Key message 2 – Governments need to get their natural resource management policy chain right

Getting natural resource management policies right is more important than in any other domain of policy. Unfortunately, most countries get it wrong. In order for there to be a viable framework for the exploitation of natural resources, several interdependent decisions have to be implemented. Figure 1 below demonstrates our understanding of the key component, all of which need to be developed in order to turn resources into sustainable revenue.

The chain below represents the natural chain of events in the discovery process: Natural resources are discovered, then exploited, and then taxed. The government prepares the investing environment, and then uses much of the revenues it receives to scale up domestic investment. While we show this as a linear decision process, we realize that, in fact, efforts need to be put on various fronts simultaneously. When strong policies in all or most of these NRM policy areas are present and implemented, we can say there is good governance of natural resources. Each of these poses substantial challenges.

THE 5 NATURAL RESOURCE MANAGEMENT POLICY AREAS

Discovering

Countries typically under invest in prospecting. Because of the political risks surrounding prospecting, private companies have not invested enough in searching for resources. This is why so little of Africa’s likely sub-soil endowment has been discovered. When prospecting is left entirely to private companies the government is placed at an informational disadvantage – companies can take advantage of the fact that they have more and better information about the mine than the government. Companies can thus under report the amount and value of the resource exploited, and they can also get resource exploitation rights for a lower price.

In order to counter this problem, we recommend governments invest in public surveys of mineral resource wealth. This does not imply that the government should directly undertake the prospecting process itself, but rather contract a reputable company to produce surveys of mineral resource wealth. This survey can then be used to attract companies to bid for exploitation rights in a setting where both government and private parties have similar access to geological information.

Exploiting

At the exploitation stage, the problem is one of dealing with the very large positive and negative externalities generated by the resource exploitation process. Let us start with the positive.

One of the most beneficial aspects of natural resource exploitation is the infrastructure it generates, such as transport links and healthcare facilities. Unfortunately, it is not a given that the infrastructure privately built as part of the exploitation process will be shared with public users, or will be built with public uses in mind. It is possible, at the contract negotiation stage, for the government to insist on multi-use or multiuser infrastructure. The small extra cost to companies achieves a much larger social gain so that it is mutually beneficial for a government to accept a little less tax revenue in return for open usage of valuable infrastructure.

A good example of this is the contract signed between the Government of Guinea and the Rio Tinto corporation in 2014 for the development of the Simandou iron ore mine. The mine is planned to become the largest integrated iron ore mine and infrastructure project ever developed in Africa. Upon completion, the project is expected to double the gross domestic product of Guinea. The Government contract essentially traded off some tax revenues in return for the construction of a railway to be designed for multiple uses by third parties. Whenever possible, we recommend the government studies the possible positive side-effects from the exploitation infrastructure and ensures exploitation contracts allow social benefits to be fully realised.

On the downside, the most obvious negative consequence of natural resource exploitation is the environment damage that too often occurs as a result of exploitation. While the nature and extent of such damage can often not be predicted in advance, what the government can do is ensure contracts clearly stipulate who is liable in the case of environmental damage, and set up a working system of public compensation for environmental damage.

Taxing

Governments have a strong interest in maximizing the revenue raised from natural resource exploitation, most of which comes in the form of taxation. However, imposing a tax on extracted resources is particularly hard because of the difficulty of monitoring and verifying the company’s declared resource exploitation revenues. This is another problem due to a party having more information than the other.

This problem is further exacerbated by the presence of corruption. In setting the tax and royalty rates, the government faces an internal agency problem. That is, the government must delegate the negotiation to a small group of its members and resource extraction companies have a strong incentive to bribe these individuals. In doing so, corrupt officials allow those companies to keep a higher share of the natural resource rent, which would otherwise have been given to the government and could have been used to benefit broader society. To protect itself, the government needs to adopt a negotiation process that is transparent.

This internal agency problem is compounded by the information problem. That is, because the government has considerably less knowledge as to the Discovering Exploiting Taxing IGC Growth brief Harnessing natural assets for inclusive growth 5 true value of its natural assets than does the company extracting them, corruption is more difficult to detect. A solution to both the agency and the information problem is to first invest in public geological information, and then to hold a well-conducted auction of the extraction rights, inviting bids on the royalty rate companies would be willing to pay.

In order to ensure proper and efficient taxation mechanisms are in place, we recommend governments: (1) Adopt transparent negotiation processes; (2) Auction extraction rights; (3) Put strong transparency arrangements for revenue management in place (a first step for which would be to join the Extractive Industries Transparency Initiative (EITI); and (4) Set up proper procedures to allocate extraction rights and binding agreements about tax rates.

Investing in investing

In a development setting, characterized by a chronic lack of capital, it is sensible that a government should use much of its resource revenues to invest in domestic assets such as infrastructure, rather than save it. Saving all of one’s resource income does not maximise the long-run income of low-income, growing countries, because they have so much need for investment now. However, poor countries usually start with very limited capacity to invest productively. Before scaling up domestic investment, it is therefore sensible to improve the capacity to invest. We term this phase ‘Investing in Investing’.

‘Investing in Investing’ includes both developing the public sector’s ability to conduct large-scale investment projects, and removing impediments to private sector investment. Building public sector capacity involves the design, selection, implementation and evaluation of projects. Countries vary a lot in each of these skills, so there is much to learn from neighbours who perform those activities better. Enhancing private sector capacity involves removing unnecessary bureaucratic hurdles, deepening financial markets, and trying to reduce the cost of various types of capital goods where they are more expensive than the global average. Until investment capacity has been built, savings should be deposited abroad, where returns are higher, to be brought home as capacity improves. To squander a brief period of high revenues on misjudged investments would be a tragic waste of a rare opportunity.

Investing

Effectively investing the revenues from natural resource exploitation is the most essential step to ensuring that the exploitation of the resources is sustainable and benefits the country in the long term. Revenues arising from the depletion of nonrenewable resources are by nature unsustainable. After all, countries are effectively depleting assets in the ground. There is thus a powerful case to be made for those revenues to generate at least equally valuable assets on top of the ground. For this reason, governments should try to invest large shares of their natural resource revenues into infrastructure and other forms of capital that support long-term growth.

However, while countries must ensure appropriate investment is made, they must also safeguard it for the future. To that effect we recommend countries endeavour to save large amounts (between 30%–60%) of all tax revenue generated by natural resource taxation. Those savings will be available for the next generation, which might no longer be able to draw revenues from natural resources.

Another problem that sound investment helps avoid is price volatility. Commodity prices being highly volatile, natural resource revenues are volatile too, which leads to uncertainty in the public budgeting process. In order to ensure stable public expenditure, a public expenditure smoothing rule needs to be put in place, and funded by savings generated in surplus years.

However, saving revenues for the future can be politically challenging. The pressure on governments to spend revenues on consumption is intense for several reasons. On the one hand, the average citizen is extremely poor and wishes to benefit from this new-found wealth now, not in the distant future. Similarly, the political horizon is short, and upcoming elections always make it attractive for politicians in power to spend natural resource revenues in ways that support consumption – for example by funding fuel subsidies – instead of investing it in capital goods. Finally, the prevalence of corruption makes citizens suspicious of politicians’ actions. To make investing in assets feasible, citizens must be able to trust that resource revenues not visibly used for mass consumption are being spent on assets rather than being captured by the elite.

Chain of events in the discovery process