Oil and Gas in Federal Systems. Black Auditorium. The World Bank, Washington, D.C. March 3 rd and 4 th, 2010

Transcription

1 Oil and Gas in Federal Systems ** Black Auditorium The World Bank, Washington, D.C. March 3 rd and 4 th, 2010 Organized by the World Bank and the Forum of Federations, with sponsorship from NORAD Oil and Gas in Federal Countries BRAZIL Sérgio Wulff Gobetti i Helder Queiroz Pinto Junior ii Juliana de Carvalho Sardinha iii The Forum of Federations is undertaking a study the factors that affect the management of petroleum resources in federal systems, of which this draft paper is part. This paper is an informal document which publication is intended to provide reference material for the Conference on Oil and Gas in Federal Systems, organized by the World Bank to further the dialogue on development and public finance issues that are common to federal and decentralized petroleum-producing countries. A revised version of this paper will be included in a publication by the Forum of Federations which is expected to be completed by June The manuscript of this paper has not been prepared in accordance with the procedures appropriate to formally edited texts. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed herein are those of the author(s) and do not necessarily reflect the views of the International Bank for Reconstruction and Development or the World Bank or of the Forum of Federations and their affiliated organizations, or those of the executive directors of the World Bank or the governments they represent. The World Bank and the Forum of Federations do not guarantee the accuracy of the data included in this work. Draft not for citation without authors permission 1

2 1. Overview The recent oil discoveries in the off-shore geological stratum known as pre-salt and the changes proposed by the government in the oil-sector fiscal and regulatory model have stirred up a major conflict among the 27 federal entities (and their 5,563 municipalities) over current and future oil revenues. The new potential reserves lie in the continental platform offshore just three states (São Paulo, Rio de Janeiro and Espirito Santo), which make up Brazil s most developed region: the Southeast. The central issue is over how far these states and some of their municipalities should enjoy special access to the potentially huge new revenues from off-shore resources. The Brazilian Constitution states that oil reserves found on- or off-shore belong to the Union, but an infra-constitutional piece of legislation has granted states and municipalities about 60% of the income royalties, which in 2008 accounted for 0.7% of GDP, totaling R$ 22.6 billion (US$ 12.4 billion). Rio de Janeiro state, including its municipalities, has been by far the largest beneficiary of these resources. The current model of oil appropriation and royalties sharing dates back to the late 1980s when the country was being redemocratized and drafting a new constitution, characterized by a broader process of fiscal decentralization. At the time, Brazilian oil production amounted to about 200 million barrels per year (less than a third of today s output). In 1997, after several changes, the model was finalized, with the enactment of the so-called Petroleum Act. The Petroleum Act was part of broader reforms introduced by the Brazilian government in the 1990s, a key objective of which was to break the monopoly of Petrobras, the federal company, in both upstream petroleum activity and refining. The Act created the Brazilian National Agency of Petroleum, Natural Gas and Biofuels (ANP), with responsibility for regulation of the oil, natural gas and biofuels industries. The government wanted to make the industry more competitive by stimulating the entry of private agents and by promoting their partnership with Petrobras, especially in upstream activities. The move to oil block auctions consolidated the opening process and permitted greater transparency, thus bringing in some dozen operators into the upstream. The new regulatory model increased the royalties and created other fiscal takes by government, while keeping the essential features of the decentralized oil revenue-sharing structure favorable to the few off-shore states established in the 1980s. As it turned out, the new financial arrangements favored even fewer municipalities than before, thereby aggravating the geographical concentration of petroleum revenues. Brazil s unique decentralized sharing of petroleum revenues, favoring very few states, has bred growing concerns in recent years as royalties income has increased by over 300% since 2000 and as the tremendous potential of the pre-salt fields has become clear. Besides royalties, oil companies have increased their payments of income tax, which are shared by the Union with all states and municipalities according to their population. The prospects for next years are that these oil revenues (royalties and income taxes) will increase even more when the new oil fields of pre-salt start producing. Brazil s oil reserves may quadruple to over 70-billion barrels and become the eighth largest in the world, at par with Russia. These prospects suggest immense possibilities for Brazil, just as they bring upon the country a host of macroeconomic, fiscal and federal challenges yet to be fully grasped by Draft not for citation without authors permission 2

3 economic and political leaders. In response, the federal government has proposed important changes to the regulatory and fiscal model. One important novelty proposed is to replace the system of concessions with a production-sharing arrangement, in the hope of broadening the government-take and reinforcing national control over oil production and sales. The federal government s share of off-shore revenues would also rise substantially, but the few off-shore states would still stand to receive vastly disproportionate shares of this potentially huge revenue stream. These proposals have excited intensive debate in Congress and among state governors. On the one hand, the governors of Rio de Janeiro and Espirito Santo claim their natural right over pre-salt oil reserves given their location abutting the continental platform even though the resources are some 100 miles off-shore. On the other hand, a large number of northeastern governors embrace the notion that the oil belongs to all Brazilians and are pushing for amendments aimed at enlarging the share of royalties to be universally distributed among all federal entities and municipalities from a special fund. The most relevant macroeconomic and fiscal challenges have yet to be duly addressed. One of the government bills recently passed by Congress determines that a share of the oil revenues obtained by the federal government be placed in a social fund for use in social investments while mitigating the effects of foreign exchange inflow and building savings to future generation. However, the rules to reconcile such objectives, to direct the use of saving and govern their withdrawal have yet to be settled. In addition, no attempt has been made to regulate the use of resources transferred to states and municipalities or to encourage these entities to set up their own savings, thereby complicating the macroeconomic handling by the federal government, especially given the high volatility of oil income. 2. Historical and Regional Context of the Petroleum Industry The history of the oil industry in Brazil begins in the year 1858, when the Marquess of Olinda signed the first decree giving the right to extract the mineral bituminous for the manufacture of kerosene from land situated on the banks of the river Marau, in the then province of Bahia. However, the first news related to the search for petroleum, came in 1891 with the appearance of clay sediment on the coast of Alagoas. The first well drilled with the aim of finding oil was in 1897, in Bofete, São Paulo state, reaching a depth of 488 metres with a very modest production of petroleum. During this period, exploration activities were amateur and disorganized. The creation of the Geological and Mining Service in 1907 marked the beginning of an organized governmental role regarding petroleum exploration and it led to many wells being drilled in some Brazilian states; these were unsuccessful. During the 1930s, the government of Getulio Vargas addressed the question of foreign ownership of subsoil resources and in 1938 passed a law requiring all petroleum activities to be carried out by Brazilians. In this same year the National Petroleum Council (CNP) was set up in order to evaluate applications for exploration and development permits for oil. The decree that created the CNP also declared the country s petroleum resources to be a public good and regulated the import, export, transport, distribution and commercialization of petroleum and its derivatives. Thus although petroleum had not yet been discovered, it came to be considered as patrimony of the Union. In 1939, a well drilled in Lobato, Bahia, while not economic, was sufficiently promising to promote further exploration in the region of the Recôncavo Baiano. Finally, in 1941, the Candeias field was discovered and this led to the first oil production in Brazil. There were further discoveries in Bahia, and the CNP extended its exploration into other states. Draft not for citation without authors permission 3

4 Drilling continued on a small scale, and, in the late 40s, oil exploration began to generate a debate around the choice of the best policy that Brazil could adopt, with heated differences around nationalist and privatization proposals, the defense of the state monopoly, and the future organization of the Brazilian oil industry. Finally, after an intense public debate, on October 3 rd, 1953, President Getulio Vargas signed a law that created a state monopoly for the exploration, development, refining and transport of petroleum and its derivatives. The law also created a new federally controlled corporation, Petrobras (Petroleo Brasileiro S.A.) charged with carrying out this monopoly. In 1963, the monopoly was widened to include the import and export of petroleum and its derivatives, which reinforced the negotiating power of the Brazilian government and Petrobras. The creation of Petrobras accelerated petroleum exploration which, until then, had been carried out by private interests on a small scale. Petrobras grew rapidly in its first decade, supported by the policies of President Juscelino Kubitschek s government to grow 50 years in 5 (Alveal 1994). Petrobras strategy notably took advantage of extremely favorable external conditions associated with the first decade of the BHI. Creating mechanisms that would provide a relatively stable control of resources and their distribution was, in the infancy of the BHI, crucial for the objectives of Petrobras and Brazil. Developing such complex industry required: engaging and promoting local suppliers of capital goods, while the need to import foreign equipment and technical assistance were growing as the company was expanding upstream and financing the construction of refining facilities. In 1953, the daily oil consumption was 170 thousand barrels, almost all of it imported as refined product because national production was only barrels per day. In order to reduce this dependency, the company intensified its exploration activities and while developing its technical staff. By 1960, Brazil was producing 65 thousand barrels per day and this had risen to xxx thousand barrels per day by Until then production was concentrated on land, mainly in the state of Bahia. However, the tremendous increases in international prices that occurred with oil shocks of 1973 and 1979 made the costs and risks of exploration offshore viable. It is worth highlighting the recent discoveries of the Brazilian subsalt, whose most conservative estimates regarding the size of the reserves 70 billion barrels would already place the country in a relevant position in the international petroleum scenario. Added to the current reserves of around 13 billion barrels, the total reserves would elevate Brazil to an equivalent position of Venezuela in terms of the availability of reserves. In 2007, the level of proven reserves was 12.6 billion barrels, 93% of which were located offshore (see table 1). The oil production registered in 2007 was approximately 1.8 thousand barrels per day, of which 89% represents offshore production. The state of Rio de Janeiro alone represents 80% of oil production and reserves, which denotes a concentration and asymmetry in the distribution of oil resources throughout the Federation. Draft not for citation without authors permission 4

5 TABLE 1 Brazilian Oil Proved Reserves, Production and Consumption (million barrels) Year Consumption Proved Reserves Production R/P , ,0 68,6 19, , ,8 80,3 18, , ,4 97,8 17, , ,8 124,1 14, , ,0 172,6 11, , ,1 204,4 10, , ,4 215,7 10, , ,8 215,0 11, , ,1 209,1 13, , ,8 223,7 12, , ,0 237,3 19, , ,3 234,7 20, , ,7 238,0 20, , ,2 242,4 20, , ,4 252,9 21, , ,0 262,1 23, , ,7 294,6 22, , ,9 316,8 22, , ,3 366,1 20, , ,3 413,5 19, , ,5 462,8 18, , ,2 488,0 17, , ,3 547,1 17, , ,6 567,6 18, , ,0 562,8 20, , ,3 627,1 18, , ,0 660,0 18, , ,8 668,9 18, , ,5 693,0 18,2 Source: BP statistics 3. Federal system and constitutional provisions The constitutional and legal framework grants the Union rightful claim over mineral resources in the subsoil and over the entire continental platform, while establishing the need to compensate oil-producing states and municipalities financially. This results from a process of fiscal decentralization that marked the transition from military dictatorship to democracy, in the 1980s. The current Brazilian Constitution dates back to 1988, three years after Tancredo Neves was elected as the first civilian president in 21 years. In the course of its republican history, Brazil has had seven constitutions, which denotes political instability and a succession of centralizing, dictatorial regimes in the country for over a century. From a historical point of view, Brazil s federal and democratic experience is fairly new and rather inconsistent. Between 1930 and 1945, for instance, Brazil went through what historians refer to as the Vargas Era. For 15 straight years, President Getúlio Vargas, a populist and nationalist Draft not for citation without authors permission 5

6 politician, laid the foundations of industrialization and labor law in Brazil. He also took authoritarian and centralizing measures, politically appointing state governors and, after a new Constitution had been passed in 1937, suppressing the freedom of parties, undermining the independence among power and compromising federalism itself. With Vargas deposition in 1945 (although he would eventually be reinstated as President by popular vote, in 1951) and the new Constitution of 1946, the country was back on its way to democracy and a federal revival. In the fiscal arena, for example, the new constitution granted states and municipalities a vast array of competencies, ranging from sales, exports and property taxes (states) to excise taxes on public entertainment, economic actions, crafts and trades and urban property (municipalities). In 1953, states and municipalities earned the right to indemnity for oil extraction in their territory. This democratic phase was interrupted by a military coup d état in 1964, which ushered in a long dictatorship with five military presidents taking turns in office. In the social and economic domain, the military regime was characterized by an aggravation of State intervention and by accelerated growth and considerable wealth concentration. As regards politics and federalism, the scene was marked by repression to the opposition, limited autonomy granted to states, the political appointment of governors and mayors, and growing tax centralization. Under the pretext of tax rationalization and modernization, the constitutional reform of 1967 favored a concentration of competencies with the federal government, including the ability to intervene in state VAT legislation then called ICM) 1 as as part of its system of tax breaks on exports. However, to offset the financial scarcity at subnational levels of government and distribute public monies among the regions, the reform increased the system of intergovernmental transfers, thereby creating a series of revenue-sharing mechanisms as well as funds for states (FPE) and municipalities (FPM) linked to income tax (IR) collection and that of the federal tax known as IPI. The centralizing bias was also felt in the government s stance on royalties. In 1968, when Petrobrás made its first off-shore oil discoveries in a field off the coast of Sergipe state, the military government then in office determined that the 5% indemnity for future oil income would stay with the Union, and would not be transferred to states and municipalities as dictated by the 1953 law that dealt with on-shore production. It is no coincidence that one of the first bills passed during the civilian administration of president José Sarney, in 1985, dealt with acknowledging states and municipalities rights to off-shore royalties. In addition to oil-producing states and the so-called bordering states 2, Law 7453/85 also contemplated a Special Oil Fund (FEP) to make sure that part of the oil royalties would be shared by all entities in the federation. This mechanism is still in force, although with lesser relative weight. The federal and social tensions repressed during the military dictatorship and liberated in the process of redemocratization were reflected in the Constitution of 1988, which amidst other things fostered an ample process of tax decentralization. The new Constitutional not only recognized the right of states and municipalities to financial compensation for on- and off-shore oil production, but it also widened the autonomy and tax base of states and 1 Later, in 1988, it became known as ICMS (Imposto Sobre Circulação de Mercadoria e Serviços). 2 The concept of bordering state is defined in the next section. Draft not for citation without authors permission 6

7 municipalities, as well as the rates of taxes linked to the funds just mentioned FPM and FPE. The Constitution of redemocratization also reaffirmed the State monopoly in the oil sector, as well as a whole set of rights and social benefits which would later be the subject of a public sector reform initiative. The 9th Constitutional Amendment, of 1995, marks the end of the nationalistic era, and the Fiscal Adjustment Program of 1999 resumed tax centralization by way of federal levies not shared by states and municipalities. The constitutional amendment nº 5 changed article 177 of the Brazilian constitution, permitting the participation of private companies in exploration and production (E&P), thereby ending the monopoly until then held by the Union. From then on, until the petroleum reform in the second half of the 1990s, the successful trajectory of growth of the industry, led by the state company Petrobras, positioned Brazil as one of the most expressive economies in the 20th century, launching the country as one of the most promising frontiers in world oil industry development. In the long term, the reform of the BHI (Brazilian Hydrocarbon Industry) sought to meet three general objectives associated with the dimensions of economic efficiency: productive, allocative and distributive. The first, related to the sector itself, although of significant systemic implications for the development of the Brazilian economy, consisted of the expectation of cost reduction in the various segments of activity of the oil industry and natural gas (exploration /development/ production, refining, transportation, distribution and re-sale). The second was to stimulate the level of investments in the oil industry, from the reduction of institutional barriers, thereby generating, as a result, the participation of new operators in the upstream and downstream. Finally, the third objective resides in the significant increase in the flow of tax revenues, due to the increase in the levying of tributes expected with the arrival of new operators and the increase in national production. The new Brazilian oil legislation (1997) promoted a gradual opening, in combining the title holding of the rights of property of the Union concerning the hydrocarbon resources and the maintenance of the by-laws of the mixed capital company Petrobras, with the majority shareholding of the Union, and also preserving its vertical structure as well as its operational capacity. This law ratified the property rights of the state company in the areas of production in which it was operating, and in its refinery assets, equipment and infrastructure of transportation and warehousing. However, following the objective of creating a new standard of industrial organization, it established free access of third parties to the transportation and warehousing of the state company. In this context, Law nº 9.478/97 consolidated the new institutional scenery of the oil industry in Brazil, establishing the guidelines for its regulation. This regulatory framework had the aim of stimulating competition, attracting investments in the area of energy production and regulating government participation in the exploration and production of oil and gas. The regulation of this industry was then attributed to the Brazilian National Agency of Petroleum, Natural Gas and Biofuels (ANP), a federal regulator, linked to the Energy and Mines Ministry (MME), which was in charge of carrying out bids for the exploration, development and production concessions of oil and natural gas, concluding contracts stemming from these and inspecting the execution of the same. Draft not for citation without authors permission 7

8 This agency has the role of rule making and regulating the actions of all operators, including the state company Petrobras in the Brazilian oil and natural gas market. It shall be noted that, as other regulatory agencies, ANP has concessionary and regulatory powers. 3 According to this new model, the state begins to take up the function of regulator, transferring the activities of exploration and production to private companies by means of the concession contracts concluded with ANP. To sum up, with the enactment of the Petroleum Law, it was established that the rights of prospection and production of natural gas in Brazilian territory would continue to belong to the Union, the administration of which being the duty of ANP, by means of concessions to private and state companies. In spite of its innumerous missions, it is undeniable that one of the tasks of ANP has been the organization of the process of entry of new companies in the upstream segment. By means of the mechanism of auctioning exploratory blocs, this process of opening has been very successful, due, above all, to the number of interested parties and the collection of subscription bonus. The principal results of these auctions point to a confirmation of the leadership of Petrobras, which bought at auction most of the blocs on offer, due to the geological experience of the Campos sedimentary basins. The results clearly demonstrate that the monopoly on exploration and production has ended. In this economic sector, for over forty years, only Petrobras operated investment programs in E&P. The auction permitted the entry of new players, thereby attracting the participation of foreign and national private companies to the national Petroleum sector. Even with the increase in the number of operating companies, Petrobras continued to be the main company of the sector and the principal winner of all of the rounds of bids. It is important to note that many blocs involved partnerships and consortiums of the entering companies with Petrobras. The need to share risks and mainly the technological competence required by the exploratory effort in frontier offshore areas are factors that drove forward the strategies of co-operation between the international companies and Petrobras in restructuring the Brazilian upstream. These strategies marked the entry of large, global petroleum groups and the internationalization of the upstream segment in Brazil, demonstrating the engagement of Petrobras was fundamental for the success in restructuring this segment. At present, close to 68% of the working capital of Petrobras is held by different national and international groups, but the company is still controlled by the Union, which holds 55.6% of ordinary shares. Until 1998, only Petrobras was active in exploration. In 2008, around 70 concessionaires from over 15 countries, ten of which were of national capital, operated in the Brazilian sector of oil and natural gas. 3 However, this might change as a result of a bill currently in the Congress that aims to introduce some limitations to the functions of the regulatory agencies in the country. The trend is that the conceding power remains in the hands of the Executive and the regulatory organ exercises only the attributions of regulation. Draft not for citation without authors permission 8

9 4. Petroleum Revenue Arrangements in Context of Federal Fiscal Regime For the sake of clarity, one could divide the current taxation structure of oil revenues in Brazil into two major categories: 1) Financial and special imposts specifically related to petroleum, including traditional royalties over gross production revenues (called royalties), royalties over the net income from oil fields (called special entitlements), signature bonuses, occupation or concession fees. 2) Direct taxes on oil companies profits, as in any other sectors, including the corporate income tax (IRPJ) and the social contribution on net profits (CSLL). Brazil has a complex web of financial arrangements, whereby many federal revenues are hypothecated for different purposes. In these cases, typical petroleum revenues are shared with producing states and municipalities, while the corporate income tax are linked with entitlement funds (shared with all states and municipalities) and social contribution on net profits are strictly linked to the federal government s social security system. Table 2 shows the different specific petroleum levies with the collection results between 2000 and 2008 and their distribution between governments. This includes the modest dividends paid to the Union as a shareholder of Petrobras, but excludes the value-added taxes and taxes on fuel sales. The total government-take from oil income in 2008 accounted for 1.32% of GDP, against 0.57% in 2000, showing the growing importance of oil-related government entitlements. Of this overall revenue, 44% on average belongs to states and municipalities. About 61% of the royalties and special entitlements are redistributed to sub-national governments, with 48% of income tax (IRPJ) revenues channeled to entitlement funds and regional funds, while the remaining resources are appropriated exclusively by the Union. Table 2 Brazilian Public Revenues from Oil and Gas (% GDP): Revenues Royalties 0,16 0,18 0,22 0,26 0,26 0,29 0,33 0,28 0,36 Union 0,04 0,05 0,06 0,07 0,07 0,08 0,09 0,08 0,10 States/Municipalities 0,12 0,13 0,16 0,19 0,19 0,21 0,24 0,20 0,26 Special Participations 0,09 0,13 0,17 0,29 0,27 0,32 0,37 0,27 0,39 Union 0,04 0,07 0,08 0,15 0,14 0,16 0,19 0,13 0,19 States/Municipalities 0,04 0,07 0,08 0,15 0,14 0,16 0,19 0,13 0,19 Subscription bonus* 0,04 0,05 0,01 0,00 0,03 0,05 0,05 0,00 0,07 Occupation fee* 0,01 0,01 0,01 0,01 0,01 0,01 0,01 0,01 0,00 IRPJ e CSLL 0,27 0,28 0,31 0,49 0,32 0,50 0,49 0,42 0,39 Union 0,18 0,18 0,20 0,32 0,21 0,33 0,32 0,27 0,25 States/Municipalities 0,09 0,10 0,11 0,17 0,11 0,17 0,17 0,15 0,14 Petrobras Dividends* 0,01 0,09 0,06 0,11 0,09 0,11 0,11 0,08 0,10 Total 0,57 0,73 0,77 1,16 0,98 1,28 1,35 1,06 1,32 Union 0,32 0,44 0,42 0,66 0,54 0,73 0,76 0,57 0,73 States/Municipalities 0,25 0,29 0,35 0,51 0,44 0,55 0,59 0,49 0,59 Source: Secretary of National Tresury (SNT) and Gobetti e Serra (2009) (*) Revenue exclusive of Union Draft not for citation without authors permission 9

10 Indirect taxes on fuel sales are excluded, since they are paid by consumers and do not affect oil revenues. In any event, it should be noted that the Union levies taxes on fuels, and the same holds true for states and municipalities. In fact one of the taxes (CIDE) is shared by all. Although Table 3 shows the share of states and municipalities in oil revenues, it says very little about how these resources are horizontally distributed in each sphere of government. It also fails to offer a historical evolution of such levies, especially of the financial compensations for oil-related activities. While taxation on oil companies profits is shared with all states and municipalities through entitlement funds, according to quotas directly proportional to their populations (municipalities) and inversely proportional to their per capita income (states), the royalties and special entitlements are distributed according to very complex rules that have been and continue to be amended over time. The payment of special tributes on oil income in Brazil was established for the first time in Law nº 2004, of October 3rd 1953, together with the law that created Petrobras. In its article 27, it determined the payment of an indemnification of 5% (that we call royalties) on value of the land production of oil and gas with the value being fixed by CNP at this time. Revenue from these on-shore royalties started to be shared exclusively among states and municipalities at an 80/20 ratio, respectively. In 1969, with the discovery of oil off the coast of Sergipe state, the government extended the collection of royalties to off-shore production, only this time keeping the all indemnity payments. Only in 1985, with the approval of Law 7453, were states and municipalities entitled to royalties from off-shore production, at a rate of 80%, split as follows: 20% for all states and municipalities, 30% for the bordering states and 30% for the bordering municipalities and those encompassed in their geo-economic areas. The concepts of bordering and geo-economic jurisdiction required further regulation, and as a result only in 1986, after the enactment of Law 7525 and additional norms, did the sharing of such revenues start to take place. The definition of bordering or coastal proximity was determined by the existence of oil fields within the area formed from the projection of orthogonal lines extending towards the continental platform from the territorial borders of states and municipalities (in the case of municipalities parallel lines were also considered). According to Serra (2005), there is no economic justification for the sharing of royalties among municipalities, especially not on the basis of a geometric criterion such as coastal proximity, which shows no direct correlation with the economic impact of oil-related activities on a local level. Yet, this concept somehow made its way into the 1988 Constitution and later gained key weight in further legislation dealing with royalty distribution. As originally drafted, the legislation extended the benefit of royalties not just to the bordering municipalities, but to all those having industrial processing and treatment plants for oil and natural gas (primary production area), as well as those cut through by pipelines (secondary area) and the municipalities bordering those in the primary area. Each of these groups gets a percentage of the municipal quota, which is then pro-rated among the municipalities according to their populations. In 1989, Law 7990 increased the list of municipalities enjoying those royalties. The new act required that 10% of royalties from on-shore or off-shore production be sent to municipalities featuring installations for the loading and unloading of oil and natural gas. Draft not for citation without authors permission 10

11 This adjustment in the distribution of royalties was made in parallel to a reduction in the share reserved for states (of on-shore production) and for the special funds (of off-shore production). With the advent of the Petroleum Act in 1997, the taxation regime on oil revenues was eventually readjusted, through an increase of the pre-existing tax rates, which jumped from 5% to 10%, save for low-yield fields. Factored in the adjustment was also the international prices 4 and the creation of the three other types of governmental participation previously mentioned in this section, which can be detailed as follows: I) Subscription bonus consists of a single payment made by the bid winning company on signing the concession contract. ANP is the only beneficiary of its levying and its minimum value is established by the same in the bid notice. II) Occupation or retention fee is an inhibiting factor, so that the area does not remain retained as an unexplored area. This is because if the concessionary decides not to produce in the area in question, it is exempt from the royalties and special participation. It has also ANP as the single beneficiary. III) Special participation this kind of royalties is thus denominated, since the charging of which falls on special cases, that is, it is not charged on all producing fields, but only in those that possess a large volume of production or are highly profitable. Besides this, the special participation is also different from the royalties since it is charged quarterly (whereas the charge of royalties occurs on a monthly basis) and because it bases itself on a system of progressive aliquots (exemption of 10%, 20%, 30%, 35% and 40%) which falls on the net revenue of the quarterly production of the field, bearing in mind its location, time of operation and production volume inspected in the quarter. The federal government is the beneficiary of 50% of its resources: 40% of the total is destined to the Ministry of Mines and Energy and 10% for the Ministry of the Environment. The producing or bordering states appropriate 40% of the resources and the producing or bordering municipalities 10%. These multiple factors creation of new government participations, adjustment in aliquots and in reference prices of calculation, as like the boom in oil prices have contributed to the expressive increasing of the public revenues. The levying of the total government participations in 2008 was to the order of US$ million, whereas in 1997, this amount corresponded to US$ 150 million (see graph 1). More than 90% of it comes from offshore production. GRAPH 1 4 ANP uses a parametric formula which has as reference the price of Brent type and the exchange rate real/dollar (both quoted in the months of actual production) Draft not for citation without authors permission 11

12 15,000 10,000 Brazilian Government Participation (US$ millions) 5, Royalties Special Participation Source: ANP In addition to increasing the government take, the Petroleum Act also modified the revenuesharing structures, both vertically and horizontally, not least at the municipal level. On the one hand, municipalities which until then derived benefits from the special fund only (shared by all) were now included among those privileged by specific rules, such as the one extending royalties from locations fitted with loading and unloading installations to any other somehow impacted by such operations. On the other hand, the natural trend towards revenue-concentration was aggravated by the special sharing rule and just as well by the additional 5% royalty tax rate increase. In practice, royalties started to be shared according to four distinct rules, depending primarily on the on-shore/off-shore variable, and the 10% royalty tax rate was split in two: the basic tax rate and the supplemental tax rate. The sharing of royalties pertaining to the basic 5% tax rate continued to follow the rule introduced by Law 7990/89, which in the case of off-shore production ensured 30% to bordering municipalities and those in their respective geo-economic domain. As for the royalties pertaining to the additional tax rates introduced by Law 9478/97, only bordering municipalities would be privileged in a manner proportional to the yield of oil fields contained in their respective area coverage (and no longer in proportional demographic terms). The same rule applies to the special entitlements to be shared among municipalities: Only the coastal municipalities lucky enough to have their orthogonal and parallel projections intersect with oil fields should benefit from those revenues. According to Serra (2005), in the case of off-shore production this privilege was granted to bordering states and municipalities as a sort of compensation for losses allegedly incurred by such states (especially Rio de Janeiro) from their VAT and ICMS taxation. In Brazil, the VAT largely stays with the producing state, save for oil and electric power, where tax collection is entirely shifted to consuming states. Hence, Rio de Janeiro does not get to keep the ICMS levied on fuel refined in-state, unless it is consumed internally, and as a result ends up incurring losses when compared to other states. In any event, it is important to note that the flaw in Brazil s tax system lies in allowing producing states to keep a part of the ICMS collected, when it should be entirely shifted to consuming states. This tends to be the norm for VAT in most federations. In other words, while the differentiated treatment given to ICMS on fuels helps explain the historical royalty benefits enjoyed by the bordering entities, it does not serve to justify the principle. Draft not for citation without authors permission 12

13 Table 3 offers a summary of the application of rules and overall impact thereof on the sharing of royalties and special entitlements. Table 3 Brazilian distribution of royalties and special participation on federation: Basic aliquot Adicional aliquot Tipo de (5%) (5%) Special Compensação Participation Land Sea Land Sea Media Union 20% 25% 40% 50% 39,4% States 52,5% 24,5% 52,5% 24% 40% 33,9% Producing/Bordering 70% 30% 52,5% 22,5% 40% 35,2% - Redistribution through VAT* 17,5% -7,5% -2,1% All (special fund) 2% 1,5% 0,8% Municipalities 47,5% 55,5% 22,5% 36% 10% 26,7% Producing 20% 15,0% 0,9% Bordering 22,5% 10% 10,0% Bordering/Producing Zone (PZ) 21% 4,6% PZ Neighbourhood 9% 2,0% (Des)embarkation locals (DEL) 10% 10% 3% 3% 3,1% Affected by DEL 4,5% 4,5% 1,1% From producing states (through VAT) 17,5% 7,5% 2,1% All (special fund) 8% 6% 3,0% Total 100% 100% 100% 100% 100% 100% Source: ANP, Gobetti and Serra (2009) (*) The same criteria that is applied to VAT/ICMS: municipalities receive 25% of state revenue As shown, the share of states can reach as much as 33.9% of the pool of resources, with municipalities holding an additional 26.7%. As for the criterion behind the shared financial compensation among municipalities, the bordering/primary production area status (encompassing 69 city halls in 2008) ensures 14.6% of funds. This share is three times bigger than the quota of the 116 municipalities that are directly or indirectly impacted by loading and unloading oil operations (4.3%), which in principle have greater exposure to the social and environmental impact resulting from oil exploration. On the other hand, the value currently distributed to all 5,564 Brazilian municipalities through a special fund accounts for only 3% of the total royalties and special entitlements. As a result of this sharing agreement, the state and municipalities of Rio de Janeiro hold 75% of the decentralized resources. Even more remarkable is that 50% of the shared royalties and special entitlement funds go to only 10 cities in the state (Chart 2). The city of Campos dos Goytacazes alone received US$ 667 million in 2008, which represents 20% of all government entitlements to municipalities. This revenue-concentration effect can be explained by certain geographic coincidences that favor Campos dos Goytacazes. Not only is the city located in an oil-production area, it also enjoys the good fortune of having its orthogonal projections encompass the lion share of the country s most productive oil fields, thanks to the special shape of its coast (see Figure 1). The result: the municipality in question is entitled to 12% of the municipal royalties plus 53% of the special entitlements which are greater in value than the former. The arbitrariness behind this rule is so huge that São Francisco de Itabapoana, a city very close to Campos (shown as the last dot in Figure 1), receives the equivalent of just 0.65% of Draft not for citation without authors permission 13

14 the neighboring town, that is, 153 times less. The reason: the shape of its coast is such that the orthogonal projections do not intersect with the oil fields, despite their close proximity. GRAPH 2 Concentration index of Brazilian oil revenues amongst municipalities: 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: ANP and authors. Accumulated rate of participation in total revenue, with municipalities ranked from higuest to lowest revenue Figure 1 Orthogonal Projection over Rio de Janeiro coast Source: Department of Mineral Resources, Rio de Janeiro In addition to being unfair, the current rules have proven unable to significantly improve the social and economic indicators in the municipalities favored by those royalties. In some cases, there is evidence that the abundance of resources has created tax laziness and waste, which in turn translates in low levels of autonomous taxation and high public spending (see Gobetti and Serra, 2009). These problems derive in part from the weakness of institutions and provisions, including the legislation stipulating the rules of financial compensation. While funds available to the Draft not for citation without authors permission 14

15 Union have several strings attached, those geared to states and municipalities are practically unencumbered. Such distortions in the distribution and application of royalties, as well as the competition among states for the new pre-salt wealth, has brought about a series of draft bills aimed at replacing the orthogonal line criterion with proportional mechanisms, parallel lines or with a system to broaden the pool of royalties shared by all states and municipalities. This debate gained momentum after the government sent to Congress in 2009 a draft bill establishing a production-sharing arrangement for pre-salt oil fields. The bill introduced no changes to the current rules for royalty and special entitlement distributions from existing concession areas, but proposed a new system of oil-income appropriation to pre-salt aimed at increasing both the government take and the federal share in oil revenues. In terms of imposts, the major change proposed is the elimination of the special entitlement and the creation of a new concept of State s share on profit oil (similar to Norwegian system). While the special entitlement in practice represents the government s share of surplus profits, it now accounts for 20% of the profit oil, with 50% of these revenues transferred to states and municipalities. In the proposed new regime, this entitlement shall be stipulated by each contract at a rate of at least 50%, while the revenues shall go exclusively to the Union. The net effect of this change is that the federal entitlement on governmental petroleum revenues from the pre-salt would be 75%, in contrast with the 40% in concession areas. This change is opposed by the governors of Rio de Janeiro, Espírito Santo and São Paulo, who would be the major beneficiaries should the special entitlement system be extended to the pre-salt. The governors of northeastern states, in turn, oppose the proposal because presalt royalties, which are seen as a national treasure, would continue to flow massively to bordering states. Currently, as shown in Table 4, 81% of the decentralized compensation revenues to states and municipalities remains in Rio de Janeiro and Espírito Santo. In 1997, that percentage was of just 54%. So, the Petroleum Act, from a federal point of view, accentuated regional differences in favor of oil producing states. Representative Henrique Alves, the rapporteur charged with analyzing this bill at the House, tried to please all parties concerned. He left the profit oil with the Union, but increased royalties from 10% to 15% while changing their distribution with a view to enlarging the pool to be shared by all states and municipalities. In spite of the controversy, no alternative has been proposed so far that would introduce some sound social and economic reasoning in the royalties distribution, nor has any effort been made to increase the productivity of their application for current or future generations. As it turns out, the dispute boils down to each federal entity simply trying to secure a greater share of the pie. Table 4 Regional distribution of oil revenues in Brazil (US$ million): Federation unit 1997 % Total 2008 % Total Acre 0,15 0,10 5,15 0,07 Alagoas 2,13 1,42 58,77 0,79 Amazonas 4,82 3,21 149,58 2,00 Amapá 0,13 0,09 4,78 0,06 Draft not for citation without authors permission 15

16 Bahia 14,17 9,44 235,96 3,16 Ceará 3,20 2,13 62,48 0,84 Distrito Federal 0,05 0,03 1,26 0,02 Espírito Santo 3,67 2,45 397,08 5,31 Goiás 0,47 0,31 16,20 0,22 Maranhão 0,63 0,42 22,31 0,30 Minas Gerais 2,09 1,40 56,10 0,75 Mato Grosso do Sul 0,20 0,13 6,92 0,09 Mato Grosso 0,26 0,18 8,97 0,12 Pará 0,52 0,35 20,04 0,27 Paraíba 0,79 0,53 20,35 0,27 Pernambuco 2,43 1,62 62,67 0,84 Piauí 0,38 0,25 13,32 0,18 Paraná 2,72 1,81 33,93 0,45 Rio de Janeiro 75,20 50, ,58 75,37 Rio Grande do Norte 19,38 12,91 234,66 3,14 Rondônia 0,16 0,11 5,90 0,08 Roraima 0,10 0,06 3,60 0,05 Rio Grande do Sul 2,06 1,37 51,39 0,69 Santa Catarina 0,76 0,51 31,65 0,42 Sergipe 8,19 5,46 179,22 2,40 São Paulo 5,20 3,46 149,15 2,00 Tocantins 0,28 0,19 9,72 0,13 Total 150,15 100, ,74 100,00 Source: ANP and Authors 5. Macro economic challenges While the pre-salt discoveries provide the prospect of Brazil becoming a major international player in oil markets, developing the resource, which is very much on the technological frontier, will demand an immense effort and considerable innovation. Moreover, the prospect of very much larger petroleum revenues presents the macroeconomic challenges of dealing with potentially very volatile revenues, both fiscally and in the country s international payments. Obviously, countries too heavily dependent on oil risk having overvalued exchange rates that undermine other sectors of the economy. They can also face pro-cyclical pressures that accentuate the economic cycles with a potential to de-stabilize non-oil industrial sectors as well as government operations and finances In such countries, failure to adjust fiscal policy to adequately offset oil price volatility increase de-stabilizing pressures, with high spending during price peaks and undesirable investment cuts at times of contraction. Brazil currently faces serious exchange rate issues from its larger-than-average appreciation vis-a-vis the dollar. This is as much a reflection of the massive inflow of foreign direct investments as of the large domestic and external interest rate spread. Draft not for citation without authors permission 16

17 To tackle this problem in the context pre-salt, the government sent to Congress a draft bill to create a fund that will hold all future oil revenues. As stated in its article 2, the idea is to build public, long-term savings, offer a source of income for social and regional development and amortize the effects of income and price fluctuation in the national economy. Although the fund was dubbed social, in an effort to add to its political legitimacy, the government s priority is clear: to prevent an inflow of dollars that may cause undue exchange rate appreciation. However, two problems not yet tackled threaten to compromise the strategy or make it excessively onerous from a fiscal point of view. The first relates to the high cost of Brazilian public debt and the poor coordination between monetary and fiscal policies in Brazil. With an annual interest rate of 6%, there appears little point in having the government accumulate financial assets abroad, where interest rates are much lower. It is more appropriate to use the revenues to liquidate public debt bonds. Yet, if it were to do so, the government would increase liquidity in an already overheated economy, thereby forcing the central bank to reduce the interest rates or else issue new bonds. In practice, this dilemma is already embedded in the relationship between the Treasury and the Central Bank of Brazil, and translates into two concurrent and opposing movements in the fiscal arena: a decline in net debt and an increase in gross public debt. The net debt had been declining until the onset of the crisis brought about the need to accrue a significant primary surplus, but this surplus was eventually kept by the Central Bank and hence did not prevent the number of outstanding bonds from increasing. At the same time, the accumulation of foreign exchange reserves in the country, which are also assets, was funded through the issuance of public debt. The cost of accumulating dollar-denominated assets and of issuing bonds at an actual rate of 6% per annum accounts for 1.5% of the GDP every year, on average, according to the Central Bank s own statistics. The second issue when establishing a sovereign fund is that given the degree of decentralization of oil revenues and the lack of spending control on the part of states and municipalities, the federal government may find itself swamped in its effort to build savings and mitigate income fluctuations. This could eventually render the country virtually unable to foster social and regional development investments. In fact, the current fiscal and monetary framework and the federal structure both get in the way of solving the macroeconomic challenges that lie ahead for Brazil. And without solving these problems, the country will find itself in dire straits when it comes to the other structural challenges outlined in the foregoing requiring massive federal infrastructural, social and economic investment. 6. Environmental and Social Issues IBAMA (Brazilian Institute of Environment and Renewable Natural Resources), a Brazilian federal organ, establishes environmental standards, designates environmental zones, evaluates environmental impacts, and issues and monitors licenses subject to environmental conditions. In 2006, IBAMA created a Directory of Environmental Quality and a Directory of Environmental Licensing. Draft not for citation without authors permission 17