result from an exploration investment or is it a known resource? Are there other particularly challenging technical or political risks? Is the project consistent with the government’s policy objectives and overall legislative framework, and do these policies seem sustainable? What is the timing profile of anticipated revenue flows? How were rights to exploration, development and production awarded? How were the project’s terms set? Was there a transparent process, competitive auction, open access on standard conditions, or were they negotiated? Who are the investors? Are there benefits or costs not captured by the financial analysis that should also be taken into account? Are there any issues of special concern? Even if the fiscal sharing is reasonable, are there any terms that are questionable or possible outcomes that threaten the deal’s sustainability? 20 CHAPTER 2: Sharing Financial Benefits at the National Level SHARING THE FINANCIAL BENEFITS endowments, administrative capacities, and policies and AT THE NATIONAL LEVEL politics differ. As a result, although there are some broad common approaches, tax policies, structures, and rates Many governments and other stakeholders believe the vary widely among countries. financial benefits of oil, gas, and mining projects should be shared because these natural resources are part of a country’s collective wealth (that is, they are part Cross-Country Comparison Of of the national “patrimony”). Resource projects can Terms And Conditions generate high levels of profits (“rents”) above their full IFC usually starts a project assessment by comparing the costs of production, but will eventually deplete these project’s fiscal terms and conditions with those that exist nonrenewable national assets, effectively creating a one- in other countries. This may sound simple but can be time opportunity to generate benefits. difficult in practice because of the detail and variety in the terms and conditions that are used internationally, and The possibility of high levels of profitability and the non- their tendency to change. Table 2.1 highlights key aspects renewable nature of mineral resources strongly influences of different fiscal regimes from a few selected countries.3 public debate and policy. When private investors are developing resources,1 especially when they are foreign, Nonetheless, this sort of cross-country comparison helps governments usually aim to optimize the share of the to contrast a range of fiscal terms and conditions and can project’s financial benefits that accrue to their countries flag important differences early in the review process, through the fiscal take and other terms under which they especially for terms such as royalty and corporate tax permit development to take place.2 rates, which are usually important parts of resource taxation and often enjoy great political visibility in While the objective of optimizing the overall share of rent summarizing ‘what a country is getting.’ However, is straightforward in theory, it is complex in practice. without a strong pattern of either tough or generous terms Agreements and taxation frameworks must accommodate across several dimensions, cross-country comparisons uncertainty about what future benefits a project will are not sufficient to draw reliable conclusions about the generate. Country circumstances, natural resource fairness of a particular deal or fiscal regime. For example, one country may have a higher withholding tax on dividends paid than another, but may allow the 1 When projects are owned by state companies, as a large share of the world’s withholding tax paid to be offset against any corporate oil production projects are, the division of fiscal net benefits becomes a concern tax that is due. In the apparently lower-tax country, for different levels of government if subnational revenue distribution exists. the latter arrangement may not be allowed. In another There may also be issues about how a state company is managed, how other stakeholders are treated, and how the net benefits are being used. 2 How the economic rent in mining and hydrocarbon operations is expected to be shared between the government and the investors is detailed in a country’s fiscal regime. In the mining sector, fiscal terms are generally set by law. Petroleum sector law defines the framework for petroleum operations and the basic structure of the fiscal terms, while project-specific terms are usually set in the relevant contract or license (Alba 2009). 3 For a more comprehensive example in the mining sector, see PwC (2012). 21 TABLE 2.1: Cross-Country Comparison of Select Mining Tax Terms VALUE- IMPORT ADDED GOVERNMENT ROYALTY CORPORATE WITHHOLDING DUTIES TAX (VAT) PROFITS TAX EQUITY/STATE RATEa TAX RATE TAXESc EXEMPTION EXEMPTION HOLIDAY OWNERSHIP Guinea 3.5% 30% n.a. Yes Some n.a. Yes, complex Ghana 5.0% 25% 8% n.a. Yes n.a. 10% free South Africa 0.5–7% 28% 10% (dividends) n.a. Yes n.a. No 10% (dividends) Yes, complex Mongolia 5.0% 25% n.a. Yes No 20% (interest) formula 35% (dividends) State Mining Chile 0–14% 18.5% n.a. Yes Yes 4–35% (interest) Company Peru Sliding scaleb 30–32% 4% Yes Yes n.a. No Trends 3.0–5.0% 30–35% 0–15% Usually Usually Rarer Sometimes Note: This table illustrates only selected terms and conditions that may apply and may not be generally applicable. Terms change frequently, and comparisons can quickly become obsolete. a. Royalty rates vary by commodity. b. Peru’s revised approach applies a royalty of 1 to 12 percent and a Special Mining Tax (2 to 8 percent) based on operating income. For projects with stabilization agreements, a Special Mining Burden (4 to 13 percent) has been agreed (EY Peru 2014). c. Rates vary depending on what the tax is applied to (such as interest and dividends). n.a. = not applicable. example, one country’s tax regime may look relatively international markets outside investor and government generous, but its resources are of poor quality and high control; ii) account for how these project characteristics cost compared with those available in apparently more interact with the country’s full package of taxes; iii) highly taxed countries. test outcomes, including the projects financial rate of return (FRR) and the distribution of its Net Present Different countries’ tax frameworks and project Value (NPV), against a variety of assumptions about agreements may have been formulated at different points key operating factors. For IFC, the use of NPV4 and in the price cycle, and, in some cases, apparently generous FRR are a core part of its analysis of the financial terms reflect low prices at the time of agreement. performance of prospective projects. There are many ways in which investors and governments Looking At Project Specifics— can benefit financially or be adversely affected. To present Financial Modeling a full picture, all financial costs and benefits need to be To obtain a fuller picture of a potential investment, captured in the modeling and analysis. Box 2.1 describes IFC will look closely at project specifics and construct its own financial models to predict possible project outcomes. The purpose of this modeling is to i) reflect specific project characteristics such as resource size and richness, capital costs, costs of production, and 4 IFC usually uses a 10 percent real discount rate but may test project performance expected sales prices, which usually are determined in against other rates. 22 what issues should be considered to fully capture all In the mining sector, the Effective Tax Rate (ETR) captures financial costs and benefits. the government’s share of a project’s net benefits after capital and operating costs. An ETR of 50 percent shows that the government and the private sector each receive Measures For Capturing The Public 50 percent of the net benefits of the project. A number of And Private Take studies have modeled the outcomes of mining projects in There are some commonly-used measures that capture to generate an ETR as one measure of fiscal benefit sharing the distribution of a project’s fiscal benefits between in different countries (World Bank 2006). The ETR can the government and investors. In the oil and gas also be used to create some comparability of fiscal regimes sector, two frequently used summary statistics are the across countries. A 2004 study about international tax “government take” and the “effective royalty rate” regimes in 24 countries, modeled the prospective ETR (EFR). Government take is the share of revenues after for each country by applying the fiscal package to the all costs that the government collects over the life of a same hypothetical copper mine. The ETR, or government project. The effective royalty rate is the minimum share take, ranged from roughly 30 percent to 63 percent (Otto of revenues after costs that the government collects from 2004). For some purposes, using the “marginal effective a project in any one tax year throughout its life. This rate tax,” which shows how incremental changes in revenues indicates how low a government’s share of a project’s are shared, is also used. net benefits may be in any one year. It may not say much about benefit sharing over the life of a project, but could From IFC’s perspective, a weakness of using the ETR, the indicate issues in the timing of government receipts. EFR, and government take to measure benefit sharing 23 BOX 2.1: Capturing all Financial Costs and Benefits All relevant costs and benefits should be captured in the financial model to present a complete picture of the project’s total financial profile for both governments and investors. Fully capturing applicable costs and benefits requires rigorous analysis and should include potentially key items, such as transfer pricing or thin capitalization. Investors incur costs through their investments and receive benefits through their share of net cash flows, usually distributed as dividends. In addition to normal sales revenue, investors can extract value through service charges from associated companies that more than recover the costs. Sometimes investors may benefit from transfer pricing. Even though many agreements and often general tax law prohibit inappropriate transfer pricing, a 2013 study identified transfer pricing as a potential major source of lost revenues for African governments (Africa Progress Panel 2013).5 Investors commonly use a mix of equity and debt to finance projects to leverage their post- tax equity returns or to manage their exposure to project risks through non-recourse finance.a Financial structure may have some impact on overall benefit sharing through its impact on taxes payable. “Thin capitalization” rules will limit this as the rules control the amount of debt that a company can take on and the rates of interest it can pay. (See discussion of transfer pricing and thin capitalization in Appendix A.) Countries incur costs and receive benefits from projects through different forms of taxes (Appendix A) and from the country’s share of net profits, if any. Countries may also benefit financially if the country gains access to energy or other resources at below-market value, and if the country receives infrastructure or other services from the project at below-market values. Conversely, if a country supplies a project with a service such as electricity or other infrastructure at below its cost or market value, supplying this service will be a cost to the country. Note: a. Nonrecourse finance refers to funding from commercial and other lenders that will be repaid from the project only when the lenders have no or limited recourse to the investors if the project does not go well. 5 Some analysts have questioned the scale of the estimates quoted in the Africa Progress Panel Report. See, for example, Annex C in ICMM (2014). 24 is that they do not allow for differences in the timing of DRIVERS OF PROJECT OUTCOME AND cost and benefit flows over the life of a project. FISCAL BENEFIT SHARING In theory, host governments should collect 100 percent To evaluate the public and private take of a resource of the rent of a project (the project return above the project, IFC uses the project’s NPV6—which accounts for investors’ cost of capital) in the form of taxation and the timing of costs and benefits. Investors, governments, profit sharing. While this can happen, IFC sees it as too and individuals value funds available today more than simplistic a benchmark. In judging the reasonableness they value the same funds tomorrow, as costs and income of the government take, measured by the project’s NPV are uncertain and can fluctuate. Using an NPV-based accruing to government, IFC also takes account of the approach that discounts cash flows over time helps adjust FRR, which in turn signals the level of risk investors are for timing differences in payments and receipts. Box 2.2 taking. A higher private take for a low-return project describes adjustments that should be made to cash flows. may be just as reasonable as a much lower private take for a high-return project. To form a view about the fiscal Investors usually spend money on exploration over many benefit sharing, IFC considers a number of factors that years before a discovery is made. Projects may take many drive project outcomes. more years to plan and construct before funds start to flow back to investors. At the same time, governments typically do not participate in the up-front investment Uncertainty About Prices And Other Project and capital expenditure of a project. Nonetheless, they Inputs Is Material usually start to earn income in the form of royalties A fundamental lesson learned in IFC’s investment or nonprofit-related taxes once production starts or experience is that outcomes can be very different than sometimes even before. In other words, governments expectations at the outset when projects are being usually start receiving some income long before investors planned and built. Any forecast of benefit sharing needs receive regular profit distributions. Conversely, there to reflect this uncertainty with key variables, including are examples of investors who receive substantial cash eventual production levels, costs, and prices, which flows during periods of high prices, while profit taxes to can and do change frequently. Moreover, tax regimes governments are delayed for a number of years because may behave differently as profitability changes, and a of generous depreciation provisions or tax holidays. country’s terms may also change. In IFC’s experience, NPV measures will show a smaller IFC usually estimates a range of possible outcomes for share of a project’s net benefits accruing to the investors FRR, future profits, taxes, and NPV splits by running when compared to ETR or government take. This is different scenarios with different values for key project because of the typical pattern of investment, profit, and tax variables (production levels, costs, price changes). The net flows that projects face (as described above). In particular, fiscal benefit, or rent, of a project and how it is shared can projects with relatively low rates of return will show a change markedly from a “base case”7 forecast. notably smaller share of net benefits being received by the private sector when an NPV-based measure is used. The variability in projected FRR gives IFC a measure of the risk that investors are taking. For example, for the For more discussion on IFC considerations about natural resource projects that IFC finances, project rates estimating NPV, see Appendix B. of return are expected to be relatively high—in the range of 20 percent—which compares to around 10 percent for 7 While IFC looks at a range of outcomes using different assumptions, it usually works around a “base case” that uses a set of reasonable values 6 IFC usually uses a 10 percent real discount rate, but may test against other rates. for key project inputs and drivers. 25 BOX 2.2: Adjusting Cash Flows for the Cost of Time and Uncertainty The financial benefits and costs of a project consist of a series of cash flows, both positive and negative, that can extend over many years. Typically, there are large outflows over a relatively short period at the start as investments are made to build the project, followed by a longer stream of net positive flows once production begins. In assessing the profitability of projects and in making a reasonable assessment of their benefit sharing, analysis should move beyond a simple addition of flows to adjust for the following two factors: 1. Inflation: Even modest levels of annual price inflation over long periods mean that the same amount of money in the future will be worth much less in real terms (what it can buy) than it is today. Proper analysis is needed to allow for these increases in inflation by using consistent assumptions about inflation throughout the project analysis (assumptions about costs, prices, financing costs, taxation treatment, and, ultimately, about converting net cash flows to real terms). 2. Time value of money: Funds that are received years in the future are less valuable than funds available today that could, for example, be spent or used for other investment. NPV- based analysis adjusts for these timing differences in a project’s cash flows by discounting future flows. For example, if it is assumed that for every year a receipt is delayed, its value is reduced by 10 percent, then, in NPV terms, a payment of US$100 to be received in three years is worth only US$75.13 today. Investors typically use as their discount rate a “cost of capital” return that markets expect investments to earn. This expected rate of return can vary by subsector and time period. For industrial companies, 7 to 11 percent in real terms after tax is common. The appropriate discount rate for governments is generally argued to be as low as 2 to 3 percent in real terms. IFC applies a common discount rate of 10 percent real to project cash flows to investors and governments. This is because revenues from natural resource projects are highly uncertain and a discount rate of 2 to 3 percent for governments is too low for many developing countries. Developing country governments are frequently short of investment funds and have uses for these funds with prospective rates of return well in excess of 2 to 3 percent. There is always uncertainty around expected future cash flows from projects. Using a range of assumptions for key variables can test for alternative outcomes. How project returns and benefit sharing change with different assumptions and scenarios provides an important insight into the risks carried by the different stakeholders. See Appendix B for further discussion of these issues. 26 industrial projects, generally. In practice, IFC finds that for reasonable at one point have come to look less so many of its projects, the risk of low returns or even losses because revenues to the government have not increased for private investors are very real. Particularly in periods proportionally to the rise in commodity prices. But the of low prices, while governments may receive over 100 pendulum is swinging back, as more recently, prices percent of the NPV flows of a project, investors can lose have fallen, and together with sharply increased costs, money. As investors continue to pay royalties and other companies’ profits have been squeezed. In response to taxes, they may fail to earn sufficient profit for the capital pressure from their shareholders, many companies have expenditure they have incurred. cut back on capital spending. Where IFC has found investor returns robust across Exploration And Technical Risks a reasonable range of assumptions about commodity Make Or Break a Project prices, they are likely to be very profitable projects being taxed at very high tax rates.8 For example, some Projects bear different types of risk, but exploration oil projects may face marginal tax rates of close to 90 risk is particularly high. Historically, exploration is percent. For such projects, governments would take 90 a very risky investment, with a failure rate above 80 percent of the benefit of a rise in oil prices, but would percent.9 When assessing how project NPV is shared also absorb 90 percent of the cost of a fall. between government and investors, IFC usually includes past exploration costs as part of the project costs (see The timing of when deals are negotiated or evaluated Appendix B). in the resource price cycle can be very important. As it happens, in recent years, higher-than-expected The risk of exploration failure is also important in commodity prices have meant that investors’ profits determining an appropriate rate of return for private have risen far beyond levels thought likely at the investors. When countries offer unproven exploration time the terms and conditions of some deals were set prospects, companies will take on the high risk of (Stevens and others 2013). As a result, deals that looked exploration only if the terms for future production are attractive enough to cover expected losses on unsuccessful exploration spending. Companies seeking 8 Marginal tax rate is the rate of tax paid on each additional dollar of profits. For example, for most individual taxpayers, the tax rate on income increases as income rises. People with low incomes may be paying only 10 percent on each additional dollar of income received, but high earners may be paying 50 percent on each 9 Many oil industry analysts assume a success rate of only 1 in 10 for extra dollar. drilled exploration wells. An important lesson is that outcomes can be very different from expectations at the outset when a project is planned. Any forecast of benefit sharing needs to reflect this fundamental uncertainty. 27 to develop known resources, or to explore where the even sometimes take on demand and price risks if they potential exploration success already is very high, will guarantee the sale of project output. not require as high a prospective reward, all else equal. In other cases, resources may be relatively well known, but Political Risk Creates Costs even in these cases, the technical challenges of extracting the resource from the ground may be formidable and Political risk increases investor’s required rate of return seen as high-risk. and impacts the distribution of net benefits. Investors’ perceptions of the political risks of long-term investment will vary by country, and investors will require higher rates Tax Structure And Other Terms Impact Investor of return for investments in countries seen to be at higher Risk And Government Take risk. Countries that are (re) opening their resource sectors Tax structure will also impact the risks carried by to private investors have a limited track record of successful investors. A tax structure with a combination of a high private-sector investment (and may even have a record royalty rate that applies regardless of profitability and of poor treatment of private investors). Such countries a low profits tax rate holds higher risks for an investor will usually initially need to offer more attractive terms to than an alternative combination of a lower royalty rate encourage investment, especially if they face competition but a higher corporate tax rate. In the former, investors from countries with a more established sector.11 will have to pay royalties even in periods of low prices, when projects may be incurring losses. In such a poor Investors’ previous international experiences will strongly profitability scenario, the government’s share of NPV influence their expectations about the political risks may be more than 100 percent. projects will face in a particular country. Governments may be able to manage perceptions and effectively In general, progressive taxation based on profitability reduce risks, even in the short term. The Multilateral is most likely to encourage investment by reducing Investment Guarantee Agency (MIGA) helps remove investor risk. It should also help ensure governments possible obstacles to investment by offering political risk a better share of high profits during periods of high insurance for foreign investments in developing countries. prices. But progressive taxation of profitability creates 12 By being party to an investment, IFC can also signal more variability in government revenues than taxation support and confidence in a country to other investors. of project income. This may seem more risky to governments. In practice, IFC finds such progressive Other devices can increase investors’ comfort level. taxation is more likely for oil and gas projects (although For example, contracts with long-term stability clauses some oil taxation terms are very regressive). For most for key terms with independent arbitration processes mining projects, royalty and corporate profits tax rates may help. However, such long-term “risk-reducing” are usually fixed regardless of the level of profitability.10 contracts themselves could become a source of risk if As a result, the government’s share of NPV usually they inhibit appropriate flexibility to deal with radically declines as profitability increases from very low levels. changed circumstances. Governments may also take on risks that might otherwise have been carried by the investor. For example, when they make commitments to build and operate infrastructure that could have been built by the investor. They may 11 To rank countries for their overall attractiveness as investment locations, industry reports use various measures of the attractiveness of a country’s resource base compared to its tax terms and perceived riskiness. For example, the Fraser Institute of Canada produces an annual review of the mining industry that uses surveys of mining investors’ views of mineral endowments and government policy to determine the attractiveness of countries from a mining investment perspective. 10 In recent years, linking tax and royalty rates to the rate of profitability has 12 Concerns about investment environments and perceptions of political risk often been the subject of much debate in the mining sector. Only a small number inhibit foreign direct investment. Besides offering political risk insurance, MIGA of countries have introduced a linkage between profitability and tax rates to also provides technical assistance to improve investment climate, and dispute increase the share of revenues and profits paid to government as profits increase. mediation services. 28 As prices and profitability of resource projects have • Competitive processes, where terms set by risen since the early 2000s, some governments have auction are a good indication that a reasonable deal come under public pressure to renegotiate13 deals was struck. because of a public perception that they have not received a fair share of the windfall from higher prices. • Bilateral negotiations, where terms are In such cases, they may assess the risk of collecting more negotiated between the investors and government, revenues in the short run at the expense of discouraging may offer a higher risk of a poor deal for the new investment and revenues in the longer run. Several government. This is not necessarily the case, especially countries, among them Chile and Peru, have changed if such negotiations are conducted transparently terms to recover a larger share of the benefits of higher- within a clear policy and administrative framework than-expected prices after a process of engagement and with effective government oversight.14 This option dialogue with investors. requires considerable government skill and capacity, and commitment to transparency. Since 2012, as a condition of investment, IFC requires the publication How Was Access To The Resource Obtained? of key terms at minimum and the current EITI How Were Terms and Conditions Set? standard also encourages publication of contracts. The quality and transparency of award processes to resource development and how terms and conditions • Open access through the regulatory process: for exploitation were set can have a direct bearing on For many natural resources (including a large share how net benefits are distributed. The likelihood of a fair of mining projects), access is set by government deal is greater if access is granted in line with clear laws policy and regulation. This is usually done on a and regulations with limited space for project-specific first-come, first-served basis for access to exploration exceptions or where there is transparency of process acreage that comes with preset standard terms with and vetting by the public. As noted below, unexamined, conditions for any subsequent production phase. The bilateral agreements may be more likely to be unbalanced World Bank generally encourages this approach in and renegotiated or cancelled in the future. IFC examines the mining sector. in detail how resource rights were obtained. In practice, deals may involve a mixture of approaches. Three commonly used options for awarding rights to Even after an auction, some degree of final negotiation resources include: 14 There has been a tendency to negotiate for confidentiality clauses, which ultimately is likely to not be in the interest of any contract party. In fact, there is a strong case that full publication is advantageous for all three main stakeholders: the public, the investor, and the government (IBA 2011; 13 For a discussion of some of the issues relating to changed circumstances, see Rosenblum and Maples 2009). In recent years, more investors, governments, and Sachs, Toledano, and Mandelbaum (2013). industry bodies are advocating publication of contracts. 29 30 may be involved between the winning bidder and the CRITICAL AREAS FOR REVIEW government. Some open-access regulatory processes may also include a provision for negotiation of some The outcome of a package of fiscal terms may look specific terms. reasonable in overall NPV terms, but there may be a number of aspects that need further review. For example, JUDGING OVERALL REASONABLENESS OF IFC will look carefully if: FISCAL BENEFIT SHARING • There are terms such as extended tax holidays that Ultimately, IFC makes a judgment about the will create long delays in significant government reasonableness of the fiscal benefit and cost sharing in revenues, even if prices and industry profits turn out a project after considering the various factors discussed to be high. above in its own financial modeling. 15 • There are complex relationships between the investor In recent oil, gas, and mining projects, the share of project and related companies, such as for the supply of NPV (10 percent real) expected to accrue to government has material amounts of services or for the offtake of the averaged around 60 percent when using IFC “base case” project’s output. assumptions. For mining projects, a higher-than-average share accruing to government usually occurs in projects • The government has taken on onerous and whose profitability is projected to be relatively low and potentially risky obligations such as supplying royalty payments are relatively important. For oil projects, infrastructure to the project, or difficult or expensive a higher share going to government is more likely driven by future funding commitments. the high taxation of profitable projects. • The aggregate marginal tax rate is relatively low. There are other studies or reviews of outcomes that IFC Although benefit sharing is reasonable at low prices can draw on. A 2012 International Monetary Fund (IMF) and profits, if prices and profits rise, the country will study that reviewed a number of countries found that benefit much less than may be expected. while there were significant variations and uncertainties about the data, governments seemed to collect at least 33 Finally, even a reasonable sharing of fiscal benefits at percent of the rent (net project NPV) for mining projects16 the national level will not necessarily mean that the deal and 65 percent to 85 percent for oil projects (IMF 2012). is acceptable to all stakeholders. As discussed below, Fiscal regimes that did not reach these levels were seen as subnational levels of government and communities may also potential concerns. There have been a number of studies in be concerned about the share of revenues they will receive. the mining sector that compare expected splits between the public and private sector across different countries, using hypothetical projects (Otto 2000, 2001, 2004). 15 The analysis is intended to capture all financial and economic costs and benefits and includes items that would not be captured by standard financial modeling. Examples are benefits such as the value of oil production taken directly by government under a production-sharing contract, or the supply of output to local users at below its economic value, or costs such as the supply of electricity by the government to the project at below-market value (Also, see Box 2.1). 16 Although, based on model simulations, the IMF believed that 40 to 60 percent should be achievable. 31 IFC Guiding Questions on Financial Benefit Sharing among Different Levels of Government Do any affected subnational governments have the right to tax natural resource projects, and if so, how? Does the central government have a formula for sharing the revenues it collects with other levels of government, how is the sharing determined, and how does it take place? Are the revenues that are expected to flow to subnational governments significant (particularly to the directly- affected local governments), and how widely are the revenues shared with lower levels of government and regions adjacent to the producing areas? Are there constraints on what the revenues can be used for? What are expectations of affected local governments and communities concerning the scale, timing, and volatility of revenues? Are reasonable transparency and accountability mechanisms in place to help ensure that revenues received by local governments will be properly accounted for? Do subnational levels of government have the capacity to effectively manage and use revenues from the project? Are natural resource revenues integrated into local budgeting, with a plan to use revenues to help the impacted communities? Are the developers, local governments, and other stakeholders collaborating effectively to protect communities and is engagement with communities productive? Where revenues flow to communities from voluntary payments by developers, are there conflicts of interest, governance issues, or concerns about fair treatment of neighboring communities; and how is spending evaluated by governments and communities? 32 CHAPTER 3: Sharing Financial Benefits at the Local Level SHARING AT LOWER LEVELS OF GOVERNMENT: Sharing arrangements in each country are a product STATE, DISTRICT, MUNICIPALITY of political processes, power dynamics, and economic and social context, and are influenced by the role the Subnational governments1 (SNGs) and local communities resource sector plays in the overall economy and its have increasingly demanded a greater share of fiscal contribution to central government budgets. Because of revenues and positive development benefits from the spatial concentration of natural resources in many resource projects over the last decade, which has been countries, tensions can also emerge between SNGs characterized by high prices and an investment boom about the access to fiscal revenues and their relative in the mineral and hydrocarbon sectors. There are pros distribution between regions. and cons for devolving the power to raise and manage resource revenues to subnational and even municipal The main ways through which SNGs can access revenues levels of government. Criticisms of fiscal decentralization from the resource sector is either by levying and collecting focus on weak capacity of SNGs to manage intrinsic taxes directly on resource companies or through transfers volatility in revenue flows, and limited know-how of of resource revenue from the central government. public financial management, planning and investments, and fragility of financial control systems. They also point to poor accountability of local authorities and corruption Local Collection Of Natural Resource Taxes as a result. Moreover, complete decentralization of In the vast majority of countries, the state or national resource rents could deprive central government of funds government (or the people collectively) owns the minerals necessary for providing national functions and could and consequently is the main authority that sets the create geographical disparity and conflict. terms for natural resource projects, collects tax revenues, and uses them for the purposes of government. SNGs In contrast, proponents argue that devolution would are often not allowed to raise sector-specific taxes from enhance allocative efficiency, as SNGs can more natural resource companies, but experience varies. accurately determine needs and find appropriate solutions. Importantly, supporters argue that producing In a number of countries, provincial or even lower levels regions must be compensated for negative impacts and of government levy their own taxes on natural resource for the loss of a non-renewable resource which local projects that are within their boundaries. National communities feel they own. constitutions may give ownership of mineral rights to SNGs, or a process of fiscal decentralization over time may have enabled lower levels of government with the right to levy taxes on energy and mining projects. There are different taxation instruments that are 1 Subnational government is defined as all levels of government below the deployed to raise revenues, some of which are specific national (central or federal) level and includes the state or local government to the resource sector while others are general tax tools sector. A state, province, or region is defined as ‘the largest geographical area into which the country may be divided for political or administrative purposes’ levied broadly on all economic activity. The suitability (World Bank 2008). of a particular tax instrument for local taxation and 33 collection depends on many things, including the example, in June 2013, the legislature of Santa Cruz administrative ability of local levels of government. province approved a controversial annual tax of 1 percent on the value of mineral reserves. A study on fiscal decentralization and mining taxation surveying 23 countries finds that where local tax collection Local taxation will need to be compatible with the occurs the most frequently chosen instruments are simple prevailing national resource development policies and in their administration. Local governments often levy consistent with national, state, or provincial taxation taxes, such as royalties, and collect land-use or license rules. Even when states or provinces are given the fees and administrative charges. Local governments right to raise taxes, broader government objectives and generally do not collect general taxes, including sales taxes actions may reduce the net impact. For example, when a and profit taxes. However, there are some exceptions. central government has a policy to equalize revenues or For example, in Canada and the U.S., some provincial spending among different regions, it may reduce its own governments do collect corporate income tax (Otto funding and distribution of fiscal resources to resource- 2001). Also, export and import taxes, which may be part taxing states. of international obligations, are usually reserved for the central government. Revenue Allocation Of Natural Resource Tax Revenues To Local Government Some examples of countries where lower levels of government tax natural resource projects include: In many countries, central governments transfer resource revenues to lower levels of government and • Australia, where mineral resources belong to some even to communities. They share the revenue the states, which set and recover royalties from in accordance with distribution rules that are vested production and other specific taxes such as land generally in law or the constitution. The scale and taxes, transaction taxes, and payroll charges. importance vary widely. At one extreme, for example, only a small part of a single tax, such as a royalty, may • Canada, where the provinces also charge royalties, be redistributed—although if distribution is down to the but in addition can impose a range of other taxes, municipal level, even small amounts can be relatively such as a profits tax, excise duties, important. At the other extreme, all revenue may be and payroll taxes. pooled and distributed between the central government and SNGs. Within countries, the approach to revenue • Argentina, where the provinces can charge royalties distribution may vary between the oil, gas, and mining on mineral production and impose other taxes. For sectors. For example: Sharing arrangements in each country are a product of political processes, power dynamics, and economic and social context, and are influenced by the role the resource sector plays in the overall economy and its contribution to central government budgets. 34 • In Ghana, for mining, all taxes are collected by Some countries do distribute extractive revenues to the central government, and only 20 percent of the non-producing regions (Bolivia, Indonesia, Nigeria), royalty on mineral production is redistributed to lower and in others even private individuals may be direct levels. The central government retains 80 percent; recipients. A review of seven resource-rich countries finds 10 percent is shared with the country’s Minerals that countries where revenues from the natural resource Development Fund; and 10 percent goes to the Office sector represent a large share seem to be more likely to of the Administrator of Stool Lands, which further redistribute some of taxes collected to non-producing distributes to producer district, trade council and regions (Morgandi 2008). In addition, distributions customary land title holders. Taxes on mining profits, may take account of disparities between regions by, which potentially should be much more important in for example, applying an equalization formula which times of high prices, are not redistributed. considers the size of the population, income levels, etc. • In Mexico, approximately 16 percent of oil taxation Enhancing The Effectiveness Of is shared among all states based on the general Local Resource Revenues federal revenue-sharing arrangements. A negligible share goes to municipalities and the major part goes Effective management and public investment can be to the federal government. challenging irrespective of the magnitude of revenue transfers to SNGs. Many central governments find the • In Nigeria, revenues from oil account for more task of managing the flow of revenues difficult due than 70 percent of national taxes. Thirteen percent to their volatility; and such tasks may be particularly of oil revenues are returned to producing states, problematic for local governments. Local governments with the balance shared according to an agreed may also find it difficult to dedicate incoming funds formula for sharing federal revenues. Overall, for future needs, especially in the face of immediate the net result is that approximately 46 percent is demands in the present. For example, funds allocated retained by the central government. The balance to finance a project’s closure should be set aside when goes to producing-region state governments and the project is operational to ensure the government’s municipalities (approximately 22 percent) and ability to pay for possible long-term environmental costs to other state governments and municipalities beyond the life of the project. (approximately 32 percent). In response to this challenge, central governments may • Peru stands out for the extent to which the central earmark part of extractive revenues to be distributed government shares the mining revenues collected to regions for specific purposes. Despite their good with lower-level bodies. The Canon Minero, which is intentions, this may further constrain the ability of a fiscal transfer system, requires that 50 percent of all local governments to use them as they need. In Peru, mining taxes collected be redistributed to producing- for example, revenue flows to producing regions are area governments and producing-area municipalities. very large, but low municipal government capacity and demanding central government restrictions and Specific extractive-related revenues (royalties, for procedures have resulted in large unused amounts of example) are often shared with producing regions using revenues or in the perception that revenues are not the derivation principle. This means that the allocation of being used well. revenue is commensurate with each region’s contribution to mineral and hydrocarbon production. Allocations to To deal with weak local capacity, central governments producing regions can be sizeable, and in the absence may impose a social spending requirement on of other regional fiscal redistribution or equalization investors as a way to leverage the presence and project mechanisms, this approach may lead to significant development skills of private companies. In Papua disparities in wealth and living standards and inequalities New Guinea, for example, the central government uses between producing and non-producing regions. developers, in consultation with the local community, 35 THE PROS AND CONS OF CASH TRANSFER TO INDIVIDUALS Some economists feel direct distribution of revenues to citizens is an effective way to reach them and can improve their lives (Arezki and others 2012). However, direct distribution only happens in relatively few places, such as Alaska in the United States. Sometimes, members of a particular community or group may benefit financially directly from projects, such as landowners in Papua New Guinea and members of aboriginal groups in Australia whose traditional land title is recognized. In Canada, First Nations members enjoy rights that can lead to royalties and other benefits flowing to them. In South Africa, some communities may have rights to an equity share in mines nearby. Revenues that flow to groups can be substantial, and their distribution across current and future beneficiaries requires effective and transparent management. Traditional communities and individuals who have little experience with a cash economy may not successfully manage large amounts of funds and could easily end up worse off. There is the potential for vulnerable groups, such as women, to be further marginalized in cash transfer systems. Disparities among neighbors may raise issues, and cash distributions may generate dependency or credit problems rather than sustainable development. In general, cash flows will be a more effective form of benefit sharing if they are part of a broader package of development objectives and appropriate delivery mechanisms. 36 to choose and manage infrastructure projects. The costs perceptions, and not necessarily facts, can be important of such projects are credited to the developers’ payable in shaping debate and local attitudes. corporate tax. Companies can use foundations and trusts as vehicles for such spending (Wall and Pelon IFC does not set any benchmarks for revenue ‘take’ 2011) to achieve wider stakeholder participation and across levels of government in its review of benefit transparency in decision-making, and in some cases, sharing. Countries vary significantly in their practices. continuity beyond project closure. Clearly, the intention of existing legislation and regulations should be met. However, the extent to To the extent that companies (or foundations) can which the fiscal benefits of a project are shared with manage social services and public infrastructure lower levels of government, including municipalities better than local governments and municipalities, this and communities, and how this should be done, will approach may be useful for dealing with the lack of ultimately depend on local circumstances and the project capacity at the local level in remote, poor communities. or projects concerned. However, there are also potential drawbacks. For example, investors may not be particularly competent Some governments argue that no special transfer at designing and managing a community project, and of revenues to producing regions is justified. These may focus on communities close to the project site, governments hold that the most effective approach to resulting in potentially unequal treatment between governance and development is for national governments communities and local tensions. Also, the role of the to collect all tax revenues and then use them to benefit private developer as provider of important services to the country as a whole, including producing areas. They communities is likely unsustainable (projects close, feel that the producing regions will gain net benefits from investors leave) and may inhibit the development projects in their regions, such as jobs, infrastructure, of a local government’s management skills and and economic activity, so no additional resources are accountability. Increasing local accountability is an justified. Other governments and commentators maintain important development objective to ensure longer-term that natural resource projects impose costs on producing service provision and the ability to address post- regions, and that communities should be compensated closure issues. adequately for the ‘loss’ of a non-renewable resource. In general, investments that are not fully integrated into Investors usually contend that some revenue from municipal or regional development planning will be less projects should be given back to local governments and effective. It is important for the private investor to work communities to help ensure that local people noticeably with the local government from the outset to engage benefit and to address potential project needs. They the government strategically. This may include helping may be concerned that affected communities do not to build the capacity of local government partners. The experience positive benefits, irrespective of the underlying greater the dependency on the role of private investors, causes, and are less likely to support a project. the bigger the necessary adjustment at the time of project closure. In the absence of obvious benefit flows to local communities from centrally collected taxes (i.e. in the form of new infrastructure or additional social services), What Is A Reasonable Level Of investors’ social license to operate will depend largely— Resource Tax Sharing? and sometimes exclusively—on the company’s own Overall, the trend is towards greater access by SNGs initiatives. The need for company initiatives tends to and even communities to natural resource revenue. This increase if local residents have low levels of confidence in trend is driven by fiscal decentralization generally, but their central governments. But even if central governments also by demands from producing regions to harness more allocate fiscal revenues to the provincial or municipal level, benefits of projects in their regions. There is no agreement investors have to take into account the time it may take on what an optimal revenue allocation between different before these funds arrive. Tax receipts via redistribution levels of government looks like, and in all cases, may lag behind project construction and the start of 37 operations by several years. Therefore, revenue flows investment decisions are informed by lessons from will not be available to meet the immediate needs and successes and failures. expectations arising from projects, which may be greatest in the projects’ earliest stages. Typically, such timeframe To enhance transparency—and ultimately the issues are not clearly understood by all stakeholders, accountability of local government—IFC works with leading to unmet, accumulated expectations over the years. key local players, such as the media, civil society leaders, universities and others on the monitoring and tracking Whatever the level of sharing, several factors can support of investment flows. IFC helps build knowledge and the legitimacy of a particular arrangement. Clarity of understanding of good public investment practices. As legislation, universal application, and transparency in a result, local media becomes more active, reporting implementation are as important as having effective and regularly on the use of resources. On the back of local efficient systems for revenue distribution. Perceptions of media coverage, citizens are able to ask more informed unfairness and disparity between producing and non- questions and provide feedback to their representatives producing regions can undermine legislation and any on investment decisions. Ultimately, this leads to a more national consensus or shared purpose that may have informed and more transparent dialogue between local been created. It is for these reasons that IFC places governments and their constituencies as well as greater high importance on transparency, understanding, and social accountability. Local governance improves, as accountability for the collection, management, and captured by the IFC’s Good Governance Index.2 deployment of fiscal revenues. In Peru, IFC has long-standing programs with other partners to increase awareness, accountability, and IFC ADVISORY SERVICES— capacity at the local level. IFC has worked with local REVENUE MANAGEMENT governments, communities, and civil society to take IFC’s approach is to accept national government policy a “push-pull” approach—helping local governments and practice, and it will support projects in which no increase their capacity to access and use funds and, in revenues are collected by, or explicitly distributed to, local parallel, increasing awareness in the wider community governments. However, fiscal transfers can be significant with the aim to hold local government to account for and, if well invested, have the potential to significantly prudent management of resource-related revenue. change the level of public infrastructure, the quality of service provision and improve people’s lives. Fifty percent of central government tax revenue from mining are redistributed from the central government IFC’s revenue management (RM) work seeks to enhance to different levels of local government. At the municipal the potential impact of extractive-related revenue flows level, the revenues are relatively large in relation to other that are, by legislation or accepted practice, transferred sources of income. However, municipalities have had to local-levels of government that have decision-making difficulties designing projects that satisfy public investment power over the funds they receive. IFC with support requirements, limiting their ability to use funds. from donor partners and extractive companies provides technical assistance to local governments (municipalities) Some of the results of IFC’s ongoing work include: to increase well-targeted public investment while also building the capacity of communities to monitor revenue • Quality of investment management improved on flows and the effectiveness of public investments. average 40 percent in 30 municipalities (as measured These programs have shown positive results. Many by IFC’s municipal investment management municipalities typically adopt good practices along the assessment methodology). investment management chain and improve decision- making, resulting in better resource allocation to meet the basic needs of their communities, i.e. water provision. Local government officials can track the performance of their investment portfolio and can ensure that future 2 http://mim.org.pe/menu/MetodologiaPreparacion 38 • Authorities monitor the progress of prioritized projects to ensure necessary coordination and timely Disparity between decision making. There were 1,041 projects worth US$390 million closely monitored in 2013. These producing and projects register at least 10 percent more progress than other projects. non-producing regions • Seventy five percent of the multi-annual programs are can undermine aligned with priority areas (e.g. health, education, water and sanitation, roads, etc.) national consensus • In 2012 and 2013, municipalities completed 140 and a country’s projects addressing the population’s basic needs, benefiting 183,466 people. shared purpose. • A web-based platform provides permanent access to information and expert advice. There were more than 19,000 registered users, 22,000 visits per month, and 32,923 issues resolved. 39 BOX 3.1: Lessons Learned from IFC Revenue Management Programs3 Building Local Government Capacity—What Works? • Start with the big picture. Government officers often act in silos. They need a basic understanding of the overall framework for public financial management and their role in the process. • Aspire to changing behavior. Focus should be on how to change day-to-day behavior in key areas through well-structured guidance, tools, and practical examples of good practice. • Concentrate capacity building efforts in a few key areas. Identify and concentrate on the key bottlenecks. Focus on how things can be done better by sharing proven good practices and support their adaptation through simple tools. • Develop trust. Provide practical advice and solutions. • Be mindful that absorptive capacity is weak. New practices and requirements need to be phased in and targeted so as not to overwhelm already under-capacitated local governments. • Capacity building has limits. There are limits to how much know-how small municipalities will be able to absorb and maintain in-house. Furthermore, some expertise might only be needed occasionally. The important point is not necessarily to have the expertise in-house, but to identify and have access to it when needed. IFC REVENUE MANAGEMENT—OBSERVATIONS sector to provide public goods as a substitute for an AND LESSONS LEARNED underperforming public sector. While building the capacity of local governments In the absence of local government capacity, companies is partly the responsibility of central government, often agree to invest in services for local communities companies operating locally have an opportunity to in education (building or improving schools), sanitation engage and help improve local government skills to (building water reservoirs, sewage systems, wells, manage and invest fiscal revenues. Companies and local latrines, etc.) or health (building or improving sanitary authorities ultimately share a common goal, namely that posts or small hospitals). While this can make sense resources paid are invested wisely to benefit the local where local government is underfunded, it may not be population. Increasing local benefits may help local the best alternative when they are receiving significant authorities to secure their political mandate and support fiscal transfers. Building capacity of local government a company’s social license to operate. Moreover, helping is more sustainable and less likely to undermine local governments to invest wisely and provide essential democratic processes. A by-product of working public services alleviates the pressure on the private with local government is the possibility of forging a 40 BOX 3.1 (continued) Creating Civil Society Demand for Good Governance—What Works? Creating Civil • Address Society Demand information for needs. Goodanswer Reliably Governance—What Works? the questions people have on their minds. Establish permanent access to information about the project. Disseminate information • Address information through different needs. channels Reliably to reach answer different groups.theTranslate questionstransparency people have on intotheir minds. Establish permanent accountability, access to information by accompanying informationabout withthe project. Disseminate education information about the project, e.g. the through different channels to reach different groups. investment cycle, investment decision criteria, etc. Translate transparency into accountability, by accompanying information with education about the project, e.g. the • investment Disseminate cycle, investment decision information criteria, and consistently etc. in small doses. Information must be accessible and in a format that can be easily presented and used by the media. • Disseminate information consistently and in small doses. Information must be • Focus onand accessible in a format capacity that can building andbe easily presented of dissemination and used by the accurate media. information, not on advocacy. Emphasis should be put on building the capacity of local leaders, media, • Focus on capacity and surveillance building committees and dissemination to track, of accurate monitor, and disseminate data information, not accurately. Moreover, on advocacy. Emphasis should be put on building the capacity of local they must have an understanding of key aspects of public financial management and leaders, media, and surveillance investment committees to provide to track, adequate monitor, feedback and to local disseminate data governments, makingaccurately. Moreover, them aware of the they must have an understanding of key aspects of public financial management population’s concerns and of how their performance is viewed. Accuracy in reporting and and investment to provide factual engagement adequate with feedback authorities to local has proven governments, successful making in raising them awareand responsiveness of the population’s concerns and of how accountability of local government. their performance is viewed. Accuracy in reporting and factual engagement with authorities has proven successful in raising responsiveness and • accountability of local government. Make use of comparator data. For example, IFC’s Good Governance Index provides performance data and can be used for providing feedback to local governments.3 • Make use of comparator data. For example, IFC’s Good Governance Index provides performance data and can be used for providing feedback to local governments. 3 Building Local Government Capacity: https://vimeo.com/111179419; Creating Civil Society Demand for Good Governance: http://vimeo.com/109164586 more collaborative relationship to manage risks and • There are strong local expectations for specific opportunities over time. revenues and benefits, but no provisions for them. Through its revenue management programs, IFC has • Revenue distribution occurs, but there is conflict gathered useful lessons with respect to building local among stakeholder groups with respect to access to government capacity and promoting civil society demand and adequacy of compensation. for good governance. • There are allegations of corruption and mismanagement of funds at the local level. CRITICAL AREAS FOR REVIEW • Local-level capacity to manage and invest fund IFC takes a country’s revenue distribution regime as given is very weak. and does not treat any one regime preferentially in its benefit-sharing assessments. However, IFC will review the implications on benefit sharing in more detail if, for example: 41 IFC Guiding Questions on Project Impacts on the Local Economy What is the potential impact of the project on the local community and country in terms of linkages to local suppliers, to local off takers or purchasers of product, and local employment? What are the expected employment multiplier and local spend of the project? Has the investor compared project demand for skills, materials, and services with the available local human and business resources, including the capacity of local suppliers? What are national government requirements for local procurement and employment? Are they realistic? Do they offer reasonable returns for any resulting extra costs or tax reductions? Are there potential areas for competitive local supply and import substitution, and are programs in place to develop local suppliers, including financing sources? Are local businesses aware of opportunities? Are the investors’ recruitment, skills training, procurement, and supplier development plans aimed at enhancing local participation? Are they consistent with community expectations and aspirations for development? Are they integrated as appropriate with government programs? Does a review of skills and procurement demand across the industry exist? Does a sector wide approach to building local capacity exist? Have the investor’s regular international suppliers assessed the prospects for local supply and subcontracting, joint ventures, and skills upgrading? Is there the potential for all investors present in a particular location to work together and optimize the development of the local supplier industry? What is the potential for competitive local processing of production from the project? Can, for example, part of production, including oil and gas, be economically used locally and help develop downstream industries or provide more secure and competitive local energy access? Are there opportunities to meet the infrastructure needs of the project in a cost effective way and have local communities and the economy generally also benefit? Is there scope for increased coverage of infrastructure services at reduced costs? Is there potential for a collaborative approach to jointly serve community, national, and project needs? 42 CHAPTER 4: Linkages to the Local Economy Many countries and host communities see the and services needed by projects. Such services may natural resource sector as a potential vehicle for local include camp management, civil works, and equipment economic development through job creation and local maintenance. The supply of local consumable goods— sourcing, as well as construction of shared infrastructure. ranging from provision of food to raw materials that can While there are good examples of developed and be used in manufacturing uniforms and personal protective developing countries whose resource sectors have equipment—also offers the potential for establishing local been harnessed for economic growth and sustainable production capacity and economic development. development, one persistent criticism of modern capital- intensive and technologically-advanced resource projects In general, the larger and more sophisticated the economy is that they can be “enclave” projects—that is, projects and the bigger its existing resource sector, the larger the with weak links to the rest of the local economy. Another relative role of local suppliers is likely to be. Very small, criticism is that they generate limited benefits from the poor, non-industrialized countries with new resource relatively small numbers of jobs they create. sectors are less prepared to develop strong linkages between natural resource projects and local suppliers— The impacts of natural resource development will vary at least, not quickly. But even relatively small linkages by economy and project. Australia, Canada, Norway, into local economies with their multiplier impacts Sweden, the United Kingdom, and the United States are welcome where there are few if any comparative are well-known examples in the developed world of opportunities in manufacturing and services. sustained economic contributions by the natural resource sector. Brazil, Chile, Mexico, and South Africa are four Governments may be able to broaden linkages through examples of developing countries whose local resource appropriate government policies (Tordo and others sectors have generated large linkages with the rest of 2013). For example, the governments of Norway, the their economies and directly and indirectly account for United Kingdom, and Australia have promoted their oil significant numbers of jobs. and gas services sectors to exploit the new opportunities that emerged as large-scale projects started up in their In many cases, jobs created in the oil, gas, and mining countries. A mix of reasonable requirements for local sectors are highly skilled and relatively well paid. In participation and initiatives to develop local skills and addition to the workers the sector employs directly, capacities with private actors worked well. projects indirectly create more jobs through the multiplier effect from project spending on suppliers of Local content policies need to be compatible with the goods and services. scale and prospects of the country’s resource sector and the existing skills in the economy. Unrealistic expectations and sudden requirements may create ENHANCING LOCAL PROCUREMENT uncompetitive suppliers with an uncertain long-term Although many projects require products and services future, impose unnecessary costs on projects impacting from specialized international suppliers, there is often their profitability, possibly reduce the number of opportunity for increasing local content. Local suppliers projects undertaken, and ultimately reduce the and subsidiaries can be competitive providers of products country’s tax revenues. 43 RESEARCH FINDINGS ON EMPLOYMENT AND MULTIPLIER IMPACTS A World Bank study on the linkages between mining and the economy found that in Chile, the sector accounts for over 700,000 direct and indirect jobs, or approximately 10 percent of the workforce (McMahon and Moreira, 2014). In Peru, the estimated number of jobs created by its mining sector was similar. Another study found that the multiplier impact—the total number of jobs eventually created from one job in the mining sector— can be 10 or more (Apoyo 2009). An assessment of the Ahafo mine in Ghana found that the employment multiplier was 28 (Kapstein and Kim 2011). Allowing for the impact of government spending of mining tax revenue, the number of jobs created would be even higher. Another World Bank study found that, in Zambia, 2,448 direct jobs in mining led to 26,850 jobs overall (World Bank, 2011). 44 Governments will not maximize value from local content oil companies to successfully develop oil refining and programs if the overall business environment for the chemical projects based on the quality of their resource, private sector is poor and hampered by unnecessary location, and scale. However, local processing that is barriers to competitive business development. Before uneconomical is a high-cost way to create relatively imposing costly local content- or material-processing few jobs, will impose additional costs on other local programs on the resources sector, governments should industry, and will not be a good basis for sustainable work with the private sector to understand the most diversification and growth. pressing impediments and remove barriers to private- sector growth. For energy, in particular, the high cost of imported fossil fuels often means that the development of competitive Investors can generate linkages and support local local energy resources, such as oil, gas, and coal, can economic development if they proactively identify ways, make a major contribution to reducing the cost and individually or collectively, to grow the capacity of local increasing the security of local energy supplies for local suppliers. In practice, for a successful program to increase businesses and consumers. local content, industry engagement with government and other partners is essential. PROVIDING AND SHARING INFRASTRUCTURE IFC has worked with companies for over a decade on How the infrastructure associated with natural resource strengthening linkages and ensuring the participation projects is developed can have important impacts on of local SMEs in their supply chain (Figure 4.1). benefit generation and benefit sharing. Most projects will Success of such efforts depends on strong investor require supporting infrastructure for their construction commitment, partnerships between other purchasing and operation, especially those in remote undeveloped companies, industry associations, government and locations. A major mine will need roads, rail, ports, other stakeholders. A comprehensive approach to local airports, power and other fuel supplies, and water. business development is necessary. This includes training, Oil and gas developments may require long-distance support to help bid for and meet competitive company pipelines, ports, and terminals, as well as supporting requirements, and ability to access financing. processing facilities and access roads. In some cases, the costs of needed infrastructure can be substantial and, if A recent example of an IFC supplier development built by the project investor, can account for the major program is a project being implemented in Guinea with part of a project’s costs. Rio Tinto in the context of the company’s Simandou Iron Ore project (Box 4.1). The ‘Local Supplier Development Lack of suitable infrastructure or barriers to building Program’ builds on the successful implementation of a new infrastructure will deter new investments in pilot that focused on basic management capacity building relatively poorly-developed regions. The cost of needed and training. The follow-on project aims to enhance the infrastructure is often beyond the financial capacity of development impact of the Simandou project and Rio any one investor or government, particularly in Africa, Tinto’s operations. where big resource finds require bulk transportation. Where demands and capacity to pay can be pooled between investors and users, governments, investors, PROCESSING AND USING NATURAL RESOURCES and communities could all gain. Shared arrangements The processing of raw materials (beneficiation) and use should be equitable and appropriately regulated.1 of locally produced resources can also foster broader Natural resource projects can play a critical role as development and impact overall benefit sharing. anchor customers and facilitate the construction of large However, as with local content, industrial processing and beneficiation will be a net benefit only if they make economic sense given the product, the markets, and the country’s comparative advantage. A number of oil-exporting countries have used their national 1 See Toledano et al. 2014 for a review of the issues and country cases. 45 infrastructure that would otherwise not happen or be community, local roads, water supply, and school and long delayed. hospital buildings as part of their community programs. Power links to communities often happen through the When infrastructure, such as a road or railway, can be installation of renewable power sources2 (solar, wind, built by a project for its own needs, it may be able to be hydro), which are also increasingly sought after by the used by others at no or relatively low additional cost. In mining industry to complement, if not substitute for, other cases, there may be extra costs to expand capacity more expensive sources of power (diesel generation) beyond the needs of the project. However, if these extra or unreliable, erratic, and often insufficient grid power costs can be shared equitably with other users, then both (Ernst & Young 2014). other investors and the country can benefit from greater access to infrastructure at a lower cost. In some cases, the infrastructure investment may not turn out to be very productive or of much benefit if it Where projects do buy infrastructure services from the is not part of an integrated approach that ensures that government, especially in the case of smaller, poorer the teachers, nurses, doctors, and medicines needed countries, the value of the contract can be relatively to operate services will be available. Even more basic large. Governments should charge an economic price infrastructure investment, such as for roads, needs to be for these services. This price could change over time, integrated into an appropriate process for maintenance and long-term contracts and periodic renegotiations and repair if the benefits are not to be quickly lost. Close should recognize this. For example, over time, the most coordination with and support for relevant government economical source of a new power supply in a country agencies may be needed. In addition, there will be issues may migrate from low-cost hydro to higher-cost fossil about how nearby communities are treated, the approach fuel. As this migration happens, the economic value of to growth in demand, and the sustainability of services the power supplied is likely to increase substantially, and following a project’s closure. governments that are committed to supplying for long periods at a low price will suffer economic losses. LOCAL PRIVATE SECTOR OWNERSHIP Governments may take on some of the risks of the Foreign investment flows bring huge advantages to project if they commit to building new infrastructure developing countries and are key contributors to their primarily to supply a natural resources project. For development. International investment flows are a large example, project construction may be significantly part of the oil, gas, and mining sectors in particular, and delayed, or the project may fail and close down. there are many enduring and successful relationships Governments and developers need to understand which between foreign resource developers and countries. risks are being allocated and who is best equipped to However, foreign ownership can be politically sensitive, carry or mitigate these risks over time. especially in times of high prices, when there are concerns about whether the country is getting a fair share of the In some recent resource project deals in Africa, benefits of developments. Local investor involvement in governments and investors have agreed that in lieu of the sector—directly in production or in businesses that an up-front payment for access to a known resource or supply production projects—is seen as one way that for lower future tax payments, the developer will build countries can benefit from resource development. Local and operate infrastructure for the country. Whether investors may share in profits, but local ownership and these arrangements are a good deal for countries will active investment may also be important for the growth depend on the true value of the infrastructure being of local firms and entrepreneurs. built compared with available alternatives, such as collecting more tax or profit revenues and building the infrastructure independently through competitive bids. 2 Examples include projects by Randgold Resources (Kibali); IamGold (Rosebel At the community level, projects often provide small-scale Gold Mine); African Barrick Gold (projects in Tanzania); Barrick Gold (Punta infrastructure investments, such as power for the local Colorada mine); Antofagasta plc. 46 FIGURE 4.1: IFC’s Experience in Strengthening Local Businesses’ Linkages to Natural Resource Projects Azerbaijan—ACG/BTC SMEs: 264 New contracts: $881m Jobs created: 388 PERU—Yanacocha India—Cairn SMEs: 218 (Rajasthan) New contracts: $38.5m SMEs: 357 Jobs created: 1,880 New contracts: $4.07m Jobs created: 4,174 Peru—LNG Mozambique— SMEs: 191 Mozlink New contracts: $6.7m SMEs: 75 Jobs created: 288 New contracts: $27m Jobs created: 2,041 Ghana—Ahafo Zambia—Copperbelt South Africa—Lonmin SMEs: 99 SMEs: 338 SMEs: 133 New contracts: $17.4m New contracts: $26.5m New contracts: $45.4m Jobs created: 279 Jobs created: 146 Jobs created: 330 Note: *In most cases, numbers of jobs created are estimated/extrapolated and subject to significant uncertainty. ACG/BTC = Azeri-Chirag-Gunashli/Baku-Tbilisi-Ceyhan; LNG = liquefied natural gas; SMEs = small and medium enterprises. 47 BOX 4.1: IFC Local Supplier Development Program—Rio Tinto Simandou Iron Ore Project in Guinea To optimize its economic impact on local communities, Rio Tinto is developing its local supply chain. However, local businesses lack technical and management skills, consistency in delivery, and an understanding of international firms’ requirements for health, safety, and environmental standards. As a response, Rio Tinto and IFC launched the Local Supplier Development Project in late 2012. The Objective of the Program The objective of the program is to support the Simandou project to: i) increase local supplier capacity to overcome weak organizational structures, lack of management and low levels of financial and technical skill, and poor access to markets and finance; ii) create market opportunities by adapting procedures and policies of the Simandou project for easier local sourcing from small and medium-sized enterprises (SMEs); and iii) meet expectations for local content despite the limited capacity of the local private sector. Given the economic fragility in which the Simandou project is being developed, expectations are high from the government and the host population that the project will be a catalyst for local private-sector development. The program is designed to focus on both national suppliers in Conakry and local suppliers in the 10 prefectures impacted by the Simandou project. The program consists of various interventions that are targeted at Rio Tinto, local SMEs, and other actors involved in the cultivation of local entrepreneurship. IFC provides ongoing technical support to Rio Tinto’s different operational departments to identify local supply opportunities, particularly SMEs that are active in priority sectors, such as earthworks, agriculture, construction, and transport. Program Interventions The program is also training SMEs on financial and management skills using Business Edge, an IFC-backed business training program, as well as specific topics relevant to the mining sector, such as health, safety, environment, and others. Particular emphasis is put on identifying and developing women entrepreneurship opportunities. To leverage expertise widely, local training firms and independent trainers are certified in the use of IFC Business Edge methodology. Preliminary Results Thus far, local content principles have been developed and included in the investment framework and a number potential opportunities to contract local businesses have been identified in priority sectors, such as road maintenance, earthworks, catering and transportation. The program created a local training market through 17 local consulting firms who have become Business Edge franchises in Guinea. Over 200 SMEs have been trained and coached, and a database of over 400 SMEs is in place to facilitate interactions between the mining sector and local businesses. Moreover, the program set up an enterprise center in the city of Beyla to provide business services and facilitate communication between local suppliers and Rio Tinto. The current phase of the program has resulted in at least 61 SMEs reporting improved performance with US$286,000 in increased revenue and 131 jobs created or maintained. 48 BOX 4.1 (continued) Lessons learned A close partnership is necessary to deal with changing circumstances. Soon after the launch of the supplier development program, development of the Simandou project slowed and construction temporarily stopped. Partners were able to make quick amendments to the program, including a prioritization of women entrepreneurship, to ensure continued implementation. Dedicated personnel are required. Effective and strategic program coordination and planning depend on dedicated personnel who are also incentivized for successful implementation and delivery. Human and financial resources must be set aside. Outreach must be targeted at women. Unless the program specifically targets women in its advertising or holds events for women only, women are unlikely to be reached effectively. Despite expectations, general marketing and advertisement to the general supplier population has attracted few women. Even women-owned SMEs frequently send male participants to trainings. Training curriculum must contain modules that specifically address women entrepreneurship needs. 49 50 When the sector and the local economy are both large CRITICAL AREAS FOR REVIEW enough, local companies may emerge naturally and over time move up the value chain. However, governments During the assessment, IFC looks for potential barriers sometimes encourage local investors to work with local to a project’s potential to extend its impacts beyond companies by offering preferential access to resources its revenue contribution and its immediate economic or through compulsory local partner rules. As with benefits. These barriers include: local content and processing requirements, government intervention may carry economic costs if local private • Poor links to the local economy, with no plans investors gain access to state resources at prices below to strengthen these links for project operation prevailing market rates. Poor policies could lead to the and construction emergence of passive local investors whose access to secure investment opportunities are ensured through their • Unrealistic government requirements for local political connections rather than business acumen. content and employment that are not feasible within the time expected and that may distract from more There may be differences in the amount of taxes realistic approaches government will collect from local compared to foreign investors. Given the complexity and multiple objectives • Local processing/beneficiation requirements that of tax structures, these differences are likely to vary, create relatively few jobs at significant cost depending on specific circumstances. For example, the transfer of ownership between local investors is more • A poor overall business environment that stifles the likely to be captured by capital gains tax provisions capacity of local business to respond to opportunities than the sale of an asset by one foreign investor to another. Foreign investors, however, are more likely • Weak recruitment and training plans to increase local to pay withholding taxes on dividends and interest. participation in job opportunities. In practice, though, both types of investors will try to offset any perceived costs and possible advantages of local compared to foreign ownership through their corporate structures. 51 IFC Key Guiding Questions on Project Environmental and Social Impacts Have project environmental and social risks and impacts been identified and evaluated? Has a mitigation hierarchy been adopted to anticipate and avoid risks and impacts to workers, affected communities and the environment? Where avoidance is not possible, does the mitigation hierarchy minimize and compensate/offset risks and negative impacts? Are appropriate strategies and processes identified to manage adverse impacts and enhance positive impacts? Are national requirements and IFC Performance Standards (IFC PS) on Environmental and Social Sustainability being observed? Are investor commitments to Good International Industry Practice (GIIP) and the IFC PS credible? Does the project have the appropriate policies, staff capacity, and systems in place to manage operations in accordance with these standards? Has a Stakeholder Analysis been conducted? Have all communities and other stakeholders likely to be impacted been identified? Have baseline surveys been conducted to gather information about concerns and expectation to guide environmental and social management plans, community development plans, and future monitoring and evaluation? Is it understood how different stakeholder groups within communities and the country will gain or lose from the project? Has a Stakeholder Engagement Plan (SEP) been devised and implemented? Is there an ongoing process that will run throughout the project life to ensure effective participation by all affected stakeholders, including local communities, civil society, local businesses, local and national government, and investors? Is there an appropriate system of community and public reporting on outcomes and are there appropriate independent oversight, monitoring, and evaluation mechanisms in place and sufficiently resourced? Is there an independent grievance mechanism? Are individual and community issues addressed and community consultations underway to inform, consult, and understand concerns? Are opportunities for community feedback and participation included? Is there an agreed community development plan, consistent with the project and local government plans in areas such as jobs, entrepreneurial opportunities, infrastructure and services? Are local government and others engaged to support sustainability and leverage impacts? Does the community broadly support the project? If there are groups that do not support the project or if there are concerns, are these understood and appropriately addressed? Is an easily accessible and effective grievance mechanism in place? Are there processes and resources available to address long-term issues, such as closure, and unforeseen, but costly risks, such as natural disasters? Are there cumulative impacts that need attention? 52 CHAPTER 5: Environmental and Social Benefits and Costs Resource projects have social and environmental The Performance Standards form the basis of the Equator impacts, the scope and nature of which will depend Principles,1 and thus are used as environmental and social on the project, the location, and the social, economic, requirements for a large number of the world’s project environmental, and cultural context. This section financiers. Other agencies, both public and private, have provides an overview of how IFC looks at a project’s also adopted the Performance Standards on a voluntary social and environmental impacts and opportunities as a basis. Governments, donors, NGOs, and reputable part of an overall benefit-sharing review. This section is private investors also have their own requirements. IFC not intended to cover all of the social and environmental requires a project’s compliance with all local laws. issues that need to be considered by governments and others when setting policies, permitting developments, Ground Rules For Managing Impacts and managing projects. Projects have negative and positive impacts on people and the environment in ways that differ by country, region, MEETING IFC ENVIRONMENT AND SOCIAL context, and project. In order to ensure the effective PERFORMANCE STANDARDS performance management throughout the project, IFC IFC requires that its appropriate environmental and requires its clients to carry out an integrated assessment social standards be met by all the projects it supports of the environmental and social impacts, risks, and (IFC 2012). The Performance Standards are a risk opportunities of the project, and affected stakeholders management tool and are not intended to be prescriptive must be given access to project-related information. from a procedural perspective. They provide a framework Communities and stakeholder groups generally have for clients seeking IFC financing for their projects, strong views about whether particular impacts or risks with guidance on how to identify , avoid, mitigate and are material to them. IFC views their participation in manage risks in a sustainable way, including stakeholder meaningful consultation—and even appropriate inclusion engagement and disclosure of project-level activities. in decision-making—about projects that impact them as Together, relevant requirements of the eight standards a vital part of assessing project legitimacy and fairness. should be met throughout the life of an investment by Formal consideration in decision-making is required in IFC, with actions and milestones agreed upon between projects with potential significant adverse impacts, and IFC and its clients. The Standards define the principles all projects affecting Indigenous Peoples. This is referred by which projects are planned and implemented to avoid to as Informed Consultation and Participation (ICP) in negative material impacts where possible, or to offset and IFC’s Policy on Environmental and Social Sustainability. compensate for them where not. IFC assesses whether this process has been undertaken 1 “The Equator Principles (EPs) are a credit risk management framework for determining, assessing, and managing environmental and social risk in project finance transactions, which often are used to fund extractive industry projects globally” (IFC 2014). 53 FIGURE 5.1: IFC Performance Standards PS1: PS2: PS3: PS4: Assessment and Labor and Working Resource Community Management of E&S Conditions Efficiency and Health, Safety Risks and Impacts Pollution Prevention and Security PS5: PS6: PS7: PS8: Land Acquisition Biodiversity Indigenous Cultural and Involuntary Conservation Peoples Heritage Resettlement and Sustainable Management of Living Natural Resources 54 and whether there is ‘broad community support’ (BCS) While companies need water for exploration and for the project in the affected communities. It also gauges processing, host communities and governments are whether community support for a project is possible becoming more cautious and proprietary, particularly and/or precarious over time. This is prudent given the given uncertainties of climate change, catchment-level increasing importance of community attitudes and water data, and potential cumulative impacts across their capacity to delay or even stop projects, triggering industries. Many states have laws providing that people high costs to investors (Davis and Daniel 2011). In and animals must receive water ahead of industry if a practice, enlightened investors treat the ability to deal shortage occurs. Even companies operating at best- in with community concerns as a competitive advantage -class standards are subject to political pressure and rather than as a defensive measure. For natural resource social anxieties (regarding water) that can be strong projects, IFC has for some time required that impacted enough to shut projects down or spark costly delays. communities should benefit and that they broadly As companies have learned to manage their water support the project (Box 5.1). footprint more carefully inside the fence, they now must grapple with how to collectively manage catchment-level concerns with diverse stakeholders. A full understanding Assessing Environmental And Social Impacts of water risks is still evolving. However, companies that At the local level, environmental and social impacts adopt policies and practices and are recognized water intertwine with and influence culture and livelihoods. stewards will have competitive advantages through Environmental and social impacts may be positive or cooperation with government and stakeholders as well negative. Generally, projects will be considered from the as better managed costs. perspective of their potential environmental and social costs, and focus will be put on identifying, avoiding and Developments may also bring indirect or induced mitigating negative effects and risks. impacts. For example, the construction of access roads enables easier transport for people to move into the area Typical risks and key issues are summarized below, for settlement or logging. There may be low-probability followed by a description of positive impacts that are also but high-cost risks, such as a major oil spill from an oil seen from natural resource development. platform blowout or the uncertain long-term cost of mitigating acid rock drainage from a mining project. The physical environmental impacts of projects may be concentrated in a single area or reach across greater The social impacts of projects on communities can territory, depending on the scale and scope of operations be substantial. Changes brought about by extractive including construction and infrastructure. Land will investment can have negative social impacts, such as be used for mining, processing, waste disposal and rapid urban growth, physical and economic displacement ancillary infrastructure sites. Water will usually be used of communities, weakening of traditional social for production, and any effluents must be appropriately structures, new conflicts, and even impoverishment. managed with recycling if feasible. Projects may bring How people are affected and their perception of these noise, traffic, dust, emissions, and management of sites impacts may differ. Communities living near projects to avoid pollution during construction, production, and are more likely to be most impacted physically. More processing is critical. distant communities may perceive impacts and have expectations about how they will be treated. Projects Water may be a highly contested resource and competition near isolated, poor communities will differ from those on over its access and use must be managed holistically from the edges of cities. Different groups within communities both an environmental and social perspective. Access, will also vary in the degree to which they gain or lose, quantity, and quality issues upstream and downstream can often substantially. Local communities themselves can be cause increasing concern and often create conflict across diverse and differences and disparities can be exacerbated diverse topographies and types of projects. Like land, by new resource finds and developments. Customs, water rights are organized differently according to local legal rights, and governance capacity, as well as investor laws and custom. behavior, will drive some of these dynamics. 55 BOX 5.1: Broad Community Support International practice varies regarding the rights of communities to share in the benefits of extractive projects and their rights to approve or veto projects. Some communities have strong legal rights to share in the fiscal flows of projects and may benefit substantially in financial terms. Others may receive nothing in financial terms and may benefit directly only in other ways, such as through jobs, community spending, or access to infrastructure services. In its Management Response to the Extractive Industries Review (EIR), the World Bank Group introduced the requirement that local communities should benefit from and broadly support oil, gas, and mining projects financed by IFC or another member of the World Bank Group. Where there is no absolute test of the reasonableness of the overall package of costs and benefits, the community’s support or lack thereof is an important potential measure of a project’s viability. As part of its appraisal process of proposed projects, IFC verifies whether there is Broad Community Support where applicable. A community’s support was adopted as a condition for natural resource projects after the conclusion of the EIR. In 2006, the IFCs Policy on Environmental and Social Sustainability, which was further revised in January 2012, broadened the requirement for broad community support beyond the resource sector for projects with significant adverse impacts. Source: World Bank (2004)2 2 World Bank Group Management Response to Extractive Industries Review (2004) http://www.ifc.org/wps/wcm/connect/ industry_ext_content/ifc_external_corporate_site/industries/oil%2C+gas+and+mining/development_impact/development_ impact_extractive_industries_review 56 Social and environmental impacts on communities often However, projects may also bring benefits to communities inter-relate, as can be seen with land and water. These and the environment. Resource projects will likely assets are the foundation of people’s lives and livelihoods, bring jobs, training, and skills development that will particularly in rural areas where many extractive be especially valued in remote communities with projects are located. Projects typically involve significant few alternatives. Business opportunities will open up local land access and acquisition, which may require for suppliers and contractors and in some cases for resettlement and the loss of land used for subsistence or downstream purchasers of a project’s output. Energy and economic activity. This introduces complex negotiations other raw materials can also help spur the development and the navigation of rights, customs, legal, and of local businesses or enhance quality of life through, for engagement processes across sometimes very large groups example, access to reliable electricity. Taxes paid to local of people in addition to the challenge of supporting and governments can fund a range of activities, including transition to new homes and communities. project-related environmental and social oversight and enforcement and pursuit of government development Confusion, competition and conflict are not uncommon. objectives more broadly. Land issues may come up repeatedly either because people feel they did not get reasonable compensation Projects and their secondary impacts can also be positive the first time or because recurrent access is needed for the environment, as new business opportunities may for project maintenance. Companies are often under reduce the pressure to expand farming or poaching to new pressure to access land quickly, which may shortcut areas. Other examples include financing land offsets to consultation processes to the possible detriment of protect valuable biodiversity, or programs to help preserve relationships, the company’s social license to operate, and protect the environment and help local communities and the project’s bottom line. enhance the value of their land’s ecosystem services. Additional social pressures can come from project- Investors usually have community programs to provide induced in-migration of workers and others seeking jobs benefits to the local stakeholders. However, community and opportunity. Migrants have the potential to become development programs need to be designed with the powerful new stakeholder groups and influx of new participation of stakeholders, and have clear objectives people may upset community life, traditional norms, and strategies to achieve them. To be effective, and local leadership. There may be disruptive change community programs need to be an integral part of to land values, production systems, livelihoods, new the project’s core business plan. Absent participatory or increasing income and wealth disparities, inflation planning, community programs often fail to deliver in food prices, spontaneous unplanned settlements, real sustained benefits even if they aim to address and cumulative impacts.3 Influx of new populations fundamental needs, such as health and education. will put strain on public infrastructure, services, and utilities. IFC believes early recognition, understanding, Many impacts will cease once production stops. Some and management of project-induced in-migration will may be reversible, and some may be irreversible. For help minimize negative impacts and associated costs example, land used for mining or oil development may (work stoppages or disruptions, demands for financial be rehabilitated and used for farming or forestry, and compensation, permit delays, provision of public offshore oil fields can usually be decommissioned with infrastructure), and ensure that the overall project has a little permanent impact. Some impacts, however, will be positive developmental impact (IFC 2009a). permanent, and some may even continue to accumulate after project closure. The Impacts Of Project Closure Although an industry may continue in a country for 3 Cumulative impacts are those that result from the successive, incremental, and/or combined effects of an action, project, or activity when added to other existing, many years, ultimately, individual projects will close planned, and/or reasonably anticipated future ones. (IFC 2013) down as resources are depleted. The process of closing 57 a mine or oil field can be challenging for communities, an important process of negotiation with investors and and the risk of economic and social disruption requires governments. However, land rights held by one group careful planning to ensure the management of post- can lead to conflict with community members who do closure costs and risks. Governments must ensure that not have land rights, or with neighboring communities investors (and their successors) are responsible for and that may not be equally affected by a project, but still able to meet any ongoing costs. Otherwise, the country expect to benefit. and community will bear these costs. This is already happening in many countries that have hosted mining For Indigenous Peoples as defined by IFC Performance and oil projects for long periods of time. Standard 7, IFC may require that projects be subject to FPIC, Free, Prior and Informed Consent. This The finite physical nature of natural resource projects requirement is triggered in certain circumstances and the sometimes difficult process of closing them involving significant risk to the community of may be put forth as reasons natural resource projects Indigenous Peoples. The circumstances and guidance are unlikely to generate sustainable project benefits. related to FPIC are described in Performance However, IFC’s perspective is that eventual resource Standards 7 and its accompanying Guidance Note. The depletion and project closure do not in themselves mean requirements listed in the Performance Standard apply that resource projects cannot bring overall sustainable to those aspects of a project under a company’s control, benefits to a country and its people. Economies and does not apply to government actions. While constantly change, as do technology, tastes, and governments may consider that this right can ultimately comparative advantages. Developed countries have many be overridden if the needs of the country require it, examples of sectors whose importance has dwindled the existence of FPIC typically enables communities over time. For example, textiles, iron and steel, and to negotiate for a fair share of the fiscal and non-fiscal coal mining were the mainstays of the British Industrial benefits of a project. Civil society and other groups are Revolution, but are now almost insignificant in the calling for this approach to be applied more broadly British economy. What matters is whether a project has to all natural resource projects, and not just those increased the number and diversity of opportunities for concerning indigenous people (Greenspan 2013). the community, and whether the process of development and operation has enabled human, social, and physical Investors are usually not opposed to dealing with capital to be net-enhanced. communities on the basis of recognizing both formal and traditional rights and good practice standards, and they generally welcome clarity and consistency in RIGHTS IMPACT BENEFIT SHARING their relations with governments. Where legal rights are WITH COMMUNITIES recognized, through their impact on negotiations and In some cases, local communities have legal rights, such benefit sharing, they may help ensure that projects receive as land and water rights, ownership of the underlying and maintain community support. A number of resource resource, or veto rights over developments that companies, including members of the International impact them. These rights may put them in a strong Council of Metals and Mining (ICMM), have also negotiating position with investors (and governments) adopted FPIC in certain circumstances as the basis for and may have an important impact on the project’s their engagement with indigenous peoples potentially overall benefit sharing. impacted by their projects (ICMM 2013). For example, local landowners who are recognized as Where ownership or collective rights to consent exist, also owning the resources under their land should be communities and landowners may be able to stop able to negotiate substantial royalties or other forms projects or aspects of projects, but in IFC’s experience, of payments from investors. In Papua New Guinea, communities and landowners often want developments landholding customs and weak governance at the local to proceed because of the benefits they will bring. level mean that landowners effectively control access Landholder rights may help facilitate effective negotiations to mineral resources on their soil, and this right drives and lead to more durable and long-lasting agreements 58 BOX 5.2: Gender Impacts of Projects Without special efforts to take account of gender issues and risks, projects typically benefit women (and children) less than men, and may expose women to new problems. Women tend to be substantially underrepresented in the oil, gas, and mining workforce.a An undifferentiated view of community benefits that does not account for gender differences risks providing a misleading picture of the net benefits on the ground. A review of the gender impacts of onshore oil projects in three countries found that women typically bear more of the costs of development and receive fewer of the benefits than men.b How impacts are experienced can relate to changes in economic position and in social status.c This differential impact is accentuated when existing gender inequalities are pronounced, putting at risk the developmental impact that could otherwise be achieved. Failing to properly assess gender differences is a missed opportunity. More attention to gender issues during project implementation and when engaging with communities could alleviate negative impacts that resource developments can bring to communities. Similar experiences have been identified in mining projects.d Companies are increasingly aware of the win-win aspects of proactive policies regarding gender. Community programs are more successful and company workforces more safety conscious, for example, when women are incorporated. Women reportedly make up more than half of the heavy equipment workforce at Newmont’s Ahafo mine in Ghana. Some industry analysts report that companies can gain a competitive advantage if they are proactive in employing and mobilizing women.e The proportion of women in the workforce is generally low, especially at higher level jobs. The industry group Women in Mining and Pricewaterhouse Coopers found that women fill fewer than 10 percent of board positions in the top 500 mining companies.f This figure, similar to the oil and gas sector, is the lowest of any industrial sector. They also found a positive correlation between the number of women on a mining company’s board and its financial performance. More resource companies and governments have initiated programs to promote women in the workforce recognizing the myriad benefits this can bring to project and community development.g But alongside hiring efforts, additional sensitization and practical changes often need to be made at the operational level to retain female talent. Note: a. IFC 2009b. b. Scott and others 2013; see also Extractive Industries, Gender and Communities at World Bank extractive industries website, http://www. worldbank.org/en/topic/extractiveindustries/brief/gender-in-extractive-industries. c. See, for example, Souza and others 2013. d. See report of Women in Mining Conference, PNG, www.worldbank.org/en/topic/extractiveindustries. e. Kapstein and Kim 2011; Keenan and Kemp 2013. f. Women in Mining 2013 g. Newfoundland and Labrador Department of Natural Resources 2011 59 60 among communities, investors, and governments than HELPING COMMUNITIES BENEFIT MORE would have been the case absent these rights. FROM PROJECTS: PROCESS IS KEY How a community views its share of benefits and how In recent years, human rights-based approaches to it uses a project’s fiscal revenues are important inputs development have become more prominent. There is in how IFC views the fairness of a deal. The process general consensus that business should respect human of community engagement is vital in this respect rights. Human rights considerations have become (IFC 2008, 2010a, 2010b). Where national and local more common in high-impact industries but no governance capacity and accountability are weak, there uniformly accepted approaches for human rights due is a greater risk that benefits may be wasted. In these diligence and impact assessment exist. IFC recognizes contexts, investors need to be even more proactive in the responsibility of business to respect human rights considering how their projects can benefit communities which, in part, finds expression in inclusive and and seek appropriate partners to realize such benefits. participatory engagement processes as well as access to Development initiatives that benefit both the community effective grievance mechanisms that can facilitate early and the project—improved local access roads and water indication and prompt remediation of various project- supplies, training of local people to secure project related grievances. More generally, each of the IFC PS jobs, and other entrepreneurial opportunities—are has elements related to human rights dimensions that more likely to receive support from all parties and be businesses may face in the course of their operations. successfully implemented and maintained. Every project IFC stresses the need to identify and address high risk and community is different, but the ultimate objective circumstances related to human rights issues, and must be the generation of positive impacts and shared recommends that this be done within the overall context value that is sustainable in the longer term. of a robust environmental and social assessment process and management system. Good processes for sharing benefits with communities include: In response to extractive company requests for guidance around human rights and conflict, a set of tools was • Maintaining active relationships built on trust designed to help implement the Voluntary Principles with communities through appropriate and (VP) on Security and Human Rights.4 Particularly aimed effective communication. This implies that genuine at those operating in areas of geographical conflict consultations and participation in decision- and weak governance, the tools contain four practical making will happen whenever possible and that modules co-financed and developed by ICMM, IFC, the perceptions and expectations are closely aligned global oil and gas industry association for environmental with reality. and social issues (IPIECA), and the International Committee of the Red Cross (ICRC). Initiatives such • Carrying out comprehensive, participatory baseline as these mentioned can coalesce industry actors around studies of the community’s socioeconomic, cultural work toward a common standard of behavior even when heritage, and socio-environmental context before government requirements vary. project development, agreeing to joint objectives for the project’s community programs, monitoring outcomes (including community feedback), and responding as needed. This helps address misconceptions, manage expectations, and assuage fears or concerns. • Establishing robust grievance mechanisms that are understood, accessible and linked directly to 4 http://www.ifc.org/wps/wcm/connect/Topics_ Ext_Content/IFC_External_Corporate_Site/ project performance measures. Where justified, Guide+to+Human+Rights+Impact+Assessment+and+Management/ third party mediation may be required. IFC http://www.icmm.com/document/2199 61 maintains a similar practice via the World Bank • Integrating project development and community Group Ombudsman’s Office.5 development plans as effectively as practicable with local and national government planning to support Actively looking for “win-win” solutions that can benefit development aspirations and balance the expectations the project and the community. For example, imaginative and demands of different communities. local staff recruitment and training, finding synergies in the provision of infrastructure between development and WHAT IS REASONABLE COMMUNITY wider community/country needs, and nurturing local BENEFIT SHARING? supplier networks for lower cost and better local impact. IFC’s approach requires that communities, at a minimum, • Using approaches, such as formal Community be protected from harm and recompensed for damage Development Agreements or processes, such as Papua done to them by resource projects. Rights given by New Guinea’s Development Forum, as vehicles to constitutions, common law, and regulation must be fully bring investors, communities, national and local respected, especially in key areas such as land acquisition governments, and other stakeholders together for and livelihood restoration. IFC PS provide a framework a common purpose and understanding of project that, if implemented effectively, ensures that communities outcomes and opportunities. are protected and compensated. IFC uses environmental and social specialists with diverse expertise to ensure • Foundations and other long-term approaches may that the suite of potentially negative impacts and be good vehicles to achieve community development appropriate mitigation strategies are identified. A full objectives if they ensure broader stakeholder understanding of the risks and impacts, their magnitude, participation and helping identify areas of focus distribution, and how they change over time depends on and consistency of priorities across actors, such as appropriate data collection and accurate measurement. company, governments, donors, and communities IFC PS requires that risks and impacts are identified and (Wall and Pelon 2011). that a meaningful environmental and social baseline is established with impacts evaluated over time to a level of depth and sophistication commensurate with the type, size, and intensity of the project. 5 The Office of Compliance Advisor Ombudsman (CAO) is an independent IFC PS also requires that communities—when recourse mechanism for IFC and MIGA. The CAO addresses the concerns of significantly and adversely affected—are engaged and individuals or communities that are affected by IFC/MIGA projects, fosters greater public accountability of IFC and MIGA, and ultimately works to consulted in a way that enables them to bring their enhance the social and environmental outcomes of projects. perspectives and expectations into a project’s net benefit- 62 sharing design. Similar to other areas of benefit sharing different groups or adjacent communities discussed in this paper, there is no single benchmark • Benefits distributed in unsustainable ways or indicator that signals a fair arrangement. Legitimate and reasonable arrangements are arrived at through • Lack of a clear strategic plan to benefit communities negotiation between the project, the government, and • Lack of coordination among other relevant the community over time. Success depends on inclusive, actors, such as local government, health services, respectful, and transparent processes. For IFC, an community organizations, and even other nearby important gauge is the quality of stakeholder engagement developments, etc. and ultimately the community’s expression of support. (Examples of good processes are discussed further below.) • History of conflicts or abuses. How benefits are shared within a community also Environmental matters. There will be winners and losers as different groups (young and old, men and women, the best- When projects are implemented well and are in line and least- educated, etc.) are impacted differently and with IFC PS and other standards, the potential material have varying opportunities to benefit. Costs may be environmental impacts should be known, mitigated broadly felt, but important benefits, such as jobs and where possible, and offset or compensated for in entrepreneurial opportunities, will likely be distributed instances when mitigation is not possible. Areas of more narrowly. The poorest and most vulnerable groups concern for IFC might include: who are frequently excluded from the community’s • Weak commitment of investors to environmental decision-making processes are at greater risk of not standards, or weak capacity to implement the benefiting. These groups may include ethnic minorities, standards, or inexperience in doing so disenfranchised social classes, and women (Box 5.2). Adjacent communities may also experience important • Large, uncertain environmental risks differences in impact. • No clear plans and arrangements for potential long- term and post-closure environmental management CRITICAL AREAS FOR REVIEW • Weak government oversight and enforcement capacity • Risks of cumulative impacts from other developments, Social including those that are attracted to the region at least partly because of the success of the project There are no quantitative standards for how much communities should share in the benefits of natural resource projects because community rights and government policies vary widely across countries. Consequently, assessing how communities are treated, the processes used to engage with them, and the relationships established, may be as important as an enumeration of benefits and costs. Areas of concern for IFC might include: • Lack of regular, diverse stakeholder engagement • Weak community support for the project • Strong opposition by a minority or group • Sharply different treatment of and benefits to 63 Continuing a Dialogue This discussion paper is an initial IFC attempt to By sharing IFC’s approach with stakeholders and encourage an open debate on how to best assess the providing a framework for assessing this complex area, sharing of costs and benefits generated by natural this discussion paper is also meant to be a resource for resources development. Written from the perspective stakeholders to use in designing an equitable sharing of of IFC, the paper explains a wide range of issues, the costs and benefits from natural resource projects. including how the institution, as both investor and development organization, determines whether benefits IFC has benefited from feedback from many and costs are shared reasonably and, ultimately, stakeholders who expressed great interest and whether IFC can support a particular project. enthusiasm. Our aspiration is that this paper will Fundamentally, a project must be profitable, but complement as well as stimulate work by others that profitability can be only a starting point. can enrich the collective knowledge and debate. 64 Appendixes APPENDIX A: RESOURCE DEVELOPMENT AND TAXATION There is a large pool of literature about the nature of nonrenewable resources and their ownership and optimal taxation. Most reviews of resource taxation identify four key objectives that should drive design: 1. Governments should collect as much of the “rent” (returns generated from the project over and above what is needed to incentivize investors) as possible, and doing so usually requires progressive taxation (IMF 2012). 2. Taxation structures should be “neutral” and not lead investors to develop a resource in a suboptimal way. 3. Investors need adequate compensation to incentivize them to take risks and invest. 4. Taxation structures need to allow for government capacity to negotiate, design, administer, and carry the risk of different forms of taxation. Uncertainties and Flexibility If there were complete certainty about the nature of a resource and its future outcomes, estimating its rent and designing an optimal tax structure or agreement would be relatively straightforward. Once in place, taxation structure and agreements should ideally be responsive to changing market dynamics, but getting this right is not always easy, given the complexity of designing and administering appropriate tax systems and the demands these systems put on taxation authorities and investors. In practice, there is considerable uncertainty about the values of the key parameters that determine a project’s success. This uncertainty will decrease over the life of the project, but will not wholly disappear. In the exploration phase, there may be considerable uncertainty about whether a viable resource even exists. Even when a resource is identified, there will be uncertainty about the capital costs preconstruction; about production levels, operating costs, and sales prices in the operating phase; and about closure and decommissioning costs at the end of project life. There is debate about what the appropriate return to investors should be, how much rent will be generated, and how this rent should be shared. Any form of contract intended to last over the long life of a resource (sometimes decades)runs the risk of coming under pressure as circumstances change significantly from when the contract was signed. In theory, contracts can be written to build in flexibility. In practice, contracts may not cope well with major changes. 65 Over the last 10 years, for example, very high commodity prices have led to large increases in profits and company values across the resources sector. While volatile prices are a normal part of the commodities business, and a few years of high prices would not generally signal a major change from expectations, there has emerged a view that high commodity prices in the last decade present a ‘new normal’. There seems to be a strong perception in some countries that they have not participated enough in the windfall. Various oil, gas, and mining country governments have moved to renegotiate and change terms and conditions to capture more of the increased value, as a result. Common Considerations in the Mining, Oil & Gas Sectors Most resources are developed subject to specific resource taxes given the particularities of extractive projects, i.e. their potential to generate high levels and volatility of profits. There are, however, some commentators who believe there may be less rent from many resource developments than commonly assumed (Tilton 2010). And they even question whether the resources sector should have a special taxation regime. Nonetheless, resource taxation regimes do exist, and there are some common considerations in how they are constructed. Balancing sector prospects management capacities and revenues: Governments and investors need to take a long-term perspective of the prospects of projects and the sector that may receive investment and operate over decades. To create the perfect resource framework is very difficult, given the uncertainty of outcomes, the associated complexity of particular taxation systems, and frequent administrative capacity limitations. Governments will have to compromise between optimizing rent collection, neutrality, and administrative and political practicality. Governments may offer standard terms and conditions, rather than negotiating deal by deal. The resources taxation framework should be linked to the overall taxation framework and to other aspects of government policy, such as requiring good accounting standards, transparency, and access to information. Setting terms: Clarity and stability in terms and conditions are important factors for investors and for governments aiming to attract investment. When governments want to negotiate deal by deal, they need to develop the skills to set terms and conditions and to administer them effectively during the duration of the contract. Given the monetary values at stake, increased knowledge about the issues, and the availability of specialist expertise for hire internationally, acquiring these skills may not be as difficult as sometimes suggested.1 Increasingly, transparency about contracts and payments is an important factor in generating confidence about the reasonableness of deals and promoting their durability. Standard, non-negotiated terms are seen as offering the two benefits of simplicity and being less prone to corruption. Some commentators believe that governments will be comparatively weaker negotiators because they will usually have less understanding of a resource’s true prospects. However, there is a trade-off, and governments can supplement standard terms and conditions with some degree of negotiation. Competitive bidding through auctions and other processes to access known resources or prospective exploration acreage is one way to use the market to optimize tax receipts, enhance transparency, 1 For example, see the approach taken by Angola as described in McKenzie, Goldsworthy, and Sunley (2009). 66 and discourage corruption. While they can be complex, auctions can help bypass the complexities and uncertainties that negotiated deals involve, not least because of their demands on government capacity and oversight. Whether terms are standard or negotiated, large changes in circumstances that are outside the reasonable range of (expected) uncertainty will put agreements under pressure. Having in place or establishing mechanisms to handle such changes constructively will be helpful. Common taxation principles: Resource projects often generate rents, and taxation arrangements should include some mechanism(s) to recover a share of these rents. Governments have many possible taxation instruments and a wide range of approaches and combinations of these have emerged and are used today. These instruments are based on country, sector, project specifics, and on policy and precedent. Governments will vary in their capacity to carry the risks that some forms of benefit sharing will impose on them (for example, full equity investment). Some approaches are very sophisticated in how they tax projects, simultaneously aiming to capture a major share of the resource rent for government and offering appropriate incentives for private investors. Some common principles across the resource sector include: • Progressive taxes, such as the corporate profits tax, which increase government tax take as profitability rises, are better than regressive taxes, which impose costs not related to profitability, but to output or price, such as royalties. • For practical and political reasons, some form of regressive tax such as a royalty tax based on sales, is likely to be part of an overall package.2 The package would likely also include a corporate profits tax and sometimes a mechanism to recover a higher share of exceptional profits (rent). • Tax holidays, in which governments agree not to levy profits taxes and possibly other taxes for a number of years regardless of profitability, are usually not needed and are not encouraged by the World Bank. Overgenerous depreciation allowances that allow the rapid tax write-off of long- life equipment may also pose problems for the timing of government profits from tax flows. • Full or partial exemption from import taxes and value-added taxes for export-oriented resource projects is common. • Some form of modest withholding tax on payments for foreign services may be helpful, although it will impact costs and taxation neutrality. Differences between Sectors While there are considerable variations in taxation within the mining and oil sectors, there are also long-standing and fundamental differences between these sectors. 2 Given the depletion of a particular resource, some economists see a royalty payment as an appropriate fee for the resource’s depletion, and therefore an essential component of resource taxation. These economists argue that the capacity of a project to pay the royalty should guide the decision of whether to develop the resource. Normally, governments need to commit to allow development at the exploration investment stage when there is no clarity whether the resource is economic to develop. 67 Mining projects usually take place within standard sets of terms and conditions that are relatively simple in structure. However, very large projects can be an exception and may involve complex, negotiated contracts. Sometimes, even smaller deals have some component of negotiated terms. Typically, standard terms include a royalty of 2 to 5 percent on sales (a regressive tax), and a simple progressive tax, such as a corporate profits tax at a rate of 30 to 40 percent. Other terms could include a dividend withholding tax and exemption from import duties and the value-added tax. Depending on the actual rates, such packages can generate a reasonable share of the resource rent to governments and are relatively simple to understand and administer. What they do not do well is capture large increases in rent (windfall profits) generated by unexpected large and sustained increases in prices. For example, with a corporate tax rate of 30 percent, and a royalty rate of 2.5 percent, all other things being equal, only 31.75 percent of any increase in revenues from a price rise accrues to government.3 Very large mining projects are more likely to be based around individually negotiated deals, although some smaller deals may have some negotiated component. Even negotiated mining agreements often do not contain the sort of sophisticated progressive tax terms that many, if not most, oil projects have. Oil project taxation structures typically are more sophisticated and effective in capturing high levels of profits than typical mining tax structures. Some of the differences from mining are higher levels of profitability and greater rent in the oil and gas sector. While there are different approaches to oil taxation, many terms include provisions for an increasing share of a project’s net flows to go to government when prices or production increase. Some approaches will relate the share of benefits going to government to the cumulative rate of return earned by the private investor. In some cases, the marginal share of profits going to government may reach more than 80 percent (Lundgren, Thomas, and York 2013). Gas projects are often treated differently from oil investments. Due to their transportation and market issues, gas projects are more likely to sell their gas at prices that are below the international price of oil. Gas projects usually are likely to have less sophisticated profit-sharing arrangements than is often the case for oil projects. The degree of state ownership is another important difference between the oil, gas, and mining sectors. While state ownership varies across countries, the oil sector has a higher degree of government equity participation, varying from complete state monopoly to significant or majority private ownership with substantial state equity interest. Government Equity Participation A government equity stake in a resource project can be an alternative to taxes as a way of accessing a share of profits. Government equity participation may also be important politically. Some argue that government ownership may give it greater insight into operations and thereby improve policy or taxation effectiveness. A counterargument is that government ownership may create a strong 3 For example, an additional dollar of revenue from an increase in prices will generate an additional royalty of 2.5 cents for government and 97.5 cents (100 minus 2.5) gross profit increase for the project. Leaving aside timing differences, this increased profit will generate extra taxes for government of 29.25 cents (97.5 x 0.3 cents), giving a total revenue of 31.75 cents. 68 government lobby in favor of the state resource development entity at the expense of broader policy demands. In practice, the accumulation of profits in state companies is not necessarily the same as the country’s treasury receiving the funds in the form of taxation. As part of their overall fiscal framework, governments need to ensure that state corporations are appropriately taxed and managed. Depending on the terms under which it is held, equity ownership will bring a different mixture of risk and reward to governments and usually will increase government risk compared to the potential tax alternative. As a normal equity investor in a project, a government will have to put up its share of the equity capital needed to fund the investment before it generates revenues. As an owner, a government will also be exposed to the risk that the venture will not to earn a satisfactory rate of return or fail completely. There are ways in which governments may be able to tailor their equity involvement to manage their risk-return balance. For example, governments sometimes require private investors to initially finance the government’s share of equity with repayment to the investor out of the government’s share of future profit flows. Governments can also reduce their risk by holding an option (but not the obligation) to invest in equity in the future at historic cost or some other value once it is clear how the project will actually perform. Alternatively, they could simply negotiate the right to receive a share of the equity profit flows, with no financing obligation. This third alternative is effectively what happens in the oil sector with production-sharing contracts. Equity participation and rights need to be seen as part of the overall fiscal and investment conditions package. The rights and options that a government has will impact the distribution of benefits (and risks) to private investors, and this distribution will have costs in terms of other conditions and taxes that can be imposed. Moreover, some forms of equity rights held by governments require investors to provide funding for government that may be repaid only out of future profit flows. The charges that investors can make for such financing will also impact the net benefit sharing of governments and investors. Other Issues in Resource Taxation Relevant for almost any resource tax structure, a number of practical issues recur and can impact how much tax is actually collected compared to the tax indicated by the resource’s value and the taxation system. What follows is a discussion of six related issues that have recently attracted considerable attention. Transfer pricing: Generally, taxation arrangements relating to resource agreements (and in general purpose tax legislation) explicitly state that output and services will be sold and bought at fair market prices. Resource production companies may be part of integrated companies that produce, trade, and process materials and buy and sell from associated companies. Local companies may receive expert technical services or supplies from international affiliates. In the absence of a market-based, third-party relationship, companies need to establish appropriate transfer prices for transactions between themselves. By mispricing these transactions, there is considerable scope for investors to effectively transfer profits from what is considered a relatively high-tax local regime to another low-tax regime, possibly in an offshore financial center. As a result, governments will receive lower amounts of taxes than they should receive under legal agreements or tax law. Some studies have claimed that the amounts 69 of taxes or profit sharing being evaded in this way are substantial in the African resources sector (Africa Progress Panel 2013). Using inappropriate transfer prices usually is contrary to general tax law and is considered tax evasion. Governments should ensure that requirements concerning pricing are known and effective and, where appropriate, part of the resource development agreements. For example, the International Bar Association’s Model Mine Development Agreement4 proposes that transactions with affiliated companies follow the Organisation for Economic Co-operation and Development’s (OECD) “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration,”5 based around arms-length market pricing as the appropriate basis for transfer prices. Governments also need to ensure sufficient capacity to identify risks and to audit properly. While it can be complicated to validate sales and cost values for some commodities, for many commodities quoted market prices exist, or reasonable unbiased relationships can be derived using the more widely quoted prices of related products. Furthermore, considerable expertise exists internationally, the cost of which is likely to be low compared to the value at stake. IFC is often an equity investor in projects and tries to assures itself that pricing between the company in which it invests, and the company’s associates is based as much as possible on verifiable market prices. “Thin capitalization” is a special case of transfer pricing. Investors usually have incentives to finance projects through a mixture of equity and debt financing. When the leverage ratio between equity and debt goes beyond typical industry standards, and interest charges go well above market rates, the financing structure can become a mechanism for tax reduction. Most governments have “thin capitalization rules” 6 to limit financial structures to proportions that are close to what is market appropriate. In many cases, companies employ complex tax and financial structures to minimize taxes in ways that are legal in the investment country and in their home countries and that account for the relevant tax treaties between both. In some cases, structures are driven to minimize tax in their home countries as the result of deliberate government policy objectives. For example, current U.S. tax policy, which does not tax international profits that are not brought back into the United States, may encourage the use of offshore tax financial centers as a means for U.S. companies to invest across a number of countries. Governments and the public generally may be surprised at the complexity of arrangements and perceive that taxes are being avoided inappropriately. In some cases, this may put considerable pressure on governments to react and remedy what is seen as unfair. Recent examples of apparently legal, but very low, corporate tax payments by foreign companies in the IT and other sectors in the United Kingdom are an example of this tax avoidance from outside of the natural resources sector. Currently, there is an international reaction against the aggressive tax planning and transfer pricing of multilateral businesses. The G20,7 for example, issued a 15-point action plan that covers this kind of tax planning. 4 www.MMDAProject.org. 5 http://www.oecd.org/ctp/transfer-pricing/transfer-pricing-guidelines.htm. 6 “Thin capitalization rules determine how much of the interest paid on corporate debt is deductible for tax purposes” (http://en.wikipedia.org/ wiki/Thin_capitalisation_rules). 7 The G20 members are Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Republic of Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, the United Kingdom, the United States, and the European Union. 70 Offshore financial centers: Almost all foreign investors use offshore financial centers as a mechanism to manage ownership of investments and to optimize tax payments. These centers are not illegal and are not necessarily associated with tax evasion. Tax optimization for investors may mean taking advantage of home country policies and tax legislation that discourages the direct remittance of profits from foreign investments to home. These policies many have allowances that delay any tax payable on profit until it is repatriated. A third-party low tax base enables investors to flexibly redeploy pretax profits elsewhere. Investment host governments should not necessarily have a problem with this. Host governments that can reasonably structure tax arrangements to enable investors to take credit in their home country for local taxes paid probably can increase their own tax revenues, as a result. Offshore financial centers may also play a part in schemes intended to disguise true ownership of assets and flows of illicit funds. Governments need to be alert to what may be money laundering and respond appropriately in their approach to taxation audits, requirements for disclosure of contracts, and beneficial ownership, among other factors. International initiatives are working to increase the information flows and information about offshore centers and their clients. IFC will support investments that involve the use of entities based in offshore financial centers that meet WBG policy guidelines (World Bank Group 2011).8 Stabilization clauses and changes in terms and conditions: Investors about to commit to investments that will pay back only over a long time, are often concerned that the tax terms and conditions under which they will operate may change after the investment is committed, the project is operational, and their relative negotiating power with a government is significantly reduced (the “obsolescing bargain”). Such investor concerns may delay investments. To help alleviate these concerns, governments sometimes agree to include stabilization clauses in agreements that guarantee that key terms will not vary over the project life and provide specific remedies if they do. A United Nations-sponsored study supported by IFC concluded that, if reasonably drafted, such clauses may serve a purpose by reducing perceived risks and encouraging investment, especially for large, complex projects with long paybacks (Shemberg 2009). In general, countries can strengthen their reputations as good investment locations by respecting agreements made. However, when circumstances change considerably, these agreements may come under pressure because the distribution of net benefits is no longer perceived to be fair. A number of governments have made this case in recent years when large rises in commodity prices have boosted the profitability of resource projects (Toledano et al. 2014). Timing of resource taxation flows: Closely related to concerns about the overall sharing of benefits from resource projects is the timing of government flows. Profits-based taxes usually will be the most important source of revenues to government on the condition that the project is profitable. However, it will usually be several years between the announcement that a project will begin construction and the date it begins producing. Moreover, even if the project is profitable early on, 8 http://www.ifc.org/wps/wcm/connect/corp_ext_content/ifc_external_corporate_site/what+we+do/due+diligence 71 sometimes several more years pass before it pays taxes, because depreciation and other tax terms may delay the date that the profits tax is payable. These lengthy delays can frustrate both the government and the public, especially in countries in which resource development is starting, and particularly in the case of large projects for which expectations are great. In some ways, investors are best placed to understand when they are likely to be paying taxes, in what form, and the level of uncertainty about these payments. In contract discussions, investors should have a strong interest in ensuring that governments understand these issues of delay, and that in the investors’ communication and consultation processes, the wider public understands these issues as well. The risk of delayed or uncertain taxes on profits needs to be considered carefully when governments and investors structure agreements. This risk is one of the reasons that governments usually have a royalty component in the taxation package. Other approaches or forms of nonprofit-related taxes that may be adopted by governments, with different advantages and costs, include: • Up-front payments generated through auctions or negotiated fees and signature bonuses for access to known resources and prospective exploration areas. • Greater focus on other taxes such, as import taxes, that could be levied on imported equipment and materials even in the construction phase, and that can increase project costs up front. • Less government equity investment requiring up-front financial commitments. • Minimizing tax terms that delay payment of the profits tax, such as tax holidays or generous depreciation provisions. • Borrowing against (uncertain) future tax receipts, although doing so may pose risks in terms of fiscal management and public disappointment when tax revenues that finally come in are committed to repay borrowing. • If delays in tax receipts come as a surprise, governments may be prompted to change the previously agreed terms and conditions to generate revenues immediately. Capital gains on assets sales: In the last five years, foreign investors have sold or attempted to sell the rights to nonproducing resources in a number of countries for large profits. The governments of these countries felt that if the investor was realizing a substantial profit, the government should receive a share in the form of taxation. However, there was no agreed or unambiguous taxation mechanism to do this. For example, the change of ownership might be effected not through the direct sale of the asset, but through the sale of shares in an offshore company that directly or indirectly owned the asset. There was no consensus among the parties on whether such transactions realized a capital gain that was taxable under the existing tax frameworks and agreements. Governments have tended to feel that it was unreasonable that the original investor was realizing a large profit without any immediate tax due as a result. The high prices realized also suggested that the existing tax structure might have been too generous or that the resource was more valuable than governments had originally believed. In some cases, governments have attempted to claim a tax from the purchaser and not the seller. 72 This is likely to remain a complicated and evolving area of taxation in which governments need to clarify intentions and legislation, and companies may need to be aware when they negotiate the sale or purchase of assets. Offshore accounts: Some local civil society groups have questioned the use by investors of offshore accounts for receiving and holding the proceeds of production sales (Akabza and Ayamdo 2009). It is suggested that using offshore accounts leads to loss of benefits to a country from its resources sector, and that the proceeds of sales—which are usually denominated in U.S. dollars—should be converted and held in local currency accounts. While offshore bank accounts can be a means of facilitating corruption, investors view the use of such accounts as essential to pay for foreign-currency-denominated costs, such as interest and debt repayment costs, fuel, supplies, and equipment. Forced automatic conversion of U.S. dollar proceeds into a local currency with the risks of depreciation and nonconvertibility would materially increase risks to investors, discourage investment, and increase required rates of return. Banks and other international lenders will be much less likely to lend to projects for which currency convertibility is a risk. In practice, once governments have agreed on an overall framework for the development of a resource, their real interest is not in the gross sales proceeds of production, but in the taxes, profits, and other payments due under the agreement. Forced repatriation of gross sales proceeds seems unlikely to offer any sustained net benefit to governments or countries. APPENDIX B: IFC MEASURES TO ASSESS NATURAL RESOURCE PROJECTS IFC uses the following measures of project financial and economic performance (all adjusted for inflation to real terms) to assess resource projects: • Economic rate of return (ERR) estimates the overall economic rate of return that a project earns. The ERR is a broader measure of a project’s rate of return than the financial rate of return, FRR (see below), because it aims to include all of the economic costs and benefits. Thus, the ERR will be calculated before taking off taxes that are a financial but not an economic cost, and it will bring into its calculation benefits and costs such as, market externalities that are not be captured by the project’s accounting. For example, an adverse environmental impact that is not paid for by the project is an example of an economic cost that would be included as such in the ERR. For IFC, it is fundamental that the ERR is positive and high enough to show that the project is generating a reasonable economic return for the resources it employs. Without this, economic value is being destroyed, even though it may be attractive to investors because the FRR is high enough.9 The ERR says nothing about the sharing of benefits of a project, only that it is creating real economic value that is available among all stakeholders and society at large. 9 A project could have a high FRR for investors, but a low or negative ERR for the world as a whole, if, for example, the project was supported financially through subsidies from the government or users (for example, through import restrictions or tariffs). 73 TABLE A.B.1: Share of Net Project Benefits Going to Government (hypothetical project) (%) INVESTOR REAL POST-TAX NPV AT 10% NPV AT 0% RATE OF RETURN Base Case Profitability 97 38 10.1 Higher Profitability Scenario 56 35 16.8 • Net present value (NPV) establishes the value that the project creates above all of its costs, including an appropriate cost of capital for the funds invested. That is, projects with a positive NPV will earn an ERR that is above the cost of capital of the project. How the NPV is shared is core to understanding the overall benefit sharing of a project. • Investor’s financial rate of return (FRR) shows the net financial rate of return (after tax but before financing charges) that accrues to the private investment made in the project. Other measures IFC may also use from time to time include: • Return on investors’ equity: Investors usually finance with a mixture of equity and debt. IFC will also estimate the private return that the private investment earns on its equity investment (after tax and financing charges). This gives IFC insight into how attractive the project may be to the investors it is supporting. • Return to the domestic economy measures the return the country earns in all forms on the resources it commits to the project. It provides a guide to the overall attractiveness of an investment from the country’s perspective. This can be a useful test for governments that plan to invest resources to support the project on the expectation of a broad range of national benefits, especially when the investors are all foreign. Selected Issues Discount Rates to use: There is a rich and active business school and economic literature about such estimates, and in particular about the appropriate cost of capital that should be used for NPV analysis and to set benchmarks for ERRs. For simplicity, IFC uses a common 10 percent real discount rate for its NPV calculations. This is close to many estimates of the appropriate cost of capital for resource investment, which vary according to the historical time period used to estimate them. IFC will also look at how benefit shares vary using different discount rates. How important the choice of discount rate may be depends to a certain extent on the project. However, a positive discount rate when calculating the public versus private take will invariably reduce the share of total benefits going to the investors. This is because of the typical nature of the project investment cycle where investors put up the capital expenditure for the project in the beginning and it will be some time before they reap profits. Typically, the higher the discount rate the lower the private investor’s share will be. 74 Higher profitability projects will be relatively less impacted than low-rate-of-return projects. For example, an IMF study of a number of mining and petroleum-producing countries found that projects with relatively high rates of return did not experience much change in the proportions of NPV cash flows to the governments when different (lower) discount rates were chosen (IMF 2012). However, for low-rate-of-return projects, changes in the discount rate used can have a marked impact on shares. This can be illustrated by using a simple hypothetical model (Appendix C) of a resource project and looking at how NPV shares differ between one based on a zero percent discount rate and one based on a 10 percent real discount rate. Using this simple model, in a lower-rate-of-return “base case,” the share due to government changes from 38 percent to 97 percent, as the analysis changes from not discounting flows (a 0% discount rate) at all to applying a 10 percent discount rate (table A.B.1). In the “higher profitability” scenario, the government share changes less, from 35 percent measured on a zero percent discount rate basis to 56 percent measured on an NPV (10 percent) basis. Project scope: An important factor in IFC’s decision to invest in the development of a project will be the expected net economic benefits that the development will bring going forward—treating past spending on exploration as sunk costs. These net benefits are captured by the economic rate or return. However, in its review of the overall benefit sharing of the project—the split of NPV—IFC will include the preconstruction spending by the investors, including on exploration. In some cases, allowing for such spending may be relatively straightforward. For example, an investor may have taken out an exploration license, explored for a few years, found a resource, evaluated it, produced a bankable feasibility study, and then approached IFC for financing as it moves into the development phase. Adding back such predevelopment costs to get a sense of the overall sharing of costs and benefits including these costs is relatively straightforward. In other cases, the discovery may have followed a decade or more of unsuccessful exploration in the same region or in different regions of the country or even in adjoining countries. It is a judgment call as to which portion of these past costs should be included in an analysis of benefit sharing for a particular project. Sometimes, the investor developing the project may not have found the resource, but instead bought the rights to it from another investor, possibly at a substantial premium. While the acquisition price is a cost to the new owner and developer, part of the price may be profit to the seller, who may or may not have paid taxes on such profit. The overall private sector balance of costs and benefits will be different from that of the investor who is developing the project. This difference may lead to differences in perspective between investor and government on how profitable a development is and the reasonableness of the benefit sharing. Depletion of resources and future generations: There is a rich literature about the economics of natural resources and their depletion. When it comes to benefit sharing, it is important to address the issue of benefit sharing across generations. For example, it is argued that a country today and for some time will enjoy the taxes and other benefits that flow from a natural resources development, but future generations will not benefit in the same way if the resource is depleted. From this perspective, benefit sharing assessments should take into account the issue of whether and how future generations should be compensated and what are the implications for resource development. National wealth accounting is one possible framework to consider in the context of evolving approaches to national accounting. 75 Arguments against the need for accounting for depletion focus on the ambiguity about whether resources will be actually depleted in practical terms, given the potential for new discoveries and technological advances that will expand the resource base. Depletion may be true for a specific resource, but not for resources generally. And, typically, societies do pass on greater wealth to future generations than was inherited, although its form may change without specifically accounting for the benefit derived from natural resources development.10 APPENDIX C: INTRODUCTION TO SIMPLE MODEL AND SCENARIOS Financial models of oil, gas, and mining projects can be very complicated, in part because of the nature of projects themselves and the key factors that drive their success. Additional complexities are created by the multiple forms of taxes that interact with one another and with other assumptions such as financial structure, interest rates, exchange rates, and inflation. A simple model can help illustrate key characteristics of a project and tax system, provided limitations arising from these simplifications are kept in mind. The hypothetical model in tables C.1 and C.2 is intended to illustrate what might happen to a government’s share of the net financial benefits of a project measured in NPV terms. This model assumes that the government made no investment in the project and receives revenues only in the forms of profits taxes and a fixed percentage royalty on sales. To keep it simple, the project is not leveraged and is financed by the investor in the form of equity. In practice, this scenario would be unlikely, and introducing debt probably would increase the overall share going to the private sector, but not by much. No tax holiday for a profits tax is assumed here. And the project is assumed to pay tax once the accumulated net profits after accumulated depreciation are positive. It is assumed that the government does not collect any taxes based on capital and operating costs, such as import duties and nonrefundable value-added tax. In reality, this assumption is not unusual, but in some cases, these forms of tax can be important, especially in the early or preoperational phases of a project. Other forms of payments to the government that would likely exist, such as land rental and administrative fees, are not assumed here and are not likely to be important to the overall messages. Governments may also earn taxes on employees’ salaries and spending, but these taxes are not included here. The investor’s net returns are the sum of the investment costs and its share of profits after taxes. No account is taken of any additional taxes that the investor (if a foreign investor) or the investors’ shareholders may pay in the investor’s home country. From a high-level economic perspective, a decision as to whether to support a project depends on costs and benefits going forward, so past exploration spending would not figure in. However, from the perspective of sharing the financial benefits of the project, past costs of the investor to find and appraise the resource are figured in here. NPV estimates are made on the basis of a 10 percent real discount rate. All dollar values are expressed in real terms. For simplicity, prices are assumed to be constant at scenario values through all the years of the scenario. 10 Some of the richest resource-producing countries do account for and plan to preserve the benefits of their resource development for future generations through sovereign wealth funds and other mechanisms intended to ensure that the financial flows from resource developments are used for longer term development or future generations. 76 TABLE A.C.1: Hypothetical Mine Model Assumptions ASSUMPTIONS Profitability Scenarios: Poor Base High Prices US$/ton 250 360 450 Annual production tons 950,000 1,075,000 1,250,000 Capital cost US$ million 1,000,000,000 900,000,000 950,000,000 Unit production costs $/ton 220 180 160 Project life years 20 20 20 Years to develop 5 5 5 Past exploration costs (NPV to year 1) US$ million 125,000,000 125,000,000 125,000,000 Depreciation per year (%) 20 20 20 Royalty (%) 4 4 4 Tax rate (%) 30 30 30 TABLE A.C.2: Hypothetical Mine Model Outcomes by Scenario DISCOUNT LOW CASE SCENARIO BASE CASE SCENARIO HIGH CASE SCENARIO RATE IRR: -7.5% IRR: 10% IRR: 16.8% Distribution of % Total Distribution of % Total Distribution of % Total financial flows Project financial flows Project financial flows Project (US$ million) Flows (US$ million) Flows (US$ million) Flows Government >100% Government 38% Government 35% Royalty 190,000,000 309,600,000 450,000,000 Corporate tax (1) 760,619,999 1,717,499,999 NPV @ 0% Government 189,999,999 1,070,219,999 62% 2,167,499,999 Total Flows Investor Neg Investor Investor 65% Total Net (745,000,001) 1,774,779,999 4,007,499,999 Cash Flow Overall (555,000,002) 2,844,999,998 6,174,999,998 Project Total Government >100% Government 99% Government 56% Royalty 73,526,233 119,809,061 174,141,075 Corporate Tax (1) 335,835,793 567,161,593 Government 73,526,232 455,644,854 741,302,668 NPV @ Total Flows 10% Investor Neg Investor 1% Investor 44% Total Net 576,061,254 2,653,660 576,061,254 Cash Flow Overall 1,317,363,922 458,298,514 1,317,363,922 Project Total Note: IRR = internal rate of return; Neg = negative; NPV = net present value. 77 Glossary Beneficiation: The processing of raw materials. Financial rate of return: Rate of return earned on the project funds invested–usually expressed in real terms Commodities super cycle: Longer-lasting period of (after adjusting for inflation) and, most often, after tax. higher commodity prices than in a normal commodity However, practice varies in this respect, so financial rate price cycle. of return may be quoted on a pretax basis. Cost of capital: The minimum return markets require Government take: Share of revenues after costs that the for investment in a particular project or sector. government collects in all forms over the life of a project; this rate provides an overall measure of benefit sharing. Derivation: Distribution of tax revenues to extractive-producing areas. Internal rate of return: See financial rate of return. Dividend withholding tax: Taxes levied on dividends Marginal effective tax: Rate that shows how that are paid out (usually) to foreign investors. incremental changes in revenues are shared. Economic rate of return: Rate of return earned on Marginal tax rate: Rate of tax paid on the additional project funds invested, but including all economic costs dollar of profits earned. and benefits, not just the financial ones (as in financial rate of return). Monte Carlo analysis: “A problem-solving technique used to approximate the probability of certain outcomes Effective royalty rate: Minimum share of net revenues by running multiple trial runs, called simulations, using that the government collects in any one tax year from a random variables” (http://www.investopedia.com/ project during its life; indicates how low a government’s terms/m/montecarlosimulation.asp). share of a project’s net benefits may be in one year. Net present value: Value of a future stream of Effective tax rate: Government’s share of a project’s payments and receipts discounted by a rate to allow for net benefits after capital and operating costs; effective the different timings involved. tax rate is effectively net present value at a zero percent discount rate. Real post-tax rate of return: Financial rate of return/internal rate of return after taxes and adjustment Equity ownership: Owners of the project or enterprise. for inflation. Real rate of return: Financial rate of return/internal rate of return after adjusting for inflation. 78 Rents: Net fiscal benefit; returns generated from a Thin capitalization: When a project or company is project over and above what is needed (cost of capital) to highly leveraged with a large amount of debt supported incentivize investors. by only a small amount of equity. This status can be seen as a special case of transfer pricing. “Thin capitalization Resource corridor: Physical area around a resource rules determine how much of the interest paid on [such] project, usually a transport corridor through one or debt is deductible for tax purposes.” (http://en.wikipedia. more countries. org/wiki/Thin_capitalisation_rules) Social license to operate: Approval (usually tacit) Transfer pricing: Setting prices for transactions among of a community for a project to take place and operate associated companies other than being set independently in its area. in arms-length market-related transactions. Transfer pricing sometimes is needed. 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