Today extractive companies - those specialised in extracting natural resources from the ground - are operating in environments that are very different to those in which they operated 10 or more years ago. The oil industry is a good example. As oil reserves in areas such as the North Sea run dry, the oil companies are having to drill in new areas, such as the Caspian basin and west Africa, to maintain the flow.
As Rory Sullivan, director of investor responsibility at Insight Investment explains: “These are very risky environments – they are unstable and have little or no regulation. For the oil and gas industries the movement beyond the OECD to operating in more risky environments will be a key value driver. Those companies managing the risk most effectively will be the most viable in the long term.”
In its Q1 2005 Investor Responsibility Bulletin, Insight Investments highlights the fact that many institutional investors have substantial investments in extractives companies which operate in fragile emerging economies. It explains that the enormous resource revenues the host governments receive often give rise to poor governance, corruption and conflict. “As a result the risk to companies operating in these environments can be substantial,” it notes.
The report continues: “However, this risk can be ameliorated and profits and investment returns enhanced if steps are taken to create more stable, transparent operating environments where the rule of law, economic prosperity and social cohesion prevail.”
The risks that companies might face include disruptions to production and expropriations from governments.
They mighty also face reputational risk where they are investing in the country but no broader social and economic development seems to be taking place as a result of their considerable cash payments to their host governments.
In the last 20 years the oil gas and mining industries have come under closer scrutiny in terms of the contribution they are making to developing economies. “While the industries themselves claim that they are contributing to a better environment generally, many NGOs claim they are doing nothing – revenues are being siphoned off, and the companies don’t pay taxes,” says Sullivan.
Extractive industries maintain that their contribution is positive and that FDI is a stimulus to the local economies. “The evidence is mixed – some have benefited and some have not,” says Sullivan. “It is partly a function of government.”
The problem is the confidentiality clauses that are written into contracts where the companies and/or governments might not wish to disclose how much money has changed hands in the awarding of a contract. After all, contract values are commercially very sensitive information. The contracts contain details of signature bonuses, royalties, fees and taxes.
Sullivan cites the example of BP which, two years ago, decided to disclose how much it was paying the government in Angola. The Angolan government then told BP that if it
published such information again it would not be allowed to operate there in the future.
Industry country representatives, NGOs, IMF and the World Bank have been getting together with the host government in each country to decide how to move forward on the transparency issue. “The fact that so many groups and bodies are working together on such an issue is unusual and is a sign that the matter is being taken very seriously,” says Rachel Crossley, a director of investor responsibility at Insight Investment.
She adds: “President Obasanjo of Nigeria has set out the aim of improving transparency. At the other end of the scale is Angola where $4-5bn (E3-4bn) have disappeared over a period of about five years.”
The transparency issue prompted the UK government to launch the Extractive Industries Transparency Initiative (EITI) in 2002 to promote greater transparency in countries with substantial revenues from natural resource extraction.
The EITI has attracted significant interest and support. In May 2003 a group of 10 investors representing £466bn (e687bn) under management issued a statement of support for EITI. So far, 59 investors representing $8.3tn assets under management have signed up. “These are impressive figures that include most of the major names in investment management,” says Crossley.
Sullivan explains that investors are some way from needing to know about individual amounts that change hands. “We tend to look at a country from a higher level, which includes broader economic and political risks,” says Sullivan. “That said, if there is no disclosure then the company or government concerned is likely to be high risk, which is an important consideration for the institutional investor. This is especially the case as extraction continues to shift towards developing economies.”