Driving transparency in extractive industries to minimize risks for investors

David Diamond discusses the need for greater transparency to help all parties involved.

While prices for natural resource commodities, such as oil, gas and precious metals, remain volatile, interest in extractive industries – oil, gas and mining - should continue over the long term. Global demand for these non-renewable natural resources is likely to be supported by a projected 36% rise in global energy use by 2035 according to the International Energy Agency.

Nonetheless, extractive industries present numerous environmental, social and governance (ESG) challenges of interest to investors. After the BP-linked oil spill in the Gulf of Mexico higher costs linked to pollution controls are an issue for oil companies operating deep offshore platforms. Employee health and safety is an on-going concern for mining companies seeking to reduce workplace accidents, such as ArcelorMittal.

One particularly difficult challenge is securing long term supply for resources located in areas where political, economic and social instability is often the norm. Social unrest has regularly threatened Royal Dutch Shell operations in Nigeria, and during the “Arab Spring” for ENI in Libya. Poor governance and lack of transparency often lie at the root of the problem, as local populations fail to see any socio-economic benefits from the financial wealth generated by resource exports. According to The Economist, resource nationalism has recently jumped to the top of the list of worries for global mining companies, notably in Africa, as countries seek to boost their share of resource revenues.

Natural resources: the paradox of plenty

Governments in resource-rich countries are tempted to favour the export of natural resources in order to benefit from the financial bounty that they represent: it is simply easier to generate income from extractive industries than to build a strong and diversified economy. On the face of it, this activity is very profitable – at least in the medium term - for the governments themselves, the oil, gas and mining companies involved and their shareholders.

However, this does not necessarily translate into a sustainable long-term approach. Most countries rich in natural resources have tended to under-perform economically. In regimes that are rife with corruption, the income derived from resource extraction is more commonly distributed to the political, military and commercial elites rather than being invested in economic and social development projects. When governance is weak, the results are often corruption, poverty and increasingly conflict.

These effects are however not inevitable and encouraging greater transparency in countries rich in these resources could mitigate some of the negative impacts.

Benefits to companies and investors focus on limiting political and reputational risks. Political instability caused by opaque governance is a clear threat to investment. In extractive industries, where investments are capital intensive and dependent on long-term stability to generate returns, reducing such instability is beneficial for business. Transparency of payments made to a government can also help to demonstrate the contribution that the company’s investment makes to a country.

Would transparency and improved governance best be achieved by initiatives in countries or through stricter regulation of companies where they are based?

Investors increasingly believe that both may be necessary.

Today, 37 countries, totalling a population of over 900 million people, implement the EITI, and it is increasingly recognized as a global transparency standard, in turn supported by the G8, G20 and institutions like the World Bank. Key stakeholders supporting the initiative include over 70 of the largest oil, gas and mining companies, 80 institutional investors and dozens of civil society organisations. Moreover, after Norway, the United States and Australia are now leading the way as the first OECD countries to implement and pilot the EITI.

Today, financial markets are just beginning to recognise the value of the EITI label

Of the 37 countries now implementing EITI, Azerbaijan was the first country to be declared EITI Compliant by the EITI Board in 2009. In May of the following year Fitch Ratings announced that they upgraded Azerbaijan’s long-term foreign and local currency Issuer Default Ratings (IDRs) to ‘BBB-’ from ‘BB+’. In the press release, Fitch indicated that it “draws comfort from the transparency of the SOFAZ [the State Oil Fund that leads on EITI], underlined by Azerbaijan being the first country to be fully compliant with the international Extractive Industries Transparency Initiative.”

Although other rating agencies such as S&P have not yet followed suit so explicitly, the S&P Sovereign Government Rating Methodology and Assumptions includes a “Political Score” , where the “transparency and accountability of institutions, data and processes…including [a country’s] perceived level of corruption” are considered. As such, a commitment to EITI may contribute to a country’s improving its sovereign credit rating over the long term.

However, regulation is likely to play an increasing role in assuring transparency for extractive companies. In the United States, Dodd Frank legislation, as per the Security and Exchange Commission (SEC), now requires all SEC registered companies from the extractive sectors to publish government payments on not only a country-by-country basis but also project-by-project. The European Union has signalled its intention to follow suit. 

As a result, in October 2011 over twenty institutional investors representing over €2.5 trillion in assets, including Allianz Global Investors, wrote to Michel Barnier, European Commissioner for Internal Market and Services, in qualified support for draft transparency legislation. This would require multinationals to disclose financial information such as production shares with governments, bonuses, royalties, and taxes for each country in which they operate via their annual statements.

The investors stated that they support the EU’s initiative for increased transparency both through country-led (EITI) and regulatory approaches. They stressed that the two are complementary and ultimately enhance the prospects for risk adjusted investment returns by improving disclosure, which contributes to more stable and transparent bidding markets for contracts, licences and permits, and lowers the risk that governments will seek to renegotiate or rescind contracts or nationalise projects. 

However, investors also warned the Commissioner against exposing extractive companies to conflicting legal requirements. To this end, the investors propose that regulators work towards a single global disclosure regime with a mutually recognised reporting process across jurisdictions in order to build consistent reporting standards across global markets.

The investment case for transparency is clear. It is the first step leading to better governance in resource rich countries. Ultimately, this should produce a more stable investment climate of benefit to extractive companies, their shareholders and local populations.

David Diamond represents institutional investors on the international EITI BoardHe is Global Co-Head of ESG at Allianz Global Investors.