Stabilization Clauses And The Freedom Of Parliament To Impose New Taxes Or Royalty

BY NANA ADJOA HACKMAN

In the highly volatile world of oil and gas contracting, the common law principle that all contracts entered into should be performed in good faith, often finds itself threatened by attempts by host governments to re-negotiate contracts, and in more severe cases, attempts at expropriation or nationalisation. The basis on which states are able to do this almost unflinchingly is the international law concept of State Sovereignty. One of the ways by which international oil companies have sought cover against such situations is by the inclusion of stabilization clauses (in whatever shape or form) in international oil agreements. How can Ghana ensure that, unlike the controversies in the mining sector, the stabilisation clauses in oil contracts strike a proper balance between investor interest and national interest?

The international law concept of sovereignty clothes states with an immense amount of independence and control over their territorial jurisdictions and whatever falls within same, including any natural resources found within the geographically defined territory of the sovereign state.

The exercise of sovereignty over natural resources would ordinarily be expected to translate into vast wealth to a state upon the discovery of a resource within its sovereign jurisdiction. We in Ghana know too well, this is not always the case. The reality is that there are many states that do not possess adequate capital, technology and know-how to tap into these resources and generate income in a self sufficient way and Ghana is one of these.

This, calls for partnership between sovereign states and strategic foreign investors; an interdependence which is fraught with many tensions over the long term duration of these relationships. There is at all times that swinging pendulum called “bargaining power”, which depending on whose side it swings, determines which way things should go.

The idea of sovereignty over natural resources carries with it certain sensitive, nationalistic sentiments that the sovereign state as owner of the resource, must at all times get better out of the deal. Because of this, at times when host states find themselves in a higher bargaining position, they begin to seek changes to the existing investment agreements in order to obtain a higher stake. A typical example is the 2009 budget of Ghana which seeks to raise the minimum mining royalty from 3 percent to 6 percent, in spite of binding stabilisation clauses with major mining companies operating in Ghana.

On the other hand, investors seek a stable investment environment under which they can recoup their investments and earn estimated profits. They rely on the principle that contracts entered into would be performed in good faith.

The position of states is amply demonstrated in the terminations of concessions and expropriations that characterised the oil industry in the second half of the 20th century. Similar events have continued to occur even within the last three years in countries like Venezuela and Bolivia. Here, the unfolding controversy is with the Ghana government exercising its implied first option to buy the stake of Kosmos Energy, raising issues of what is considered reasonable space of time that the host nation is allowed to have in having to exercise that first option, if it so chooses.

Foreign investors especially in the hydrocarbons industry have sought to counter the actions of sovereign states and minimise such political risk by the use of mechanisms like contractual stabilization clauses, legislative stability arrangements, bilateral investment treaties, multilateral investment treaties as well as informal mechanisms like goodwill gestures.

1. THE CONCEPT OF STATE SOVEREIGNTY

By a UN General Assembly Resolution in 1962, the principle of permanent sovereignty of states over natural resource wealth within their territorial jurisdiction was recognised and strengthened.

Under this principle, “the right of peoples and nations to permanent sovereignty over their natural wealth and resources must be exercised in the interest of their national development and of the well-being of the people of the state concerned.”

All activities regarding the exploration, extraction and sale of the natural resources are to be done according to the national laws of the sovereign state.

Section 4 of the UN resolution allows for nationalisation, expropriation or requisitioning by a state, provided that it is done for “reasons of public utility, security or the national interest” and “appropriate compensation” is paid. Section 8, further highlights the limitation on sovereignty by placing a responsibility for foreign investment agreements entered into by or between sovereign states to be observed in good faith.

By a subsequent resolution dated 26th July, 1974, the UN General Assembly reaffirmed the above provisos.

The principle of permanent sovereignty grants sovereign states significant control in the management of these resources. It serves as a good basis for governments to negotiate a higher take in petroleum agreements to satisfy the nationalistic sentiments that the ownership of natural resources breeds in the citizens of a country.

Owing to the usually long duration of petroleum agreements, some lasting on an average between 20 to 30 years, the temptation for the host nation to make changes to the original agreement governing petroleum operations is great. Such changes are usually very likely upon the discovery of petroleum when the previously strong position of the IOC begins to diminish and there is an immediate shift in bargaining power in favour of the host country. This is known as the concept of “obsolescing bargain”.

Governments may also seek a renegotiation in times of rising oil prices, when they feel that the economic projections upon which they negotiated and signed the agreement initially have changed. Ghana is currently witnessing nominal record price hikes in gold and higher profit margins for the mining companies. At such times, governments may feel and indeed may be under pressure from their citizens to obtain a greater share of the profits being generated.

Again, governments may be influenced by emerging concepts around the world such as the imposition of taxes on obnoxious environmental practices, taxes to finance modern health and safety measures, the provision of security, and as compensation for local communities among others, to change the fiscal regime of the agreement.

There are a variety of actions that host governments may take to alter the existing arrangements to the detriment of the IOC. The government may pass new laws and regulations that indirectly have a negative effect on the performance of the agreement by varying the existing legal and economic environment. In recent times, this has been termed “creeping expropriation”.

The host state’s action may also be direct in the form of increments in tax and royalty rates, imposition of new taxes and royalties, increasing the percentage of participation of the SOC, as well as imposing restrictions on the IOC’s right to export or to repatriate its profits. Where the contract is a PSC, changes may be made to the cost oil and profit oil splits to benefit the host country.

2. STABILIZATION CLAUSES

The use of stabilization clauses is a direct response to unilateral actions of host governments that altered the positions of foreign companies under previously concluded long term investment agreements. Investors rely on stabilization clauses to ensure relative stability of the main investment conditions needed for the successful performance of their investment ventures.

For the foreign investors and their bankers, stabilization concerns among other things, the stability of the fiscal regime to ensure investment recovery, security of tenure over property and title, the ability to sell, the ability to retain and repatriate foreign exchange earned and the ability to operate the project under reasonably foreseeable conditions. Foreign Investors would also be concerned about non financial matters like changes in labour and environmental law or changes in the interpretation of the existing law to the extent that it affects their interests adversely.

The ‘Freezing’ Clause is the traditional form of stabilization clause. What this clause did was to state specifically that the governing law of the contract was the law of the host state at the time of the execution of the contract. By so doing, the clause sought to ‘freeze’ the parties’ rights and obligations agreed in the contract such that subsequent changes to the law of the host state would not be applicable to the particular contract for the duration of its term.

In practice it is rare especially in recent times for host governments to agree to an absolute ‘freezing’ of contract terms which permanently protects the parties’ rights and obligations agreed in the contract such that subsequent changes to the law of the host state would not be applicable to the particular contract for the duration of its term. More moderate forms of the clause can be found in petroleum contracts in Angola, Iraq, Malta, Cambodia, Kazakhstan, Poland, Tunisia and here in Ghana.

Article 26 of The Petroleum Agreement of 22 July, 2004, among the Republic of Ghana, Ghana National Petroleum Corporation, Kosmos Energy Ghana HC and the EO Group in respect of West Cape Three Points Block Offshore Ghana, contains an interesting mix of stabilisation clauses.

It stipulates, inter alia, at paragraph 2: ‘The State, its departments and agencies, shall support this Agreement and shall take no action which prevents or impedes the due exercise and performance of rights and obligations of the Parties hereunder...’

More interesting is Article 26.3, which reads: ‘This agreement and the rights and obligations specified herein may not be modified, amended, altered or supplemented except upon the execution and delivery of a written agreement executed by the Parties. Any legislative or administrative act of the State or any of its agencies or subdivisions which purports to vary any such right or obligation shall, to the extent sought to be applied to this agreement, constitute a breach of this agreement by the State; provided, however, if the Petroleum (Exploration and Production) Law, 1984 (PNDCL 84) is amended or replaced (superseded), Contractor shall be entitled to enjoy and this Agreement (and any new petroleum agreement referred to herein) shall be deemed to include (or include – as applicable) the terms and conditions in such amendment or replacement law that favourably affect the rights and/or obligations of the Contractor under this Agreement.”

The Kosmos Energy agreement also contains an Equilibrium or Economic Balancing Clause. Unlike the freezing clause, this clause does not seek to restrain the host government from directly or indirectly altering the terms of a contract or altering the conditions under which the contract is to be performed. They rather seek to mitigate any adverse economic impact of such changes on the IOC.

Thus, Article 26.4 of the Kosmos Energy agreement reads in part: “Where a Party considers that a significant change in the circumstances prevailing at the time the Agreement was entered into, has occurred affecting the economic balance of the Agreement, the Party adversely affected thereby shall notify the other Parties in writing of the claimed change with a statement of how the claimed change has affected such economic balance… If such significant changes are established by the Parties to have occurred, the Parties shall meet to engage in negotiations and shall effect such changes in, or rectification of, these provisions as they may agree are necessary to restore the relative economic position of the Parties as at the date of this Agreement.”

The equilibrium or economic balancing clause takes the form that in the event that the host government takes an action that has a negative impact on the economic benefits of the IOC under the contract, there would be an attempt at re-balancing to bring the parties back to the status-quo ante. This re-balancing may be done through negotiation or in some cases may occur automatically. The clause, as in the Kosmos Energy case, includes an option to resort to arbitration in the event that the parties fail to reach an agreement within a stated time frame. Another example of such a clause can be found in a 1998 contract for the Sofala Field in Mozambique.

In effect, what article 26 seeks to do is to prohibit the state from directly making changes to the agreement or passing legislation that adversely affects the benefits and entitlements of the IOC under the agreement. It then goes on to ensure that in the event that such changes that negatively affect the investor occur indirectly, Ghana is under an obligation to restore it to the economic position it would have been in, had such change not occurred.

3 STATE SOVEREIGNTY VERSUS STABILIZATION CLAUSES

3.1 DEVELOPED / DEVELOPING COUNTRIES

In discussing the relationship between the concept of permanent sovereignty over natural resources and stabilization clauses, it should be pointed out that some states do not offer investors the option of contract based stability at all. The usual basis for this denial is that the current administration cannot enter into arrangements that would have the effect of tying the hands of future governments. This is typical of most OECD countries. Indeed in these countries, there isn’t the option of legislative stability either. The question may be, why not here in Ghana?

In many Latin American countries including Peru, Colombia, Venezuela, Chile, Ecuador and Panama, the practice is to grant stability to IOCs and other foreign investors not in the form of contractual stabilization clauses, but through legislative stability arrangements.

OECD countries, for instance, which are perceived to have little or no political risk have considerably high bargaining power and would thus refuse to grant IOCs the luxury of a stabilization clause. This is also true of countries with high levels of proven reserves of hydrocarbons and which can therefore attract foreign investors without having to commit too much. Ghana does not see itself to be exactly under any of the two categories.

Developing countries usually agree to the use of stabilization clauses in petroleum contracts because of their perceived low bargaining power at the time of entering into these agreements. Many developing countries, like Ghana, are so desperate to attract IOCs with the needed investment and expertise to conduct exploration and production that they are willing to agree to many of the conditions set by these investors including the insertion of stabilization clauses. Where the country’s level of proven reserves is low, marginal, or speculative like Ghana’s was until recently, its bargaining power is even lower and there is increased pressure to accept terms from IOCs that they would otherwise not accept, given a stronger bargaining position.

3.2 LIMITATIONS TO FISCAL STABILITY

There are constitutional limitations to stability clauses. This is because in many countries including the U.K and, in fact, Ghana, it is legally impossible for an incumbent government to enter into agreements that would place constraints on a future government’s ability to raise existing taxes or enact new tax laws. However, this constitutional issue has never been tested under the Fourth Republic.

But, the writer would argue that in Ghana a stabilization clause that attempts to freeze existing tax laws in relation to a project therefore may have little chance of success in the court of law. Lawyers from both sides may argue and arbitration may be threatened, but the constitution should prevail. The economic issue may, however, revolve around how any such changes on tax laws affecting stabilization clauses may in turn affect the wider foreign investor confidence.

3.3 LIMITATIONS TO SOCIAL AND ENVIRONMENTAL STABILITY

In recent times concerns have been raised about attempts by IOCs through the use of sophisticated stabilization clauses, to restrict states from regulating on environmental and social matters including health, safety and human rights issues. This has been in the wake of a modern trend towards raising standards in environmental and social matters in the international oil industry.

The situation becomes morally persuasive when the state has to meet international obligations and standards on such environmental matters. This is even where international law may come to a state’s rescue.

It is, therefore, safer for countries to exclude environmental and social matters from the scope of application of the stabilization clause, thus preserving their sovereign right to legislate towards sustainable development in the nation’s interest.

3.4 THE EFFECTIVENESS OF FREEZING

International law recognises the right of host governments to expropriate even in the face of a previous guarantee that they will not. The host state just has to pay compensation to the IOC in that event. Again, nationalisations that took place between the 1950s and the 1970s showed that although stabilization clauses had an effect on the amount of compensation awarded to the IOCs at arbitration, they were not successful in preventing the nationalisations.

Doubts about the effectiveness of this freezing type of stabilization clause in trying to prevent the state from the exercise of its sovereign prerogatives is what led to the new approach to stabilization in the form of economic balancing.

3.5 THE EFFECTIVENESS OF ECONOMIC BALANCING In the author’s opinion, this new approach to stabilization is more beneficial in the sense that it allows both the host government and the foreign investor to strike some sort of balance between the need to legislate and take other actions in the interest of the host country, and the need to honour agreements signed in good faith. An economic balancing clause in an agreement provides a pre-arranged practical way of dealing with a situation where the host government is asserting rebus sic stantibus (A customary international law doctrine that allows treaties to become inapplicable because of a fundamental change in circumstances, provided for under Article 62 of the Vienna Convention on the Law of Treaties, 23 May 1969, 115 UNTS 331, 8 ILM 679 (1969) entered into force 27 Jan. 1980) and the IOC is claiming pacta sunt servanda (A basic rule of civil and international law that agreements must be kept).

In reality however, the effectiveness of the economic balancing clause has not yet been tested. As a form of further assurance, the clause is in some agreements linked to the arbitration clause so that in the event of a failure to arrive at equilibrium the IOC may resort to arbitration. No recent award has however been made to give insight on the enforceability of the economic balancing clause at law.

In conclusion, the writer is of the opinion that while states continue to guard firmly their sovereign rights over natural resources, contractual stabilization clauses would continue to be relied on by foreign investors as a tool for ensuring the stability of long term petroleum investment contracts for a long time to come. Whether the two themes would develop to the level capable of being described as peaceful bedfellows in the economic balancing clause however remains to be seen. Nevertheless, though not tested, both state officials and foreign investors operating in Ghana should know that stabilization clauses offer but, arguably, limited comfort to the investor in the sight of Ghana’s constitution, regarding the freedom of Parliament to introduce new levies. darlingrid@yahoo.com

The author is a lawyer and an expert on Oil & Gas policy and law with the Centre for Energy, Petroleum and Mineral Law and Policy, University of Dundee