Why Institutional Investors Support Transparency
By Nicolas Maennling and Perrine Toledano
The increasing technical risks of global natural resource development have been well-documented. What is less understood but no less important are the growing political, regulatory and reputational risks involved in meeting the world’s growing resource needs. Whether it is the threat of production disruptions in the Niger River Delta, nationalization or abrupt changes in tax policy risks in Venezuela, or a tenuous license to operate in Guatemala, country and project-specific non-technical risks are becoming more acute as companies push further into the frontiers of petroleum and mineral exploration.
To better assess non-technical risks, evaluate management strategies and support efforts to hold resource-rich country governments accountable, Section 1504 of the Wall Street Reform and Consumer Protection Act (known as the “Dodd-Frank Act”) requires the disclosure of tax and other payments to host governments by extractive industry companies listed with the U.S. Securities and Exchange Commission (SEC) on a project-by-project level.
When the Dodd-Frank Act passed in 2010, its Section 1504 was a groundbreaking provision and served as a model for other countries. However, Section 1504 was successfully challenged by the American Petroleum Institute and the U.S. Chamber of Commerce in 2013; accordingly, the courts have remanded the rulemaking back to the SEC.
The SEC will announce its final payment transparency rules under Section 1504 by the end of June 2016. As outlined in our submission to the SEC on Oct. 30, 2015, there are seven reasons why disclosure of payments to governments by extractive industry companies is of importance to institutional investors. Transparency of payments to governments will:
- Support investors in their assessment of the effectiveness of the risk diversification within a portfolio. The diversification of portfolios is the basic technique for risk management used by investors. A portfolio of different kinds of investments should yield higher returns and cause lower risks than any individual investment in the portfolio. Project-level payment reporting helps deploy sound risk-diversification strategies where a key component of projects’ costs (i.e. taxes, royalties and other payments to governments) become known.
- Help investors adjust assumptions on a major cost to the project. To estimate the value of projects, investors often rely on the standard tax regime of a country. However, this is too simplistic, as projects are different in terms of fiscal regimes, geography, infrastructural improvement initiatives by the company, among others, which may entitle some projects for varied tax incentives relative to others. In some countries, such incentives are included in contracts, which supersede the law and are mostly confidential. In addition, multinationals use their worldwide corporate structure to practice transfer pricing and lower their taxable income, which in turn creates differences between the effective tax rate and the statutory level. In the presence of project-level payment disclosure, investors are better able to estimate the true net present value of projects and companies.
- Help investors assess the exposure to commodity price downturns. Investors use the all-in sustaining costs (AISC = production costs + operating costs + financing expenses + taxes and related payments + capital expenditure) to understand which projects are more susceptible to declining commodity prices. With project-level payment disclosure, investors can better understand the goverment’s risk sharing and elasticity of the tax regime with respect to prices, thereby improving the accuracy of the cost curve assessment.
- Lower the cost of capital. The lower cost of capital is the result of equity holders and investors granting more trust to the companies they are investing in. This trust might be warranted given that that companies that disclose earnings and tax payments have shown to financially outperform those companies that did not disclose government payments.
- Lower political risk. Sovereign debt rating agencies include transparency as a key indicator for measuring the perceived level of corruption. Evidence suggests that Extractive Industry Transparency Initiative implementation and compliance have become leading indicators of substantive efforts to reduce political risk and enhance stability in the eyes of credit rating agencies. However, this transparency initiative has limited coverage. Section 1504 could fill this gap.
- Better understand the risks of fiscal regulatory change. If the effective tax rate of a project is far below the average of peer producing countries while the internal rate of return of the project is relatively high, there may be pressure to renegotiate the contract or revise the fiscal regime. Project-level payment data will help assess the project internal rate of return and effective tax rate.
- Help solve the principal–agent problem. The investor must carry out due diligence to ensure that the company behaves accordingly and in line with what is reported. Transparency of payments at the project level provides additional information useful for investors to monitor companies’ behavior and profitability.
The reasons outlined above and the SEC submissions by institutional investors worth over $9.8 trillion in support of Section 1504 highlight the need for the SEC to release strong payment transparency rules in order to fulfill its mission to “…protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”
Project level reporting is becoming the new standard with the European Union, Norway, Canada and Australia having implemented or being in the process of implementing project-level reporting requirements based on the originally proposed Section 1504 rule. Furthermore, the new Extractive Industry Transparency Initiative standard foresees project-level reporting. Not aligning the transparency rules to this new standard would make it more complicated for investors to assess and compare the oil, gas and mining companies in their portfolios.
Nicolas Maennling is a senior economics and policy researcher, and Perrine Toledano is head: extractive industries, at the Columbia Center on Sustainable Investment.