Local content requirements: On preventing the oil and gas industry from becoming an ‘enclave’

Introduction

In my New Year’s Day column this year I had indicated there are three policy priorities which seemingly guide government’s preparations for the development of its impending oil and gas-based extraction sector. If these priorities are interpreted in their broadest sense, they could be expressed as 1) establishing a sovereign wealth fund (SWF) and, relatedly, designing a fiscal regime for the sector; 2) providing a governance framework, which is based on international best-practices; along with a dedicated or stand-alone regulatory commission for the extractive sector; and seeking membership of the Extractive Industries Transparency Initiative (EITI) as two main institutional planks; and 3) legislating/regulating/prescribing local content requirements (LCRs) that would operate along the sector’s entire value chain.

In last week’s column I had completed discussion of the first two priorities. Today’s column begins consideration of the third priority. After this, I shall discuss issues centring on an appropriate fiscal regime for Guyana’s oil and gas sector. I wish, however, to recognize here that logically, discussion of the oil and gas fiscal regime should precede today’s. This is because, as will become evident later, concerns related to LCRs logically arise beyond mobilizing government revenues from the sector and also well beyond the depletion/exhaustion of Guyana’s finite oil and gas reserves.

What is local content?

Readers should be aware that the concept of ‘local content’ has evolved significantly during the 2000s. Originally it was considered as the “requirement that a producer ensures a certain percentage of inputs in the production process come from local sources.” (S Lester, International Economic Law and Policy Blog, 2013) Nowadays, the notion is treated with explicit emphasis on the localization of production, growth, and development potential. Consequently, this has occasioned debates around whether “state policies promoting localization create barriers to trade”? And, if so, whether these are consistent with the free trade provisions of the world trade organization (WTO)?

Thus S Silva (2013) has bluntly claimed: “The aim of LCRs is to create rent-based investment and import substitution incentives.” The author goes on to elaborate that LCRs direct foreign investors/companies to ensure a minimum threshold of goods and services is procured locally. This directive is, effectively, the creation of import quotas through government policy. Such development represents a policy shift from protected export platforms in developing countries (which thrived in the 1960s and 1970s) to welcoming foreign direct investment (FDI) and then imposing LCRs. Such a policy shift reduces the investment risk in poor countries.

LCRs origins

The development rationale for LCRs in Guyana is rooted in the country’s historical experiences of extensive and intensive reliance on the fortunes and misfortunes of extractive industries’ sales in world markets. As noted, at the outset of this long ongoing series on Guyana’s extractive sector (started December 2015) it contributes hugely to GDP growth and performance; foreign exchange earnings; tax revenues; employment; as well as environmental challenges to our biodiversity.

Similar to other small, poor, open economies which are dependent on the growth of FDI extractive industries, Guyana has, over time, taken on traditional functional enclave features. The companies that have dominated the economy bring a substantial proportion of the goods, services, equipment and critical staff they need from abroad. This limits spillovers to other non-extractive sectors. And, in so doing, the potential for domestic growth and development, especially in the areas of agriculture, manufacturing and services is severely constrained.

However, the oil and gas sector, because of 1) its high capital requirements; 2) dependence on cutting edge technology; and 3) well trained operatives, supervisory and managerial skills, requires strong policy measures to foster the growth and utilisation of spillovers and linkages to other sectors. If left to spontaneous evolution, experience reveals limited spillovers and linkages to domestic firms, along with limited employment in the sector. This latter is due to the sector’s high capital intensity. Indeed, it appears that enclave characteristics in small, poor, economies like Guyana are more prevalent in the oil and gas industry, than in other extractive industries.

The goals/aims of LCRs are many. If pressed, I would suggest these can be concentrated in the following seven items: 1) to secure growth and development offsets for when oil and gas revenues peak because depletion rates have also peaked; 2) to leverage oil and gas revenues in order to develop downstream value added products; 3) consequent to 2, to promote the diversification of the economy especially through non-extractive sector growth; 4) to strengthen inter-industry linkages (backward and forward); 5) to place research development and innovation more centrally in Guyana’s productivity growth and development; 6) to combat the environmental challenges (degradation, destruction, pollution) to our biodiversity endowment; and 7) to foster economic, political and social stability.

Forms of linkages

Researchers who have studied these phenomena have identified four major forms of linkages, based on global practices aimed at breaking down enclave features through LCRs. These are firstly the use of fiscal transfers. This entails mobilizing revenues through taxes and non-tax sources (sale of assets – land) from the oil and gas value chain (this will be discussed more fully later). It also includes capital spending by the state on beneficial activities, which the oil and gas sector qualify for; a good example is spending on infrastructure.

Secondly, there are spatial linkages. In the case of Guyana this would include government spending on items like, infrastructure, transport, communications, and ports. These enhance the geographic (spatial) integration of Guyana’s offshore, coastal, intermediate, and interior geographies and their economic cohesion.

Thirdly, there are linkages through knowledge development; for example, training in STEM (science, technology, engineering and math) and public spending dedicated to Research & Development, as well as Innovation (RDI).

Finally, inter-sectoral and inter-industry linkages are also advanced. There are both forward linkages (downstream value added activities like processing, services) and backward linkages (supplies of inputs to the sector, like consumables, services (accommodation, business-related), as well as other goods and services.

Next week I will elaborate on this discussion.