V. Ramani's web The world through my lens

My earlier blog on India’s oil exploration policy (16 November 2012) has elicited responses from some old friends. Their comments have drawn my attention to two issues that are engaging the upstream petroleum (exploration and production) sector. The first relates to the ‘gold plating’ of exploration and production costs and its impact on government take from the producing field; the second concerns effective regulation of the upstream sector. Before taking up these two topics in my next blog, I feel it is necessary to acquaint my readers with the fiscal arrangements in place in the upstream petroleum sector. This blog will, therefore, explain the fiscal regime with some mathematical examples and highlight the rationale of its operation.

The New Exploration Licensing Policy (NELP) fiscal regime is modelled on the fiscal regime adopted for bidding rounds in the 1980s and 1990s, with some modifications. The contractor is entitled to recover in full the aggregate costs incurred on exploration, development and production operations as well as royalty payments (these are collectively referred to as cost petroleum). The contractor can opt to allocate 100% revenues from production to recover costs as long as aggregate costs yet to be recovered are greater than the revenue realised in any financial year or can opt for a percentage less than 100%: this is a biddable item. A notable feature of the NELP production sharing contract fiscal regime is that all costs (whether exploration, development, production or royalty payments) which are not recoverable from petroleum revenues in a particular year can be carried forward to subsequent years and recovered from revenue realised in those years. The pre-tax investment multiple (IM) for calculating the sharing of revenue net of cost petroleum between the contractor and the government in any year is worked out by the following formula:

IM_n+1 = (E_n+D_n+P_n+R_n) +PP_n – (P_n+R_n)/E*+D*

Where

IM_n+1 = Investment multiple in year n+1

E_n         = Cumulative exploration costs recovered for all years upto and including year n

D_n         = Cumulative development costs recovered for all years upto and including year n

P_n          = Cumulative production costs recovered for all years upto and including year n

R_n         = Cumulative royalty payments recovered for all years upto and including year n

PP_n      = Cumulative profit petroleum entitlement (including incidental income from petroleum operations) of the contractor for all years upto and including year n

E*     = Cumulative exploration costs upto and including year n

D*     = Cumulative development costs upto and including year n

Cost petroleum recovered by the contractor together with profit petroleum to which it is entitled (both computed over the contract period) constitute the gross revenue of the contractor. The IM being computed on net income, production costs (P) and royalty payments (R) are deducted from cost petroleum in its computation. Since exploration and development costs are incurred largely in the initial years of a PSC and taper off in later years (unless fresh discoveries warrant further expenditure on exploration and development), E_n+D_n will over time coincide with E*+D*. Essentially, it is PP, the profit petroleum share accruing to the contractor over the contract period, which will determine how high the IM rises. This value of the IM has great significance for the share of profit petroleum taken by the government on a year to year basis, as will be evident in the succeeding paragraph.

The main component of the bid evaluation process in the NELP is the percentages of profit petroleum offered to government by bidding companies in the first (less than 1.500) and last (greater than 3.500) tranches of the IM, since royalty payment is mandatory. Based on these two percentages, the percentage values for tranches between 1.500 and 3.500 would be interpolated based on a linear scale. An example would help clarify the picture:

As is clear from the above table, the share of government in net revenue rises progressively as the IM moves to higher tranches of profitability.

A view has been voiced in public discourse that the pre-tax IM method of determining government share is fraught with the danger that the producing company would be tempted to inflate (gold plate) costs to reduce the profitability of the venture and thereby confine government share to the lowest one or two tranches as well as reduce the quantum of profit petroleum available for division between the contractor and the government. It has, therefore, been suggested that a flat share of gross revenue (based on production) be taken by the government so that the ‘evils’ of gold plating do not lead to a reduction in government share. There are at least three problems with such an approach:

(a) royalty on oil and gas at between 10% and 12.50% of gross value is already levied on companies. A further flat rate levy implies an extension of the royalty approach. It also makes a risky, cost-intensive venture unviable at the outset by taking a large chunk of the pie away from the contractor, postponing the payback on its investment;

(b) the flat rate approach is insensitive to the fluctuations in economic rent arising from windfall gains. This could arise on account of rise in oil/gas prices, as has been witnessed over the past decade. Oil prices have climbed over fourfold since the turn of the century. A flat rate revenue sharing approach entered into in, say, 1998 (when oil prices were under US$ 20) would have greatly reduced the revenue share of government today (when oil prices stand at over US$ 80). There is also another possible scenario: a dramatic drop in exploration and development costs after contract execution because of advances in technology would also confer huge benefits to the contractor, with the government not sharing in the windfall gains.

(c) a flat rate regime could also adversely affect the exploration and development of marginally profitable discoveries. A ‘one-size fit all’ flat tax regime does not account for the varying geological prospectivity and the differing costs of exploration and exploitation of discoveries in different petroleum basins (both onshore and offshore) of the country. Varying the flat tax rate across different regions would invite the accusation of arbitrariness in rate fixation.

This is not to discount the need for vigilant monitoring of the contractor’s operations to ensure that government is not deprived of its legitimate share of profit petroleum. However, merely because, as a society and government, we lack confidence in our regulatory institutions is no reason to look for simplistic fiscal solutions that deny government its rightful share of economic rent from petroleum operations. This is a topic we will turn to in the next blog.

Coal, that black diamond, is currently generating more heat than light… at least that is the conclusion one reaches on reading and viewing the current debates on what is popularly referred to as “Coalgate”. At the heart of the controversy is the (apparent) failure of the government to allot coal blocks to private parties through a bidding process rather than by direct allotment, as has been done over the past decade. Unfortunately, the focus is largely on the allocations to apparently undeserving parties rather than on the issue of what is the most cost-efficient method of mining coal to meet the energy requirements of the country. Once again, we are in the uncomfortable situation of a public sector versus private sector debate rather than an assessment of how best to meet the country’s fuel requirements.
The first bogey that needs to be laid to rest is the contention that coal mining and extraction should vest entirely with the public sector. A public sector monopoly with its cumbersome processes can hardly be expected to meet the rising demand for coal. It would be interesting (and instructive) to analyse why the coal sector was not opened up to private investment at around the same time (1974) as the petroleum sector. After the first oil shock of 1973, surely India’s energy planners should have been giving serious thought to augmenting supplies of alternative fuels for the power sector, given India’s large coal reserves in relation to its petroleum reserves. There could be two possible reasons for this (in hindsight) costly oversight. The first (rather charitable) explanation could be that it was felt that the public sector could meet the coal requirements of the power sector. This explanation could probably have had credibility till 1991, when the Indian economy underwent a U-turn. By 1991, the capability of the public sector to meet crucial infrastructure needs was being seriously questioned. International agencies like the World Bank, IMF & ADB leant on the Indian government to fully open up the petroleum sector (from exploration for oil and gas to refining and marketing of petroleum products) to private (Indian and foreign) investment, when approving loans to bail out the Indian economy in a crisis situation. However, they exerted no similar pressure as far as the coal sector was concerned. It could be surmised that the clout of international oil and gas companies being significantly more than that of global coal mining companies, the pressures from the former influenced the views of international lenders to a far greater extent. But why did the Indian government not proactively go in for opening up the coal sector as well to private investment in 1991? After all, the critical balance of payments situation in 1990-91 should have awakened policy planners to the dangers of an energy crunch, which required concerted action in respect of all fuels, not just petroleum. The explanation for this policy failure will necessarily have to be not so charitable to the Indian government: it reflects the vested economic and political interests that were against giving up control over the lucrative coal sector. The major success in petroleum discovery and production post-1974 was in the offshore Bombay High field; since offshore allocation of petroleum exploration licenses lay squarely within the competence of the Indian government, it was relatively easy for the central government to offer offshore exploration blocks in successive exploration rounds between 1980 and 1995; even the offer of onshore blocks got little attention, because the production in onshore areas was located largely in the states of Assam and Gujarat and had not led to the development of powerful pressure groups as in the coal sector. In contrast all coal blocks were onland, in states like the then undivided Bihar and Madhya Pradesh, Odisha, Goa and Andhra Pradesh. Equally important was the coalition of interests that had developed in the coal sector (unlike in the limited onshore petroleum mining sector). Politicians, mining sub-contractors, transporters and labour contractors, among others, stood to gain from the many contracts that could be garnered from the operations of the public sector entity. With such an array of pressure groups opposed to any change in the existing system, it comes as no surprise that the coal sector remained a public sector monopoly.
What steps could, if taken over the past twenty years, have helped in avoiding the present brouhaha in the coal sector? This requires an examination of the possible policy framework that would not only have ensured a transparent system for entry of private players in the coal sector, but would also have enabled greater cost efficiency while also giving government a greater share in revenues generated from increased production (and value addition). The experience of a bidding process in the petroleum sector over three decades could well serve as a guide to the development of a robust allocation and management system in the coal sector.
First and foremost, there is need to shed ideological blinkers regarding private investment in the coal mining sector. It is not good economics to have an inefficient public sector that extracts lesser quantities of a mineral at costs which are higher (for given geological conditions) than the international norm. This was the logic behind the New Exploration Licensing Policy (NELP), introduced in the petroleum exploration sector since 1999, which required Indian public sector oil and gas companies to compete for oil and gas exploration blocks with domestic and international players in bidding rounds. Competition in the coal sector will improve economic efficiency by exposing all companies to best international mining practices and encourage cost reduction efforts to improve profit margins. There is, of course, the issue of how to permit companies with no previous expertise in coal mining to bid for blocks. Here, the path followed in the petroleum sector can be adopted. Indian private or public sector companies newly entering into coal mining activities could be considered if they bid jointly with Indian or foreign companies with previous experience in this sector. This was how companies like Reliance Industries, Gujarat State Petroleum Corporation and Videocon Industries were able to enter the petroleum exploration and production sector.
More importantly, there is need to lay out a specific contractual framework within which all companies (private and public sector) must carry out operations. Petroleum exploration and production activities have been carried out under the ambit of production sharing contracts. Developing similar contractual arrangements for the coal sector would not only streamline operations relating to prospecting for and extraction of coal but also enable putting in place a fiscal regime that allows companies to earn a reasonable rate of return on the capital invested by them while also giving government a share in the profits realised from the sale of coal produced. The important features that will need to be a part of such contracts are detailed in the succeeding paragraphs.
The first requirement is the specification of the duration for which the coal block will be allotted to the successful bidder and the manner in which coal resources in the block will be assessed and exploited. In case there is need for a company to carry out a geological assessment of the block, the period for such assessment should be specified, with the proviso that production plans must be prepared and approved in a specific time period. Any unreasonable delay on the part of the contracting company in commencing production should invite sanctions ranging upto termination of the contract. The specification of a contract period for the block (with provisions for extension by mutual agreement between the company and government) enables the computation of the likely revenues from the block (under different assumptions regarding future coal prices) and is crucial for determining the proportions in which revenues (net of costs) will be shared between the company and government.
The second aspect relates to the sharing of the “economic rent” from the sale of coal (and possibly coal gas) produced from the coal field. As in the petroleum sector, the company could first be required to pay a flat-rate royalty linked to the value of gross production. It would then be permitted to recover its costs of prospecting, capital investment and operation from the gross revenues less royalty. Revenue (net of royalty and cost recovery) would then be shared between the company and government based on a resource rent tax, which could, as in the petroleum sector, be based on the post-income tax return on investments in the project by the company. The company would also be liable for corporate income tax on its profits after payment of all government levies, including royalty and resource rent tax.
Profit determination is crucially linked to the pricing of coal and other by-products. Where coal is permitted to be sold in the open market, a fair third-party arm’s length sale price would have to be determined to ensure that government gets its due share of revenues. In the absence of a free market for sale of coal, prices may need to be set by an independent regulator to meet the needs of different sectors of the economy. Here, the pricing policy will have to be such as to meet the profit concerns of the private investor as well as the requirements of the economy.
Transparency and fairness in allotment of coal mining leases can be ensured through a single-stage bidding process. Once technically qualified bidders have been shortlisted, the financial packages offered by these bidders would be evaluated in terms of the net present value (NPV) of revenue streams accruing to the government over the life of the contract in the form of royalty, resource rent tax and income tax, discounted at an appropriate interest rate. The successful bidder would be the one offering the highest NPV to the government (based on assumptions regarding production over the contract period, coal price and the discount rate, applied to all the bids). This has been the approach adopted by the Indian government for award of petroleum exploration blocks in successive bidding rounds down to the present day and seems perfectly adaptable for use in the coal sector.
The introduction of such a system in the coal sector would go a long way in ensuring a transparent, rule-bound method for award of coal blocks. Of course, after the award of the blocks, a rigorous regulatory framework would be necessary to monitor production, set the price for sale of coal (and coal gas and other by-products, where produced) and approve costs incurred in extraction of coal. There is also the issue of coordination between the central and state governments, since many clearances for coal production would need to come from the state government. More significantly, there is the question of how the revenues which are to accrue to the government will be shared between the central and state governments. While royalty and a large portion of the corporate income tax will flow to the state governments in accordance with laid down financial devolution norms, a formula for sharing the resource rent tax between the central and state governments will need to be evolved, possibly through the recommendations of future Finance Commissions, by widening their terms of reference to include non-tax revenues.
What is evident is that there can be a well-defined path for allocation of a natural resource like coal, which meets the requirements of fairness and transparency while also addressing the differing concerns of the principal stakeholders – the operating companies, the state governments, the central government and local communities. Such an approach will reduce the likelihood of future controversies and will promote investment in a crucial natural resource sector, contributing crucially to the raw material requirements of a growing economy.

“It is a bad workman who blames his tools.” The constitution of the Rangarajan Committee to review the production sharing contracts (PSC) for petroleum exploration and production seems to be a case where the problems of the Government of India with private oil explorers and producers are sought to be blamed on the PSC rather than on those charged with its implementation. Since the media discussion on the subject has raised issues which one thought had been answered in the first flush of liberalisation in 1991, a dispassionate look is required at what really the problem in this sector is and whether the wrong area is not being focused on.

Actually, there is nothing wrong with the PSC devised for the New Exploration Licensing Policy (NELP). The NELP was fashioned on the PSCs of the 1980s and 1990s, with the only real change being the introduction of a royalty payment on oil and gas production. Even the royalty payment as part of the fiscal regime has been palatable to NELP bidders only because of the high oil prices: it is unlikely that companies would have accepted this levy in the low oil price scenario of the 1980s and 1990s. However, what has probably been the greatest plus point of the PSCs has been the linking of government revenue share to the profitability of the oil/gas venture. The statement in a recent Mint article attributed to the Director General of Hydrocarbons (DGH) is fraught with adverse implications for government revenue share. If government share is linked to production rather than profitability, windfall profits accruing to an investor from rising oil/gas prices will not be shared with the government. In fact, this was one of the major factors which influenced adoption of this fiscal model by the Government of India, which has thereby been a major beneficiary of the dramatic oil price increases from the 18 dollar per barrel level of the mid-1990s to the 90 dollar levels of today.

Regulatory inadequacies are a major cause for the recent controversies. The PSC mandates a clear procedure for sanctioning field development expenditures by companies. Nothing stopped the DGH from refusing to approve expenditures on the grounds of inflated costs. If the DGH was sure it was on firm ground on the Reliance D-6 field cost issue, it (or the government) should not have been worried over reference of the issue for resolution to a sole expert or to arbitration. To keep the issue dragging for months and years while all sorts of wild public speculation were encouraged is hardly the way to inspire investor confidence. The same applies to the company claiming that the gas reserve estimates are less than earlier anticipated. A clear technical view needed to be taken on this issue rather than indulging in public debate on geological reserves.

At the heart of the DGH supervisory riddle is the Petroleum Ministry’s approach to PSC administration. If the intention is to have a strong, independent regulator, the Petroleum Ministry ought to ensure that the DGH is staffed by permanent professionals from the oil industry who do not have to look over their shoulders each time they take a decision. Instead, the DGH refers each and every matter to the Ministry for resolution. Matters are not helped by immediate (often uninformed) public scrutiny of each and every move by the Ministry. The result is what might be termed policy paralysis. Instead of going by the letter and spirit of the PSC, issues settled by government decisions in the past are revisited at the cost of contractual sanctity. Take the example of the transfer of interest in Cairn India to Vedanta. The Petroleum Ministry was insistent that the company must meet the condition of royalty payment, never mind that the Fourth Round (1991) bidding conditions specifically exempted companies from royalty payments. That Vedanta agreed to pay royalty was more a reflection of its keenness to get government approval for the transfer of interest in Cairn India rather than on the merits of the contractual position.

What is more worrying is the schizophrenic approach to private investment in this sector. Let one thing be clear: India is a country with only moderate prospectivity as regards oil and gas reserves. International oil companies will invest risky exploration dollars only if they are guaranteed a stable contractual regime and consistency in government policy. It is the entry of these players (with or without Indian partners) that has seen oil/gas production from new exploration blocks in the last decade in the Krishna-Godavari, Rajasthan and Cambay (Gujarat) areas, at a time when the national oil companies, ONGC and OIL, have no new discoveries of any significance to show. Yet, when a major discovery of reserves, as in Rajasthan, by a private player takes place, there is an immediate uproar over the profits that the private company will realise, without an understanding of the revenue (and, of course, the petroleum) benefits that the country stands to gain from the venture. Everyone, from the media to the government and elected representatives, feels the country is being short-changed in the bargain. Instead of creating an environment which encourages more investment in what is undoubtedly a risky sector, attention is focused on how to extract “more golden eggs from the goose”.

Let us as a country be clear on what we want. If we want to be insecure and mistrust every investor, we must accept that scarce exploration dollars will flow to those countries which have far more attractive prospects. However, if we are prepared to deal maturely with private investment, with fair, impartial regulatory mechanisms in place, we can have our cake and eat it too.

Dear Prime Minister,

I went through your speech on the occasion of Civil Services Day on April 21 this year. The recent rash of arrests of senior civil servants in states like Maharashtra, Andhra Pradesh and Uttar Pradesh has certainly caused disquiet in the civil services. The merits of the charges against them in cases ranging from Adarsh to Emaar and the NRHM will be decided in the appropriate judicial forum. What causes greater concern is the failure to address the root causes of what I can only term as a growing tragedy. Tragedy not because of what it portends for individual civil servants but because of its implications for the health of the administrative system and the country as a whole.

There were three issues you touched on in your speech: neutrality, system and process change and bold decision-making (with no witch hunting for bona fide mistakes). Let me start with neutrality. Successive political leaderships at both the central and state levels have, over the past thirty years, diluted this concept almost to the point of no return. While proximity of the bureaucracy to the powers that be has always, to some extent, promoted individual advancement, the wholesale dominance of the political element in postings has sent a very strong message to the bureaucracy. Can we deny that postings even in the Government of India are very largely dependent on the fancies of individual Ministers? Gone are the days when a powerful Establishment Officer would send a panel of names to the Ministry, which could only accept one name or reject all of them and send them for reconsideration. Today, it is no secret that a word from the Minister decides the posting in a Ministry at the centre. The less said about the state governments, the better. The concept of a “committed bureaucracy” (first touted in the 1970s) is the norm in all states, give or take some honourable exceptions. If we really want neutrality, we should seriously implement the concept of Civil Service Boards in both the centre and states (with representation from outside the bureaucracy as well) so that postings are made on merit and suitability and not on political proximity.

System and process change is another area where there has been more talk and superficial action rather than any desire for deep-rooted reform. We still have extremely centralised (hence, discretionary) systems of procurement for items from supplementary nutrition under ICDS to arms purchases for the defence forces. Apart from some tinkering with e-tendering and the like, there has been no attempt to delegate procurement to different levels to check the temptation of centralised corruption. Moving to computerised systems, especially in areas of public interface, has been halting and disjointed, dependent more on flashes of individual brilliance and dedication. To give an example, the Bhoomi initiative in Karnataka is yet to be replicated on a national scale. Vested interests in different departments work against the implementation of such system-transforming changes. Our penchant for ascribing deeper motives to any effort is being manifested once again in the UID, where expert views are being trotted out to defend privacy and raise security concerns. We are in danger of letting the “best become the enemy of the good!” Thank God we were able to withstand the criticism of EVMs, which (as anyone who has participated in the election process will affirm) has, along with electoral ID cards (another system reform), greatly reduced the scope for booth capturing and bogus voting.

Of greatest concern is the pattern of politician and bureaucrat-chasing that we are seeing over the past two years. A PIL or a CAG report is used to conduct a trial by media, where guilt is proclaimed even before all facts and the legal position have been examined and before judicial or political processes have worked themselves out. A period of pre-trial incarceration in jail seems to have become the norm, even where the accused is unlikely to evade investigation or tamper with witnesses. The tortuous course of police (or CBI) investigations and subsequent judicial processes guarantee at least a decade or two of court attendance for a bureaucrat implicated in any such case. It would be in the interests of both the system and honest bureaucrats if all such cases were brought to a closure within a time frame of two to three years. The system would benefit by cleansing the Aegean stables of corrupt elements and the honest bureaucrat would be reassured that even if s (he) is charged in any case, s (he) would get justice fairly quickly. In the Adarsh case, the charge sheet has been filed well over a year after investigation started. The Kerala palmolein case has dragged on for over eighteen years with no hint of closure. In the 2G case, even a decision taken ten years ago has been made a ground for launching investigation against a former Telecom Secretary. Contrast this with the speed of the investigation and judicial process in the insider trading scandal in the USA! In such a scenario, no bureaucrat will go in for any decision (leave alone a bold decision).

In some ways, the situation is reminiscent of the period of Jacobin Terror in France after the French Revolution, with the bureaucrat in the place of the French nobility. A lynch mob mentality (with pre-judged guilt) seems to have become the social norm in recent times. It is not the corrupt bureaucrat who will suffer in such a situation. The honest bureaucrat, who lives only on his reputation, and does not have the resources to fight a protracted legal battle, will be the victim. The consequences are obvious: decision making will slow down at a time when the challenges confronting the country are growing at an alarming pace. Mr. Prime Minister, unless we address the basic causes of the current malaise, we are condemning ourselves to a period of continued ineffectual governance. The real sufferers will not be the bureaucrats: as in the case of post-Revolution France, it will be the people (in this case) of India.