Time to reassess how provinces manage their natural resources
The policy consensus that has guided economic decision-making for decades is being challenged like never before. In a new series, the Financial Post explores the opportunities and unknown costs of the Great Rethink.
John Hartwick calls the economics rule that bears his name “boring,” even though it's been embraced by governments in places such as Norway, Chile, Kuwait and Botswana.
“There are a bunch of mathematical equations that fit together like a jigsaw puzzle. That's why economists consider it exciting,” said the emeritus professor of economics at Queen's University in Kingston, Ont.
The Hartwick Rule, published in 1977 in the American Economic Review with an assist from famed post-war economist Robert Solow, states that exhaustible natural resources such as oil should be replaced with a substitute asset when they are extracted or else a jurisdiction will erode its total net worth.
Norway has most famously followed the Hartwick Rule. As a result, it will confront whatever comes in the wake of the COVID -19 pandemic with a US$1-trillion sovereign wealth fund. But Gulf states such as Kuwait have hundreds of billions of dollars in reserves from oil wealth, effectively turning a physical asset into a financial asset.
Developing countries like Botswana and Chile, too, have established funds from diamond and copper mining. Even subnational governments, including Alaska and New Mexico, have seen fit to turn the proceeds from resource extraction and the sale of state land into portfolios that offer the prospect of continuous returns.
But in Hartwick's home country, the rule has largely been ignored.
“People don't invite me to the Rotary Club to talk about this stuff,” he said.
That could soon change. The coronavirus pandemic has blown holes in provincial budgets across the country, hitting provinces with large natural resource industries particularly hard. But Canada, blessed with both a sophisticated financial industry and vast supplies of natural resources, will have to finance the recovery phase of the COVID -19 crisis largely out of pocket, because a generation of decision-makers opted to maximize resource wealth in the present, rather than save it for future use.
There's a palpable sense of regret as finance ministers overhaul their budgets and reckon with credit downgrades, so it may be time to invite Hartwick out to talk about this stuff since there are growing calls to rethink how natural resource revenues and wealth are managed.
Much of the debate about managing resource wealth in Canada has focused on Alberta's failure to keep up with Norway's savings rate, much to the ire of Albertans, who point out the province is a subnational government, and one that makes major payments into the wider Confederation, while Norway is a sovereign and autonomous state.
Alberta's Heritage Savings Trust Fund was established under former premier Peter Lougheed, who ran the province from 1971 to 1985, and it exists today with about $17.2 billion in assets. But successive governments since his reign have scaled back contributions and, since 2008, Alberta has only added enough each year to ensure the principal isn't eroded by inflation and population growth.
Alberta Finance Minister Travis Toews said that, for now, Premier Jason Kenney's government will continue to use funds from natural resources to help correct a budget deficit that is projected to be $24.2 billion this year as a result of the pandemic, or 230-per-cent higher than its initial budget deficit estimate of $7.4 billion.
However, in a notable turn for the United Conservative government, Toews suggested new revenues could be back in play after previously resisting the idea of new taxes.
“We will be rolling out, basically, a budget reset in 2021,” he said.
“Once we have a definitive plan to balance the budget, and at the point we get there, that would be an appropriate time to be asking the question of whether we should be investing in the Heritage Fund or paying down debt.”
Toews also noted the province is reviewing its options for “additional fiscal capacity” and revenue sources to lessen its dependence on natural resource extraction.
“Down the road, we will need to be looking at our revenue structure and our tax structure and the Heritage Trust Fund and its relationship to non-renewable resource revenues,” he said.
Toews's situation might be a cautionary tale for other provinces.
None were blessed with Alberta's vast stores of both oil and natural gas, but several produce significant quantities of non-renewable natural resources of their own.
Currently, the only dedicated Canadian fund that's sharply growing is Quebec's Generations Fund, established to eliminate the province's debt.
The fund is projected to grow using revenues from hydroelectricity and mining to $11.7 billion by March 31, 2021, from $8.3 billion this year.
But British Columbia now produces a third of Canada's total natural gas output, and that proportion is growing. Saskatchewan is home to uranium extraction, potash mining and oil and gas. And Ontario and the territories produce significant quantities of copper, zinc, gold, diamonds and other minerals.
“We are not any different than Alberta,” said University of British Columbia Sauder School of Business professor Werner Antweiler, who counts environmental economics and resource management among his research interests. “When you point at Alberta, there are four fingers pointing back at your own jurisdiction.”
Former B.C. premier Christy Clark established the Prosperity Fund in 2013 with $100 million and intended to create a $100-billion reserve from the returns on liquefied natural gas (LNG) development. The fund earned $8 million last year and has not been built up even though B.C. wells produce more than five billion cubic feet of natural gas per day.
The temptation, always, with these funds is to use the money generated on political pet projects such as investing in the local economy, trying to spur economic diversification or building infrastructure.
B.C.'s government posted a $1.5-billion budget surplus in 2019, but Premier John Horgan chose to spend the excess funds on infrastructure rather than make a deposit into the Prosperity Fund. The province's natural resource revenues almost perfectly matched that budget surplus: not including forestry royalties, the province pulled in $1.4 billion in natural resource revenues that year.
Antweiler said there's a case to be made for using sovereign wealth funds to build infrastructure such as schools and universities in developing countries like Chile, but using those same funds in developed countries, where the need is arguably less, has had a checkered history of success.
“Governments aren't always effective in placing the money in the right spots,” he said. “The future wealth is disappearing because of incompetent management.”
Oddly, Canada's most disadvantaged communities follow the Hartwick Rule to the letter and, partly due to strict regulations, have turned physical assets into financial assets.
Laurence Booth, a professor of finance at the University of Toronto's Rotman School of Management, said the Indian Act requires that one asset be replaced with another, so bands have been forced to save their resource wealth and, in a frustrating exercise for many bands, ask the federal government before they're allowed to spend.
Jim Boucher, the former longtime chief of the Fort McKay First Nation in northern Alberta, said his community has been saving natural resource revenues as required in a trust, which has helped diversify the community's revenues and now generates $5 million per year.
“Our philosophy was that we never had a deficit because we couldn't rely on anybody to bail us out,” he said.
Asked whether it's frustrating that the provincial governments haven't followed the same strict rules, Boucher said Canadian provincial governments have a history of running deficits.
“We didn't want to be like the province,” he said.
Political calculus has been a driving factor in many resource-wealth decisions in Canada over the years, and that has led to some questionable decisions.
Jack Mintz, the University of Calgary economist who in 2007 chaired a savings panel for former Alberta premier Ed Stelmach on the Heritage Fund that suggested enlarging the fund to $100 billion by 2030, said the provincial government at the time was concerned that building up a huge fund would cause future federal governments to withhold funding for Alberta projects.
“Alberta was always shy about building up too large of a Heritage Fund because they were worried that it might become a target for the federal government,” said Mintz, adding that the experiences of several U.S. states suggest that Alberta's worry about federal pillaging was unfounded.
For example, New Mexico paid little mind to Washington when it set up its Land Grant Permanent Fund and Severance Tax Permanent Fund, which combined will pay out US$1.1 billion this year to finance new schools and hospitals.
As good as that sounds, in almost all cases, sovereign funds become the centre of heated debates about their effectiveness or the way they are managed.
“We have plenty of examples of sovereign wealth funds around the world, but we have few examples of success,” said Veljko Fotak, associate professor of finance at the University of Buffalo and an expert on sovereign wealth funds.
Fotak said funds have been established in some countries to save wealth for future generations, others for local economic development or diversification, and others to invest in infrastructure or to stabilize commodity price fluctuations. In each case, he said, it's not always clear how effective the funds have been in fulfilling their mandates.
Even on the basis of returns, he said most sovereign wealth funds are selective and biased in what they disclose.
The father of the Hartwick Rule has watched these debates about saving non-renewable natural resource revenues play out in Canada and beyond with some detachment.
“I'm kind of an armchair fiddler, so I don't get emotionally involved in these things,” Hartwick said.
Still, he has a theory now for why certain countries have been better at building up sovereign wealth funds with natural resource revenues than others.
Norway has such a small population relative to the size of its resource that “they've got the best of both worlds,” Hartwick said. “They've been able to assuage the current population by giving them baubles in the private sector and that's kind of an unusual case.”
That, he said, seems to be the key to a national or subnational government's success in following his rule: Can you save and spend at the same time?
Once we have a definitive plan to balance the budget, and at the point we get there, that would be an appropriate time to be asking the question of whether we should be investing in the Heritage Fund or paying down debt.