Inter-generational equity and the rationale for Guyana’s “Sovereign Wealth Fund”

0

The policy of investing resource revenues in reproducible capital suggests irresistibly that some appropriately defined stock is being maintained intact, and that consumption can be regarded as the “interest” on that stock (Solow 1986).

Since the discovery of oil and gas reserves in the Stabroek Block in 2015, the emerging industry has become an important part of the Guyanese economy.  Over the last three years, capital and operating costs per barrel of oil equivalent in the Guyana Basin has fluctuated and most industry experts predict this trend to continue.

This is in part due to production focusing on both new discoveries and marginally-adjacent fields where exploration is technically easier. It also reflects cost inflation in the oil and gas industry more widely due to increased demand for exploration equipment and a shortage of skilled labour in key areas of the industry.

Furthermore, as the Guyana offshore industry matures operators will face costs from decommissioning existing platforms and operations in exhausted fields (I will address this issue in future articles and related publications).

Invest all profits or rents from exhaustible resources in reproducible capital such as technologies. This injunction seems to solve the ethical problem of the current generation short-changing future generations by “overconsuming” the current product, partly ascribable to current use of exhaustible resources (oil, gold, and other natural resources).

Under such a program, the current generation converts exhaustible resources into technologies and “lives off” current flows from the innovations and labour. Under such a program one might assume that in some sense the total stock of productive capital was never depleted since ultimately the exhaustible resource stock will be transmuted into a stock of innovative working systems and, given that these systems are assumed not to depreciate, no stock either of machines or of exhaustible resources is ever consumed (Hartwick 1977).

Government Revenues from Oil and Gas

Under the current constitutional and fiscal settlement, tax revenues from oil and gas production in the Guyana Offshore Basin (GOB) are reserved to the Guyanese government. The current Stabroek fiscal regime comprises of three primary elements; royalties, profit share after cost recovery and corporation income tax (CIT); paid on profit.  Therefore, having large reserves of oil and gas presents an economy such as Guyana with considerable opportunities over the short and long-term benefits. Experience has shown that these assets also create considerable challenges to a country’s economy and political system.

The general principle behind the creation of an oil fund [Natural Resources Fund or Sovereign Wealth Fund] is to transfer a share of the wealth generated from oil and gas production to a separate fiscal account where it can be saved and invested over the long-term rather than consumed immediately. This requires a conscious decision by policymakers to forgo a proportion of possible current consumption in favour of long-term investment. This is not straightforward. Current needs and demands on the public finances are typically more clearly defined than future needs.

Public Policy Rationale for an Oil Fund

There are a variety of public policy objectives which could be served by an oil fund or in Guyana’s case a Natural Resources Fund (NRF) or Sovereign Wealth Fund (SWF). In practice and with the correct design for Guyana, a SWF (oil fund) can be used to help achieve; by several of these policy objectives simultaneously.

  • Long-term fiscal sustainability

NRF or SWF (oil funds) can facilitate the creation of renewable wealth from a non-renewable and finite resource.

  • In most cases, the key motivation behind the creation of an oil fund (NRF or SWF) has been to provide a vehicle for sustainable resource management such that the returns from non-renewable oil and gas revenues can be converted into a renewable financial pool of wealth.
  • Oil and gas reserves represent an important element of a country’s asset stock. Investing a share of the revenues received from oil and gas production in financial assets such as equities and bonds, leads to the creation of a new asset – financial wealth. Unlike oil and gas reserves, returns from such assets can provide a permanent income stream. Provided that the underlying principal of these financial assets is maintained, equities, bonds and cash holdings are able to generate income flows year on year, via interest payments, dividends and rising asset values. An NRF or SWF (oil fund), by converting the temporary wealth generated by oil and gas production into financial assets, can therefore lead to the creation of a permanent source of revenue which would continue to generate income beyond the point when oil and gas reserves have been exhausted.
  • Inter-generational equity

NRF or SWF (oil funds) can provide a mechanism to save some of the temporary windfall from oil and gas revenues and allow the benefit of a country’s natural resources to be shared across generations.

  • The most obvious motivation behind the creation of an NRF or SWF (oil fund) is to provide a transparent mechanism to save a proportion of the temporary financial windfall from oil and gas production for future generations.
  • Oil and gas reserves are potentially very lucrative with the ability to earn billions of dollars for countries fortunate enough to have them located in their jurisdiction. As with any one-off financial ‘windfall’, many countries have found it prudent to ‘lockaway’ a proportion of these returns in ‘rainy day funds’ or ‘heritage funds’.
  • Saving an element of this windfall ensures that future generations can share in the benefit from a country’s natural resources. Of course, if this saving comes at the cost of increased borrowing in the general budget, future generations would inherit debt and savings simultaneously. Ensuring that the former does not dominate is critical to this benefit being achieved.
  • Macroeconomic stabilisation

NRF or SWF (oil funds) can help to stabilise the macro-economy, limiting any inflationary effect on demand when oil and gas prices rise sharply, and helping to cushion demand when oil and gas prices fall.

  • In addition to assisting in the development of sustainable wealth creation and providing a mechanism for inter-generational saving, NRF or SWF (oil funds) also have the opportunity to act as a short-term stabilisation mechanism. This will be especially important for a small economy such as Guyana, where oil and gas production will contribute a significant amount to the government treasury.
  • Oil and gas tax revenues are typically subject to variability as a result of fluctuations in underlying commodity prices and hence in the profitability of the operating companies and the taxes that they pay.
  • Faced with such volatility spilling over into the general government budget, NRF or SWF (oil funds) can act as a stabilising mechanism, transferring relatively higher levels of the fund’s wealth to the government budget in lean years and relatively lower levels in good years. This could ensure predictability in the budget process and in the setting of policies and spending programmes. Thus, while the funds do not stabilise commodity prices themselves, they mitigate against commodity price volatilities translating into wider macroeconomic (particularly fiscal) instability.
  • Furthermore, the funds can, in theory, be used to assist the wider economy during lean economic years, finance automatic stabilisers and facilitate growth.
  • Efficient resource allocation within the economy

NRF or SWF (oil funds) can prevent negative spill-over effects from the oil and gas sector impacting upon other sectors of the economy.

  • A common concern faced by many small economies with substantial natural resources, particularly developing countries, is the impact that the sector’s success can have on the development of other aspects of the economy. In small countries with significant oil and gas reserves, academic evidence has shown that in certain cases, these economies have actually performed relatively poorly when compared to apparently similar countries who do not have oil and gas sectors; this is often referred to as the ‘resource curse’. There are a number of possible explanations for this phenomenon, including the overvaluation of exchange rates (often referred to as ‘Dutch Disease’), high unit labour costs, lack of sufficient incentives to invest in human and physical capital stocks relevant for other sectors of the economy and general instability spilling over from fluctuations in oil and gas prices. These effects mean that the non-oil and gas producing sectors in the economy can be squeezed, resulting in a loss in competitiveness and long-term decline in economic growth.
  • By enhancing stability in the economy and providing a transparent mechanism for investment, oil funds can be used to mitigate the effects of any negative spillovers from natural resource extraction.
  • Promoting industrial diversification

NRF or SWF (oil funds) can be used as a mechanism to assist in economic diversification.

  • Oil funds can also be used as a transparent funding mechanism to assist in the diversification of a country’s economy into areas of economic activity other than oil and gas production. This can ensure economic and social development continues at a pace once oil revenues have been exhausted. By having a diversified economy, a country can also avoid being overly exposed to sector specific shocks.
  • Furthermore, international evidence clearly demonstrates that investment in capital, both public and private, and research and development are essential drivers of productivity, competitiveness and long-term economic growth. Increased productivity – that is, more or higher quality output per unit of labour input – represents an efficiency gain that lowers average production costs.
  • The development of these assets can be assisted by allocating a proportion of not only the direct tax revenues from oil and gas production but also the returns from the fund to finance additional investment. Such ring-fencing of withdrawals from the fund can lead to a higher level of investment than would otherwise have been the case and assist any transition in the economy toward an age where the importance of the oil and gas sector is more limited.
  • Once more, appropriate checks and balances are often desirable to ensure that this is undertaken in the best possible manner. In practice, designing rules that govern the magnitude and composition of spending have proved useful in many countries.
  • Providing local benefits

NRF or SWF (oil funds) can provide a mechanism to ensure that local communities benefit from the extraction of natural resources in their area.

  • In practice, the majority of the financial benefits from oil and gas extraction are captured by residents outside the area in which the reserves are located (i.e. shareholders of oil and gas producing companies and general population). Establishing an oil fund can be used as a mechanism to ensure that local people benefit from the extraction of natural resources in their area by effectively ring-fencing a share of the revenue windfall for residents most directly affected. Many countries have found this desirable, especially if the extraction of the resource imposes an environmental or social cost on local residents.
  • Developing sustainable energy.

NRF or SWF (oil funds) can use some of the wealth generated from oil and gas production to facilitate the development of renewable energy sources.

  • In addition to providing a source of revenue to both the private and public sectors, oil and gas currently meets the majority of most countries’ energy demand. However, energy demand will undoubtedly need to shift toward alternative and low carbon energy sources.
  • However, relative to oil and gas processes, many alternative energy sources remain in development. An oil fund’s income and capital can in theory be channelled to assist the advancement of new techniques and technologies in alternative sources of energy creation, providing benefits not only in terms of economic sustainability, but also in the sustainability of a country’s energy supply. It could also be used to invest in the infrastructure which will be required to deliver low carbon energy systems in the future.
  • One area where this has significant potential is carbon capture. Carbon capture is especially relevant for the oil and gas sector as it can replace water and natural gas and other technologies for promoting enhanced oil recovery. There is therefore a double benefit – increased oil output plus reduced carbon emissions. Development of the relevant technology and expertise will take time and require financing, creating investment opportunities in which an oil fund can invest.

Therefore, an NRF or SWF (oil fund) for Guyana should be able to ensure that there is progressive economic growth from the seven pillars outlined above, is achieved in the medium and long terms.