A holistic approach to audit of extractive industries

The discovery of mineral resources usually promises to bring prosperity in form of higher tax revenue, increased employment, improved infrastructure and trade, greater growth and wealth creation for all. However many resource-rich countries have not lived up to their development potential due to the “resource curse” of the negative effect of natural resources on the economy, society and politics in these nations. Even where the extraction of natural resources has led to economic growth, it has not necessarily been translated into better human development outcomes.

The exploitation of natural resources begins with the government’s decision to extract for jurisdictions where the sub-soil natural resources ownership rights are retained by government. Governments hold the rights to their resource endowments and they decide who should undertake exploration and production of oil, gas and minerals and under what terms. The exploration and production rights may be allocated by the government using various mechanisms which include concession, production sharing agreement, service agreement, and licence based on several investor selection mechanisms which include open door mechanisms ( first come, first served basis or direct negotiations) or through a competitive bidding process. Regardless of the mechanism used to allocate and grant rights for the extraction of natural resources, Supreme Audit Institutions (SAIs) need to focus attention on “Award of Contracts and Licences” a stage considered critical to the Extractive Industries (EI) value chain because a badly negotiated contract has a ripple effect on the subsequent stages of the value chain and could potentially erode the benefits accruing from the exploitation of the natural resources.

The EI value chain encompasses the government’s decision regarding the exploitation of natural resources, awarding contracts and licenses, regulation and monitoring operations, collection of taxes and royalties, revenue management and distribution and implementation of sustainable development policies as illustrated in the figure below.

Figure 1: Extractive industries value chain
Figure 1: Extractive industries value chain

The value chain concept provides a comprehensive integrated approach to developing extractive industries. As compared to the other segments of the value chain like regulation and monitoring of operations, collection of taxes and royalties, revenue management and allocation where quite a number of reports have been authored by SAIs,” Award of contract and Licences”  segment reviews by SAI’s remain scanty. It should be appreciated that the concept of value chain in the extractives industries highlights the importance of how the individual “links” in the chain create overall benefit for the extractive industries. Therefore strengthening one link in the chain may push undesirable performance to other parts of it; hence necessitating a holistic approach.

In extractive industries, contracts/concessions/licenses span a long period of time and therefore a host government that consents to unfavourable terms may not realize better human development outcomes for its citizenry from the extraction of natural resources. Whereas it can be argued that it is incumbent on the relevant government ministry/department/agency to secure favourable contract terms that foster sustainable extraction of natural resources, a review of contracts and licences is still necessary and SAIs should take keen interest in this aspect of the value chain. For example a well-functioning revenue management and allocation system is of limited value if the initial contract is not balanced and does not allow the government to capture sufficient taxes and royalties from the industry.

 To further demonstrate the significance of the risks associated with the “Award of Contracts and Licences” segment of the value chain and the ripple effect to other stages of the value chain, below are highlights of some areas that SAIs could focus on. 

  • Local content requirements. In a bid to promote the local economy with regards to extractives industries, host governments normally embed local content requirements as part of the contract negotiations. This is likely to be a source of risk since the public officials responsible for the award of contracts or licences may impose particular local companies onto those foreign companies wishing to operate in the country to enter into partnerships. This could in turn affect effective monitoring and enforcement of compliance if the local partner fails to perform since the value is accrued to the corrupt public officials.
  • Opacity in contract negotiations. Contracts negotiated in secrecy exacerbate the risk of violating or circumventing the existing laws for payment of taxes and royalties by setting incredibly low rates compared to the national rate and offering tax exemptions. This would in turn lead to potential revenue losses to the host government.
  • The award of licenses and contracts in extractive industries is usually characterized by various payments among which include signature bonus. This is very common in the oil and gas industry where a one-off payment is made to the host government upfront in exchange for the company being granted a right to exploit a natural resource. This kind of payment is susceptible to abuse by public officials involved in contract negotiations due to the non-uniform criteria used to define its size. Therefore it could constitute an avenue for bribery payments. It is critical that SAIs take keen interest in ascertaining how such one-off payments are determined.
  • Inadequate legislative, regulatory and governance framework in licensing and contract award processes. It is of fundamental importance that the laws, rules and procedures governing the choice of systems for the award of natural resource extraction rights are clearly stipulated. This helps to mitigate corruption and investments that are not in the public interest and foster accountability.

It is therefore incumbent on SAIs to focus on, and institute robust auditing procedures for this key segment of the EI value chain because neglecting it could result in erosion of all the benefits associated with natural resource exploitation.

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