UEF Energy Law Review

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2 UEF Energy Law Review Managing Editors Eduardo G. Pereira Adjunct Professor of Energy Law UEF Law School Kaisa Huhta Doctoral Researcher in International and European Energy Law and Policy UEF Law School Advisory Board Andrew B. Derman, Senior Partner, Thompson & Knight LLP Angus Johnston, Professor of Law, University of Oxford Anna Ovcharova, Head of Offshore Projects Legal Support, Rosneft Carlos Bellorin, IHS Petroleum Analyst; Adjunct Law, Lecturer at SciencePo and Queen Mary University. Darío G. Lamanna, Professor, Universidad Viña del Mar (UVM); Legal Manager, CNP. Harry W. Sullivan, Adjunct Professor S.M.U. Dedman School of Law, Senior International Attorney, Assistant General Counsel Kosmos Energy Henrik Bjørnebye, Professor of Law, University of Oslo John B. Paterson, Professor of Law, University of Aberdeen José Alberto Bucheb, General Manager, University of Petrobras Kati Kulovesi, Professor of International Law, UEF Law School Tomás Lanardonne, Counsel/Manager of Neuquen Office, Perez Alati, Grondona, Benites, Arntsen & Martinez de Hoz UEF Energy Law Review is a peer-reviewed academic journal specialized in international and European energy and natural resources law. UEF Energy Law Review offers one issue per year. ISSN ii

3 Table of contents Regulatory and Contractual Challenges for Unconventional Resources: An International Perspective... 1 Eduardo Guedes Pereira, Leonie Reins, Leslie Zhang ( 张伟华 ), Hirdan Costa and James C. Nace, Jr. To what extent should a Host Government interfere in the drafting and conclusion of a Joint Operating Agreement? Tonje P. Gormley, Anna Ovcharova and Eduardo G. Pereira Legally Protecting Upstream Investments Martin Andrew Jarrett Governmental Participation in Upstream Projects: The Brazilian Pre-salt case Eduardo G. Pereira The Potential Impacts of a Construction Agreement Structure on a Bank Consortium s Collateral Package for a Project Loan Laura Huomo iii

4 Regulatory and Contractual Challenges for Unconventional Resources: An International Perspective 1 Introduction Eduardo Guedes Pereira, Leonie Reins, Leslie Zhang ( 张伟华 ), Hirdan Costa and James C. Nace, Jr. 1 The recent shale boom in the United States of America (USA) has brought about an unprecedented and unforeseen amount of job creation and economic impact while opening the door to a burgeoning international shale gas industry. Due to the growing success in the USA, other nations have been encouraged to assess the potential of their unconventional resources economically and to attempt to mirror the success that has enabled the USA to develop and benefit from its booming shale industry. To replicate the American success, however, countries and investors who were not initially part of the shale gas boom must make a lot of progress, especially considering the legal and social challenges in different jurisdictions. Although there has been some environmental opposition towards the exploitation of unconventional resources in the USA, it has brought along considerable benefits from political, strategic, employment, economic, and business points of view. 2 The USA s experience has encouraged unconventional resource exploration elsewhere in the world; however, it is unlikely that the same impact will be felt anywhere else due to the unique 1 Eduardo G Pereira is a Counsel at Morais Leitão, Galvão Teles, Soares da Silva ( and adjunct professor of energy law at the University of Eastern Finland and Reykjavik University. Dr. Pereira specialises in international petroleum law, contracts, business and regulations. Contact details: Dr. Leonie Reins is a Post Doctoral Research Fellow at the Department of International and European Law at KU Leuven in Belgium. Contact details: Leslie Zhang ( 张伟华 ) is an in-house counsel at China National Offshore Oil Corporation( CNOOC )and currently holds the position as the Director, Project Management Division, CNOOC Legal Dept. Contact details: or Hirdan Costa is a lawyer and a professor. She holds a PhD in sciences from the University of Sao Paulo and is a Visiting Professor at the Energy and Environment Institute, (IEE-USP). She has been working in the energy sector since Contact details: James C. Nace, Jr., is a partner at Albert, Neely & Kuhlmann, L.L.P. ( in Fort Worth, Texas. He is licensed to practice law in Texas, Pennsylvania, and West Virginia and is board certified in oil, gas and mineral law by the Texas Board of Legal Specialization. Contact details: Hirdan Costa would like to acknowledge the sponsorship of Fapesp and BG Brasil through the Research Centre for Gas Innovation, FAPESP Grant Proc. 2014/ , as well as gratefully acknowledge the support of the Institute of Energy and Environment, USP, and, Brazilian National Agency of Petroleum, Natural Gas and Biofuels ANP, without which the present study could not have been completed. Additionally, the authors would like to acknowledge the support of Livia Amorim, Yanal Abul Failat,Tomás Lanardonne and Igor de Souza Tostes for their support and contribution towards the conclusion of this paper. 2 U.S. Energy Information Administration, Natural Gas Overview, , available at (last accessed ) PWC, Shale Gas; A renaissance in US manufacturing, , available at (last accessed ). 1

5 way in which the USA s legal framework deals with the ownership of hydrocarbons, the amount of technical data and expertise, the availability of water reservoirs and resources, as well as the large variety of service providers in the country. 3 Any country keen to develop shale gas or foster any other unconventional activities is confronted with the challenge of how to attract foreign and/or local investors willing to take the risk to find and develop unconventional sources and to address the expectations and concerns of the local community. The importance of the second stipulation can be seen in the examples of France and Bulgaria, the governments of which imposed a permanent ban on shale gas activities or the UK, where the government imposed a temporary ban until In order to encourage both the investors and to achieve consensus from the local communities, incentives are required from the relevant host governments, who, outside North America, will generally hold ownership rights over the natural resources. Many countries are debating the development of unconventional resources but few seem to have progressed far enough to provide incentives for potential investors and local communities. 5 One of these exceptions is England 6 where the oil industry, as the UK Onshore Operators Group (UKOOG), has produced a Community Engagement Charter committing the industry to engage with local people, residents and other stakeholders. This paper aims to briefly outline the legal frameworks relevant to the global rise of the shale gas sector 7 and highlight the concerns of the various stakeholders in shale gas exploratory activities in order to understand the best practices and experiences which have been established by different jurisdictions. First, section 2 will provide an overview of estimated reserves in the USA, UK, China, Argentina and Brazil. Section 3 will then discuss the background and development of the shale gas industry in these selected countries. Section 4 will examine the contractual and regulatory challenges facing shale gas extraction. Finally, Section 5 presents the conclusion of the paper. 8 2 Reserves and Estimates In the oil and gas industry, there are significant differences between a potential reserve, a probable reserve and a proven reserve. 9 3 U.S. Energy Information Administration, World Shale Resource Assessments, , available at (last accessed ). 4 Ibid. 5 Ibid. Maican, Ovidiu Horia, Legal Regime of Shale Gas Extraction, , available at: (accessed ). 6 The comments do not include Scotland, Wales or Northern Ireland, where the exploitation of onshore hydrocarbons is a matter devolved to the respective governments. 7 See U.S. Energy Information Administration, supra, note 3. 8 Although environmental challenges are one of the key issues for any unconventional development, they will not be directly addressed in this article although a variety of environmental concerns and regulations will be touched upon. 9 SPE International, SPE Petroleum Resources Management System Guide for Non-Technical Users, , available at (last accessed ). 2

6 In order to secure and confirm the existence of an oil and gas reserve, large investment is an initial requirement. 10 Without these investments, no exploration activities can occur. Securing a large amount of probable reserves is one of the key steps to creating an attractive environment for investors. 11 Figure 1. Assessed Shale Gas and Shale Oil Basins of the World 12 Many countries have already assessed their potential reserves for unconventional resources. In the following, the reserves and estimates in the USA, UK, China, Argentina and Brazil are examined. 10 UK Government, New direction for UK energy policy, 2015, available at (last accessed ). The Northern Oil and Gas Directorate and Department of Indian Affairs and Northern Development, Oil and gas in Canada's North, , available at (last accessed ). Beckman, J Frontier exploration, pipelay dominate activity in northern Europe, , available at 50/international-e_p/frontier-exploration.html (last accessed ). 11 For further information see David Johnston and Daniel Johnston, Introduction to Oil Company Financial Analysis (PenWell, Tulsa 2006), Daniel Johnston, International Exploration Economics, Risk, and Contract Analysis (PenWell, Tulsa 2003), Robert C. Nicholls, A Review of Some Aspects of the Organization and Financing of Mineral Resource Ventures, 1 U.N.S.W. Law Journal (1976), U.S. Energy Information Administration/U.S. Department of Energy. EIA/ARI, World Shale Gas and Shale Oil Resource Assessment. Technically Recoverable Shale Gas and Shale Oil Resources: An Assessment of 137 Shale Formations in 41 Countries Outside the United States, , available at (last accessed ). 3

7 2.1 USA The USA is currently ranked fourth in the world with 665 trillion cubic feet (Tcf) of technically recoverable shale gas reserves. 13 The production of shale gas has increased in the United States from 300 million cubic feet in 2000 to 9.6 Tcf in 2012, to 11.3 Tcf in 2013, which amounted to 47% of the country s overall natural gas production that year. 14 One of the main differences in the US is the amount of information available in contrast with other countries around the world. 15 Thousands of wells have been drilled in recent decades. 16 In this sense, it is easier to make more accurate estimations about unconventional resources in the US than in most jurisdictions. 2.2 UK Estimating shale gas and oil reserves in the United Kingdom (UK), or in any other EU member state, however, is difficult and often inaccurate due to the low number of shale wells drilled. 17 In 2013, the US Energy Information Administration (EIA) estimated that the country s technically recoverable shale oil reserves were equivalent to 700 million barrels and the shale gas reserves to 26 Tcf. 18 On the other hand, the British Geological Survey (BGS) estimated that there could be around 1300 Tcf of shale gas just in the Bowland-Shale area located in central England. 19 In order to explore this area sufficiently and assess the market feasibility of the resources, around wells would need to be drilled in a timespan of three years. 20 The uncertainty related to the quantity of available resources is a central barrier to shale gas development in the UK China According to the IEA statistics, China is one of the most resourceful countries in the world in terms of shale gas reserves. 22 The volume of technically recoverable shale gas in China has been estimated at million Tcf. The production of shale gas of China in 2015 is estimated to reach Bcf, according to the Twelfth Five-year Plan ( ) by the National 13 See U.S. Energy Information Administration, supra, note US Energy Information Administration, Annual Energy Outlook With Projections to 2040, 2015, available at (last accessed ). 15 U.S. Energy Information Administration, Drilling Productivity Report, , available at (last accessed ). 16 Ibid. 17 Oliva, Pol, Costa, Hirdan K M, and Moutinho dos Santos, Edmilson, Barriers to shale gas development in Europe, , Article presented at Shale Gas Seminar, Institute of Energy and Environment, University of Sao Paulo, Sao Paulo, Brazil, available at (last accessed ). 18 U.S. Energy Information Administration, supra, note Andrews, I. J, The Carboniferous Bowland Shale gas study: geology and resource estimation, , British Geological Survey for Department of Energy and Climate Change, London, UK, available at dshalegasreport_main_report.pdf (last accessed ). 20 Ibid. 21 U.S. Energy Information, supra, note U.S. Energy Information Administration, supra, note 3. 4

8 Energy Administration. 23 It is fair to say that the Chinese shale gas industry is currently in its infancy. However, with governmental support and the influx of various investments, the shale gas industry in China is facing a quick development in the coming years. Between 2005 and 2014, the capital invested in shale gas exploration in China hit USD 4 billion and the number of wells drilled amounted to more than The annual target production volume of shale gas in China 2025 stands at more than 1.05 Tcf, which sets a challenging goal. 2.4 Argentina Estimates of technically recoverable shale gas resources in Argentina are the second highest in the world. 25 Because of the expected large but as yet unproven and unmeasured reserves of shale gas, the Los Molles and Vaca Muerta formations in the Neuquén Basin are the most important ones in Argentina. 26 According to KPMG (2014), estimated reserves of shale gas in Vaca Muerta are 1,140 Tcf and Los Molles are 1,044 Tcf, out of which technically recoverable resources are estimated at Tcf. 27 These estimated reserves of shale gas represent, in turn, approximately 49 times the proven reserves of conventional gas in Argentina. 28 Therefore, the reserves in Vaca Muerta represent 35% of Argentinean shale gas resources. It is the most promising area and is experiencing a rapid development, with around 240 wells drilled by the end of However, it should be noted that the vast majority of wells drilled so far have been mainly to search for oil and not natural gas. This does not respond to local energy needs, given that the largest deficit occurs in the supply of natural gas. 30 This problem could be overcome through incentive programs for gas production, or expanding programs such as the programme for stimulating the additional injection of natural gas, created by Resolution 1/2013 which has recently managed to mitigate the decline in domestic gas production National Development and Reform Commission, the Twelfth Five-year Plan, , available at (last accessed ). 24 China Geological Survey Bureau, The report on Chinese shale gas resources, , available at (last accessed ). 25 Oliva, Pol, Costa, Hirdan K M, and Moutinho dos Santos, Edmilson, supra, note KPMG, Economic study on conventional resources, shale oil & gas in Argentina: current situation and prospects, , available at (last accessed ). 27 I.e. applying a recovery factor of 27 %. KPMG, Economic study on conventional resources, shale oil & gas in Argentina: current situation and prospects, , available at (last accessed ). 28 Berkenwald, Mariano, Costa, Hirdan Katarina de M., Santos, Edmilson Moutinho dos, Shale prospects in Argentina: potential and barriers to the development of unconventional, 2015, Article presented in Energy Outlook in Latin America and the Caribbean: Challenges, Constraints and Opportunities, 5th ELAEE/IAEE Latin American Conference, Medellin, Colombia, Online Conference Proceedings Database, available at %20the%20Caribbean:%20Challenges,%20Counstraints%20and%20Opportunities (last accessed ). 29 Navazo, Christian, Inversiones. US$ millones para Vaca Muerta, , available at _ (last accessed ). 30 KPMG, supra, note Ibid. 5

9 2.5 Brazil In Brazil, the scenario is similar to the UK, China and Argentina. The shale industry is fairly young and the amount of data is quite limited. However, the National Agency of Petroleum, Natural Gas and Biofuels (ANP) has estimated the potential unconventional reserves in some Brazilian sedimentary basins. They have stated that the potential of the Parnaiba basin is 64 Tcf, 32 Parecis basin is 124 Tcf, Reconcavo is 20 Tcf, and San Francisco is 80 Tcf. 33 According to the ANP estimates, Brazilian reserves of unconventional gas in onshore basins may be higher than the volumes of natural gas reserves existing in the fields of the pre-salt Santos Basin. 34 According to the EIA, the estimated recoverable unconventional gas resource (shale gas) is around Tcf Background and Development of the Shale Industry Unconventional operations broadly defined as those for tight oil and gas found in lowpermeability rock and shale gas in particular are not a novelty in the energy sector. Hydraulic fracturing operations, a process that uses a high-pressure fluid (typically consisting of water, sand, and various additives) to create factures in underground rock formations have been commercially conducted since the 1940s. 36 The primary new aspect to operations is hydraulic fracturing combined with a horizontal drilling technique into shale formations that were previously-thought not to be commercially recoverable and the scale of the operations in the USA. 37 Many other jurisdictions are trying to replicate the USA s success. The sections below will explain the brief development of the shale industry within the USA, UK, China, Argentina and Brazil. 3.1 USA Even though hydraulic fracturing had been used in the United States since the 1940s to produce oil and gas primarily from vertical wells it was not until the 1980s and 1990s when Mitchell Energy decided to try the practice in the Barnett Shale, a low-permeability formation underlying Fort Worth, Texas, and the surrounding communities, that shale gas became commercially profitable. 38 Other companies jumped on the bandwagon, combining the method with horizontal drilling techniques, until at one point the Barnett Shale 32 Each TCF unit is equivalent to approximately 28,3 billion m 3 of gas. 33 ANP s estimation is based on a survey regarding the Barnett field in Texas, where Energy Information Administration shows that Barnett has a potential of 30 trillion cubic feet (Tcf) of gas to 1,196 cubic km of rock. Chambriard, Magda, General Director of ANP, Opportunities for Investments in the Brazilian Oil & Gas Industry & 1st Pre-salt Round, , available at (last accessed ). 34 Ibid. 35 U.S. Energy Information Administration, Technically Recoverable Shale Oil and Shale Gas Resources, , available at (last accessed ). 36 Thomas E. Kurth et al., American Law and Jurisprudence of Fracking, 277(47) Rocking Mountain Min. L. Found. J. (2010). 37 Ibid. 38 For an overview of the key drivers for shale gas in the various states and why certain states have high levels of shale gas development refer to O. Schenk et al., Unconventional Gas Development in the U.S. States: Exploring the Variation 5(4) European Journal of Risk Regulation (2014),

10 accounted for 70% of all US gas shale production. 39 These methods were quickly applied to other shale plays, including the Eagle Ford Shale in south Texas, the Bakken Shale in North Dakota and Montana, the Marcellus Shale in Pennsylvania, Ohio, West Virginia, and New York, the Permian Shale in west Texas, and others. The US is consequently the biggest producer of shale gas by volume, having extracted 13.4 Tcf in 2014 alone. 40 In total, over 100,000 wells were registered in the United States as of January Although shale gas extraction has significantly lowered natural gas prices and created many jobs in the drilling areas, these activities also face public opposition from certain special interest groups, various landowners, and some state and local jurisdictions. This opposition, however, is not comparable to other countries due to the legal framework of private resource ownership in the United States. 3.2 UK UK s shale gas exploration has been active since the 1950s, approximately 200 wells both onshore and offshore have been hydraulically fractured since then. 42 Currently, there are around 120 producing sites, which corresponds to 20,000 barrels of oil per day or about 1% of the UK s consumption. 43 It is important to note that hydraulic fracturing in the UK has been the subject of much public concern. A consequence of this reticence to operations caused a temporary moratorium, which existed from the spring of 2011 until the end of 2012, after seismic events occurred at a drilling site at Preese Hall near Blackpool. After carrying out geomechanical studies and a public consultation, 44 a detailed seismic monitoring system was put into place and the moratorium was lifted in December Scotland and most recently Northern Ireland have also introduced a moratorium on fracturing. Several test drillings have taken place to date. 46 Northern Ireland issued a controversial moratorium on hydraulic activities in September The Strategic Planning Policy Statement for Northern Ireland (SPPS) states that in relation to unconventional 39 Oil and Gas Journal, Barnet Shale, 2016, available at: (last accessed ). 40 U.S. Energy Information Administration, Natural Gas - Shale Gas Production, , available at (last accessed ). 41 FracFocus, Total Well Sites Registered, 2016, available at (last accessed ). 42 UKOOG - UK Onshore Operators Group. Fact Sheet: The History of Onshore Oil and Gas, , available at (last accessed ). 43 Ibid. 44 E. White, M. Fell, L. Smith, M. Keep, Shale gas and fracking (House of Commons Library, Briefing Paper SN06073, 2015). 45 DECC, Written Ministerial Statement by Edward Davey: Exploration for shale gas available at (last accessed ). 46 For a timeline for UK development of shale gas, see DECC, Facts about fracking, available at e_shale_gas_and_oil Facts_about_Fracking_ pdf (last accessed ), at 7. 7

11 hydrocarbon extraction there should be a presumption against their exploitation until there is sufficient and robust evidence on all environmental impacts. 47 Other than Poland, the UK is one of the few EU Member States with a very proactive attitude towards shale gas, having introduced several government programs promoting this activity 48 even though shale gas in the UK is still in the exploration stage China In comparison with the long history of the shale gas industry in North America, China is still very much in the preliminary stages of developing the shale gas industry. China only began exploration activities in 2005, and did not start to make substantial and noticeable improvements on shale gas exploration activities until between 2008 and The petroleum industry in China classifies its activities in shale gas into three specific stages: the first stage, from 2005 to 2010, is called the study phase in which the Chinese government initiated the official shale gas development study; 2. the second stage, from 2010 to 2015, is called the industrial experience phase in which the shale gas industry entered into an experimental stage with a higher Chinese governmental support; 3. the third stage began in 2015, and is referred to as the massive production phase in which China plans to produce its shale gas on a large scale. As China is implementing an aggressive strategy to develop its abundant shale gas resources, the Chinese shale gas industry 52 is now attracting more attention from various 47 NI Department of the Environment, Strategic Planning Policy Statement for Northern Ireland (SPPS) - Planning for Sustainable Development, 2015, at Petroff, A. U.K. plans big tax breaks for shale gas CCN Money, , available at (last accessed ), and OGJEditors: Tippee, Bob et al., UK outlines proposed tax break for shale gas, Oil&Gas Journal, , available at (last accessed ). Also see: UK Government, Coal Authority, Department of Energy & Climate Change, Environment Agency, Health and Safety Executive, and Office of Gas and Electricity Markets (Ofgem), Policy paper to 2015 government policy: energy industry and infrastructure licensing and regulation`, , available at: (last accessed ). 49 For an overview of the licenses granted, see Oil & Gas Authority, Petroleum Act 1998 Onshore Licensing`, ,, (last accessed ). 50 According to Fuyarong, The current situation and forward-looking in Chinese shale gas industry, Petroleum Geology and Engineering, November 2013, the shale gas discovery made in 1996 raised the attention of Chinese petroleum industry but no detailed and systematic geophysical studies or operations were conducted until Gongxiaoli, The shale gas developments in China, China Science Paper, , available at (last accessed ). 52 Chinese government now classifies the shale gas as an independent mining category. In this regards, the Ministry of Land and Resources is authorized to open the shale gas industry to various investors. 8

12 investors. 53 With the specific purpose of encouraging competition, the shale gas industry in China has become available to privately owned enterprises (hereinafter POEs) and International Oil Companies (hereinafter IOCs) 54 since the 2nd bidding process in This is marked a change, as previously all oil and gas licenses in the Chinese upstream sector had been granted to Chinese National Oil Companies. 56 POEs did not have the option to participate in the exploration, development and production of oil and gas fields within the Chinese territory and IOCs could only participate in the upstream sector by executing Production Sharing Contracts (hereinafter PSCs) with Chinese National Oil Companies. With this new policy in place, one hurdle for investing in the shale gas industry in China has been removed for private investors and involvement of IOCs and more capital flux into the shale gas industry can be expected Argentina The first informal description of the Vaca Muerta Formation can be attributed to Bodenbender, who in 1892 announced the existence of bituminous shales in the Salado river valley in southern Mendoza, Argentina. 58 According to the EIA, 59 drilling and production testing is already underway in the Neuquen Basin, where the area of the Vaca Muerta Formation have been evaluated at depths of between 6,000 and 11,000 ft. Including figures for earlier Repsol operated wells, Yacimientos Petrolíferos Fiscales (YPF) drilled 37 Vaca Muerta wells throughout To assist the above-mentioned developments, a new Hydrocarbons Law was enacted in late October This law, presented as an instrument for recovering energy self-sufficiency, 53 According to the notice to further strengthen the exploration and exploitation with supervision and management in the shale gas resources released by Ministry of Land and resources of the People s republic of China, all kinds of investors meeting the threshold are encouraged to make investments in the shale gas industry and the relevant statistics in the shale gas bidding indicate more investors pouring into shale gas industry. 54 Pursuant to Chinese regulatory directives, an IOC which is willing to participate in the shale gas industry shall form a Joint Venture with its majority shareholding owned by a Chinese domestic partner. 55 For the qualification requirements and outcomes in Chinese 2nd shale gas bidding process, see the qualification files by the Ministry of Land and Resources, , available at (last accessed ). 56 Chinese mineral resources law provides that the extraction of conventional oil and gas shall be approved by the state counsel, which, in practice, means that only the state owned petroleum companies can be granted the oil and gas licenses (conventional sector). 57 See National Development and Reform Commission, supra, note Leanza, Héctor A., The Vaca Muerta Formation (Late Jurassic Early Cretaceous): History, Stratigraphic Context and Events of this Emblematic Unit of the Neuquén Basin, Argentina, available at (last accessed ). 59 U.S. Energy Information Administration, Technically Recoverable Shale Oil and Shale Gas Resources: Argentina, , available at (last accessed ). 60 A National Oil Company (NOC), Yacimientos Petrolíferos Fiscales (YPF) is an Argentine corporation named YPF SOCIEDAD ANÓNIM and located in the City of Buenos Aires, Republic of Argentina. For more details, see Yacimientos Petrolíferos Fiscales, Corporate governance-by laws of YPF sociedad anónima, , available at (last accessed ). 9

13 was designed to develop the unconventional activities. The details of this innovation will be discussed in the next sections. 3.5 Brazil The Brazilian government made the decision to expand the reserves and develop production of natural gas from unconventional resources during the 12th Bidding Round of Exploratory Blocks. It was a continuation of shale activities, as some pioneer companies had been conducting unconventional activities in the previous decade. 61 This bidding round focused on onshore areas favourable to natural gas accumulations. 62 ANP offered 240 onshore areas, located in the states of Amazonas, Acre, Tocantins, Alagoas, Sergipe, Piaui, Mato Grosso, Goiás, Bahia, Maranhão, Paraná and São Paulo. At the final result, ANP had managed to auction off 72 blocks. 63 However, a few months after the 12th Bidding Round, several public civil actions were triggered in order to prevent the use of the hydraulic fracturing technique in blocks acquired in the aforementioned auction. This will be further discussed in section In a nutshell, the lawsuits that followed have highlighted the environmental risks that the use of this technique in unconventional reservoirs could represent to underground water. These lawsuits have argued that the activity in question merits further feasibility analysis, with previous technical evaluation of sedimentary basins, as well as regulation by the National Environmental Council. 65 Sarney Filho, a Brazilian Congressman, has furthermore proposed the Bill of law, n /2013, that may suspend the hydraulic fracturing for a period of five years while there is no clear definition of risks brought about by development of these activities. 66 Therefore, unconventional resources in Brazil are currently not a subject of the similar incentives and support schemes that exist in other jurisdictions. 4 Contractual and Regulatory Challenges for Shale Gas Extraction The following section will establish four challenges that need to be overcome in order for an unconventional exploration activity to succeed. The first sub-section deals with host government contracts. The second sub-section explains the relevance of the ownership of resources. The third sub-section addresses the importance of community support. The final sub-sections cover the investment climate. These are legal and operational obstacles that investors and governments involved in the exploitation of unconventional hydrocarbons typically face. These are also issues that the key stakeholders should 61 Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, Pre-Bidding Notice For The Granting Of Concession Contracts For Activities Of Exploration And Production Of Oil And Natural Gas, , available at (last accessed ). 62 Ibid. 63 Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, Results of 12 th Bidding Round, , available at (last accessed ). 64 Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, Signature of Concession Agreements, , available at (last accessed ). 65 Ibid. 66 Sarney Filho, Jose, Bill of law n /2013, , available at (last accessed ). 10

14 consider before investing in exploratory activities. Furthermore, these are the key issues any country must consider if they intend to achieve similar results as the USA. 4.1 Host Government Contracts The business structures for unconventional hydrocarbon investments are often different to those for conventional hydrocarbons. 67 This rationale is based on the fact that for a conventional oil and gas operation the reservoir has a known depletion cycle and a fairly precise location which allows companies to project their costs and profits and additionally relinquish the remaining of the block to the government (i.e. area outside the development/production field). 68 In the context of a shale gas or other unconventional operation, the precise definition of the reservoir is far less certain and the business model is different, as many more wells, often speculatively planned, will be required to develop and fracture in the relevant areas. 69 These differences require changes in the common provisions in many host government contracts, such as the obligation to relinquish a certain amount of areas and an altered minimal work program. This is particularly important as, whilst an appraisal period is usually short, the drilling of numerous shale gas wells may require up to 50 years. 70 Although shale gas and other unconventional resources have peculiarities away from conventional development, few countries have addressed these concerns in their relevant laws and contracts. 71 Addressing these concerns is a basic requirement for any investor as the legal regime needs to be able to support the related investments. Currently, however, these needs are not met by laws and host government contracts, as will be described below USA The United States is unique in that in situ hydrocarbons (and most other minerals) are generally privately owned vested in the owner of the land on which those reserves are located unless a complete mineral severance has occurred, in which case an individual or corporation may own the minerals underlying another s land and not in the state, as is the case most everywhere else in the world. Notable exceptions exist, of course: the US government owns the hydrocarbons underlying federal lands, and individual states often own the minerals under rivers, lakes, public roads, and other lands set aside for public use 67 Boykett, Tim; Peirano, Marta; Boria, Simone; Kelley, Heather; Schimana, Elisabeth; Dekrout, Andreas, Oil contracts: how to read and understand a Petroleum Contract, Open Oil Net, 2012, available at: pdf (last accessed ). 68 See SPE International, supra, note Chopra, Satinder Sharma, Ritesh K., Keay, James and Marfurt, Kurt J. Shale gas reservoir characterization workflows, 2012, available at DOI (last accessed ). 70 Humphrey Douglas, Shale: a Guide to Tailoring Legislation, SPAs, Farm-in Agreements and JOAs in Developing Unconventional Basins, 6 IELR (2014), See U.S. Energy Information Administration, supra, notes 2 and For example, Brazil, Algeria and Colombia. 11

15 or by the legislature specifically to produce income from mineral extraction (Alaska and Texas, for example, own tens, if not hundreds, of thousands of mineral acres). In contrast to other jurisdictions around the world, however, oil and gas development has been conducted extensively on private property, as private owners have a direct interest in producing their resources. This simple fact encourages more private enterprise in the US hydrocarbon sector than any other place in onshore basins. Generally, in order to develop hydrocarbons, individual leases are signed between landowners and oil and gas companies. These private arrangements are typically individually negotiated and are therefore subject to flexible terms and conditions including, but not limited to, duration (usually including a 1-5 year primary term during which the lessee may drill a well and extending as long thereafter as oil and/or gas is produced therefrom in paying quantities), bonus consideration and royalties to be paid to the lessor (these vary greatly by geographic location, often a sizeable one-time upfront payment on a per acre basis as well as 1/8 1/4 of total production once it is realized), relinquishment, development programs, surface use and restoration, pooling and unitization, environmental impact and remediation, and indemnities. Lease bonus, royalty, and other payments vary greatly and are dependent on geographic location, how proven the area is, landowner sophistication, the price of oil and gas, and the amount of local leasing competition. During the peak of the Barnett Shale boom, bonuses reached $25,000 an acre and royalty rates were normally 1/4 of total production, free of cost; today, however, bonuses per acre across the country typically vary from $500-$5000 per acre and the royalties paid range from 1/8 1/4 of production, all depending on the above factors. In addition to these privatelynegotiated leases, oil and gas leases may also be taken on state-owned lands but are typically made on officially-promulgated forms and pursuant to a notice and bid procedure. After an oil and gas company has obtained leases on a significant number of acres (anywhere between 40 and 1,000 contiguous acres depending on the geology and geography of the particular play), it will form pooled units in order to more efficiently and economically produce hydrocarbons from a large area with minimal environmental impact by drilling wells from a single surface location capable of producing from the entire pool. Nevertheless, a public law dimension is still in play with regards to the exploitation of such resources in the form of environmental and health and safety legislation. At the federal level, various activities related to hydraulic fracturing fall under and are impacted by the Safe Drinking Water Act 73, the Clean Water Act 74, and the Endangered Species Act 75. Most regulation, however, falls to the state and local level. State regulation, where it exists, typically preempts rules promulgated at the county or municipal levels. In Texas, for example, the Railroad Commission (originally established in 1891 to regulate the railroad industry but now tasked with regulating the oil and gas industry, gas utilities, pipelines, and surface coal and uranium mining) through its Oil and Gas Division is statutorily tasked with preventing waste of the state's natural resources, protecting the correlative rights of different interest owners, preventing pollution, and providing safety in matters such as U.S.C. 300f et seq C.F.R (b)(1) U.S.C

16 hydrogen sulfide. 76 To achieve these goals, the Commission establishes, among other things, rules relating to pooled unit sizes, density and proration (preventing well clustering and regulating production allowables how much oil or gas can be produced from a particular well and field), spacing and setbacks (the distance a well must be from a lease or property line), and permitting and reporting requirements. Additionally, the agency conducts field inspections, testing programs, and monitoring industry activities in the field, and it has established programs to remediate abandoned wells and sites through the use of fees and taxes paid by the industry. 77 The Commission is headed by three Commissioners who are elected to six-year overlapping terms. As a result, the Commission has historically been adept at balancing state and industry interests with those of individual landowners and community members, who make up the electorate. This legal system differs from the majority of jurisdictions outside the USA. Elsewhere, a typical host government contract should and will consider the expectations of local communities, a variety of industry segments, stakeholders and competitors. Changes to relevant law and host government contracts tend to be far more difficult to implement outside of North America. These other jurisdictions face many more challenges when implementing a successful shale gas or unconventional resource industry, as the influence of private individuals and entities is not present in the same manner as in the USA UK Under the Petroleum Act 1998, hydrocarbon property is vested in the Crown. 78 Thus, in order to develop oil and gas operations, a potential investor must first obtain a Petroleum and Development Licence ( PEDL ), 79 granted via competitive auctions. In 2014, the UK s government carried out the 14 th licensing round, which covered exploration for both conventional and unconventional oil and gas. 80 Potential investors must have financial standing and technical competence as well as the appropriate insurance coverage. 81 It is important to note that in the licence itself there are no contractual changes to address unconventional developments in comparison to the licence for conventional resources Railroad Commission of Texas, Oil & Gas, 2016, available at (last accessed ). 77 Ibid. 78 UKOOG - UK Onshore Operators Group Fact Sheet: The History of Onshore Oil and Gas, , available at (last accessed ). 79 The Petroleum Act 1998, s DECC, Preparing for the 14th Round of Onshore Oil and Gas Licenses, , available at blog.decc.gov.uk/2013/12/17/preparing-for-the-14th-round-of-onshore-oil-and-gas-licences (last accessed ). 81 Ibid. 82 Ibid. 13

17 4.1.3 China In the conventional oil and gas industry, 83 the Chinese government habitually grants exploration licences to the National Oil Companies and will further grant them the exploitation permits in the event any commercial discoveries are made. Chinese Oil companies must either be approved by the State Council or be deemed qualified by the State Council to extract oil and gas (traditionally, oil and gas was deemed to include the conventional petroleum only) in order to apply for the exploration licences and/or exploration permits. 84 This was strictly recorded in a decree issued by the State Council and any revision hereto is subject to the central government s decision. To circumvent these legal obstacles in the said decree, the only way was to make unconventional resources a separate Mining category. Hence, the approval from State Council shall not apply. The Chinese government adopted a strategy to circumvent any known legal obstacles as explained above by organising the shale gas industry as an independent mining category from conventional oil and gas. 85 Because of this strategy, any Chinese companies which are willing to enter into the shale gas industry do not need to obtain an approval of their qualification from the State Counsel. Originally, the Chinese government had not planned to grant the exploration licences directly to the investors in the shale gas industry but rather to enter into an assignment contract. In the original plan, the terms of the assignment contract were roughly similar to the fiscal regime under a PSC in conventional petroleum 86, typically used between Chinese National Oil Companies and foreign investors. The Ministry of Land and Resources originally planned to have the assignment contract to provide standard clauses such as the term, the relinquishment requirement, the minimum work obligation (MWO), the penalty by failing to satisfy the MWO and other customary clauses. In the government s original plan, all the contractual terms were similar to those which are characteristically employed in a PSC. 87 The Chinese government realized that there were no special provisions that would address the shale gas peculiarities in the assignment contract. Due to this, and the lack of experiences in developing such model contracts, it decided to abolish the approach and to award licenses to the investors instead. 88 In the view of Chinese government, shale gas industry is quite new in China and a standard assignment contract requires more time to develop. Unlike the cancelled assignment contract, the production sharing contracts used in conventional petroleum 83 Based on the interpretation of Chinese Mneral Resources Law, the tight gas and Coal Bed Methane (CBM), which are classified as independent mineral category, do not belong to the conventional oil and gas sector. In order to separate the shale gas from the conventional oil and gas sector, the government has first recognized the shale gas as an independent mineral category to circumvent the legal obstacles. 84 See article 16, Chinese Mineral Resources Law, promulgated by the NPC Standing Committee, on 19 March, 1986 as amended on 29 August, See Chinese Mineral Resources Law, supra, note This plan was not crystallized in the end. 87 This approach is abandoned eventually due to some practical consideration and Chinese government has not yet decided whether to adopt a PSC-like contract in shale gas industry with all kinds of investors. 88 As explained, the investors which are entitled to hold the exploration licenses in the shale gas industry include Chinese investors and foreign investors (by forming joint ventures with Chinese investors). 14

18 industry by the IOCs and Chinese National Oil Companies are quite sophisticated and welldeveloped after 30 years of cooperation. 89 In reality, however, the Chinese government adopted a more aggressive approach in the shale gas industry (which is classified as a different category from the conventional oil and gas), in deciding to directly grant the investors the exploration licences concerning shale gas with receipt from the investor of an agreement to complete the MWO. 90 To further simplify the documentation, the investors only need to submit a letter of undertaking (without entering into any agreements) to the Ministry of Land and Resources in which the term, work obligations penalties for fulfillment of work obligations, and relinquishment obligations are provided in such letter of undertaking. 91 Based on the letter of undertaking submitted by the investors, the Chinese government granted relevant exploration licenses to the investors. There are no special terms accommodating the shale gas operations provided in the letter of undertaking submitted by the investor or the exploration licenses. Given the commercial emergence of new bidding blocks, there will continue to be negotiations between the government and the investors on the detailed terms on allocation of the production, taxes and other customarily used terms The approach shows that the Chinese regulatory framework in the shale gas industry is still at a preliminary stage and that the uncertainties still remain to be observed. Simultaneously, this is the first time that the investors can directly obtain the exploration licences from the Chinese government and the revolutionary government stance on this issue reflects the incentive policy for the investors in the shale gas industry. The Chinese government is currently planning to launch the 3 rd shale gas bidding round and the competitive bidding scheme is under preparation Argentina Argentina s provinces are the enforcement authority of the hydrocarbon legislation. 92 Moreover, these provinces have retained the power to regulate the extractive process, and furthermore have organised the auctions that result into awarded concessions. 93 The federal government is responsible for the definition of the energy strategy and for making general laws in order to regulate overall aspects of the relationship between shale gas investors and to address environment constraints. 94 Law /2007 made a significant amendment to the Argentinean Law 17,319 (the Hydrocarbons Law ). Article 29 of Hydrocarbons Law now states that it will consider the 89 In China, the current laws and regulations allow the NOCs only to hold licenses/permits in the conventional petroleum sector. The restriction is a key factor to understand the regulatory arrangements in the shale gas industry. 90 In addition to the letter of undertaking submitted by the investors, the government further requests a performance bonds issued by the investors ultimate shareholders or appropriate entities. 91 The investors who won the bidding submitted an undertaking which contained their work commitments and expenses commitment to the government. 92 See Berkenwald, Mariano, Costa, Hirdan Katarina de M., Santos, Edmilson Moutinho dos, supra, note Ibid. 94 Ibid. 15

19 terms and conditions applicable to tenders, including among others, the guarantees to be met by the bids, the scope of investments and the income that could possibly correspond to the respective authorities Licensors. 95 According to Lanardonne and Aguirre the, main goal of Law is to improve the overall investment conditions of the Argentine oil and gas industry by adopting measures, such as (i) extending exploration and production time limits and its extensions, (ii) creating a special type of Concession for unconventional hydrocarbon projects, (iii) capping royalties and other government takes, (iv) reducing government take in special types of projects, (v) reinstating the right to export a percentage of oil and gas production at zero export taxes, while maintaining abroad the export proceeds, among other benefits. 96 Thus, in order to create an investor-friendly environment, a new type of concession has been created with an extended term of 35 years. The first five years of an Unconventional Exploitation Concession (UEC) may be allocated to a project plan in accordance with acceptable technical and economic criteria, and is referred to as the Pilot Project, to determine the commerciality of the field. This type of concession can be accessed by any company that holds an exploration permit and/or conventional exploitation concession Brazil Brazil has followed a similar route to Argentina. The Brazilian authorities have adjusted their concession model to address some of the concerns related to unconventional resources. Firstly, it includes relevant definitions regarding additional time for the exploration phase and the evaluation plan. 98 Secondly, it adjusts the relinquishment provision on a case by case basis. 99 In the case of ANP, it certifies a discovery of unconventional resources and approves the non-conventional resources exploration and evaluation plan; moreover, the concessionaire will not be obliged to return areas during the extended exploration phase. 100 Thirdly, it requires further qualification from the companies who intend to conduct shale gas operations. To give an example, the company has the obligation to submit documentation required in the tender protocol which proves that, for the economic and financial qualification, the minimum net asset required shall be the amount stipulated in the Tender Protocol Lanardonne, Tomás, Aguirre, Juan Ignacio, Argentina: Amendment of the Hydrocarbons Law, , available at (last accessed ). 96 Ibid. 97 Pilot Project is a project plan that in accordance with acceptable technical and economic criteria, is intended to determine the commercial exploitation of the field. It is unclear however whether making an application for a Pilot Project results in a concessionaire assuming a firm investment commitment (such as the exploration work commitments typical of an exploration permit) or if the Pilot Project is only intended to operate as a tentative and flexible investment commitment. See Lanardonne, Tomás, and Aguirre, Juan Ignacio, supra, note Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, Concession Agreement - Clauses , , available at (last accessed ). 99 Ibid, Concession Agreement - Clause Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, Tender Protocol, , available at (last accessed ) The qualified operating companies shall be classified in three categories: Operator "A", company qualified to operate in the blocks located in deep/ultra-deep waters, shallow waters and onshore; Operator "B", company qualified to operate in blocks 16

20 Moreover, it is also of interest to mention that it is possible for the company to subcontract another company with experience on unconventional resources, which is not possible for qualification purposes on conventional resources. 102 Finally, the model provides detailed information about the exploration plan and evaluation plan for non-conventional resources. 103 For instance, item 4 states the minimum content of this Plan, such as: the geological context, consolidated timeline, the budget forecasting year-to-year, and the estimates of the minimum Local Content. Despite the efforts to set up provisions tailored to the exploration and exploitation of unconventional resources, the formula adopted in Brazil is facing some major setbacks. Looking at the 12 th Bidding Round, which included areas with potential for unconventional resources but with an insufficient amount of geological data, ANP drafted a concession contract applicable to both cases conventional or unconventional - but with particular provisions for unconventional resources. However, since hydraulic fracturing is facing social and environmental resistance in the country, the exploration of 47 blocks both with potential for conventional and unconventional resources has been paralyzed in certain areas. 4.2 Ownership of Resources The ownership of resources and surface rights have been one of the key catalysts to the shale boom in the USA. 104 As discussed, this criterion is particular to the USA, where landowners have rights to explore and to develop the resources located under their properties. 105 This peculiar characteristic cannot be replicated in many countries. 106 Elsewhere in the world, the rights to explore and to develop subsoil potential belong to host governments and states under the sovereign. 107 Therefore, it is relevant to understand how the different laws and regulations process this issue within different jurisdictions, how this specific characteristic affects unconventional resources and how land owners outside of the USA could be encouraged to allow unconventional developments which affect their property. located in 12 shallow waters and onshore; and Operator "C", company qualified to operate only in the blocks located onshore, except in the blocks of Acre-Madre de Dios Basin. See Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, supra, note Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, Concession Agreement - Clause 19, available at (last accessed ). 103 ANNEX X- General Instructions of the Exploration Plan and Evaluation Plan of Non-Conventional Resources. Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, Concession Agreement - Clauses , , available at (last accessed ). See section 1. Ibid. 106 Bernard. G. Taverne, Petroleum, Industry and Governments: A study of the Involvement of Industry and Government with the Production and use of Petroleum. (2 nd edn Kluwer Law International, Alphen aan den Rijn, 2008), Ibid. 17

21 4.2.1 USA Due to the migratory nature of oil and gas, the rule of capture has been the standard rule in determining ownership of hydrocarbons in the United States since the 19 th century 108 and though it has been significantly modified by statue, case law, and regulation, it generally stands as the basic legal doctrine for extraction rights. 109 Due to the fact that oil and gas has a tendency to migrate from underneath one landowner s tract to another, early courts equated them more with wild animals rather than hard minerals in place. Thus, one landowner is even permitted to induce oil and gas underlying his neighbor s property to migrate to his own and produce or capture the same. 110 The essence of the rule is that the first person to capture a resource owns it. With regard to shale gas extraction in Texas, this rule was recently applied in the case of Coastal Oil and Gas Corporation v Garza Energy Trust 111 as reasoning to find that hydraulic fracturing causing gas originally located under one tract to be produced from a well on another tract not to be a trespass. In so finding, the Texas Supreme Court stated that the rule gives a mineral rights owner title to the oil and gas produced from a lawful well bottomed on the property, even if the oil and gas flowed to the well from beneath another owner s tract. 112 The rule of capture, however, is not absolute. Two important limitations on the rule are that of correlative rights, which seeks to reduce waste and prevent the over-drilling that were common in the early days of the industry, and the accommodation doctrine, which attempts to balance the mineral owner s right to produce oil and gas with the rights of the owner of the surface of the land. The correlative rights doctrine, which varies from state to state, acknowledges that each landowner has a right to produce oil or gas from a shared source by a well located on his or her land limited, however, by a duty not to injure the common source of supply or produce an undue portion of the oil or gas. 113 Correlative rights may be established by court decision, 114 by statute, or by governmental agencies such as Texas Railroad Commission, as discussed above. It is not uncommon, especially in historically-producing areas, for the oil and gas in place to be owned by someone other than the owner of the surface. The mineral estate may be partially severed, in which case the surface owner would still own some portion of the oil and gas, or entirely severed, where the minerals are wholly separately owned. In the latter instance, the interests of the mineral owner and surface owner are not likely to be aligned. Generally, the mineral estate, when severed from the surface estate, has been found to be 108 D. Drummond, L. Sherman and E. McCarthy, The rule of capture in Texas still so misunderstood after all these years, 37(1) Texas Tech Law Review ( ), 1 97, for the history and background of this rule For more information about the development of the rule of capture see B.M. Kramer and O.L. Anderson, The Rule of Capture - An Oil and Gas Perspective, 35 Environmental Law (2005), Westmoreland & Cambria Nat. Gas Co. v. De Witt (130 Pa. 235 (1889) SW 3d1 5 Tex., Ibid. 113 Kingwood Oil Co. v. Corporation Commission of Oklahoma, 396 P.2d 1008, 110 (Okla 1964). 114 Ibid. 18

22 the dominant estate and the surface estate to be the servient estate. 115 This is because the underlying minerals would be worthless if the mineral owner could not access the land under which the resources are situated. 116 The Texas Railroad Commission suggests that the owner of the mineral right is allowed to freely use the surface estate to the extent reasonably necessary for the exploration, development, and production of the oil and gas under the property. 117 This mineral right is far reaching, as according to the Commission, it also includes the right to conduct seismic tests, drill wells at locations they select, to enter and exit well sites and other facilities, to build, maintain, and use roads for access to and from well sites and facilities, to build and use pipelines to serve wells and facilities on the property, to use surface and subsurface water on the leased premises for drilling and production operations, and to drill and operate injection wells to enhance lease recovery and dispose of lease-produced water. 118 Other States have similar legislation in place requiring the surface estate holder to grant the mineral interest owner not only access but permission to carry out the aforementioned activities. 119 The right of a mineral interest owner (or his lessee) to use the surface may, however, be limited by the accommodation doctrine. In Texas, the accommodation doctrine is found in common law and restricts a mineral owner s right to use the surface of a severed estate when the mineral owner s interference with a pre-existing surface use would be substantial and significantly impair the surface use. 120 The North Dakota Supreme Court stated, in Hunt Oil Co. v. Kerbaugh, that [i]n the absence of other rights expressly granted or reserved, the rights of the owner of the mineral estate are limited to so much of the surface and such use thereof as are reasonably necessary to explore, develop, and transport the minerals. 121 Generally, in practice, rather than resorting to litigation over the accommodation doctrine and in the interest of harmonious development, surface use issues and damages are typically negotiated and addressed in the underlying oil and gas lease or in separate surface use agreements between the oil and gas lessee and surface owner. The lease or agreement may provide for damages to be paid for pad sites, road use or construction, clearing trees, etc., as well as establishing where an operator is permitted to drill, its access to the premises, and what acts of remediation it will undertake when operations are complete. This unique interpretation of private ownership rights in America is one reason for the general difference in public perception as compared to other countries on the issue. Both forms of ownership have advantages and disadvantages; however, in the United States, landowners can directly profit from shale gas exploration and have an incentive to actively 115 Texas Railroad Commission, Oil & Gas Exploration and Surface Ownership, available at (last accessed ). 116 D. Rahm, Regulating hydraulic fracturing in shale gas plays: The case of Texas 39(5) Energy Policy (2011), , at See Texas Railroad Commission, supra, note Ibid. 119 P. Zeniewski, Surface level challenges for shale gas development in Europe; A regulatory perspective, European Energy Market (2012), Getty Oil Co. v. Jones, 470 S.W.2d 618, (Tex. 1971) 121 Hunt Oil Co. v. Kerbaugh, 283 N.W.2d 131 (N.D. 1979). 19

23 promote shale gas activities in the area. 122 Landowners outside the USA usually do not directly profit from mineral rights and do not receive royalties, resulting in greater public opposition UK As previously explained, the licensing regime in the UK is governed by the Petroleum Act 1998, 123 which grants a Petroleum Exploration and Development licence (PEDL) for conventional and shale gas activities. Obtaining the PEDL licence is subject to several drilling and development consents, the access right from the landowner and planning permissions. 124 The PEDL grants the operator the exclusive right to explore the licence area and produce hydrocarbons. In addition, the operator requires planning permission from the local minerals planning authority (MPA), and has the obligation to consult the Energy Agency to identify if an EIA is required and to obtain other environmental permits. Other integral parts of the PEDL procedure are the assessment of compliance with safety and environmental management systems, a well examination scheme and financial capability of the operator. 125 The operator is required to submit an Environmental Awareness Statement in the process of the PEDL application, setting out the applicant s understanding of the environmental legislation, the area and related sensitivities, especially regarding planning, as well as mitigation options and an environmental record of the company. In these early stages of the application process, neither public participation requirements nor access to environmental information are discussed. No EIA is necessary at the exploratory stage. 126 The UK s Infrastructure Act of 2015 changed the UK trespass legislation and introduces a right to deep-level land (onshore land below 300 meters) for companies in order for them to explore and/or extract oil and gas resources or geothermal energy. Simultaneously, it introduced a system for voluntary payments to local community institutions. The Secretary of State, however, has the power to force operators to pay should they not comply with the 122 See also J. Krieskz, B.D. Goldstein, K. Zell and S. Beach, Differing opinions about natural gas drilling in two adjacent counties with different levels of drilling activity, 58 Energy Policy (2013), , at In this statement, the applicant has to motivate this [1.] understanding of the United Kingdom s onshore Environmental and Planning Legislation relevant to the exploration; development, production and decommissioning stages of a project; [2.] understanding of the environmental sensitivities of the area they are applying for and their options for addressing these and their approach to establishing the eventual plan for operations; [3.] options for addressing the SEA proposed Mitigation Measures and the applicant s approach. For more information, refer to DECC, Guidance about the environmental aspects of any application - landward, 2015, available at EAS.pdf (last accessed ). 124 For detailed guidance on the planning permission process in the UK, refer to DECC, Fracking UK shale: planning permission and communities, 2014, available at (last accessed ). 125 DECC, Onshore oil and gas exploration in the UK: regulation and best practice England, 2013, available at d_gas_exploration_england_dec13_contents.pdf (last accessed ), at 14f. 126 For a detailed description of the licensing process, please refer to J. Armstrong, Regulatory provisions governing key aspects of unconventional gas extraction in the United Kingdom (Milieu Ltd., 2013). 20

24 measures, bringing in to question the assertion that this system is voluntary. Despite the fact the UK has a common law tradition, the Petroleum Act of 1934 assigned the rights to oil and gas to the Crown. The UK chose to depart from the traditional common law approaches and the 18 th century legal principle of the cujus et solum doctrine, to which the US still largely adheres. The case of Bocardo SA v Star Energy, 127 however, confirmed that the old principle of cujus et solum still has legal value. 128 The Infrastructure bill in contrast again cemented the shift away from private to public ownership 129 and solved an issue for developers faced with the hurdle of obtaining consent from numerous landowners before drilling. The Infrastructure Act 2015 introduces some safeguard clauses relating to hydraulic fracturing as an addition to the Petroleum Act It prohibits fracturing activities above 1000 meters from the surface, and introduces the need for hydraulic fracturing consent for activities at a depth of 1000 meters or more, as well as in protected groundwater and other areas (Section 4A(1)(b)). Obtaining this consent is subject to several conditions, such as the responsibility of the local planning authority to consider the environmental impact and cumulative effects of the development, independent inspection of well integrity, baseline monitoring of groundwater quality and emissions (Section 4A(5)). The Department of Energy and Climate Change (DECC) are the main authority that issue petroleum licences. They also give consent for flaring or venting activities and are in charge of risk management and monitoring, especially regarding seismic activities. Since April 2015, the DECC has handed over some functions to the Oil and Gas Authority (OGA), a new Executive Agency of the DECC. Mineral Planning Authorities take the responsibility of granting well and well pads location permissions. The Environment Agency (EA) is in charge of the protection of water resources and the treatment of waste and NORM (Naturally Occurring Radioactive Materials), as well as air emissions. The Office of Unconventional Gas and Oil (OUGO) was created in 2012 with the aim of supporting the safe, responsible, and environmentally sound recovery of the UK s unconventional reserves of gas and oil. 130 In addition, the Health and Safety Executive Agency (HSE) is in charge of guaranteeing the appropriate design and construction of a well and its casing Bocardo SA v Star Energy [2010] UKSC B. Barton, The Common Law of Subsurface Activity: General Principle and Current Problems, in A. McHarg, D.N. Zillman, A. Bradbrook, and L. Barrera-Hernandez. (eds), The Law of Energy Underground: Understanding New Developments in Subsurface Production, Transmission, and Storage (Oxford: Oxford University Press, 2014), 21 36, 25f. 129 Ibid. Barton argues that this is generally the case in common law jurisdictions. 130 UK Government, Office of Unconventional Gas and Oil (OUGO), 2012, available at (last accessed ). 131 Department for Communities and Local Government, Guidance Planning for Hydrocarbon extraction, available at (last accessed ). 21

25 4.2.3 China In China, private individuals do not own the land or the resources underneath it. There are two kinds of land ownership. One is land owned by a collective and the other is land owned by the government. 132 The land owned by a collective cannot be used to extract mineral resources but can only be collectively used for farming, planting or construction. Therefore, any land which could be used for extraction, and the minerals underneath, is owned by the Chinese government. In such cases, the land used for exploration purposes under the exploration licenses are free of encumbrances, as the Chinese government is unlikely to delay exploration on land they have a direct interest in. Additionally, there usually will be no or little resistance from the community when the investors conduct their exploration activities in the designated lands, other than the environmental claims or other claims made by the adjacent inhabitants, as the government ownership and priority is already an established relationship. 133 For the purposes of economic development, the local government and the community usually welcome the investment and the local government usually assists the investors to solve any potential problems with the community ahead of time. People who understand the Rural Land Contractual Management Right and/or the Right to the Use of State-owned Land, however, often challenge the drilling activities conducted by the investors in oil and gas industry. As the petroleum operations in shale gas industry are not currently widely conducted and most of these activities are conducted in the rural areas, resistance and oppositions from people at this point are rarely reported in the media Argentina In Argentina, the provinces are the owners of the natural resources below the surface, 134 although the national government is responsible for the coordination of the energy strategy and for enacting general rules. 135 Provinces and the Federal Government will usually seek to adopt a uniform tax treatment for hydrocarbon activities (Article 24, Law /2014). 136 For unconventional hydrocarbon exploration permits, Law /2014 sets a new maximum term of 13 years (two periods of four years and an extension of five years) According to Chinese Constitution, Land in the cities is owned by the state. Land in the rural and suburban areas is owned by collectives except for those portions which belong to the state in accordance with the law; housesites and privately farmed plots of cropland and hilly land are also owned by collectives. All mineral resources, waters, forests, mountains, grassland, unreclaimed land, beaches and other natural resources are owned by the state, that is, by the whole people, with the exception of the forests, mountains, grasslands, unreclaimed land and beaches that are owned by collective in accordance with the law. 133 In theory, all the lands are held by the state on behalf of the people. There are two kinds of land systems in China. One is the state-owned land ownership and the other is collective land ownership. The farmer can rent the land based on collective land ownership, which is called the Rural Land Contractual Management Right. All other entities and individuals can get the Right to the Use of State-owned Land, but not the ownership. 134 See Berkenwald, Mariano, Costa, Hirdan Katarina de M., Santos, Edmilson Moutinho dos, supra, note Ibid. 136 Ibid. 137 Lanardonne, Tomás and Aguirre, Juan Ignacio, supra, note

26 Moreover, the provinces and national government receive oil revenues, fixed by the Argentine Law /2014 at 12% for all provinces and states depending on the location of the hydrocarbon field. 138 With the Law /2014, provinces and national government have a new right to increase the current 12% royalty rate on actual sales prices by a further 3% in the event that an extension is granted, up to a maximum royalty rate of 18%. ( ) It also allows Provincial authorities to reduce the royalty rate down to 5% where necessary to ensure continuing production from the field. 139 Additionally, using Law /2014, it is possible to reduce the royalty rate by 25% applicable to unconventional hydrocarbon projects. In this case, a concessionaire will need to request an Unconventional Exploitation Concession (UEC) within three years from Law / Brazil In Brazil, the federal government has claimed ownership of subterranean resources, which includes unconventional resources, in accordance with articles 20, Sections V and IX and 176, caput of the Federal Constitution and article 3 of Law n. 9,478/97 (Brazilian Petroleum Law). 141 In 2013, under Law 9,478/1997, companies who auctioned blocks during the 12th Bidding Round had the obligation to sign the Concession Contract for Oil and Natural Gas Exploration and Production. 142 Under the regime, concessionaires need to pay the government take, such as signature bonus; royalties which stand at 10% of production; special participation at the amount defined in Decree 2,705, as of 3 August 1998; and, payment for the occupation or retention of area at the amount of Brazilian currency per square kilometre or fraction of the concession area. 143 They also only gain ownership of the resources after the delivery point. The put-upon owner (i.e. affected farmer) does not have ownership of the natural resources but as compensation they should receive from 0.5 to 1.0% of the production revenues as per petroleum law. 144 This payment is known as the landowners share. Moreover, the concessionaires must have the commitment to acquire local goods and services as established in the concession contract. In addition to the local content clause, it is important to note the presence of a fee for Research, Development and Innovation (RD&I) that demands a special share to an amount equivalent to 1% of the Gross Revenue of the production. 145 The concessionaire has to carry qualified expenses with RD&I in the areas of interest and topics relevant to the sector 138 Ibid. 139 Ibid. 140 Ibid. 141 See Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, supra, note Ibid. 143 Ibid. 144 Ibid. 145 Ibid. 23

27 of petroleum, natural gas and biofuel. 146 These expenses, however, will be supervised by the ANP Local Community Engagement Any oil and gas development is going to directly or indirectly affect a local community. 148 This situation is even clearer in the case of onshore development as the business itself has to be conducted within a given community, in comparison to the more distant nature of offshore development. 149 As discussed previously, from a local community perspective, each country should provide a mechanism where the local communities (specifically the affected area) share not only the risks (e.g. accident or spill) but also the profits of the business. If any country fails to address the local community participation and support, it is much more likely to experience similar results to France and Bulgaria, where severe public pressure to ban hydraulic fracturing has arisen. The sections below will describe the international practices on this matter with the purpose of understanding the attempts of different jurisdictions to address and minimise this concern USA Due to the scale and variation of American geography and geology, oil and gas operations may be conducted in rural areas (where relatively few entities are likely to be involved in the negotiation process and the community involvement is more clearly defined and contained) or, as is the case in the Barnett Shale in North Texas and the Marcellus Shale in the Northeast, around and under metropolitan areas, which include a much larger number of stakeholders. As previously noted, one of the key issues underlying shale gas development in the United States is the individual ownership of mineral rights. Typically, a private individual has the rights to the resources below his or her property and is therefore much more likely to support the development of the property due to the possible financial gain. Although development operations in America notably enjoy a fairly extensive freedom of contract, they are also subject to certain public laws, which differ at the local and state level with regards to shale gas. At the county and city level, local communities can regulate operations via zoning and other regulations. However, their ability to do so is often severely limited by the state. For example, Denton, a city in North Texas lying atop a portion of the Barnett Shale, passed a city-wide hydraulic fracturing ban in November of 2014, but was forced to repeal the same in June of 2015 after (i) lawsuits filed by groups representing both the oil and gas industry as well as state interests questioning the constitutionality of the measure and (ii) the eventual passage of House Bill 40, a state-wide statute enacted in May of 2015, providing that 146 Ibid. 147 Ibid. 148 Ellis, Colter Community Perceptions of the Oil and Gas Industry in the Eagle Ford Shale Play, 2015, available at (last accessed ). 149 Ibid. 24

28 municipal ordinances cannot effectively prevent oil and gas operations, must be related to surface activity only, must be commercially reasonable, and must not be pre-empted by another state or federal law. 150 Thus, while local authorities may have some measure of control over activities done within their jurisdictions, state law, where it exempts and preempts the same, will control. The State of New York, in response to local concerns, took state-level action generally prohibiting shale gas exploration and extraction activities if an environmental impact assessment was not completed 151 before finally banning the activities entirely in June of The New York State Environmental Quality Review Act authorised generic environmental impact statements to assess the environmental impacts of separate actions having generic or common impacts. 152 The assessment included an evaluation of impacts on water in relation to well testing; water withdrawal and consumption; flow back water handling, as well as control and emergency response planning, including spill prevention and storm water pollution prevention; management of drilling cuttings; assessment of emissions and air quality such as greenhouse gas mitigation; habitat fragmentation; and community and socioeconomic impacts. 153 In addition to this evaluation, it also included a chapter on proposed action aimed at mitigating impacts, such as noise and visual impacts, transportation, flooding, water use, and water quality standards. 154 Despite this seemingly comprehensive and thoughtful evaluation, the focus and set-up of the EIA has been subject to criticism, especially regarding its lack of consideration of cumulative impacts. 155 It has also been argued that the EIA as currently employed does not satisfy the strategic planning requirements or the management needs on a regional or state level. 156 In the case of New York, the public was consulted in the drafting of the Supplemental Generic Environmental Impact Statement (SGEIS) from September of 2011 to January of In addition, public hearings were carried out throughout November Fort Worth Star Telegram., Denton City Counsel Repeals Fracking Ban, , available at (last accessed ). For the full text of HB40, see (last accessed ). 151 Executive Order No. 41 requiring further environmental review, as well as New York State Department of Environmental Conversation, The Environmental Review Process for Natural Gas Exploration in the Marcellus Shale, available at (last accessed ), as well as B. Rahm and S. Riha, Toward strategic management of shale gas development: Regional, collective impacts on water resources, 17 Environmental Science & Policy (2012), 12 23, at NYSDEC, Revised Draft SGEIS on the Oil, Gas and Solution Mining Regulatory Program - Well Permit Issuance for Horizontal Drilling and High-Volume Hydraulic Fracturing in the Marcellus Shale and Other Low-Permeability Gas Reservoirs (2011), Ibid. 154 Ibid. 155 Rahm and Riha, supra, note 153, at Ibid. 157 New York State of Opportunity, Department of Environmental Conservation Public Hearings for High-Volume Hydraulic Fracturing SGEIS, 2011 available at (last accessed ). 25

29 Furthermore, a socioeconomic Impact Analysis Report was prepared in support of the Revised Draft SGEIS. 158 In February of 2014, the Joint Landowners Coalition of New York, a group of more than 70 thousand landowners, reacted by filing a lawsuit against the Governor of the State, the New York State Department of Environmental Protection, and the Department of Health to finalise the environmental impact assessment, ordering [the Governor s] records relative to the SGEIS Process to be opened for public scrutiny, 159 claiming that the failure to complete the SGEIS Process has created [ ] substantial economic harm and has prevented landowners from developing their mineral estates [ ] or otherwise leasing or conveying their mineral estate, all of which have been detrimental and contrary to environmental and energy policies in the State of New York, as well as to the guarantees found in the Fifth and Fourteenth Amendments to the United States Constitution. 160 Despite this, in December of 2014, the Department of Health came to the conclusion, upon completing the public review, that hydraulic fracturing should be banned hence forth. This was followed up in June of 2015, when the State Department of Health formally completed the seven-year review procedure and officially banned the activity. 161 In addition to governmental regulation, shale development issues affecting local communities may also be addressed by non-government collaborations between oil and gas companies and environmental groups. For example, based in Pennsylvania, the Center for Sustainable Shale Development (CSSD), is a collaboration of environmental organizations, philanthropic foundations, energy companies and other stakeholders committed to safe, environmentally responsible shale resource development, 162 which included, amongst others, Chevron, CONSOL Energy, the Environmental Defense Fund, Shell and the Pennsylvania Environmental Council. The CSSD has developed, to date, 15 performance standards, covering the areas of air and climate, as well as surface and groundwater. 163 Although not directly aimed at community engagement, the CSSD certifications and standards could, in the long term, assist with overcoming public opposition to shale development. The inclusion of standards regarding community engagement into the existing framework could speed up this process. More importantly, shale production has also had a significant impact on local communities in the form of investment and job creation. A 2011 study found that the Barnett Shale was responsible for creating 119,000 jobs in Texas, 164 and a 2012 study found an additional 158 Ecology and Environment Inc., Economic Assessment Report for the Supplemental Generic Environmental Impact Statement on New York s Oil, Gas and Solution Mining Regulatory Program, , available at (last accessed ). 159 Joint Landowners Coalition of New York, Inc. v. Cuomo, Index No /2014 (N.Y. Supreme Court, 2014), at 1(4); see also B. Nicholson, New York landowners sue state officials over delays in hydraulic fracturing decision, available at cfracturingdecision.html (last accessed ). 160 Ibid. 161 New York State Department of Environmental Conservation, High-Volume Hydraulic Fracturing in NYS, , available at (last accessed ). 162 CSSD, Strategic Partners, available at (last accessed ). 163 CSSD, Performance Standards, available at Performance-Standards.pdf (last accessed ). 164 Fort Worth Chamber of Commerce, A Decade of Drilling, , available at (last accessed ). 26

30 116,000 jobs to be supported by the Eagle Ford Shale in south Texas accompanied by a $61 billion economic impact. 165 The importance and impact of these additional jobs and influx of money to the local and state economies cannot be overstated and are largely responsible for oil and gas-producing states thriving during the recent recession that affected most of the US UK The UK government published a Strategic Environmental Assessment on shale gas under the SEA Directive in 2013, simultaneously as preparation for the 14 th round of onshore licensing was slated to take place in The purpose of the assessment was to identify the likely significant effects of shale gas production on local communities and to compare with existing effects arising from the gas sector. The assessment studied both positive and negative effects. The positive effects highlighted concerned expected employment opportunities (possibly 16 to 32 thousand new jobs), the reduction of net greenhouse gas emissions, and community economic contributions (3 to 12 million GBP). Possible significant negative effects related to transport and infrastructure overburdening on local communities (with an expected 14 to 51 vehicle movements daily to a site for a period of 32 to 145 weeks during the exploration and site preparation stage) and associated impacts on noise and air quality. 166 The applications for the 14 th licensing round closed. For 2015, only 11 additional exploratory licences were granted. Nine of these wells were for fracturing purposes. 167 There is no mandatory EIA required for shale gas activities in the UK. The national legislation transposes the provisions of the EIA Directive; the carrying out of an EIA is thus subject to screening and scoping. 168 When a case puts forward environmental risks, for example, the planning authority may well put forward the requirement of an EIA, but it is a case by case assessment. 169 In December 2014, the United Kingdom Onshore Oil and Gas (UKOOG), which represents the oil and gas industry in the UK, released its Community Engagement Charter for 165 Ctr. For Com. & Bus. Research, Inst. For Econ. Dev., Univ. of Texas at San Antonio, Economic Impact of the Eagle Ford Shale, , available at (last accessed ). 166 DECC and AMEC, Strategic Environmental Assessment for Further Onshore Oil and Gas Licensing - Environmental Report, , available at mental_report.pdf (last accessed ). 167 A. Vaughan, UK s shale gas revolution falls flat with just 11 new wells planned for 2015, The Guardian, , available at (last accessed ). 168 See also reply of the United Kingdom to the Questionnaire on the application of Commission Recommendation 2014/70/EU on minimum principles for the exploration and production of hydrocarbons (such as shale gas) using high-volume hydraulic fracturing, , available at (last accessed ), at 6 ( The Questionnaire ); see also for a more detailed analysis regarding EIAs for shale gas in the UK: Armstrong, note 61 above. 169 See DECC, supra, note 168, at

31 unconventional oil and gas reservoirs. Through this Charter, the industry is attempting to obtain the social licence to operate. 170 The charter is based on four principles, namely to act safely and with environmental sensitivity, to engage openly with local communities, to provide a UK based solution to our energy needs and to create jobs and economic growth. 171 Under the Community Engagement Charter operators agree to discuss their plans and listen and respond to concerns, before each of the 3 stages of operation and prior to submitting a planning application. Moreover, under the Community Engagement Charter the operators are committed to providing a community benefits package. The package consists of the following; the operators must provide 100,000 GBP per wellsite to the local community at the exploration/testing stage, even if the reservoir will eventually not be used for extraction. In addition, operators are committed to paying 1% of revenue to the local community during production and to publish evidence on how they have met these commitments each year. 172 The government has also introduced a fast track planning process to facilitate the granting of permits. 173 Aside from these rules, there is an active presence of organisations opposed to shale gas and the social disapproval of hydraulic fracturing which was only strengthened by the trembles which occurred in Lancashire (North-West England) in May At that time, the Cuadrilla Resources were performing hydraulic fracturing activities which might have triggered seismic activity in this area near Blackpool. The anti-fracking organisations, the most popular being an organisation named Frack-off, have had an influence in the media, due to several large scale protests and stunts. One in particular which stands out was their action in the Cotswolds, in which they pretended to convert the Prime Minister's house into a fracking site. 174 David Cameron s government does have a positive attitude to shale gas development, and despite the uncertainties related to the British reserves levels and the partial social opposition, it is trying to overcome the geological and social barriers related to their implementation. The position of the British government stands out in the European scenario because of two aspects. Firstly, it is one of the few governments promoting the shale gas industry. Secondly, the position of the government has experienced an evolution from the application of the shale gas moratorium to its withdrawal and the implementation of fiscal incentives for hydraulic fracturing upstream projects UKOOG, Community Engagement Charter Oil and Gas from Unconventional Reservoirs, Ibid. 172 Ibid. 173 Department of Energy and Climate Change, Faster decision making on shale gas on economic growth and energy security, available at (last accessed ). 174 Ibid. 175 Ibid. 28

32 4.3.3 China In China, the government approves the implementation of an environmental assessment report prior to the exploration activities conducted under the exploration licences and/or PSCs. In theory, the approval process should also engage the involvement of the local community that could be affected by the exploration activities. The relevant laws and regulations provide that the local community shall have the right to voice its advice or objections to such activities. But in practice, the local community was seldom consulted in the past years and the local people have to resort to the media to voice their demands and rights. Although it is not a common practice, some of the investors (especially the international investors) and SOEs who conduct the exploration, development and production phases of shale gas do have their social responsibility principles in place and the local community will occasionally be consulted prior to or during the drilling operations. 176 For example, SINOPEC released its social responsibility report in 2015 which specifically disclosed its shale gas developments and its social responsibility commitment during the petroleum operations. Furthermore, the EIA (Environmental Impact Assessment) is a precondition to issue the permit to conduct a petroleum operation. 177 There has certainly been an increase in acknowledgement of local community interests, with the emphasis on establishing harmonious society and preventing environmental liabilities by the Chinese government. 178 Some benefits agreements have been executed by the investors and local governments. The purpose of these benefits agreements is to give the people from the local community the opportunity to be trained, employed or rewarded. 179 The Chinese government specifically mandates that all the investors in the shale gas industry shall establish the operating entities during the exploitation phase in the local cities, for the purpose to creating local presence. With an aim to develop the local economy, the local presence approach will benefit the local community accordingly Previously, the people who were affected by the drilling activities usually chose not to seek damages from the investors. With the emerging of the NGO campaigns and the awakening of their rights, the investors are now more cautious to conduct their petroleum operations and there are a few Chinese regulations passed to administrate these situations. For example, the government currently requires any petroleum operation to conduct an EIA before the investors can launch the drilling activities. 177 In addition to the law the environmental impact assessment law of the People's Republic of China, there are also a lot of industry standards to follow in Chinese petroleum industry. For example, the NOCs provide for their own standards for their service providers/ contractors. Failing to reach those standards can deprive the contractors qualification of working for the NOCs. 178 The concept of harmonious society was first raised by president Hujintao of PRC at the 4th Plenary Session of the 16th Party Central Committee in The concept stresses the importance of harmonious existence of people and the environment. 179 Although there are no mandatory obligations, the local governments usually seek these benefits from the investors and the investors are willing to give local community these benefits to demonstrate their social responsibility. 180 Ministry of Land and Resources of the People s Republic of China, Ministry of Land and Resources on the strengthening of shale gas exploration and exploitation and its supervision, 2012 available at (last accessed ). 29

33 4.3.4 Argentina Socio-economic resistance against shale gas operations has also arisen as an issue in Argentina, with groups struggling to have their complaints heard in response to proposals for fracking activities. These complaints often aim to prohibit, delay or hinder the development of fracking activities. 181 Locally, the socio-environmental resistance has become stronger. Approximately 25 municipalities throughout Argentina have been declared free of fracking 182, many of them using a model of municipal ordinance prohibiting the activity that was first released by the South Oil Watch, a non-profit organisation founded in The vast majority of these municipalities are in the provinces of Entre Ríos, Buenos Aires and Mendoza, and quite remote provinces of the Vaca Muerta Formation. Their unconventional hydrocarbon potential is much lower than those that had been found in the Vaca Muerta basin. In addition, this resistance is most likely due to indigenous Mapuche beliefs covering ownership of territorial land. In the Mapuche culture, the territory is a supreme place and is considered as an essential part of their way of life. Mapuche indigenous people are considered the only heirs and protectors of their territory. 184 Until 1994, the Argentinean constitution honoured the obligation to maintain peaceful relations with the Indians and promote their conversion to Catholicism 185. From then, this text came to recognise their ethnic and cultural pre-existence, as well as community property of traditionally occupied territories and states his participation in the management of their natural resources and other interests affect. 186 Additionally, Argentina has signed and ratified the ILO Convention 169, by which indigenous peoples have the right to prior consultation on matters relating to the exploitation of natural resources in their territory. 187 On the other hand, in a survey conducted in August 2014, 63% of Argentines were in favour of the development of Vaca Muerta. In the same survey, 51% recognised that this development will inevitably have a high environmental impact. 188 This result is surprising in a country where extractive projects often generate a backlash in public opinion, and 181 See Berkenwald, Mariano, Costa, Hirdan Katarina de M. and Santos, Edmilson Moutinho dos, supra, note Observatorio Petrolero Sur, Gracias a las asambleas y los vecinos hoy tenemos 25 municipios libres de fracking en Argentina, , available at (last accessed ). 183 Observatorio Petrolero Sur, Modelo de ordenanza para prohibición del fracking, , available at (last accessed ). 184 Radovich, Juan C. and Balazote, Alejandro, Mapuches in Neuquen: Conflicts in the Economic and Symbolic Order, in Lucio Capalbo (ed), The redefined development (Centro de ediciones graficas y audiovisuales de Fundación UNIDA, Buenos Aires). 185 NATIONAL CONSTITUTION OF ARGENTINA (1853), Chapter IV, Article NATIONAL CONSTITUTION OF ARGENTINA (1994) Article 75, paragraph INTERNATIONAL LABOUR OFFICE (1989), Convention 169, Article L.M.Neuquen, Seis de cada diez argentinos quieren que se desarrolle Vaca Muerta, , available at (last accessed ). 30

34 therefore shows the level of expectation of Argentina regarding the development of unconventional oil and gas in the country Brazil In the early stages of Brazilian shale gas exploration, Brazil experienced a similar situation to the USA, as shale operations were conducted in remote areas of the country and with little or no specific regulation for shale gas operations. 190 More recently, however, shale gas has become a sensitive issue for civil society and certain environmental groups. 191 During this delicate period, it has become clear that the definition of local community should be expanded to include not only the affected areas but the civil society as a whole. The severity of this was realised when a court ruling totally stopped shale gas operations in certain areas and this has uncertainly caused serious risks for the development of the industry as a whole. 192 The Public Civil Action No was filed by the Brazilian Federal Prosecution Service ( Ministério Público Federal ) in the State of Bahia against ANP and companies that were awarded during the 12th Bidding Round of Exploratory Blocks, claiming for the suspension of its effects for blocks in the Recôncavo Basin, alleging that ANP failed to observe the environmental requirements for such 12th Bidding Round of Exploratory Blocks. 193 In November 2014, the judge in charge for this Public Civil Action granted an injunctive relief requested by the MPF to (i) suspend the effects of the 12th Bidding Round and related concession contracts until the Brazilian environmental authorities issue new regulations and studies; (ii) prohibit ANP from granting any other areas for shale gas in the Recôncavo Basin until the acts above are carried out; and (iii) order ANP to make the decision public available in its website. 194 In December 2014, five of the defendants filed a motion for clarification against the decision, which was partially granted in January 2015, clarifying that the suspension of the effects of the 12th Bidding Round and its contracts is applicable only with respect to fracking (non-conventional), and not to all the other exploration and production activities provided for under the concession contracts. 195 Recently, in August 2015, the MPF filed a petition alleging that ANP has breached item (ii) of the decision aforementioned by including certain non-conventional gas area among the blocks to be offered in the following bidding round (13th Bidding Round). 189 Berkenwald, Mariano, Costa, Hirdan Katarina de M. and Santos, Edmilson Moutinho dos, supra, note Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, supra, note Ibid. 192 Ibid. 193 Brazilian National Agency of Petroleum, Natural Gas and Biofuels ANP, Public Civil Action, 2014, available at (last accessed ) and available at (last accessed ). 194 Ibid. 195 Ibid. 31

35 As may be inferred, the environmental licensing of the 12th Round is currently facing opposition from public offices and social organisations 196, such as Fiocruz, Federal Prosecutors, Brazilian Society for the Advancement of Science (SBPC), the Brazilian Academy of Sciences, Greenpeace, among others. 197 The main thrust of their argument is that the level of uncertainty of environmental risk is too high, and as a result of this, activities should be suspended until the consequences of assuming this kind of risk are defined. 198 As already stressed, the House of Representatives Bill of Law 6904/2013 proposes to suspend the exploitation of unconventional resources over a five-year period. 199 This reality has truly brought about an unfriendly environment for business. 200 There have been attempts to overcome these challenges. For example, the recently published Decree 8,437 of April 22, 2015 defines the competence of IBAMA to issue an environmental permit in unconventional reservoirs during the exploration and production phase. 201 At the same time, the definitions of environmental licensing of activities are being discussed by a working group (composed of the ministries of Environment, Mines and Energy, ANP and ANA) that aims to encourage the use of non-conventional hydrocarbons. This group has been studying the American and European regulation. 202 However, they have not yet published their report or their conclusions Investment Climate Looking at the interest and benefit for the investor, fiscal incentives are required to encourage any unconventional resource exploration, as well as contractual adjustments for the successful shale gas operations. 204 The investment climate could be a barrier which depletes an investor's interest and the country's suitability and the country may ultimately fail in attracting investments No-Fracking Brazil - civil organisation, Fracking No, , available at (last accessed ). 197 No-Fracking Brazil - civil organisation, No Fracking in Sao Paulo, , available at (last accessed ). 198 Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, supra, note See Sarney Filho, Jose, supra, note Ibid. 201 President of Republic of Brazil, Decree 8,437 of April 22, 2015, , available at (last accessed ). 202 Jablonski, Silvio, Bill of Law 6904/2013 of Sarney Filho, , available at legislativa/comissoes/comissoes-permanentes/cmads/audiencias-publicas/audiencia-publica-2015/ discussao-do-pl do-sr-sarney-filho-que-estabelece-medidas-para-a-exploracao-de-gas-de-folhelhoxisto/apresentacoes/silvio-jablonski-chefe-de-gabinete-da-agencia-nacional-do-petroleo-gas-natural-ebiocombustiveis/view+&cd=1&hl=pt-br&ct=clnk&gl=br (last accessed ). 203 Ibid. 204 Bryan Cooper and T. F. Gaskell, North Sea Oil, The Great Gamble (Heinemann, London 1966). 205 European Parliament, Directorate-General For External Policies Policy Department, The Shale gas 'revolution' in the United States: Global implications, options for the EU, , available at 32

36 Host governments must compete on a worldwide scale to attract investors, but must balance this with receiving fair compensation from investors. 206 For more challenging areas, special concessions and incentives can be used to draw investors. 207 In this section, the main issues regarding investment climate in the selected countries will be highlighted USA The USA has a unique way of allocating hydrocarbon legal ownership, and combined with available technical data and a wide selection of service providers, it has proven to be one of the most accessible countries for unconventional resources. The success of shale gas extraction has clearly shown this as a result of the cooperation between individual landowners, oil and gas operators, and federal, state, and local authorities, all of whom are incentivized toward oil and gas extraction. The federal government has not only historically provided subsidies for the oil and gas industry, but it also, through a series of tax incentives related to how individuals and companies involved in the business of oil and gas exploration and production can book drilling, leasing, and other costs, has made the industry one of the most tax-advantaged in the nation. 208 For example, producers are allowed to write off a majority of their drilling costs as intangible costs as well as lease costs in the same year that they are accrued and the remaining drilling costs as tangible costs over a period of seven years; small producers and investors also benefited by the depletion allowance, which excludes from taxation 15% of all gross income from oil and gas. Even with these tax incentives, local and state coffers are bolstered by revenue from production and excise taxes, ad valorem property taxes, and income taxes paid by the operators on their profits and the landowners on the bonus and rental payments they receive. 209 As a result of its unique legal and investment climate, the US oil and gas industry supports more than 9 million jobs nationwide, accounts for 7% of the country s gross domestic product, and contributes more than $86 million to the Federal Treasury every day AFET_SP(2013)491498_EN.pdf (last accessed ). 206 For further information see David Jonhston, Daniel Johnston, Introduction to Oil Company Financial Analysis (PenWell, Tulsa 2006), Daniel Jonhston, International Exploration Economics, Risk, and Contract Analysis (PenWell, Tulsa 2003), Robert C. Nicholls, A Review of Some Aspects of the Organization and Financing of Mineral Resource Ventures, 1 U.N.S.W. Law Journal (1976), See also Bill Manning, Some Practical Aspects of Resources Joint Ventures, in W. D. Duncan, Joint Ventures in Australia (2 nd edition The Federation Press, Sydney 2005), 322, Bernard. G. Taverne, Petroluem, Industry and Governments: A study of the Involvement of Industry and Government with the Production and use of Petroleum. (2 nd editionn Kluwer Law International, Alphen aan den Rijn 2008), 380, Charlotte J. Wright and Rebbeca A. Gallun, Fundamentals of Oil&Gas Accounting (5 th edn Penwell, Tulsa 2008), 465, Chris Wilkinson (ed.), Joint Ventures & Shareholder s Agreements (3 rd edn Bloomsbury Professional, West Sussex 2009), 3 5, Peter Roberts, Joint Operating Agreements: A Practical Guide (Globe Law Business, London 2010), 7 13, George K. Foster, Managing Expropriation Risks in the Energy Sector: Steps for Foreign Investors to Minimise their Exposure and Maximise Prospects for Recovery when Takings Occur, 23 J. Energy & Nat. Resources L. (2005), 36 59, Andrew B. Derman, A. Melsheimer, Changing the Rules of the Game: Issues that arise under the 2002 AIPN JOA when a host government mandates a replacement contract 8(4) OGEL (2010), 1 7, V. Lowe, Recognition or Expropriation, 2(3) OGEL (2004). 208 Cussen, Mark P. Oil: A Big Investment with Tax Breaks, 2016, available at (last accessed ). 209 For more information on lease bonus and royalties, see Section 4.1.1, above. 210 American Petroleum Institute, Policy Issues, 2015, available at Issues/Policy-Items/Jobs/Energy-Works (last accessed ). 33

37 As mentioned before, although other countries can emulate certain aspects of the American model, these factors are unlikely to be provided in total by any other country in the near future UK The UK is generally perceived to have a good investment climate for oil and gas activities, 211 which has stabilised in recent years. 212 In 2013, the British Government implemented policies to overcome the two main barriers to shale gas development. It introduced important tax breaks and local community incentives to encourage investment and to overcome the local opposition to shale gas. The government also aims to reduce bureaucracy associated to hydraulic fracturing activities in the future. 213 In order to achieve the desired energy security, economic growth, job creation and tax revenues seen in the USA, the UK government has been eager to explore shale gas resources under the understanding that there is sufficient control to mitigate any risk. Also, as a direct move to encourage growth, the government has reduced the tax rate on a portion of a company s profits from 62% to 30%, of 75% of their capital expenditure. 214 Investor uncertainties, which arose after the first moratorium, have been addressed by a relatively investor friendly policy from the UK government. 215 For example, the UK Draft Finance Bill 2014 includes a new onshore or pad allowance to support the early development of onshore oil and gas projects which are economic but not commercially viable at the 62 per cent tax rate. 216 The bill stresses that shale gas is an important resource to increase national energy security and will create thousands of jobs, generate investment and cut down energy prices. 217 The UK government has made its position clear, as their focus is development, and facilitating such activity this is a primary concern. 211 See Oliva, Pol, Costa, Hirdan K M and Moutinho dos Santos, Edmilson, supra, note Ibid. 213 Ibid. 214 HM Treasury, Autumn Statement 2013, 2013, available at f (last accessed ). Prime Minister's Office, Local Councils to Receive Millions in Business Rates from Shale Gas Developments, 2015, available at (last accessed ). 215 HM Revenue & Customs, UK oil and gas fiscal regime: new onshore allowance, 2014, available at (last accessed ). 216 HM Revenue and Customs and HM Treasury, Overview of legislation in draft, 2013, available at tion_in_draft.pdf, (last accessed ), at A HM Revenue & Customs, UK oil and gas fiscal regime: new onshore allowance, available at (last accessed ). 34

38 Their rationale can be seen given the fact that today, the U.K. depends largely on energy deriving from coal, mines and alternatives need be established within the foreseeable future. 218 However, the very recent discussion regarding banning the activity in Northern Ireland and continued negative responses from local councils to develop shale exploration in England could have the power to reverse this trend China The Chinese government has expressed an uncharacteristic enthusiasm in the shale gas industry and independently introduced many subsidies to promote the exploration, development and production of shale gas. 220 As discussed above, China has drawn up an aggressive plan to develop its massive shale gas reserves and is willing to make significant investments to extract those reserves. With Chinese government strong support for the shale gas developments and the corresponding incentive policies and subsidizing it is possible to argue, at least from a governmental perspective, that the investment climate is seen as both friendly and encouraging by the Chinese authorities. 221 Compared with the strict qualification requirements in conventional oil and gas, the shale gas policy in China opens a door for all types of investors to participate in the shale gas development. To demonstrate its full support for shale gas developments, Chinese government even granted the shale gas licenses to the POEs which did not grasp highly sophisticated experiences in petroleum operations. But to mitigate any risks from previous experiences, the government requested these investors to engage experienced petroleum service providers/contractors in their shale gas developments). The government not only allows the POEs and IOCs to participate in the shale gas developments, but also urges (by publicizing specific guidelines) financial institutes to provide financial support to the entities which conduct petroleum operations in unconventional oil and gas. 222 If it emerges that acreages already held by NOCs for conventional petroleum do have unconventional gas resources, and other investors will be granted the right to explore the unconventional gas resources only if the NOCs refuse to progress quickly enough to extract the unconventional gas resources. In addition to these incentives, the Chinese government gives favourable subsidies to the investors making investments in shale gas industry. Based on the current policy, every cubic meter produced 218 Ibid. 219 Williamson, Claire, Fracking banned in Northern Ireland for the first time, , (last accessed ). 220 The treasury department of China and National Energy Bureau jointly issued a notification on 19 April, 2015, which provided that from 2016 to 2020, the Chinese government will continue to subsidize the entities producing shale gas. 221 Based on various notifications issued by various Chinese governmental agencies and the encouraging incentive plans, the conclusion of which is that the shale gas investment environment is very favourable. 222 The policy is unequivocally made clear by NDRC in its shale gas incentive plans. See the shale gas industry policy issued by National Energy Bureau (NEB). Full version of the policy can be read at: National Energy Bureau, Policy on shale gas industry in China, , available at (last accessed ). 35

39 from shale gas field is subjected to a financial subsidy equal to RMB 0.3 from 2016 to 2018 and RMB 0.2 from 2019 to In short, investments in the Chinese shale gas industry are warmly welcomed by the Chinese government, with favourable incentive polices. Although the technical challenge and water shortage issues still exist in shale gas development, the prospects in the Chinese shale gas industry seem quite promising Argentina In order to develop its shale gas potential, it is important that Argentina creates a stable investment climate. However, there are macroeconomic barriers that still need to be overcome. 224 The new Administration, chaired by President Macri 225, has started to enact new measures in order to abrogate former restrictions and increase flexibility. For instance, on December 17, 2015 the Argentine Central Bank issued a set of regulations ( ) where the US Dollar and other foreign currency will now float freely, although it is expected that the Argentine Central Bank will intervene to maintain the exchange rate within certain bands. 226 Exchange restrictions have created barriers to the importation of goods as well as sending funds abroad in the form of royalties, profits and dividends, compromising Argentina's ability to attract potential investors in the oil and gas sector. Exchange restrictions in Argentina began with the publication of the General Resolution 3,210/2011, later supplemented by various resolutions that were defining the exchange market in the country. 227 Although General Resolution 3,210/2011, later supplemented by various resolutions, creates some hurdles for the shale gas industry, the legislative changes in the licensing regime as well as large potential reserves to be explored provide reasonable encouragement for the development of unconventional resources in Argentina. Also, after the set of regulations that Argentine Central Bank published, Perez Alati et al. (2015) have pointed out, among various chances, that resident companies may purchase foreign currency for up to USD 2,000,000 per month each, for (i) making real estate, direct 223 The subsidy policy is jointly promulgated by the Ministry of Finance and the National Energy Administration.Ministry of Finance of the People s Republic of China. National Energy Administration.Ministry of Finance of the People s Republic of China., Notice of shale gas development and utilization of financial subsidies, 2015 available at (last accessed ). 224 See Berkenwald, Mariano, Costa, Hirdan Katarina de M. and Santos, Edmilson Moutinho dos, supra, note Hirdan Costa gratefully acknowledge the comments and recommendations of Tomás Lanardonne. 226 Perez Alati, Grondona, Benites, Arntsen and Martinez de Hoz, Legal Newsletter, , available at (last accessed ). 227 Gandini, Nicolas and Fonrouge, Julio C. Restricciones a la importación: es lógica su aplicación para el sector de hidrocarburos y minería?, , available at: (last accessed ). 36

40 and portfolio investments outside Argentina, (ii) granting loans to non-argentine residents, (iii) carrying out other investments outside Argentina, or (iv) saving purposes. 228 These new rules may create a more favorable environment for investments in unconventional resources in Argentina Brazil The Brazilian regulatory framework was initially conceived for large offshore investments and as a result, there are unfortunately no incentives for investing in exploration of onshore gas, particularly for unconventional gas. 230 Commonly the business model for onshore gas - either conventional or unconventional- is different from offshore models. It is worth noting that it was small companies who largely drove the shale gas revolution in the USA, as they are more attracted to a dynamic environment and endeavour to avoid high upfront transaction costs. 231 The contractual changes designed for unconventional operations have made significant progress but this alone is not enough to encourage shale gas developments in the country. 232 For example, the fiscal features could do more to address the incentives needed for the exploration of unconventional sources. Without any change in the legislation, the incentives could encompass a reduction of royalties from 10% to 5% 233 or a low signatures bonus. Further improvements such as an accelerated depreciation schedule or uplifts for exploration expenditures could be made without significant changes in the regime. Brazilian authorities are also preassured to address the regulatory and environmental challenges if they intend to progress with unconventional resources. The current status is too unstable, with many court proceedings and legislative bills in progress Conclusions In the countries discussed, with the exception of the USA, the exploration and production of unconventional resources is still very much in its infancy. On the premise that shale gas has the positive aspects of potential production and that there is sufficient control to mitigate any risk, governments are eager to explore the sector to achieve energy security, economic growth, job creation and tax revenues. Governments have already shown willingness in committing to incentivising oil and gas companies to invest in the sector. 228 Perez Alati, Grondona, Benites, Arntsen and Martinez de Hoz, Legal Newsletter, , available at: (last accessed ). 229 Ibid. 230 Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, supra, note 63..Also seejablonski, Silvio, supra, note Ibid. 232 Ibid. 233 In case of marginal fields or blocks with high geological risks, the Petroleum Act (Article 47, 1º) allows ANP to set the royalties at 5%. Brazilian National Agency of Petroleum, Natural Gas and Biofuels - ANP, Brazilian Petroleum Law, , available at: (last accessed ). 234 Sarney Filho, Jose, supra, note

41 From a regulatory point of view, the legal framework and the contractual regime should provide legislative coverage for unconventional resources. As we have seen, there are currently important gaps in various legal frameworks, mainly due to a struggle to keep up with the fast paced development of hydraulic technologies. Investors are keen to explore and exploit shale gas in jurisdictions that have a streamlined permitting process as opposed to a time-consuming and bureaucratic one. Many legal regimes still remain untested in the context of shale gas and there are many uncertainties that will surely be addressed with time. It is obvious that in this infancy period host governments should be proactive and creative in finding different alternatives to (i) include local community participation in a reasonable, transparent and fair manner, and (ii) provide clear, sound regulation to address the unconventional resources particularities, and (iii) attract new investors with fiscal incentives, flexible contractual terms and conditions for unconventional resources. If a country fails to address these concerns, it is less likely that the American success will be able to be replicated. 38

42 To what extent should a Host Government interfere in the drafting and conclusion of a Joint Operating Agreement? Tonje P. Gormley, Anna Ovcharova and Eduardo G. Pereira* 1 Introduction Oil and gas resources are almost always owned by the states where the resources are located ( host countries ). 1 Consequentially, the government(s) of those states ( host government or HG ) typically reserve(s) the right to exclusively manage the exploitation of host country oil and gas resources. 2 It could be argued that the right to resource management is derived directly from the ownership right to the same resources; however, it is also often embedded in the domestic law. The HG role as resource manager can be exercised to various extents. Some countries hold tight control over their natural resources. For example, Norway s comprehensive legal framework establishes rather extensive rules on the powers of the Norwegian state as resource manager and on how petroleum activities may be carried out. 3 Other host countries do not exercise their rights to resource management to the same extent or level of detail. For example, the license regime in Brazil allows companies more freedom in deciding how and when the petroleum activities should be carried out. The extent to which a host country exercises tight control over its oil and gas resources might be connected to the extent and maturity of the domestic legal framework for petroleum activities, the capacity, the desire, the policy and competency of the host government to act as resource manager and to intervene in the economy, as well as the * Tonje Pareli Gormley is a Senior Lawyer at Arntzen de Besche Advokatfirma AS ( She specializes in international petroleum law, and advises governments, companies and organizations. Contact details: Anna Ovcharova is a head of offshore projects legal support at Rosneft ( She specializes in petroleum law, joint ventures, mergers and acquisitions and contracts. Contact details: Eduardo G Pereira is a Counsel at Morais Leitão, Galvão Teles, Soares da Silva ( and adjunct professor of energy law at the University of Eastern Finland and Reykjavik University. Dr. Pereira specialises in international petroleum law, contracts, business and regulations. Contact details: 1 The HG ownership rights are by and large consequential to the international public law principle of permanent sovereignty to natural resources, as established and further developed in a series of UN resolutions after the Second World War. However, there are exceptions to the rule of HG ownership to oil and gas resources such as for onshore petroleum resources in the United States (US). See: Bernard. G. Taverne, Petroleum, Industry and Governments: A study of the Involvement of Industry and Government with the Production and use of Petroleum (2 nd edition, Kluwer Law International, Alphen aan den Rijn 2008) Bernard Taverne, An introduction to the regulation of the petroleum industry: Law, Contracts and Conventions (Graham & Trotman, London 1994) By and large this is done through an elaborate system embedded in the petroleum act and the appurtenant regulations whereby the Norwegian Government has retained the power to require approval and consents related to the petroleum activities at key stages and the power to stipulate conditions for the petroleum activities. Moreover, of key importance for resource management are also the powers established with respect to its supervisory powers and its powers to enforce the legal requirements in cases of non-compliance.

43 relative competiveness of the host country in attracting foreign investment to its petroleum industry. In any event, no matter how strict governmental control is over petroleum activities, the host country s right to exclusive resource management normally implies as a minimum that if a company has an interest in searching for and producing oil and gas, it must first obtain permission from the relevant host government to carry out such petroleum activities. 4 Permission is typically given in one of two forms; 5 some host governments permit petroleum activities by granting a petroleum license, which is a public law instrument. Other host governments permit petroleum activities by entering into a mutually binding contract, which is typically a private law instrument. 6 Although there has been a development towards increased regulation of petroleum activities in recent years, traditionally we have seen that the legal framework for petroleum activities is less developed in host countries adopting a contractual regime. Because a wide range of risks are inherent to the oil and gas industry, players within the industry operate within a sphere of uncertainty. This uncertainty influences award of petroleum licenses and petroleum contracts, investment decisions, development of a project and the management and operation of petroleum activities in general. Typical risks include exploration risk, operational risk, health, safety and environmental risk, technical risk and political risk - all of which can affect the estimated costs for and the successful implementation of a project. 7 Many of these risks can materialize at any time during a project, and therefore cost estimates and efficiency of operations can be, possibly severely, affected at any point in the project s lifetime. 8 Moreover, when evaluating the overall risk scenarios, one should take into consideration that a petroleum project is technically challenging and capital intensive. There is a long lead-time from initial investment until revenues can be collected. In addition, as the access to easy oil is decreasing, petroleum activities are to an increasing extent carried out in harsh and hostile natural environments and in remote areas. 9 4 For further information about the petroleum title see: Eugene V. Rostow, A National Policy for the Oil Industry (YUP, London 1948) 3 26, Danièle Barberis, Negotiating Mining Agreements: Past, Present and Future Trends (Klumer Law International, London 1998) 4 60, Mike Bunter, The Iranian Buy Back Agreement, 1 (2) OGEL (2003). 5 There are also hybrid models in use. 6 In some countries the contract is a mixture of private and public law instrument. For example in Brazil the concession agreement is a non-negotiable contract provided by the Brazilian government and it has a nature of public and administrative contract between the Government with a third party. Moreover, there are various contracts in use, including production sharing agreements (PSA), service agreements, concession agreements or hybrid models. 7 See also: George K. Foster, Managing Expropriation Risks in the Energy Sector: Steps for Foreign Investors to Minimise their Exposure and Maximise Prospects for Recovery when Takings Occur, 23 J. Energy & Nat. Resources L. (2005), 36 59, Andrew B. Derman, A. Melsheimer, Changing the Rules of the Game: Issues that arise under the 2002 AIPN JOA when a host government mandates a replacement contract, 8(4) OGEL (2010), 1 7, V. Lowe, Recognition or Expropriation, 2(3) OGEL (2004). 8 See: Bryan Cooper and T. F. Gaskell, North Sea Oil, The Great Gamble (Heinemann, London 1966). 9 For further information see: David Johnston, Daniel Johnston, Introduction to Oil Company Financial Analysis (PenWell, Tulsa 2006), Daniel Johnston, International Exploration Economics, Risk, and Contract Analysis (PenWell, Tulsa 2003), Robert C. Nicholls, A Review of Some Aspects of the Organization and Financing of Mineral Resource Ventures, 1 U.N.S.W. Law Journal (1976),

44 Against this background, it is generally not desirable for a host government to permit one single company to be solely responsible for petroleum activities in a given area. Rather, it is beneficial for the host country to require that a joint venture of competent companies ( JV ) 10 co-operate in carrying out petroleum activities in a given area. 11 Moreover, the applicable law 12 often establishes that the government can hold each of the JV parties, at least ultimately, jointly and severally liable for the JV s obligations under the petroleum license or contract irrespective of the size of their participating interests. 13 Therefore, if more parties are involved in the JV, then the HG should be at a better position to secure its interests. This approach is also beneficial for the companies involved, 14 as it allows each company to spread the risk of its total activities in a number of different projects 15 rather than having to focus on one single project. As such, any losses can be compensated through other, successful projects. 16 Thus, JV minimises risks and shares costs, for the host government and the contracting parties. 17 The JV will also establish private law relations between the JV parties, determining liabilities and responsibilities. 18 However, as demonstrated in the account of risks above, it is clear that carrying out petroleum activities in cooperation with other parties can be challenging. The JV parties involved in a petroleum project have to agree on adequate technical solutions, costs, financing and risk management. This requires careful planning and good cooperation climate amongst the JV parties. Considering the typical joint and several liability the JV parties have towards the government and third parties, each JV party also needs to take adequate precautions to ensure that their own interests are secured. This forms the background for the Joint Operating Agreement ( JOA ), which is a key legal instrument for regulation of the relationship between the JV parties when carrying out joint petroleum 10 For the purposes of this paper JV, consortium, partnership, association and JOA have the same meaning. 11 Participants in the resource industry, while generally operating as competitors, will often form alliances to explore co-operatively in a particular area. John Tarrant, Agreements to Co-Operate at Common Law, 25(3) Australian Resources and Energy Law Journal (2006) Or, in some cases, the petroleum license or the petroleum contract. 13 This situation is very similar to a tenancy, as the joint tenants have a collective, unitary interest where each joint tenant is entitled to possession of the whole of an interest which is subject of co-ownership. Peter Roberts, Joint Operating Agreements: A Practical Guide (Globe Law Business, London 2010), See: Terence Daintith, Geoffrey Willoughby (eds), Adrian Hill, United Kingdom Oil & Gas Law (3 rd edn Sweet & Maxwell, London 2009), 1140, Gerard M. D. Bean, Fiduciary Obligations and Joint Ventures: The Collaborative Fiduciary Relationship (OPU, Oxford 1995) 14 15, Kenneth Charles Mildwaters, Joint Operating Agreements, A Consideration of Legal Aspects Relevant to Joint Operating Agreements used in Great Britain and Australia by Participants thereto to Regulate the Joint Undertaking of Exploration for Petroleum in Offshore Areas with Particular Reference to their Rights and Duties (PhD Thesis presented to the University of Dundee, 1990), See: Bryan Cooper and T. F. Gaskell, North Sea Oil, The Great Gamble (Heinemann, London 1966). 16 See: Ernest E. Smith and others, International Petroleum Transactions (3 rd edition, RMMLF, Westminster 2010), 542, Sandy Shaw, Joint Operating Agreements, in Martyn R. David, Upstream Oil and Gas Agreements (Sweet and Maxwell, London 1996), 19 21, Hugh Dundas, Joint Operating Agreements: An Introduction, (1994 Summer Programme: UK Oil and Gas Law, CPMLP 09/09, 1994), See: Chris Wilkinson, Joint Ventures & Shareholder s Agreements (3 rd edition, Bloomsbury Professional, West Sussex 2009), This relationship is referred as the horizontal relationship, whereas the public relationship between the JV and HG is referred to as the vertical relationship. 41

45 activities under a petroleum license or a petroleum contract. Traditionally, host governments have been hesitant to interfere with the private law relationship amongst the JV parties. Due to the typical requirement that the JV parties are jointly and severally liable towards the government and third parties, 19 many host government thought it reasonable to let the investors regulate their own private relationship amongst them, except for the key issues related to the operatorship, transfer of interest and liabilities towards the government. Thus, the JOA was predominantly a private law instrument. In such a scenario, the JV parties are allowed to, within the framework of the applicable law, negotiate and determine their own rules which express the extent and nature of their relationship with each other. Antony Jennings states as follows: The joint venturers will commonly negotiate and execute a Joint Operating Agreement (JOA), or equivalent, which will govern the rights and liabilities of the parties as between themselves and their relationship with the group member responsible for conducting the joint operations, known as the operator. 20 This is not always the case, however. The Norwegian JOA, albeit drafted in the form of an agreement entered into between the JV parties, is by and large a standardized agreement developed by the authorities in consultation with the industry. Nevertheless, the Norwegian JOA has the same function as that of a JOA that has been negotiated and agreed amongst the JV parties. It can be said to be the bedrock of operations as it sets forth the framework and detailed rules upon which the Joint Venture will operate. 21 Consequentially, this article will discuss the following main questions: to what extent should host governments interfere with the negotiation and conclusion of a JOA, i.e. should HGs require the submission of the negotiated JOA for information only, or the submission of the negotiated JOA for approval, or issue its own standard JOA model form? Or, should the participation of the NOC in the JV satisfy the need for governmental oversight for resource management purposes? This paper will analyse and address these questions below. 2 HG intervention in JOA model form 2.1 Introduction: Using standard contractual model forms in the petroleum industry The players in the oil and gas industry often operate globally. Each region and each petroleum province clearly has its own particular needs and requirements, but by and large, the challenges that the players face are similar. Consequentially, rather than using time and effort to understand different contractual approaches on the same issues, it is easier for the players to agree on and implement similar contracts in all jurisdictions. Typically, standard contracts will represent a well-known balance of interest amongst the parties involved. If updated regularly, they will also normally incorporate any lessons learned in the industry. 19 E.g. Brazilian Law No of August 6, 1997 Article Antony Jennings, Oil and Gas Exploration Contracts (2 nd edition, Sweet & Maxwell, London 2008), Sandy Shaw, Joint Operating Agreements, in Martyn R. David, Upstream Oil and Gas Agreements (Sweet and Maxwell, London 1996),

46 This applies equally to most standard JOAs model forms. As such, standard JOA model forms facilitate agreement and implementation. Whereas most of the oil and gas regions have their own JOA model form to address their individual needs, they are all based on similar principles. 22 Despite this common thread, there are some differences between different jurisdictions and different petroleum provinces, either due to the context in which the petroleum activities are carried out (e.g. onshore or offshore) or due to fundamental differences between legal systems (e.g. civil or common law). Thus, one finds regional adaptions to standard JOA model forms. 23 As A. Martin describes in the following terms: Model contracts have been developed and used in a wide variety of ways in different jurisdictions. They are extremely flexible tools that allow users to draft effective petroleum contracts quickly and efficiently. They have spread throughout the global petroleum industry because of the significant benefits and immense value they provide to the entire business cycle. As a result, model contracts in the international industry will undoubtedly expand in their development and application in the future. 24 It is important to remember that no model form can address every issue which could be relevant for every situation; this is a highly complex industry and the laws and regulations might change from jurisdiction to jurisdiction. For example, in the jurisdiction of Greenland, the NOC will be part of the JOA, whereas the North American jurisdictions do not even have a NOC in their system. Therefore, it stands to reason that a practiced and tested standard form will be more readily approved by the oil and gas industry than a purely theoretical recommendation by any individual or institution who is not directly involved with industry practices. 2.2 Should Host Governments be informed of or approve a JOA? A HG can decide the level of participation and control of its natural resources. This is typically exercised through the establishment, implementation and enforcement of laws and regulations as well as through the host government contact with the JV. But the relationship of the JV parties might be a concern to the HG on two main issues: (a) what are the terms and conditions of their relationship and (b) how do they cooperate on a day-to-day basis. Consequentially, the HG might require a right to be informed about the signed JOA or a right to approve the JOA before it enters into force. In cases where the HG requires approval, we also frequently see that the HG has the power to stipulate conditions for approval. 22 Catia Malaquias Miles, AIPN 2002 Model Form Joint Operating Agreement in Oil and Gas Joint Ventures, 22 Australian Resources & Energy L.J. (2003), A. Timothy Martin, Model Contracts: a Survey of the Global Petroleum Industry, 22 J. Energy & Nat. Resources L. (2004), Ibid,

47 Some might argue that it is not necessary for a HG to be involved in JOA negotiation as the JOA governs the relationship of JV parties. This is especially in jurisdictions where the JOA is considered as a private law instrument. The HG interests and resource management could rather be secured by e.g. requiring that the JV parties are jointly and severally liable for the JV s obligations towards the HG, approval of the appointment and change of operator, approval of assignment of participating interests, and by requiring submission of plans for prior approval for new, key phases of the petroleum activities. 25 This is exactly the case of the licence regime in Brazil, which views the JOA as a private law instrument. The petroleum law and concession contract in Brazil only establishes these basic requirements to the JOA: 26 (i) approval of the operatorship, (ii) registration of the JV in the public registrar, (iii) approval of any assignment of participating interest, (iv) joint and several liability amongst the concessionaires, i.e. the JV parties. Others might argue that the NOC participation in the JOA is enough to secure the government control over the JV operations. Through such participation the HG will be informed of the JVs activities and might be able to influence the decisions to be made in the JV as a participant. This was one of the main reasons behind the regulatory changes to the Brazilian licence regime for the pre-salt area. For the pre-salt area, direct state participation in the JVs was introduced. Firstly, only Petrobras is authorised to be Operator and it shall retain no less than 30% of participating interest in each JV. 27 Secondly, the management committee will be necessarily composed of representatives of the government (i.e. PPSA) and Petrobras. 28 The former shall nominate half of the members, the chairman and possess a veto right. 29 The latter shall have at least 30% equity in the consortium. In any event, even if the HG is being informed of the JOA or if it approves the JOA, this will not guarantee that further information will be provided on the day-to-day operations or that in the life span of the petroleum project there will be enhanced governmental control of the JV s petroleum activities. This would rather guarantee the industry that this particular JOA is acceptable by the HG. Due to this approval, there is less of a risk that the HG may claim that the JOA entered into is unenforceable in the jurisdiction in question. For the HG, such mechanisms contribute to secure that the JOA is in line with applicable law and the granting instrument (license or contract) that awards the exploration and production rights to the JV. Therefore, if a HG is keen to keep close control of the JV terms and conditions, a mechanism to approve or even to be informed about the signed JOA will be fit for purpose to achieve the intended objective. However, if the HG is keen to keep close control of the day-to-day operations of the JV, then other measures will be required, as the prior approval of or mere information of a signed JOA does not secure information on implementation and performance of the JOA. 2.3 Should Host governments have their own standard JOA model forms? 25 E.g. for drilling, development, production and decommissioning. 26 Law n. 9248/1997 Article 38º 27 Law n /2010 Article 4º 28 Art. 23 of PSA law. 29 Art. 23 and 25 of PSA law. 44

48 The next question is whether a HG should have its own standard JOA model form and to what extent the JOA parties should be allowed to deviate from such standard under certain circumstances. Although standard JOA model forms are valuable instruments for reaching an agreement quickly, it is also important to note that a standard model form might not completely or adequately address the particular context of the planned petroleum activities in a given area, so one could argue that some leverage for specific adjustments should be allowed. A. Martin refers to industry demands, industry support and drafting philosophy as the most important elements for any standard agreement. 30 It is thus arguable that industry demands and support should consistently take priority and that adjustment thereto is fundamental to the formation of standard model forms. Moreover, the terms of the model form should represent a fair balance of interests. As mentioned above, petroleum activities are characterized by a high level of risk, costly and complex activities. Therefore, the JOA parties may wish to be able to affect the content of the JOA as the JOA has direct impact to the responsibly and liabilities they undertake. Indeed, in some jurisdictions typically where the petroleum industry is new and where the level of political risk is deemed high and in cases of high-risk projects- the JV parties will insist on such flexibility as a requirement to commit to investments. 31 Nevertheless, standardized JOAs are in use. It was mentioned above that the Norwegian JOA is by and large a standardized agreement developed by the authorities, albeit in consultation with the industry. Typically, it is a condition to the award of a Norwegian petroleum license that the standard JOA is entered into. Amendments or additions to the JOA cannot be unilaterally agreed amongst the participants; they are subject to the prior approval of the authorities. 32 Thus, the Norwegian JOA is considered as a license condition, i.e. a public law instrument, rather than a private law agreement. One may question whether this is an approach that should be adopted in other countries. Continuing to use the Norwegian example, the Norwegian practise of using a standard JOA model form must be seen in connection with the tight governmental control that the Norwegian government now holds over the management of petroleum activities on the Norwegian continental shelf in general. In this context, it is interesting to note that in the early years of the Norwegian petroleum industry, when governmental control of the petroleum activities was less stringent than today and the legal regime was not so developed, there was no standard Norwegian JOA model form. In fact, the requirement to use a standard model form was introduced as the maturity of the legal framework as well as the capacity and competency of the relevant Norwegian authorities improved. We, therefore, argue that the question raised in this heading is not one that can be answered generally: the context of the host country must be carefully considered. Indeed, 30 Such as Project Managing, Resources, Deliverables, Marketing, Education and Future Revisions. See A. Timothy Martin, supra, note 23, The U.S. is again an exception to this rule. 32. See the standard Special Terms Art

49 whereas the Norwegian model works well in Norway today, this would most certainly not have been the case in the early years of the Norwegian petroleum industry. Over the decades that have passed since the launch of the Norwegian petroleum industry, Norway has gradually developed a comprehensive well-established legislative framework. 33 The Norwegian government is now competent and has the required capacity to hold a tight grip on resource management has also held an overall steady course in the resource management so the level of perceived political risk is relatively low. 34 One may question whether the Norwegian model will continue to work as the Norwegian continental shelf matures. However, this is yet due to be tested as the Norwegian continental shelf is still attracting much interest from potential investors as there are still discoveries being made 35 and expected to be made. We argue that despite the perceived benefit of standardized model forms, this model might not fit for a host country, which is less attractive for investors, where the legal regime is less developed or the relevant authorities have less capacity and competency for resource management. HGs are advised, however, to ensure that JOAs are based on standard model forms used in the industry adequate for their respective regions. 2.4 State participation The legal framework for petroleum activities within a jurisdiction may establish a right for the HG to participate in a JV through a special governmental entity or through a national oil company ( NOC ). 36 Typically, the HG may either reserve the right to enter into the JV and, thus, the relevant JOA from its very beginning or in the later stages of a project (i.e. appraisal and production). The question of conditions and process for state participation and whether state participation is to be allowed largely depend on the HG s appetite to take on risks. Ideally, the financial and technical capacity and competency of the relevant state entity should be an important element in deciding on this matter too, but we see that this is not always the case. 37 Nevertheless, if a state entity/noc has weaker financial capabilities, then it is generally less likely that a governmental entity would participate from an early state of the project without its costs and expenses being carried by the other JV parties on its behalf for 33 The petroleum license used in Norway only contains a few specific terms for the area in question, such as the work programme. All other terms are set in the petroleum law and relevant regulations. 34 The link between the PL and the JOA also implies a modification to the general rule that parties to a joint venture agreement (such as the JOA) may change the agreement by unanimous vote: Any amendment or addition to the JOA has to be approved by the state in order to be valid. Apart from the formal reason for this (i.e. the acceptance of the JOA being a condition for being granted the PL), the rationale for the provision presumably lies in the state s general wish for standardisation and for controlling «the rules of the game. Juris Knut Kaasen, Scope of Joint Operating Agreements in Norway (Petroleum Law Seminar, St.Raphael, 2000), Recent examples include the Edvard Grieg and the Johan Sverdup fields. 36 For further information see: Eduardo G. Pereira and Anna Ovcnarova, Joint Operating Agreements: Challenges and Concerns between an IOC and NOC (Globe Law Business, London 2015). 37 Some HG use state participation as a measure to increase local content and for capacity building purposes. Although state participation might be an adequate tool for promoting local content it might work as a disincentive for potential investors and we have also seen that it might (give rise to claims that it has) impact the efficiency of petroleum activities. 46

50 a given period. 38 Likewise, if the technical competency is low, then the NOC might be given exemptions from technical award criteria or their voting rights might be limited. However, if the NOC is of a certain size (e.g. Petrobras), then the NOC should participate in the JV on the same conditions as the other JV parties. The policy that the HG adopts on this point can make a significant difference for the JV parties in terms of risk evaluations and investment decisions. Our question, however, is whether the HG s policy goals related to natural resource management can be achieved by state participation, either directly or by the participation of a NOC. The question assumes that whenever a state entity participates as party in a JOA then the HG s interests is also represented in the horizontal relationship of the JV parties. 39 Through state participation, the HG will not only ensure that it has all relevant information on each project, but it will also take part in the important managerial, technical and financial decisions. 40 Unless the HG is part of the JV, it might not be informed of the JV s operations as well as internal issues or cooperation issues that might arise within the JV. For example, a HG might not be informed about a JOA defaulting party if the other JOA parties cover this defaulting party s participation in the petroleum agreement. Another example of lack of interaction between the HG perception of the JV and the internal reality of the JV is the case of an exclusive operation. In many cases, the HG might not be aware of this and believe that all parties remain as a unit with joint operations even though they might be partially or completely segregated in practice through a variety sole risk projects. Therefore, state participation might secure a better understanding of the day-to-day operations of the JV. Furthermore, state participation might also benefit the other JOA parties. There is a view that it is beneficial to have a NOC as a party to the JOA, for instance, since having a government entity in place as a party to the JOA might help to reduce the risk of political interference on the basis that the government might be less inclined to affect adversely a particular project in which it has some investment. 41 However, we have not seen evidence that there is an inherent correlation between state participation and reduction of the political risk. Nevertheless, the possible benefits of state participation are clear: it can facilitate the day-to-day dialogues between the HG and the JV and prevent tension between the same parties. We have stated above that this discussion is based on an assumption that whenever a state entity participates as party in a JOA, the HG s interests are also represented in the horizontal relationship of the JV parties. However, it should be taken into account is that if state participation is carried out through a NOC, the degree of HG influence in the JV will depend on the level of control the HG can exercise through the NOC. If the NOC is not wholly owned by the HG, the level of governmental control will be lower. In some cases, the NOC might be 38 Usually, the costs so carried will be paid back when the revenues from the project start flowing. 39 As will be discussed in the following, the degree of real influence that such participation will entail will vary depending of the ownership structure and share of the HG in the national oil company as well as the rules on management of thereof and of course the JOA itself. 40 This can of course be done through other means, In Norway, for instance, government officers are allowed to participate at, inter alia, management committee meetings as observers. 41 Peter Roberts note 13,

51 fairly independent from the state intervention and might have their own views on how to conduct their business. In conclusion, we note that whereas state participation can increase the HG oversight and information over the JV s day-to-day operations, the specific form of participation as well as the level of the participating interest of the state entity will depend on the extent to which the HG is able to affect the decisions and the activities of the JV. Therefore, the HG should also take into account the potential impacts of state participation on the investment climate and the efficiency of the petroleum activities when considering state intervention on a policy level. 3 Conclusions Above we have stated that states have permanent sovereignty over their natural resources and that most states also wish to retain exclusive control over resource management. This assumed policy objective formed the background for discussing the extent to which HGs should interfere with the negotiation and conclusion of JOAs. We conclude that there is no single solution on this issue. Each host country has a specific context in which it operates, and in the end of the day it is this context that should be decisive when determining the optimal model for that host country at that point in time. Some HGs might only be in a position to require submission of readily negotiated JOAs for information, whereas others may be in a position to receive such JOAs for approval. Some might decide to follow the Norwegian path and issue their own JOA model form, but others might prefer to leave it to the JV parties to decide at their own. We argue that the requirement to approve or to be informed of a signed JOA will not secure stronger governmental control of the day-to-day operations of any JV. However, it would increase the governmental control of the signed terms and conditions of any JV on its jurisdiction. We also argue that the use of a standardized JOA models might not fit into a petroleum province, which is less attractive for investors, where the legal regime is less developed or where the relevant authorities have less capacity and competency for resource management. If the main objective of the host government is to assure access to information for resource management purposes, we argue that state participation in the JV might be an adequate vehicle for this. 42 Such participation will not necessarily in itself, however, enable the host government to have more control over the JVs petroleum activities than any other JV party with the same participating interest, but it would allow the HG to be informed of the day-today operations of the JV in a much closer manner. Thus, we note that tight control over resource management is perhaps best exercised through laws, regulations and petroleum contracts and/or licenses. However, such control is not achieved by regulation alone. Although it is an important first step, supervision and enforcement in case of breaches is required for regulation to achieve its objectives. 42 Or, indeed, as pointed out in foot note 33, by merely establishing regulatory requirements for provision of or access to information as well as reserving the right for state officials to attend JV management committee meetings as observers. 48

52 As a joint conclusion for the discussion above, we argue that each HG should analyse its aspirations, capabilities, the regulatory context and the possible impact on the investment climate carefully before deciding on the best policy to achieve its resource management goals JV The JOA does not operate in isolation: It has to be viewed on the background of the production licence (Production Licence - PL), to which it is made a formal condition. And further: The PL is based on the Petroleum Act, and has to be viewed in this context. Juris Knut Kaasen, Scope of Joint Operating Agreements in Norway (Petroleum Law Seminar, St.Raphael, 2000), 8. 49

53 Legally Protecting Upstream Investments Martin Andrew Jarrett 1 1 Introduction Natural resource nationalism is an anathema to private companies in the upstream petroleum sector. Upstream investments, consisting of legal assets (permits) and physical assets which make production possible, are viewed as morally defensible targets of expropriation. This is because, as upstream companies merely find and extract, but not create, the natural resource, the citizens, as represented by the state, have a stronger claim to its ownership. States may expropriate upstream investments under international law, but that right is subject to certain legal requirements, the performance of which determines the lawfulness or unlawfulness of an expropriation. In 2014, two arbitrations, Yukos v. Russia 2 and Exxon v. Venezuela, 3 were decided which involved both unlawful and lawful expropriations, respectively. Besides standing out for the amounts of damages awarded, being USD 50,020,867,798 for Yukos and USD 1,600,042,482 for Exxon, their value lies in the jurisprudence they propound. Sections 3 and 4 of this paper summarise the arbitrations mentioned above. These summaries are written with a view to contextualising the commentary in Section 5 and 6. Section 5 evaluates the rule from Exxon v. Venezuela on implementing corporate restructurings as a measure to obtain investor status in foreign investment law. Section 6 considers the findings of contributory fault in Occidental v. Ecuador 4 and Yukos v. Russia. Before beginning that commentary, an overview of the legal framework which underpins these arbitrations is provided next. 1 Lecturer, University of Mannheim, Germany. contact: Many thanks to the staff at the UEF Energy Law Review for their assistance in bringing this paper to publication. All errors are my own. 2 Hereinafter, Yukos v. Russia refers to the three arbitrations detailed in Procedural History (Section 3). 3 Hereinafter, Exxon v. Venezuela refers to Venezuela Holdings, B.V., Mobil Cerro Negro Holding, Ltd., Mobil Venezolana de Petróleos Holdings, Inc., Mobil Cerro Negro, Ltd., and Mobil Venezolana de Petróleos, Inc. v. The Bolivarian Republic of Venezuela (ICSID Case No. ARB/07/27); interim award on jurisdiction available at: (last accessed 5 August 2015) [hereinafter, Exxon v. Venezuela (interim award) ], and final award available at: (last accessed 5 August 2015) [hereinafter, Exxon v. Venezuela (final award) ]. 4 Hereinafter, Occidental v. Ecuador refers to Occidental Petroleum Corporation and Occidental Exploration and Production Company v. The Republic of Ecuador (ICSID Case No.: ARB 06/11); final award (majority decision) available at: (last accessed 5 August 2015) [hereinafter, Occidental v. Ecuador (majority award) ], and dissenting opinion available at: (last accessed 5 August 2015). The dissenting opinion concurred with the majority as regards the liability of Ecuador, but differed on the quantification of damages for that liability.

54 2 Legal Framework 2.1 Fundamentals Disputes relating to the expropriation of upstream investments are regulated by, what is commonly called, foreign investment law. At its core, foreign investment law is simple: governments exchange promises, in international investment agreements, to protect and promote investments of each other s investors in their territories. In theory, there is exchange whereby a government attracts foreign investment, while foreign investors can register a measure against political risk in their business plans. 2.2 Sources of Law Foreign investment law is principally constituted by international investment agreements. International investment agreements take numerous forms, such as bilateral and multilateral investment treaties and free trade agreements. There are approximately 3000 bilateral investment treaties in force, all of which have remarkably similar content. These international investment agreements are complemented by other sources of international law, including international customary law, general principles of law, arbitral and judicial decisions applying international law, and commentaries from eminent jurists on international law Dispute Resolution Arbitration is the principal method of resolution for foreign investment disputes. It takes two forms, ad hoc or institutional, and international investment agreements usually give the claimant investor the option to pursue either. In ad hoc arbitration, the arbitrators and parties administer the process themselves. In institutional arbitration, the process is administered by an arbitral institution by providing services such as facilities for hearings, coordinating the exchange of documentation, and composing, if necessary, the arbitral panel. The principal arbitral institution for foreign investment disputes is ICSID. 6 Its contracting states 7 may be sued before it and must enforce its awards, subject to their laws on state immunity Determination of Disputes The determination of foreign investment disputes follows a pattern. First, the claimant investor has to establish jurisdiction; in other words, to prove that the arbitrators have the legal authority to resolve the dispute. The legal authority of the arbitrators is founded on 5 Statute of the International Court of Justice, Art. 38(1)(b) (d); available at: (last accessed 5 August 2015). 6 Hereinafter, ICSID refers to the International Centre for the Settlement of Investment Disputes. 7 Currently, there are 150 contracting states. 8 Convention on the Settlement of Investment Disputes between States and Nationals of Other States, Art. 25(1); available at: [hereinafter, ICSID Convention ]. 51

55 the consent of parties to the dispute. A claimant investor gives its consent when it submits its claim, and a respondent state usually gives its consent in an international investment agreement. Giving consent in this form is subject to certain conditions, such as the claimant investor being a national of a state which is party to the relevant international investment agreement, and that it holds an investment. The conditions of consent are considered in more detail in paragraph 5.1. Second, the merits of the dispute are considered. The claimant investor has to prove that the respondent state has breached one of its obligations of the applicable international investment agreement. A breach of one of these obligations serves as a cause of action. Unlawful expropriation is one cause of action, and others include observance of undertakings, arbitrary or discriminatory treatment, fair and equitable treatment, full protection and security, and transferability of capital. Assuming a breach is proven, the appropriate remedy for such a breach will then be assessed, with damages being the default remedy. 3 Yukos v. Russia 3.1 Procedural History Yukos v. Russia is a compendious term for three separate arbitrations being: - Hulley Enterprises Limited (Cyprus) v. The Russian Federation; 9 - Veteran Petroleum Limited (Cyprus) v. The Russian Federation; 10 and - Yukos Universal Limited (Isle of Man) v. The Russian Federation 11 As the arbitrations were each bifurcated into jurisdictional and merits phases, six separate arbitral awards were written. The arbitrations were, however, heard together as the facts and applicable law were the same for each. Each claimant 12 was a shareholder in OJSC Yukos, 13 with their shareholdings cumulatively amounting to 70.5 per cent. They claimed damages in the amount of at least USD 9 Hulley Enterprises Limited (Cyprus) v. The Russian Federation (PCA Case No. 226); interim award on jurisdiction and admissibility available at: (last accessed 5 August 2015), and final award available at: (last accessed 5 August 2015). 10 Veteran Petroleum Limited (Cyprus) v. The Russian Federation (PCA Case 228); interim award on jurisdiction and admissibility available at: (last accessed 5 August 2015), and final award available at: (last accessed 5 August 2015). 11 Yukos Universal Limited (Isle of Man) v. The Russian Federation (PCA Case No. 227); interim award on jurisdiction and admissibility available at: (last accessed 5 August 2015) [hereinafter, Yukos v. Russia (interim award) ], and final award available at: (last accessed 5 August 2015) [hereinafter, Yukos v. Russia (final award) ]. 12 Hereinafter, Yukos refers to the claimants collectively. 13 Hereinafter, OJSC Yukos refers to OJSC Yukos Oil Company. 52

56 114,174,000, under the Energy Charter Treaty on the basis of an unlawful expropriation by Russia. 15 The arbitration was conducted on an ad hoc basis under the UNCITRAL Arbitration Rules Factual Background In November 2003, the Yukos corporate group was globally the fourth largest private producer of oil and gas. By November 2007, it had been struck off the registry of Russian companies. What precipitated this dramatic downfall? Privatisation of Yukos In 1995, the indigent Yeltsin government was teetering on the brink. 17 With Yeltsin sitting on a low approval rating and an election approaching, a controversial loans for shares programme was conceived. Russian banks, controlled by the oligarchs, lent to the Yeltsin government, with such loans being secured by shares in state owned companies, one of which was OJSC Yukos. 18 After defaulting on the loans, the shares were auctioned by the banks. These auctions were highly controversial as, many believed, 19 that the purchase prices for these shares were well below their market values, and the banks were usually the successful bidders. Through these auctions, Bank Menatep, whose creator and principal figure was Mikhail Khordorkovsky, gained control of OJSC Yukos Tax Optimisation Scheme After privatisation, the Yukos corporate group was restructured to implement a tax optimisation scheme. 21 Russia acknowledged that other large Russian oil companies implemented similar tax arrangements, but claimed that they were modest when compared to Yukos tax arrangements. 22 The optimisation scheme involved establishing trading subsidiaries in low tax regions of Russia. 23 These low tax regions were established in the beginning of the 1990s to foster development in economically deprived regions of Russia. 24 The trading subsidiaries were 14 Yukos v. Russia (final award) at Energy Charter Treaty; signed: 17 December 1994, in force: 16 April 1998); available at: (last accessed 5 August 2015) [hereinafter, ECT ]. 16 UNCITRAL Arbitration Rules (2010); available at: (last accessed 5 August 2015). 17 Safire, W., Essay; After Yeltsin, Who?, The New York Times, 30 January 1995; available at: (last accessed 5 August 2015). 18 Goldman, M. I., Putin and the Oligarchs, Foreign Affairs, November/December 2004 Issue. 19 See Goldman, M. I.; Putin, the Oligarchs & the End of Political Liberalization, 2(2) The Economists Voice, p. 1. For an alternative view, see Treisman, D.; Loans for Shares Revisited, 26(3) Post Soviet Affairs, p Black, B., Kraakman, R., and Tarassova, A., Russian Privatization and Corporate Governance: What Went Wrong?, 52(6) Stanford Law Review, p Hereinafter, Yukos tax arrangements refers to Yukos tax optimisation scheme. 22 Yukos v. Russia (final award) at Id. at Id. at

57 subject to minimal or no corporate profit tax, in exchange for making investments in these regions pursuant to investment agreements with the regional governments. Yukos production subsidiaries, based in high tax regions, would sell to Yukos trading subsidiaries at below market value, and these trading subsidiaries would sell at market value to non-yukos companies. 25 Profits were thereby concentrated in the trading subsidiaries and distributed to holding companies incorporated in low tax jurisdictions outside Russia Tax Reassessments Starting in December 2003, Yukos tax arrangements were reaudited for the years 2000 until Yukos tax debt was reassessed to approximately USD 24,000,000,000 for these years. 27 This was notwithstanding earlier certification from the Russian tax ministry which validated Yukos tax arrangements, and confirmed that it had no outstanding debts. 28 Russia explained that its reaudit exposed the unlawfulness of Yukos tax arrangements, and its tax obligations were reassessed upon the proper application of the law. The motivations behind these tax reaudits were contested. 29 Yukos argued that they were discriminatory, and were designed to expropriate Yukos assets under the veil of taxation and eliminate Mikhail Khordorkovsky as a political force. 30 Russia counted that they were part of general programme whereby many Russian companies were reaudited. Attempts were made to settle this tax debt, but Yukos claimed that they were futile owing to the disinterest of, and the freezing of its assets by, Russia. Russia disputed that Yukos made any genuine attempts to settle, and its asset freezes were not so comprehensive as to prevent payment. 31 On 19 December 2004, Yukos principal producing subsidiary, Yuganskneftegaz, was auctioned and indirectly acquired by Rosneft, a state owned company, for USD 9,350,000,000. This purchase price was below various estimates of its market value, 32 but Russia explained that this resulted from Yukos promise to subject any bidders to a lifetime of litigation Threats, Investigations, and Arrests Coupled with the tax reassessments, Yukos directors, employees, and external advisors were subjected to criminal investigations, arrests and, most prominently with Mikhail Khordorkovsky, convictions. 34 These criminal proceedings stemmed from the alleged 25 Id. at Id. at Id. at Id. at Id. at Id. at Id. at Id. at Id. at Id. at

58 unlawfulness of Yukos tax arrangements. Threats were also made to revoke Yukos permits, although these threats did not eventuate Bankruptcy of Yukos On 6 March 2006, a syndicate of western European and American banks, in satisfaction of a condition precedent under a loan transfer agreement between the syndicate and Rosneft whereby Rosneft became a creditor of Yukos, commenced insolvency proceedings against Yukos. 35 The debt restructuring proposed by Yukos management was rejected by its creditors, and the Moscow Arbitrazh Court ordered that Yukos assets were to be liquidated. 36 Through the auctions of these assets, per cent of Yukos assets were directly or indirectly acquired by Russia Jurisdiction The Russian government raised numerous objections to jurisdiction, the principal among which was the objection that Russia was not bound to the ECT. Russia had signed the ECT, but had failed to ratify it. Usually, Russia would not be bound failing ratification, 38 however, Article 45(1) of the ECT admitted an exception to this rule by providing that the ECT had provisional application to signatory states: 39 to the extent that such provisional application is not inconsistent with its constitution, laws or regulations Russia advocated that this provision operated to make any provision of the ECT ineffective which was inconsistent with Russian law during the period of provisional application. 40 This objection, however, was rejected as the arbitral panel interpreted this provision to bind all signatory states if their laws recognised the concept of provisional application. 41 Russian law did recognise provisional application. Other objections were advanced by Russia, including unclean hands 42 and bad faith and illegal conduct 43 objections which proposed that jurisdiction should be denied because the investments were tainted by criminality and illegality. 44 These objections, and the other objections, 45 were dismissed by the arbitral panel. 35 Id. at 1064 & Id. at Id. at ECT, Art Id., Art. 45(1). 40 Yukos v. Russia (interim award), Id., Yukos v. Russia (final award), Id., Id., for details on relevant conduct. 45 Four other objections were pursued; claim preclusion (see Yukos v. Russia (interim award) at 598), taxation measures under Art. 22 of the ECT (see Yukos v. Russia (final award) at 1447), non-protected investor (see Yukos v. Russia (interim award) at 417), and non-protected investment (see Yukos v. Russia (interim award) at 430). 55

59 3.4 Merits Attribution To establish Russia s liability, Yukos had to attribute the conduct of the relevant actors, most particularly Rosneft and its subsidiaries, to Russia. The general rule stipulates that actions of the executive, judicial, and legislative arms of government are attributable to a state under international law. 46 Actions of state owned companies may also be attributed to the state if they are acting at the direction of the state. 47 Following these rules, the actions of the Russian tax ministry, law enforcement authorities and Rosneft were attributed to Russia. 48 The evidence proving that Rosneft, a state owned company, acted at the direction of Russia was that the directors of Rosneft were concurrently serving as Russian ministers, and comments from Vladimir Putin at a press conference where he explained: Rosneft, a 100% state owned company, has bought the well-known asset Yuganskneftegaz [t]oday, the state is looking after its own interests. 49 The actions of the insolvency administrator were not attributed to Russia, and this accorded with a line of jurisprudence on this matter Fair and Equal Treatment Yukos argued a breach of the fair and equitable treatment standard as one cause of action. 51 The arbitral panel did not rule on this because it upheld Yukos cause of action for unlawful expropriation Expropriation Yukos successfully argued that Russia had indirectly expropriated its investments; 53 in other words, they were subjected to measures having effect equivalent to nationalization or 46 Draft articles on Responsibility of States for Internationally Wrongful Acts; International Law Commission; 2001; available at: (last accessed 5 August 2015) [hereinafter, Draft Articles on State Responsibility ], Art. 4(1). Applied in Yukos v. Russia (final award), Draft Articles on State Responsibility, Art Yukos v. Russia (final award) Id., Id., 1476 and ECT, Art. 10(1). 52 Yukos v. Russia (final award), Id.,

60 expropriation. 54 Indirect expropriation differs from direct expropriation as the latter involves an overt acquisition of the investment. 55 In determining whether the actions of Russia were expropriatory or not, the arbitral panel considered the objective of Russia. The relevant passage reads as follows: if the true objective [of Russia] were no more than tax collection, Yukos, its officers and employees, and its properties and facilities, would not have been treated, and mistreated, as in fact they were. Among the many incidents in this train of mistreatment that are within the remit of this Tribunal, two stand out: finding Yukos liable for the payment of more than 13 billion dollars in VAT in respect of oil that had been exported by the trading companies and should have been free of VAT and free of fines in respect of VAT; and the auction of YNG at a price that was far less than its value. But for these actions, for which the Russian Federation for reasons set out above and in preceding chapters was responsible, Yukos would have been able to pay the tax claims of the Russian Federation justified or not; it would not have been bankrupted and liquidated. 56 Accordingly, when assessing whether the nature of an action is expropriatory, Yukos v. Russia stands for the principle that the objective of the respondent state is the determining factor. This implicitly endorses the police powers doctrine. It holds that, when assessing whether a state has indirectly expropriated, the nature and purpose of the acts, which cause the indirect expropriation, are relevant. If these acts pursue some legitimate public purpose, such as tax collection, public health, or environmental protection, they cannot cause an indirect expropriation. 57 The police powers doctrine stands in contrast to the sole effects doctrine. It holds that the nature or purpose of the acts, which cause the expropriation, is irrelevant. 58 According to the arbitral panel in Mitchell v. Congo, the majority of arbitrators in foreign investment disputes prefer the sole effects doctrine. 59 It might be argued that the sole effects doctrine must be subject to an exception with respect to tax collection. This is because tax collection is of a different nature to other governmental powers which are usually classified as police powers. Tax collection necessarily involves the act of directly taking assets from a person, and this is the essence of expropriation. Compare this to the enactment of an environmental protection regulation for 54 ECT, Art. 13(1). 55 Newcombe, A., and Paradell, L., Law and Practice of Investment Treaties: Standards of Treatment (Kluwer Law, 2009), p Yukos v. Russia (final award), Mostafa, B., The Sole Effects Doctrine, Police Powers and Indirect Expropriation under International Law, 15(2008) Australian Journal of International Law, p Dolzer, R., and Schreuer, C.; Principles of International Investment Law (Oxford University Press, 2012),pp Patrick Mitchell v. The Democratic Republic of Congo (Annulment Proceedings Regarding the Award Rendered February 9, 2004) (ICSID Case No. ARB/99/7) at 53, available at: (last accessed 5 August 2015). 57

61 a drought-stricken state. It stipulates that only low-flow nozzles may be installed in all new commercial and residential developments. One company, without the expertise to produce competitively priced low-flow nozzles, becomes insolvent. The scenario above fundamentally differs from tax collection because there is no direct taking of the assets of this adversely affected company. Accordingly, when analysing tax collection in foreign investment disputes, arbitrators must necessarily characterise the relevant actions as either tax collection or expropriatory, and this characterisation will involve determining the nature and purpose of those actions Lawfulness of Expropriation Upon establishing expropriation, the lawfulness of that expropriation was assessed. The lawfulness or unlawfulness of an expropriation determines the measure of damages for the expropriation; 60 for lawful expropriations, damages equal the value of the investment at the date of expropriation, whereas for unlawful expropriations, damages equal the value of the investment at the date of expropriation or the date of the award, at the option of the claimant investor. Lawful expropriations must satisfy the following criteria: 61 - for the public interest; - non-discriminatory; - carried out under due process of law; and - accompanied by prompt, adequate and effective compensation. The arbitral panel determined that the expropriation was unlawful. 62 It focussed most specifically on the first and third criteria. For the first criterion, it identified that the expropriation: was in the interest of the largest State-owned oil company, Rosneft, which took over the principal assets of Yukos virtually cost-free, but that is not the same as saying that it was in the public interest of the economy, polity and population of the Russian Federation. 63 For the third criterion, particular emphasis was placed on the criminal investigations and proceedings against senior officials of Yukos, with the arbitral panel concluding that: [t]he harsh treatment accorded to Messrs. Khodorkovsky and Lebedev remotely jailed and caged in court, the mistreatment of counsel of Yukos and the difficulties counsel encountered in reading the record and conferring with 60 See further under below under Remedies (Section 3). 61 ECT, Art. 13(1)(a) (d). 62 Yukos v. Russia (final award), Id.,

62 3.4.5 Contributory Fault Messrs. Khodorkovsky and Lebedev, the very pace of the legal proceedings, do not comport with the due process of law. 64 To reduce the damages owed by it, Russia argued that Yukos had culpably contributed to the expropriation. 65 It pointed to various actions, including Yukos non-cooperation with respect to the auction of Yuganskneftegaz 66 and the insolvency proceedings, 67 but emphasised its tax arrangements. The arbitral decided in favour of Russia in ruling that Yukos tax arrangements abused the low tax regions programme in some regions, and its use of double taxation treaties was questionable. 68 This contributory fault was quantified as a 25 per cent reduction on total damages. 69 This finding of contributory fault is analysed in further detail in Section Denial of Benefits 70 Under Article 17 of the ECT, a state reserves the right to deny an investor from relying on causes of action in the ECT, if it has no substantial business activities in the jurisdiction of its incorporation. Russia raised this as a bar to both of Yukos causes of action. Russia developed two arguments to prove that it had exercised its right. First, it proposed that it had exercised its right in its First Memorial on Jurisdiction and Admissibility dated 28 February 2006 submitted in respect of the arbitration, implicitly asserting that the right to deny benefits could be exercised during arbitration. 71 Second, it argued that by concluding a partnership and cooperation agreement with the European Union, Russia exercised the right to deny benefits. 72 This agreement provided that companies incorporated in European Union member states, when investing in Russia, must have a real and continuous link with the economy of that member state. The former argument was dismissed because it was incompatible with the objectives of the ECT. 73 With this argument, Russia effectively advocated that it could unilaterally and retrospectively terminate its obligations towards foreign investors. The latter argument 64 Id., Invoking Draft Articles on State Responsibility, Art Yukos v. Russia (final award), Id., Id., Id., This claim bar was considered as an objection to jurisdiction in Yukos v. Russia (interim award). However, as the arbitral panel acknowledges in Yukos v. Russia (interim award) at 441, it is better characterised as a cause of action bar because it operates as a bar to claims which are supported by causes of action under Part III of the ECT. 71 Yukos v. Russia (interim award), 445 and Id., Id.,

63 failed because the partnership and cooperation agreement did not specifically contemplate the ECT, nor did the ECT contemplate the partnership and cooperation agreement Remedies Quantification of Damages As the expropriation was unlawful, damages were to be equal to the value of the investment on the date of expropriation or the final award, at Yukos option. 75 For lawful expropriations, the claimant investor may only claim damages for the value of the investment on the date of expropriation. 76 Affording Yukos the option of measuring damages at the date of expropriation or the date of award is designed to make a finding of unlawful expropriation more significant. For lawful expropriations, international investment agreements uniformally stipulate that the damages must compensate the foreign investor for the loss of its investment according to the value of such investment at the date of expropriation. Naturally, applying the same standard to unlawful expropriations would render the distinction between the two worthless. International investment agreements seldom, however, offer a standard for measuring unlawful expropriation, as noted by the arbitral panel: The text of Article 13, after specifying the four conditions that must be met to render an expropriation lawful, provides that for such an expropriation, that is, for a lawful expropriation, damages shall be calculated as of the date of the taking. A contrario, the text of Article 13 may be read to import that damages for an unlawful taking need not be calculated as of the date of taking. It follows that this Tribunal is not required by the terms of the ECT to assess damages as of the time of the expropriation. 77 The question this reasoning raises is: what is the relevant standard for unlawful expropriation? Considering the unlawfulness, it might be thought that punitive damages might be appropriate, although punitive damages are not recognised under international law. 78 On account of this, it can be appreciated how affording Yukos the option of selecting the valuation date is doctrinally attractive, and supported by other arbitral awards and scholarly commentaries. 79 Under this standard, any additional value which the investment accrues during the date of expropriation and the date of the award belongs to Yukos, and, as the analysis below reveals, Yukos was able to benefit from this. 74 Id., Id., ECT, Art. 13(1). 77 Yukos v. Russia (final award), Ripinsky, S., and Williams, K. Damages in International Investment Law (British Institute of International and Comparative Law, 2009), p See also Draft Articles on State Responsibility, commentary on Art Id., pp

64 3.5.2 Valuation of Investment Three heads of damages were identified; shareholdings, dividends, and interest on dividends. 80 Each was valued on both the date of expropriation, being the date of the auction of Yuganskneftegaz, and the date of the final award. 81 On account of the climbing oil prices between 2005 until 2015, it was apparent that the valuation of the investment on the date of the final award would yield the higher amount. This valuation came to USD 66,694,000,000. With the 25 per cent reduction for contributory fault, the final award of damages totalled USD 50,020,867, The method of valuation for each head of damage was contested between the parties. For the shareholdings, numerous alternatives were proffered 83 with the arbitral panel selecting a comparable companies method. 84 In summary, the comparable companies method involved determining the value of the shareholding at the date of the liquidation, 85 being USD 61,076,000,000, and then multiplying that valuation by a factor which represented the change in value of Russian petroleum and natural gas companies between that date and the date of expropriation or the date of the award, as applicable. 86 The valuation based on the date of the award produced the higher amount, 87 being USD 30,049,000, For the dividends, the arbitral panel estimated the dividend payments Yukos would have paid based on the expert evidence from both Yukos and Russia. 89 Cumulatively for each annual dividend between 2004 until 2014, this estimate came to USD 36,645,000, Interest Pre-award simple interest was awarded on the head of damage representing dividends at a rate of per cent, 91 accruing from 1 January 2004 until 30 June Post-award compound interest was awarded on the total damages at a rate equal to the yield on U.S. Treasury bonds as of 15 January Yukos v. Russia (final award), Id., The date of the auction of Yuganskneftegaz was 19 December 2004, and the date of the final award, for the purposes of calculating damages, was 30 June Id., Id., Id., A distinction was made between the dates of final expropriation and effective expropriation. The date of final expropriation was 21 November 2007, the date when Yukos ceased to exist, and the date of effective expropriation was 19 December 2004, the date when Yukos principal asset, Yuganskneftegaz, was auctioned. 86 Yukos v. Russia (final award), Id., This number takes into account the 70.5 per cent ownership that the claimants, who represented Yukos, had in the shareholding. 89 Yukos v. Russia (final award), Id., Id., Id., Id., On account of the substantial damages owed, Russia was granted a 180 day grace period. 61

65 3.6 Costs Russia was ordered to reimburse Yukos legal costs, but this reimbursement was capped at USD 60,000, Yukos legal costs amounted to USD 79,628, and GBP 1,066, Exxon v. Venezuela 4.1 Procedural History Exxon 95 registered its dispute with Venezuela at ICSID on 6 September The arbitral panel was constituted by Gilbert Guillaume (president), Gabrielle Kaufmann-Kohler (Exxon appointed co-arbitrator), and Ahmed Sadek El-Kosheri (Venezuela appointed co-arbitrator). Exxon advanced various causes of action to claim for approximately USD 16,600,000,000 from Venezuela. It relied on the Venezuelan Investment Law 96 and the Netherlands- Venezuela BIT 97 as the legal bases for this claim. The arbitration was bifurcated with an interim award on jurisdiction being issued on 10 June 2010, and the final award on 9 October Exxon was awarded USD 1,600,042,482, not accounting for a set-off in favour of Venezuela, 98 plus interest accruing from 27 June 2007 until the date of payment and compounding annually Factual Background Oil Opening During the late 1980s, after the expropriations of upstream investments in the 1970s, Venezuela entered its oil opening phase. Under Venezuelan law, private companies could only engage in upstream activities in Venezuela via association agreements with PDVSA Id., Hereinafter, Exxon refers to the claimants in Exxon v. Venezuela. 96 In Spanish: Decreto N 356 del 3 de octubre de 1999, con rango y fuerza de ley, de Promoción y Protección de Inversiones; available at: (last accessed 5 August 2015) [hereinafter, Venezuelan Investment Law ]. 97 Agreement on encouragement and reciprocal protection of investments between the Kingdom of the Netherlands and the Republic of Venezuela; signed: 22 October 1991, in force: 1 November 1993, termination: 1 November 2008; available at: (last accessed 5 August 2015) [hereinafter, Netherlands-Venezuela BIT ]. 98 This set-off arose through an earlier arbitration between Exxon and PDVSA [hereinafter, Exxon v. PDVSA ] administered by the ICC. The damages paid by PDVSA pursuant to the award were to be set-off against the damages in this arbitration because they both related to the same dispute. 99 The final award failed to address whether interest accrued on the total damages amount, or the total damages amount minus the set-off in favour of Venezuela. This is one issue which has been raised in an application for revision by Exxon under Rule 50 of the ICSID Rules of Procedure for Arbitration Proceedings. 100 Hereinafter, PDVSA refers to Petróleos de Venezuela, S.A., the Venezuelan state owned petroleum company. 62

66 As part of the oil opening, Venezuela encouraged private companies to conclude association agreements. Exxon was one such company, and it pursued two projects: Cerro Negro project, involving the production, upgrading, and refining of extra heavy petroleum; 102 and - La Ceiba project, involving the exploration and production of light to medium petroleum. Certain fiscal incentives were offered for the Exxon Projects. First, for the Cerro Negro project, the income tax rate would be 30 per cent, rather than the usual 67.7 per cent for income generated by upstream activities. 103 Second, the royalty rates would fluctuate between 1 per cent to 16 2 / 3 per cent depending on the stage of development and production. 104 The Cerro Negro project achieved commercial production in August Venezuela argued that production was legally limited to 120,000 barrels of extra heavy crude per day, although Exxon disputed this. 106 The La Ceiba project never achieved commercial production as it was being developed at the time of its expropriation Presidency of Chavez The succession of Hugo Chavez to the presidency saw a marked shift the regulation of upstream activities in Venezuela. In 2001, new legislation required that the operating enterprises for many upstream projects be restructured to install PDVSA as the controlling operator. The Exxon Projects, however, fell outside the scope of this new legislation. Part of the new regulatory regime included new fiscal measures. Notwithstanding a commitment to the contrary in January 2002, the royalty rates for the Exxon Projects were progressively increased from 1 per cent in October 2004 to 33 1 / 3 per cent in May 2006, accounting for the impact of a new extraction tax. Further, the income tax rate for the Cerro Negro project was increased to 50 per cent, effective from January From October 2006 until June 2007, production and export curtailments were imposed on the Cerro Negro project. Certain curtailments were to meet OPEC export quotas, while others were not. The association agreement for the Cerro Negro project permitted such measures to meet OPEC export quotas, provided the curtailment was applied pro rata to other producers. In January and February 2007, it was announced that the Exxon Projects would be expropriated. In this context, expropriation involved PDVSA becoming the controlling 101 Hereinafter, the Exxon Projects refers to the Cerro Negro project and La Ceiba project. 102 For specific details, see Exxon v. Venezuela (final award), Exxon v. Venezuela (final award), Id., 62 (for Cerro Negro project) and 74 (for La Ceiba project). 105 Id., Id., Id.,

67 operator and having the majority interest in the Exxon Projects, with Exxon being relegated to a junior partner upon payment of compensation for such relegation. If the compensation to Exxon for these new arrangements could not be agreed upon by 26 June 2007, PDVSA would acquire full control and ownership. Upon the expiration of this deadline, no agreement had been reached. 4.3 Jurisdiction Exxon advanced two bases for jurisdiction, the Venezuela Investment Law and the Netherlands-Venezuela BIT. It failed to establish jurisdiction under the former, but succeeded under the latter Venezuelan Investment Law Venezuela argued that, for disputes under the Venezuelan Investment Law, it had not consented to ICSID arbitration, as required by the ICSID Convention. 108 The relevant provision read: Disputes arising between an international investor whose country of origin has in effect the Convention on the Settlement of Investment Disputes between States and Nationals of Other States (ICSID), shall be submitted to international arbitration according to the terms of the respective treaty or agreement, if it so provides. 109 The words if it so provides were the focus of interpretation. Exxon advocated that they evidenced consent because the ICSID Convention established international arbitration as a method of dispute resolution. 110 Venezuela counted that these words meant that the treaty had to require, not merely offer, international arbitration. 111 The arbitral panel acknowledged both interpretations were possible, 112 and sought to establish which interpretation best accorded with the intention of Venezuela at the time of its drafting. Upon considering the legislative history of the provision and the usual Venezuelan practice on consenting to ICSID arbitration in its BITs, the arbitral panel concluded that Venezuela did not intend that Article 22 would evidence its consent to ICSID arbitration under the Venezuelan Investment Law ICSID Convention, at Art. 25(1). 109 Venezuela Investment Law, Art. 22. The original and unedited Spanish version reads: Las controversias que surjan entre un inversionista internacional, cuyo país de origen tenga vigente con Venezuela un tratado o acuerdo sobre promoción y protección de inversiones, o las controversias respecto de las cuales sean aplicables las disposiciones del Convenio Cons tu vo del Organismo Mul lateral de Garan a de Inversiones (OMGI-MIGA) o del Convenio sobre Arreglo de Diferencias Rela vas a Inversiones entre Estados y Nacionales de Otros Estados (CIADI), ser n some das al arbitraje internacional en los términos del respec vo tratado o acuerdo, si así éste lo establece, sin perjuicio de la posibilidad de hacer uso, cuando proceda, de las vías contenciosas contempladas en la legislación venezolana vigente. 110 Exxon v. Venezuela (interim award), Id., Id., Id., 140. This analysis of Art. 22 was followed by the majority in OPIC Karimun Corporation v. Bolivarian Republic of Venezuela (ICSID Case No. ARB/10/14) at 165; available at: (last accessed 5 August 2015). 64

68 4.3.2 Netherlands-Venezuela BIT After dismissing objections on, first, whether the American and Bahamian claimants were investors 114 and, second, whether indirect investments qualified as investments, 115 the arbitral panel considered the most substantive objection of Venezuela. It submitted that Exxon s status as an investor was the result of a corporate restructuring, the principal purpose of which, as acknowledged by the arbitral panel, 116 was to secure such status. This constituted an abuse of law, a recognised concept under international law. 117 The arbitral panel disagreed. It held that for existing disputes, any corporate restructuring for the purpose of obtaining investor status was an abuse of law, 118 but not for future disputes. 119 Distinguishing between existing and future disputes involved determining when the complaint in respect of a dispute was registered, 120 and comparing that date with the date on which the corporate restructuring was completed. If the date of registration of the complaint fell after the date of corporate restructuring, it was a future dispute, and, if before, it was an existing dispute. The dates of corporate restructuring differed for the Exxon Projects, with the date for the Cerro Negro project being 21 February 2006, and the date for the La Ceiba project being 23 November The effect of this ruling was that facts, which related to an existing dispute, could not be used to establish a cause of action. The only facts affected were the income tax increases as the complaints relating to that dispute were made in June 2005, 121 before the corporate restructurings. Accordingly, all other facts, most particularly the curtailments on production, the increase in royalty rates, and the acts which directly expropriated the investments of Exxon, could support Exxon s causes of action. This ruling is explored in detail in Section Merits Fair and Equitable Treatment The cause of action of fair and equitable treatment is found in Article 3(1) of the Netherlands-Venezuela BIT, and it reads: Each Contracting Party shall ensure fair and equitable treatment of the investments of nationals of the other Contracting Party. Pointing to the increase in royalty rates, and the production and export curtailments, Exxon attempted to prove that Venezuela had breached this obligation. 114 Exxon v. Venezuela (interim award), Id., Id., Brownlie, I., Principles of Public International Law (Oxford University Press, 2003, sixth edition), p Exxon v. Venezuela (interim award), Id., Id., Id.,

69 It was ruled that Exxon could not rely on the increase in royalty taxes to substantiate this cause of action. 122 This ruling was based on an interpretation of Article 3(1) of the Netherlands-Venezuela BIT that held that fiscal measures fell outside the remit of its stipulations. This interpretation was informed by Article 4(1) of the Netherlands-Venezuela BIT, and the applicable portion of that article reads: With respect to taxes, fees, charges, and to fiscal deductions and exemptions, each Contracting Party shall accord to nationals of the other Contracting Party with respect to their investments in its territory treatment not less favourable than that accorded to its own nationals or to those of any third State, whichever is more favourable to the nationals concerned. The arbitral panel reasoned that Article 4 operated to make fiscal measures exclusively subject to its dictates. 123 Two reasons were advanced in support of this view. First, Article 4 contained a specific rule, whereas Article 3 contained a general rule, and, following the principle of lex specialis, 124 a specific rule prevails over a general rule. 125 Second, certain portions of Article 4 would have become redunant if it did not comprehensively regulate fiscal measures. This reason is an expression of the principle that, when interpreting legal texts, an interpretation which validates should be preferred to an interpretation which invalidates Any cause of action under Article 4 would have failed because the relevant fiscal had to be discriminatory, which they were not in this case. Exxon was successful, however, when relying on the production and export curtailments to prove this cause of action. It was held that Exxon s legitimate expectations, a standard for assessing fair and equitable treatment, 128 were breached when its production was limited, 129 and the Cerro Negro project was targeted to satisfy an OPEC export quota, 130 contrary to contractual undertakings on both Arbitrary or Discriminatory Measures Exxon argued that the production and export curtailments detailed above also constituted arbitrary or discriminatory measures. This cause of action was not, however, ruled on because the damages appertaining to it could not be higher than the damages for breach of the fair and equitable treatment standard Exxon v. Venezuela (final award), Id., Scalia, A., and Garner, B., Reading Law: The Interpretation of Legal Texts (Thomson/West, 2012), pp Argument developed by Venezuela in Exxon v. Venezuela (final award) at 229, and confirmed by the arbitral panel at Scalia, A., and Garner, B., supra, note 124, pp Exxon v. Venezuela (final award), Dolzer, R., and Schreuer, C., supra, note 58, at p Exxon v. Venezuela (final award) at Id. at Id. at

70 4.4.3 Expropriation The principal cause of action for Exxon was expropriation. It developed two arguments to establish expropriation. First, there was a partial expropriation of the Exxon Projects via the fiscal measures and production and export curtailments, 132 both of which were measures equivalent to expropriation; in other words, indirect expropriation. This argument was dismissed because expropriation required a total loss of an investment or its control. 133 Second, there was a total expropriation after the failure of the negotiations between Exxon and Venezuela, a charge which Venezuela admitted. 134 The only issue in dispute was the lawfulness of that expropriation Lawfulness of Expropriation The arbitral panel found that the expropriation was lawful. To establish the lawfulness of an expropriation, Venezuela had to prove that it was: - for the public interest; - non-discriminatory; - carried out under due process of law; - accompanied by prompt, adequate and effective compensation; and - not contrary to any understanding given to the investor. 135 In considering whether the expropriation accorded to standards of due process, it was noted that the enabling law was enacted by the Venezuelan parliament and the actions of the Venezuelan executive observed that law. Further, a legitimate procedure for negotiating compensation was implemented, the failure of which was not relevant. 136 As contracts relating to the Exxon Projects reserved Venezuela s sovereign rights, one of which includes expropriation, 137 it was found that Venezuela did not act contrary to its undertakings. 138 The contentious criterion was the payment of fair compensation as Venezuela failed to pay any compensation. This appeared to make the expropriation unlawful, however, the arbitral panel disagreed, as explained below: [i]t is not disputed that the Claimants did not receive compensation and that Venezuela did not fulfil its obligation to pay compensation in accordance with 132 Id. at Id. at Id. at Netherlands-Venezuela BIT, Art. 6 (a) (c). 136 Exxon v. Venezuela (final award) at Charter of Economic Rights and Duties of States, Art. 2(2)(c); available at: Exxon v. Venezuela (final award) at

71 Article 6(c) of the BIT. However, the mere fact that an investor has not received compensation does not in itself render an expropriation unlawful. An offer of compensation may have been made to the investor and, in such a case, the legality of the expropriation will depend on the terms of that offer. In order to decide whether an expropriation is lawful or not in the absence of payment of compensation, a tribunal must consider the facts of the case. 139 Accordingly, an evidentiary question arose regarding the terms of the offer of compensation. Exxon carried the burden of adducing relevant evidence on this question, and it failed to discharge this burden. 140 The arbitral panel noted that Exxon did not adduce any testimonial or documentary evidence on the contents of the negotiations between it and Venezuela, instead relying on media reports. 141 These media reports contained statements from the Venezuelan minister for energy that Venezuela would pay book value for the expropriated investments. It was ruled that this evidence was insufficient to establish the terms of the offer put by Venezuela to Exxon during their negotiations. 142 Interestingly, in ConocoPhillips v. Venezuela, 143 a dispute arising out of the same round of expropriation of upstream investments by Venezuela, an arbitral panel, in a majority decision, ruled that the expropriations were unlawful. Specifically, it found that Venezuela had failed to conduct the negotiations for compensation for the expropriated investment in good faith because it merely offered book value for the investments. 144 The reasoning with respect to the criteria of public purpose and discriminatory nature of the expropriation was not reported. 4.5 Remedies There were two sources for the award of damages: breach of the fair and equitable treatment standard, and expropriation. The former was valued at USD 9,042,482, 145 and, for the latter, the arbitral panel was tasked with determining the market value of the Exxon Projects immediately before their expropriation Id. at Id. at Id. at Id. at ConocoPhillips Petrozuata B.V., ConocoPhillips Hamaca B.V., ConocoPhillips Gulf of Paria B.V., and ConocoPhillips Company v. The Bolivarian Republic of Venezuela ICSID Case No. ARB 07/30 [hereinafter, ConocoPhillips v. Venezuela ]; decision on jurisdiction and the merits (majority decision) available at and decision on respondent s request for reconsideration (minority decision) available at: ConocoPhillips v. Venezuela (decision on jurisdiction and the merits (majority decision)) at 394. Compare ConocoPhillips v. Venezuela (decision on respondent s request for reconsideration (minority decision)) at 16 and 17 where Georges Abi-Saab (Venezuela appointed co-arbitrator), on basis of other evidence, contests this in finding that Venezuela did not negotiate in good faith. 145 Exxon v. Venezuela (final award) at Netherlands-Venezuela BIT, Art. 6(c). 68

72 4.5.1 Valuation of Cerro Negro project Calculating according to the discounted cash flow method, the Cerro Negro project was valued at USD 1,411,700,000, 147 although this amount was subject to a set-off in favour of Venezuela in the amount of approximately USD 746,937, This set-off arose via an ICC arbitration between Exxon and PDVSA in respect of a contract relating to the Cerro Negro project. Exxon succeeded, but was required to repay its damages to Venezuela because of the prohibition on double recovery. 149 The damages paid by PDVSA were pursuant to a guaranty that it would pay damages if the Cerro Negro project were expropriated Valuation of La Ceiba project As the La Ceiba project was not generating income immediately before expropriation, it was valued according to its costs. 150 These costs amounted to USD 179,300, Interest Pre-award and post-award compound interest 151 was awarded at 3.25 per cent Costs Each party was ordered to bear its own costs, and equally share the costs of the arbitral panel and ICSID Timing of Establishing Control 5.1 Introduction As noted above, 154 the jurisdiction of the arbitral panel to resolve a foreign investment dispute is founded on the consent of the parties to the dispute. 155 The claimant investor offers its consent by initiating its claim, while the respondent state stipulates its consent in international investment agreements. 156 In stipulating that consent, the respondent state will uniformly qualify it by making it subject to four core conditions. These conditions are described as core because they are universally applicable, although there are frequently 147 Exxon v. Venezuela (final award) at This is an approximate amount because it does not include any interest accruing on this amount. 149 Exxon v. Venezuela (final award) at Id. at Id. at Id. at Id. at See Determination of Disputes (Section 2). 155 The most authoritative legal pronouncement of this requirement comes from ICSID Convention, at Art. 25(1). 156 Redfern, A., et al.; Redfern and Hunter on International Arbitration (fifth edition, 2009), at p

73 other conditions, such as submitting the dispute exclusively to arbitration, as opposed to pursuing a claim both in litigation and arbitration. 157 The first condition requires that the claimant investor is a national of another state which is bound to the international investment agreement in which the respondent state putatively expresses its consent. Second, there must be an investment, with this condition being subject to numerous sub-conditions, particularly regarding the legality of the investment. Third, the claimant investor must have an ownership interest in that investment. 158 Fourth, that investment must be located in the territory of the respondent state. This commentary focuses on the first condition. It briefly considers what amounts to a national, but its principal focus is the timing aspect of this condition. The value of Exxon v. Venezuela is the jurisprudence it offers on this question. Below, the rule from Exxon v. Venezuela on this question is identified, explained, and criticised. A reformulation of this rule is offered in view of remedying its perceived defects. 5.2 Concept of Nationality National is consistently defined in international investment agreements. These definitions stipulate that a national is a natural or legal person of a state which is party to the international investment agreement under which the respondent state is claimed from. 159 Some international investment agreements extend this definition by providing a national includes a legal person, wherever incorporated, which is controlled by a natural or legal person mentioned in the first definition. An example of this extended definition can be found in the Kazakhstan-Netherlands BIT: (b) the term nationals shall comprise with regard to either Contracting Party: (i) natural persons having the nationality of that Contracting Party; (ii) legal persons constituted under the law of that Contracting Party; (iii) legal persons not constituted under the law of that Contracting Party but controlled, directly or indirectly, by natural persons as defined in (i) or by legal persons as defined in (ii) See, for example, Agreement between the Macedonian Government and the Spanish Government on the Promotion and Reciprocal Protection of Investments; signed: 20 June 2005, in force: 30 January 2007, at Art. 11(2) & (3). Available at: [hereinafter: Macedonia-Spain BIT]. 158 This condition is usually not as explicit as the other conditions. It is generally expressed by requiring that the investment be of the claimant investor, or made by the claimant investor. See, for example, Macedonia- Spain BIT, at Art. 4(1). 159 Agreement between the Czech Republic and the Kingdom of Saudi Arabia for the Encouragement and Reciprocal Protection of Investments; signed: 18 November 2009, in force: 13 March 2011, at Art. 1(3). Available at: Agreement on encouragement and reciprocal protection of investments between the Republic of Kazakhstan and the Kingdom of the Netherlands; signed: 27 November 2002, in force: 1 August 2007, at Art. 1(b)(iii). 70

74 The question whether a natural person is a citizen of a state party to the international investment agreement it relies on is a question determined by application of the laws of that state. 161 For legal persons, the relevant connecting factor of a legal person to a state usually determines which law is applicable. For incorporation, the law of the relevant state applies, 162 but for effective seat or similar concepts, international law must decide. The concept of control cannot be briefly summarised. For present purposes, it can be said that an arbiral panel will typically examine the nature and the quantity of the shareholding of the natural person or legal person in the indirect claimant investor to resolve this issue Timing of Nationality for Natural Persons The question in this section is: when must a natural person claimant investor hold the citizenship of a state to establish himself or herself as a citizen of that state for the purpose of establishing jurisdiction? This is question is distinct from other related questions of the timing of the fulfilment of the other conditions of the consent of the respondent state, most particularly when a claimant investor must own an investment, and when control over an indirect national must be established. The focus of this commentary is the latter question, and it is addressed in detail below. It is important to appreciate that the question when a claimant investor must hold national status is only applicable to natural person claimant investors. This is because a natural person may legally change his or her nationality during his or her lifetime. By contrast, a legal person can never change its nationality; an English company could be created and acquired certain assets, but it could never migrant to become, for example, a German company. The assets of this English company could be acquired by a German company, but, in context of foreign investment disputes, this concerns the question when a claimant investor must acquire an ownership interest in an investment. Usually, a natural person claimant investor will maintain a certain national status throughout his or her life, and the only question will be whether that national status is afforded legal rights under the relevant international investment agreement. It is, however, possible that a natural person will change his or her national status during his or her lifetime. In foreign investment disputes, a change in national status is most pertinent during the time a natural person claimant investor holds an investment until any initiation of Available at: [hereinafter: Kazakhstan- Netherlands BIT]. See also ICSID Convention, at Art. 25(2)(b). For ease of reference, claimant investors who are natural persons or legal persons constituted in one of the states party to the international investment agreement will be called direct nationals, while claimant investors falling within the third category will be indirect nationals. 161 Dolzer, R., and Schreuer, C., supra, note 58, p International investment agreements usually explicitly state that a legal person must be incorporated, constituted or organised under the laws of a state. See, for example, Agreement between the Republic of Austria and the Federal Democratic Republic of Ethiopia for the Promotion and Protection of Investments; signed 12 November 2004, in force 1 November 2005, at Art. 1(b). Available at: (last accessed 5 August 2015). 163 A detailed exposition of a test for control is proffered in Aguas del Tunari S.A. v. Republic of Bolivia (ICSID Case No. ARB 02/03); at para Award available at: (last accessed 5 August 2015). 71

75 arbitration against a state. The leading arbitral award on this comes from Soufraki v. UAE. 164 There, the arbitral panel ruled that a natural person claimant investor must have national status at the time he or she initiates arbitration Timing of Control This section addresses the question of when a direct national must establish control over an indirect national. This question is distinct from, but related to, the question of when a claimant investor must have ownership of an investment. It is likely that these two events, the establishment of control and the acquisition of an investment, are likely to occur at different times. If control is established before the investment is acquired, no issue will arise with respect to the timing of establishing control. 166 If, however, establishment of control occurs after the indirect national acquires the investment, this presents a difficult legal issue. Exxon v. Venezuela adds to a growing body of jurisprudence on the question of when a direct national must establish control over an indirect national. This jurisprudence is principally constituted by arbitral awards, and the arbitral panel in Exxon v. Venezuela relied on these in making its determination. 167 After considering these arbitral awards, the arbitral panel proceeded on the foundation that the question was to be informed by the principle of abuse of right. 168 Although the arbitral panel describes abuse of right as widely known, 169 other prominent authors have noted that it has limited support. 170 Whatever its status, its content is difficult to articulate. According to one definition, it applies when: a state [exercises] a right either in a way which impedes the enjoyment by other states of their own rights or for an end different from that for which the right was created, to the injury of another state. 171 Foreign investment law has picked up on the second limb of this definition. 172 Accordingly, the question becomes: would a direct national abuse the objectives of foreign investment law if it were recognised that it had control over an indirect national, considering that that control was established after the indirect national acquired the investment? In considering this question, the arbitral panel briefly considered four foreign investment disputes. In only 164 Hussein Nuaman Soufraki v. The United Arab Emirates (ICSID Case No. ARB 02/07) [hereinafter, Soufraki v. UAE ]; award available at: (last accessed 5 August 2015). This award was subject to an application to annul pursuant to Art. 52 of the ICSID Convention. This application to annul was rejected, by a majority. 165 Id., Although the timing of the acquisition of the investment might still be in question. 167 These were considered in Exxon v. Venezuela (interim award), Id., Id., Brownlie, I., Principles of Public International Law, supra, note 117, p Kiss, A., Abuse of Rights Bindschedler, R. et al. (eds.), Encyclopaedia of Public International Law (North- Holland, 1984), p Exxon v. Venezuela (interim award),

76 one of these disputes did the arbitral panel refuse jurisdiction, Phoenix v. Czech Republic. 173 There, it was found that the purpose of corporate restructuring, which inserted an Israeli company as a direct national, was solely to establish jurisdiction for a claim under foreign investment law. 174 The evidence corroborating this conclusion was that the Israeli company directed no economic activities of the indirect nationals and the corporate restructuring was effected after the damages had the investment. Following Phoenix v. Czech Republic, if Venezuela could prove that Exxon effected its corporate restructuring to establish jurisdiction for their dispute, abuse of right would be applied in its favour. To this end, it adduced evidence of an admission from Exxon that this was the motivation for its corporate restructuring, 175 and the arbitral panel accepted this evidence. 176 The arbitral panel, however, drew a distinction between the corporate restructuring in Phoenix v. Czech Republic and the corporate restructuring of Exxon because the former occurred after the dispute had arisen, while the latter occurred before. 177 In these circumstances, the arbitral panel concluded that it was a perfectly legitimate goal to effect a corporate restructuring to establish a direct national as a controlling an indirect national. In making this determination, the arbitral panel implicitly announced a new rule on timing of control: a direct national must have control over an indirect national before any dispute with a respondent state arises. The factual predicate in this rule warranting further analysis is dispute. 5.5 Definition of Dispute Dispute is not explicitly defined in Exxon v. Venezuela, but, from its reasoning, a definition implicitly offered reads that a dispute is the registration of a complaint by one person to another person about certain past or future conduct adversely affecting the first person. It might seem perplexing that a dispute crystallises even if the relevant facts have not occurred. This aspect of the definition is, however, confirmed by the arbitral panel in Exxon v. Venezuela with reference to the dispute Exxon lodged with respect to the raising of income tax applicable to the Cerro Negro project. In April 2005, it was announced that income tax would be raised, and Exxon penned a complaint in respect of that in June The increase was formally enacted in August 2006, and took effect in January Notwithstanding this, the arbitral panel held that the dispute arose in June The finding of the income tax dispute above also reveals that a dispute arises when the complaint in respect of that dispute is lodged. It is considered that this definition of when a dispute arises leaves the rule open to manipulation. This is because the registration of a 173 Phoenix Action, Ltd. v. The Czech Republic (ICSID Case No. ARB/06/5) [hereinafter: Phoenix v. Czech Republic]; award available at: (last accessed 5 August 2015). 174 Id., Exxon v. Venezuela (interim award), Id., Id.,

77 dispute is within the control of claimant investors who may see the facts of a dispute, effect a corporate restructuring to establish a direct national as a controlling entity, and then register a complaint. The better alternative is to define the arising of a dispute according to the occurrence of facts. On this view, a dispute arises when a fact occurs which a claimant investor uses to support a cause of action. If a fact occurs before control is established, then it may not be used to support a cause of action. For example, imagine that the cause of action of the claimant investor is unfair and unequitable treatment. The relevant facts are that a claimant investor has a permit for exploration and production of petroleum and natural gas in an offshore block. After commercial quantities are discovered, the claimant investor prepares to transition from exploration to production. Between the time of the granting of the permit and the discovery of commercial quantities, a new government has been elected which has a negative view of upstream activities, and the claimant investor will have to work with this government during its transition phase. The claimant investor plans to construct a platform, and lay a pipeline along the ocean floor to the nearest port. After work begins on the platform, frequent governmental inspections consistently halt construction. At this point, the claimant investor decides to effect a corporate restructuring to place a company of a state with whom the respondent state has concluded an international investment agreement with as a controlling entity of the claimant investor. Subsequently, the respondent state declares that the ocean within 20 kilometres of its coastline is a protected environmental zone through which a pipeline cannot be built. This governmental act makes the transportation of natural gas unfeasible, and transport of petroleum more expensive. At this time, the claimant investor lodges a complaint with the respondent state. In this fact scenario, the facts which are likely to be used by the claimant investor to establish its cause of action are the governmental inspections and the declaration of an environmental protection zone. Applying the rule from Exxon v. Venezuela, all the facts from this fact scenario could be used to support a cause of action of unfair and unequal treatment, notwithstanding the timing of the corporate restructuring. If, however, the rule from Exxon v. Venezuela is modified as suggested, the governmental inspections could not be used to support the cause of action, but only the declaration of an environmental protection zone. 6 Contributory Fault 6.1 Contributory Fault in Foreign Investment Law Contributory fault is a well founded concept in international law. It forms part of the general principles of law source of international law, 178 and has been codified as follows: [i]n the determination of reparation, account shall be taken of the contribution to the injury by wilful or negligent action or omission of the injured State or any person or entity in relation to whom reparation is sought Statute of the International Court of Justice, Art. 38(1)(c). 179 Draft Articles on State Responsibility, Art

78 Its application has been limited in foreign investment disputes. 180 In addition to Yukos v. Russia, Occidental v. Ecuador is a rare example of the application of contributory fault. There, Occidental 181 breached a production sharing contract with Petroecuador when, in 2000, it executed a farmout agreement with AEC. 182 Whether the farmout agreement was approved was disputed, but it was determined that there was no approval. Relying on Ecuadorian law, Petroecuador subsequently terminated the production sharing contract for this breach in Occidental successfully argued that this termination constituted a breach of the fair and equitable treatment standard 183 and expropriation 184 under the Ecuador-United States BIT. 185 Damages awarded were in the amount of USD 1,769,625,000, accounting for a 25 per cent reduction for contributory fault, plus interest Doctrinal Analysis It is considered that Occidental v. Ecuador and Yukos v. Russia exhibit a primitive idea of contributory fault. In these disputes, two rules are applied to make a finding whether contributory fault is established, and they are analysed below. First, there must be faultworthy conduct by the claimant investor. Faultworthy was equated with unlawful and negligent 187 in Occidental v. Ecuador, and abusive 188 and questionable 189 in Exxon v. Venezuela. In construing this legal element, the relevant conduct, in Occidental v. Ecuador, was the breach of the production sharing agreement, and, in Yukos v. Russia, the implementation of Yukos tax arrangements. Second, that faultworthy conduct must cause the wrongful act of the state. 190 In Yukos v. Russia, this causal element was analysed in light of the commentary on the Draft Articles on State Responsibility.That commentary stipulated that the faultworthy conduct had to be a material cause. Acknowledging it had a wide discretion, the arbitral panel concluded that Yukos tax arrangements were a material cause. 191 The arbitral award does not report how, or if any, test of causality was applied to make this conclusion. 180 Another dispute where contributory fault was successfully argued was MTD Equity Sdn. Bhd. and MTD Chile S.A. v. Republic of Chile (ICSID Case No. ARB/01/7), award available at: (last accessed 5 August 2015). 181 Hereinafter, Occidental refers to the claimants in Occidental v. Ecuador. 182 Hereinafter, AEC refers to Alberta Energy Corporation Ltd. 183 Occidental v. Ecuador (majority award), Id., Treaty between the United States of America and the Republic of Ecuador concerning the Encouragement and Reciprocal Protection of Investment; signed 27 August 1993, in force 11 May 1997, available at: (last accessed 5 August 2015). 186 Occidental v. Ecuador (majority award), Id., Yukos v. Russia (final award), Id. 190 Id., The arbitral panel acknowledges this causal element by commenting that in some cases contributory fault was unrelated to the wrongdoing of the State (author s emphasis). 191 Id.,

79 In Occidental v. Ecuador, a counterfactual test of causation was implicitly employed; other words, the ubiquitous but for test was deployed. Following the but for test, it was asked whether Ecuador would have terminated the production sharing contract but for the failure to seek permission for the conclusion of the farmout agreement. The arbitral panel answered with the reasoning that: [i]f OEPC had sought the Minister s consent in October 2000, in all likelihood it would have obtained it and it is probable that the Respondent would not have declared Caducidad in In other words, without the violation of the law by OEPC, Caducidad may not have happened. 192 This reasoning imagines a hypothetical world where Occidental seeks permission and, referencing the evidence that Ecuador had already approved upstream activities of AEC at the relevant time, 193 concludes that permission would have probably been granted. The arbitral panel also acknowledged that the social unrest directed against Occidental was also a contributory cause Provocation: interactionism in contributory fault The conceptual realities of contributory fault are more complex than what is reported in Yukos v. Russia and Occidental v. Ecuador. In actuality, Yukos v. Russia and Occidental v. Ecuador promote a peculiar form of contributory fault, and its rules are more numerous and detailed than the account given above. It is peculiar because it has a different causal relationship to the loss of the claimant compared to the usual conception of contributory fault in Anglo-American jurisprudence. 195 According to this usual conception, contributory fault refers to a scenario where two causes, the agents of which are the claimant and respondent, have a direct sequential, but independent, relationship to the consequence. 196 An example would be where the claimant impatiently crosses the road at a set of traffic lights on a red signal, and is hit by a car driven by the respondent in excess of the speed limit. The form of contributory fault recognised in these foreign investment disputes differs from the usual Anglo-American conception of contributory fault It incorporates what philosophers on causation call interactionism. Interactionism is the idea that mental processes and physical events causally influence each other. 197 Although this idea has 192 Occidental v. Ecuador (majority award), Id., Id., Contributory fault is referred to by a number of descriptors in Anglo-American jurisprudence, most particularly contributory negligence and comparative negligence. 196 Hart, H. L. A., and Honoré, T.; Causation in the Law (Oxford University Press, 1985, second edition), pp See generally Robb, D., and Heil, J., Mental Causation, in Zalta, E. N., The Stanford Encyclopaedia of Philosophy (Spring 2014 edition), available at: (last accessed 5 August 2015). 76

80 generated philosophical objections, 198 legal causation is not bound by these philosophical objections. 199 Further, it has an intuitive appeal which makes it attactive to adjudicators. This attractiveness is based on the assumption that legal causation, for many adjudicators, is largely based on common sense principles, 200 or their conception of those principles. The question which is raised, however, is how interactionism makes this form of contributory fault different from the usual conception of contributory fault in Anglo- American jurisprudence. The answer lies in the causality between the conduct of the claimant and the loss afflicting the claimant. With the contributory fault of Yukos v. Russia and Occidental v. Ecuador, that causality is indirect because the conduct of the claimants, being the implementation and execution of the tax optimisation scheme for Yukos and the failure to obtain approval for a farmout agreement for Occidental, does not lead to the consequence, being the loss of the investments. On any reasonable application of a counterfactual test of causation, there must be intervening acts from the respondent state; in these disputes, those acts are the tax reassessments and sale of Yukos assets, and the termination of the production sharing contract. Rather than labelling this causal pattern as contributory fault, it should be specified for what it is: civil provocation. 201 With the conclusion that Yukos v. Russia and Occidental v. Ecuador recognise a defence of civil provocation in foreign investment law, the construction of the legal framework for this defence should begin. This paper seeks to make a modest start to that process. 6.4 Rules of civil provocation First, as indicated above, the claimant investor must engage in some faultworthy conduct. It is considered that when assessing faultworthiness, two inquiries must be undertaken. First, the nature of the conduct must be classified, and second, its scale must be measured. For example, from Yukos v. Russia it can be inferred that conduct which amounts to tax evasion is of a faultworthy nature. Subsequently, the scale of that tax evasion must be assessed as this will inform the consideration of the fourth rule on proportionality below. Second, the respondent state must become aware of this faultworthy conduct before it commits its breach. The application of this rule raises a number of difficult issues, specifically, attribution of knowledge, and extent of knowledge. Attribution of knowledge concerns the question of when knowledge can be imputed to the state, an artificial legal person. Generally, the law resolves this issue by identifying agents of the state, and then imputing their knowledge to the state. 202 This jurisprudence, however, is insufficiently developed to offer an answer to the following scenario. Suppose that several persons working in the ministry for the environment know of an upstream company, 198 See Maslen, C., Horgan, T., & Daly, H.; Mental Causation in Beebee, H., Hitchcock, C., & Menzies, P. (editors); The Oxford Handbook of Causation (2009), at pp Hart, H. L. A., and Honoré, T., supra, note 196, p See generally Id., pp This was implicitly recognised by the arbitral panel in Yukos v. Russia. See Yukos v. Russia (final award) at It is considered that civil provocation is a better alternative to provocation with all its criminal law connotations. 202 This is implicit in Article 4 of the Draft Articles on State Responsibility. 77

81 holding a permit for production, which has polluted an important waterway. Meanwhile, another person in the ministry for energy, without this knowledge, decides to terminate this upstream company s permit, and this termination constitutes a breach of an international investment agreement. The question is: does the state have knowledge for the purposes of the second rule of provocation? It is beyond the scope of this paper to provide a proper analysis of this question. Briefly, however, it is considered that the theoretical foundations of civil provocation in foreign investment law would define the answer. If civil provocation is conceived as an excuse, the state would not have knowledge; if, however, civil provocation is conceived as a justification, it is arguable that the state would have knowledge. The reasoning behind these conclusions is that civil provocation as an excuse is some kind of heat of the moment reaction, whereas civil provocation as a justification focuses on the faultworthiness of the relevant provocative conduct. 203 Extent of knowledge asks how much knowledge the respondent state had. The respondent state can only be provoked to the extent of its knowledge about the faultworthy conduct. For example, if the claimant investor evades taxes in the amount of EUR 100,000,000, but the respondent state believes that evaded taxes amount to EUR 30,000,000, the respondent state can only be provoked on the basis of that belief. This is an evidentiary question, with the objective of the claimant investor to show that the respondent state had no or limited knowledge, and the respondent state to show that it had full knowledge. Third, the faultworthy conduct must motivate the respondent state. In applying this rule, two questions are raised; first, whether the faultworthy conduct must be the sole reason for acting, and second, assuming there may be multiple reasons, whether the faultworthy conduct must be the dominant reason. Fortunately, both Yukos v. Russia and Occidental v. Ecuador offer guidance on these questions. For the first question, as noted above, the arbitral panel in Occidental v. Ecuador recognised that the faultworthy conduct of Occidental was not the sole reason for terminating the production sharing contract and other reasons, particularly the social unrest directed against Occidental, was another reason. 204 For the second question, the following extract from Yukos v. Russia is illuminating: even though the Tribunal has found that President Putin and his administration used Yukos tax problems as a pretextual justification for setting in motion a plan to bankrupt Yukos, as opposed to just collecting the taxes that might have been legitimately assessed against the trading companies on the basis of the bad faith taxpayer doctrine, the Tribunal concludes that there is a sufficient causal link between Yukos abuse of the system in some of the low-tax regions and its demise which triggers a finding of contributory fault on the part of Yukos See generally Dressler, J., Provocation: Partial Justification or Partial Excuse?, 51(4) The Modern Law Review (2011), pp Occidental v. Ecuador (majority award), Yukos v. Russia (final award),

82 The use of the expression pretextual justification is intriguing. It suggests that the tax arrangements of Yukos were only a secondary reason for expropriating its investment. The arbitral panel went as far as to acknowledge that there was another reason for the expropriation, specifically, the elimination of Mikhail Khodorkovsky as a political force. 206 On this interpretation, the faultworthy conduct of a claimant investor need not be the dominant reason for a respondent state to act against it. Fourth, the breach of the respondent state must be proportionate to the faultworthy conduct of the claimant investor. Importantly, if the breach is disproportionate to the faultworthy conduct, this does not act to bar its application. Rather, the respondent state is only liable to the extent of the disproportionality of its breach in comparison to the faultworthy conduct of the claimant investor. 207 The application of this rule is an arbitrary process. It involves the difficult task of accurately quantifying, with a percentage, an unquantifiable object: faultworthiness. This task of faultworthiness valuation is, notwithstanding its significance, rarely subject to analysis, and Yukos v. Russia is representative of this. It concludes, without any reasoning, that the apportionment of fault between Yukos and Russia is fair and reasonable in the circumstances of the present case Conclusion Expropriation of upstream investments is not a phase of the petroleum industry which occurred, most prominently, in the 1970s. The expropriations considered above demonstrate that expropriation has remained the principal political risk facing private companies engaged in upstream activities. It should also be expected that expropriations will remain the principal political risk into the future. As prices for crude oil sink, governments are more likely to invite private companies in to take the risk of developing new projects and upgrading old projects. If prices increase, it should be anticipated that the governments will view these projects as expropriation targets. Foreign investment law offers legal protection against future expropriations. Importantly for private companies, Exxon v. Venezuela endorses the implementation of corporate structures which aim to bestow legal protection, which international investment agreements offer, on a company within a corporate group. The only limiting factor is that these corporate structures have to be implemented before any dispute with a respondent state arises. Occidental v. Russia and Yukos v. Russia stand for the proposition that foreign investment law recognises a defence of civil provocation. Respondent states will be able to invoke this defence to reduce their liability to claimant investors who have engaged in faultworthy conduct, provided that there is causality between this faultworthy conduct and the breach of the respondent state. 206 The arbitral panel found that the reason for devising the plan was to eliminate Mikhail Khodorkovsky as a political opponent. See Id., Id., Id.,

83 Governmental Participation in Upstream Projects: The Brazilian Pre-salt case Eduardo G. Pereira* 1 Introduction The most notorious change in the Brazilian hydrocarbon regime in the last decade has been the replacement of a reasonably successful concession regime to a production sharing regime. 1 This replacement only applies for the pre-salt area as delimitated by law and strategic areas, which could be defined in the future. 2 In theory, the replacement of a concession agreement to a production sharing agreement (PSA) should not be a radical change for the petroleum industry per se. International Oil Companies (IOC) are fairly used to operating within a large variety of legal arrangements. PETROLEUM REGULATORY REGIME Service Contract Production Sharing Agreement Petroleum Licence Pure Service Contract Risk Service Contract PSAs are common in Africa and Asia. Service Contracts are more common in the Middle East and some parts of South America. Concession Agreements (i.e. Licence/Lease) are fairly typical in the western world. Several countries use a combination of these arrangements at * Eduardo G Pereira is a Counsel at Morais Leitão, Galvão Teles, Soares da Silva ( and adjunct professor of energy law at the University of Eastern Finland and Reykjavik University. Dr. Pereira specialises in international petroleum law, contracts, business and regulations. Contact details: 1 Art. 3 of Law n /2010 (PSA law). 2 Art. 2 and 3 of PSA law.

84 the same time which is referred to as a hybrid regime or a mechanism which combines features from different arrangements into one. Regardless of the type of arrangement in place, the petroleum industry is fairly versatile and able to adjust accordingly. Consequently, it is possible to argue that the petroleum industry should not be concerned with the new legal regime for the pre-salt and strategic areas in Brazil. However, there was a big fuss` in the petroleum industry about the new changes of the PSA regime in Brazil. So what is this big fuss` about? 2 The Industry criticism and challenges 2.1 Operatorship The main criticism of IOCs is the legislative restriction upon the operatorship of the pre-salt areas. In accordance with the PSA regime, only Petrobras will be legally able to operate any block within these areas. 3 Traditionally, IOCs tend to prefer the role of the Operator rather than Non-Operator. There are several reasons behind this. Firstly, the Operator has the overall control of the operation with generally no extra liability for it. Secondly, it generates more value in a potential assignment/divestment. Thirdly, it is possible to recover certain costs through a different mechanism (e.g. overheads and other accounting mechanisms). Consequently, it is easy to understand why IOCs were not very pleased with the new legislation in Brazil. It is yet to be seen whether Petrobras will be able to cope with all of these challenges by itself as a leading player in the industry or whether further regulatory changes including a step back will be required. However, it is important to stress that IOCs can contribute to the relevant committees and participate in secondments with Petrobras and Pre-sal Petróleo SA (PPSA). In this way, Petrobras and the Brazilian Government could argue that the expertise and knowhow from IOCs could be shared through these mechanisms. Some service providers, however, might have a different view. The definition of an Operator in the Brazilian PSA law refers to direct or indirect management of the operations by Petrobras. 4 Thus, it is possible to argue that the PSA law accepts sub-contracting of the operatorship but under the ultimate responsibility of Petrobras. This system was very beneficial for service companies in Mexico, for example. 5 However, it should be borne in mind that Mexico has just opened its hydrocarbon market after several decades of state monopoly as this regime was not the most beneficial for PEMEX and the Government of Mexico under current technical and financial challenges. 6 3 Art. 4 of PSA law. 4 Art. 2 and 4 of PSA law. 5 Emily Pickrell, Services companies stand to profit if Pemex makes changes, available at (last accessed 6 August 2015) 6 Daiana Villers, Mexican Energy Report: Opportunities for Historical Change, available at (last accessed 6 August 2015). 81

85 2.2 Bidding rounds & Consortium Another relevant change is the absence in the requirement to award acreage only through bid rounds. 7 The new law allows for discretion for the government to award a PSA directly with Petrobras without having the necessity to go through competitive bidding rounds as was required in the previous licence regime. However, if the government decides to go through a bid consortium, it is legally obliged to allocate 30% minimum equity to Petrobras. 8 In this case, it is important to bear in mind that under Brazilian law, any document signed in a foreign language shall prove effective only if translated in to Portuguese. 9 However, to take such a document to court, a public sworn translation is required. 10 This has significant practical relevance for international players who are used to negotiating and drafting joint operating agreements (JOA) in the English language. They must be aware of these issues (including the necessary adjustments that a civil law country requires in comparison to common law as most of the international agreements are constructed with a view of common law issues) before concluding any deal in Brazil (especially in the Pre-Salt). 2.3 Management Under the licence regime the licensee has fairly broad discretion to manage his asset, except for the standard governmental approval for aspects such as development plan, assignment, among others. Under the PSA regime, the management committee will be necessarily composed of representatives of the government (i.e. PPSA) and Petrobras. 11 The former shall nominate half of the members, the chairman and possess a veto right. 12 The latter shall have at least 30% equity in the consortium. So what is left for any IOC? They can only occupy the role of a Non-Operator and they are less likely to control any decision in the relevant management committees. There is a reasonable concern from an IOC point of view that pre-salt operations might be subject to significant governmental interference. 2.4 NOC participation Governmental participation has suffered from the relevant regulatory changes. It is important to notice that Petrobras is a company with mixed capital but the controlling shares belong to the Brazilian government. 13 The PSA regime created the company Pre-sal Petroleo S.A - PPSA. 14 This company is fully owned by the government and more likely to be subject to political decisions. 7 Art. 8 of PSA law. 8 Art. 10 of PSA law. 9 Art. 148 of Law 6015/73 (Public Registry). 10 Art. 157 of Civil Procedures Code. 11 Art. 23 of PSA law. 12 Art. 23 and 25 of PSA law. 13 Kenneth Rapoza, Petrobras Finds more Oil, But Money Heads to the Government not Shareholders, available at (last accessed 6 of August 2015). 14 Art. 8 of PSA law and Law /

86 In addition, Article 6 of the PSA law refers to the possibility that the federal government might take some equity in the PSA but it does not give details of such incremental participation. In short, most of these changes create several challenges for all parties involved. But the most interesting question goes back to 2006 when Petrobras announced the potential of huge reserves below the salt layer area. Why did the Brazilian government decide to change a reasonable and successful regime? In hindsight, was it necessary to alter the entire legal regime or would a simple adjustment in the fiscal term have done the job? 3 The rationale behind the change of the legal regime? Initially, it is important to stress that any country has the right of self-determination. In this sense, the Brazilian government has the right to determine and/or to modify its petroleum regime. However, such a right does not explain why it was necessary to modify a highly successful regime. The questions which have arisen are the following: what are the reasons and motivations behind this change? Who was benefited from it? 3.1 Financial reasons? There are a large number of articles, which indicate that the same government take can be achieved regardless the type of petroleum regime in place. 15 Any country can adjust its petroleum regime to achieve the same "magical number" as it would in another petroleum regime. M.R. de Oliveira gives a good example of this matter: (...) PSA offers no additional benefits to Brazil, since a simple change in contractual regime will not necessarily increase the government take. In addition, comparing both regimes, it was proven that it is feasible to arrive at similar government take whatever type of contract is in force. 16 Therefore, it is possible to suggest that the licence regime could offer the right balance to measure the risk/reward analysis. The Brazilian government could increase the government take for the pre-salt area by increasing the royalty and/or the special participation. This is exactly what the UK Government, for example, has done in the last 50 years. 17 The continental shelf from the UK used to be one of the major producers in the world despite having never changed its legal regime. The UK Government has always executed its changes in the fiscal term rather than changing the type of legal regime. This strategy is much more 15 See also: Daniel Johnston, International Petroleum Fiscal Systems and production sharing contracts (Penwell, Oklahoma 1994), p. 39; Kirsten Bindemann, Production Sharing Agreements: An Economic Analysis (Oxford Institute for Energy Studies, Oxford 1999), p. 88; John Gault, Crude Designs: The Rip Off of Iraq s Oil Welth - A Comment, 5(2) OGEL (2007). 16 M.R. de Oliveira, The Pre-Salt Oil Reserves in Brazil: To What Extent Is It Really Necessary to Adopt a Production Sharing Agreement System?, 21 OGEL (2009), Marios Papaparaskevas, The Taxation of Oil and Gas in the UK: Which factors fostered the decline of oil and gas production from the UKCS, CEPMLP Annual Review, CAR Vol 17, 2012/2013 and Kemp, G. A. and Rose D. (eds.), Petroleum Tax Analysis: North Sea (London: Financial Times Business Information Limited, 1983). 83

87 easily implemented and secures the most relevant objective for the government: the financial compensation. For a general investor this seems a relatively stable regime as it never shows great change. In reality, however, the UK government could be considered a fairly unstable jurisdiction from a fiscal perspective and this certainly affects any investor as the fiscal term is the key factor to make any project profitable Legal reasons? From a legal perspective, any petroleum regime can secure the government control over the assets. In fact, most petroleum regimes will implement similar terms and clauses such as description of the area, duration, minimal work program, declaration of commerciality, development plan, relinquishment, decommissioning, local content, environmental and safety provisions, liabilities, guarantees, indemnity against third parties, inspections, records, assignments, amendments, termination, dispute resolution and applicable law. It is possible to argue that some legal regimes might allow a greater government control than others. For example, a licence regime tends to require less governmental control than a PSA with regard to the way the activities are executed. In reality, however, the ultimate control remains with the state irrespective of the arrangement in place. Exceptions to this are jurisdictions where the ownership of the natural resources remains with the owner of the surface right, as in North America for example. In these cases, there is little governmental control as the ownership of the natural resources is not allocated to the government. The legal nature and conception of the ownership of the natural resource is the most relevant distinction between the most commonly adopted petroleum regimes in the petroleum industry: Model PSA LICENCE SERVICE CONTRACT Nature of the rights conferred to the IOC CONTRACTUAL ONLY INCLUDE PROPRIETARY CONTRACTUAL ONLY Ownership of recovered hydrocarbon resources SHARED IOC HG The legal regime under which the petroleum industry operates, does not necessarily affect the government take, as is suggested by the Brazilian government. Thus, the Brazilian government could have arranged its fiscal system in order to achieve the same financial income irrespective of the model adopted. This process would have been fairly 18 Ibid. 84

88 straightforward as the royalty and special participation processes were already in place and could have been increased in order to achieve the same financial benefits expected from the new PSA regime. This would have allowed for development on the Pre-Salt reserves within a shorter period of time, as well as maintained the stability and progress of the previous petroleum regime. Therefore, if there is no relevant legal or economic distinction, why was there a need to implement a new petroleum regime to develop the Pre-Salt area? The most reasonable answer is political and national security issues. It is possible to suggest that the creation of a new NOC in the Brazilian petroleum regime has clear political motivation, which is directly related to the rationale behind the new PSA. This perspective is supported by several authors, 19 such as John Gault: The primary difference between a well-designed PSA and a well-designed taxand-royalty system is not economic but political: the PSA gives the appearance that the host country NOC remains the owner of the reserves in the ground until they are produced. I have always assumed that this appearance was the primary reason why some host governments introduced PSAs in the first place. 20 Although most developing countries face popular claims to protect national resources and feel uncomfortable delegating proprietary rights to an IOC, this should not apply to the Brazilian scenario as the state monopoly was relaxed in In other words, it seems to be a regressive measure towards national restriction from private and foreign investment. 4 Conclusion In conclusion, it is difficult to understand the real necessity to change the legal hydrocarbon framework for upstream operations in Brazil. Firstly, the concession regime could have achieved the same financial compensation as the PSA regime. The Brazilian government would take the maximum benefit of its momentum as there was significant industry interest to invest in Brazil at that time and to develop the pre-salt area. A simple modification in the fiscal regime might have avoided years and lengthy debates with the parliament and with a variety of other stakeholders. Several sizeable investments were postponed due to this modification. Secondly, creation of a new NOC to "manage" the PSA operations and revenues of the petroleum law (9478/97) created a federal agency, ANP, only to deal with those issues. As a matter of fact, the participation of such an NOC creates more bureaucracy and operational 19 Johnston has the same perspective as he states that At first PSCs and concessionary systems appear to be quite different. They have major symbolic and philosophical differences, but these serve more of a political function than anything else.` (Johnston (n 12)). In addition, Bindemann suggests in his conclusion that In that sense it can be argued that a PSA is a political rather than an economic contract. See Bindemann, supra, note Gault, supra, note

89 difficulties as this NOC will have special votes in the operating committees. The main answer to this question is likely to be found further north as several countries tend to copy and paste the Norwegian model without a careful and detailed analysis why and what went well, what lessons could be learnt and what could be replicated, in part or fully, outside Norway. Thirdly, the Brazilian authorities went even further as the new petroleum regime delegates all operatorship to only one company, namely Petrobras. 21 By doing so the Brazilian government intended to boost Petrobras portfolio and, furthermore, secure a higher compliance with provisions concerning local content and national development. In other words, the Brazilian government hoped for a huge intake of local jobs and services by Petrobras, which would help to develop the Brazilian economy. Although such measures tend to principally benefit the Brazilian industry, they could also affect the Brazilian economy as a whole. National measures and the requirement for a sole operator for the Pre-Salt area are likely to deter investments by many IOCs. Besides, the local content is only one side of the coin. Local industry has to support such demand, otherwise foreign equipment and/or personnel will be implemented to cover such deficiencies. Nevertheless, it is too early to verify the real consequences of such an approach. Therefore, it is realistic to suggest that there was no definite legal or financial reason to modify the Brazilian petroleum regime, as suggested by some governmental authorities. 22 The reality is that political motivations were the key factor for this decision. It is too early to determine whether this was the wisest decision for the future of the country, and in fact, under short term analysis it would seem that the opposite is more likely to be true as there are public discussions within the congress about possible changes within the current legislation See supra, note See Reinaldo Azevedo, PRÉ-SAL Em seis meses, Serra fez mais pelo Brasil no Senado do que Suplicy em 24 anos. Basta ter clareza e saber o que se quer!, available at (last accessed 6 August 2015). and Róber Iturriet Avila, Antônio Tedesco Giulian, Petróleo: concessão ou partilha? O modelo de exploração do Pré-sal atual é o de partilha, que garante maior volume de recursos para o desenvolvimento socioeconômico, com destaque ao destino dos royalties para saúde e educação. Aécio defende o retorno ao modelo de concessão, que amplia os benefícios aos negócios privados, available at (last accessed 6 August 2015). 23 For further information about see: Senate, Eduardo Braga defende regime de partilha e conteúdo nacional, mas não descarta mudanças, , available at (last accessed ). 86

90 The Potential Impacts of a Construction Agreement Structure on a Bank Consortium s Collateral Package for a Project Loan Laura Huomo 1 This article discusses the structure of a construction agreement and its potential impacts on the contents of a collateral package granted to a bank consortium financing the construction of a natural gas pipeline. 1 Introduction Due to the scale and complexity of natural gas pipeline projects, the construction of a natural gas pipeline usually takes years to complete. The so-called earnings principle, which means that a pledge of a receivable is not enforceable against the bankruptcy creditors or foreclosure creditors of the pledgor until the obligation on which the receivable is based has been fulfilled, 2 affects the structure of construction agreements for natural gas pipelines in the Nordic countries, including Sweden. 3 This article discusses the alternatives of structuring a construction agreement and, in particular, two alternative structural models. In the first model, the construction company builds and owns the entire pipeline, after which it is transferred to the project company (hereinafter the SPV ). In the second model, the SPV enters into an agreement under which the pipeline is constructed in sections, and the ownership of individual sections of the pipeline is transferred to the SPV from the construction company upon completion of each section. If the construction company files for bankruptcy during the construction process, the latter model could serve as a basis for determining which sections of the unfinished pipeline form part of the construction company s bankruptcy estate and which sections are covered by a real estate mortgage or a business mortgage granted to the construction company's creditors. This article raises arguments against the contemporary view accepted in legal literature in relation to the pledging of future receivables in the Nordic countries, which holds that the earnings principle is taken into account at the time the pledge is 1 Dr. Laura Huomo, Counsel, LL.D, Roschier, Attorneys Ltd. 2 Tuomisto, Jarmo: Ansaintavaatimus saamisen panttauksessa in Saarnilehto, Ari, Sopimus, vastuu ja velvoite (Jyväskylä, 2007), p In Sweden, the earnings principle is referred to as 'frysninsgsprincipen'. 87

91 created. This article argues that the earnings principle does not come into effect prior to the enforcement phase of the pledge agreement. 4 2 Two alternative forms of structuring a construction agreement Natural gas pipeline construction agreements are typically drafted in such a way that the construction company builds the pipeline and the compression stations (also called pumping stations) for the SPV and the ownership of the pipeline is transferred to the SPV in sections (Figure 1). It is also common for the construction to be carried out on real estate owned or leased by the SPV. If the construction site is clearly marked, the movable property located in that area can be deemed to belong to the construction company (including the pipeline). 5 This is due to the fact that in Finland and Sweden, unless movable property is assembled in such a way that it is converted into real property that cannot be removed easily, the fact that movable property is located on real property 6 owned by another party does not mean that the ownership of the movable property is transferred to the owner of the real estate. The movable property does not become a part of the real estate due to the fact that the real estate and the movable property are owned by two different parties. It is also possible to draft the construction agreement in such a way that the ownership of the pipeline is transferred to the SPV only after the construction of the pipeline has been completed (Figure 2). In this case, the construction company 4 A pledge agreement in this context is an agreement entered into between two parties whereby movable assets or mortgage notes are pledged by the pledgor as security for a loan granted to the pledgor or a third party. 5 Kartio, Leena, Esineoikeuden perusteet (Helsinki, 2001) pp. 93 and 97; Kartio, Leena, Rakennuksen omistajan oikeusasemasta erityisesti silmälläpitäen maapohjan omistussuhteiden merkitystä (Vammala, 1974), p. 265; Jokela Kartio Ojanen, Maakaari (Helsinki, 2010, 5th edition), p. 14; Victorin, Anders Sundell, Jan-Olof, Allmän fastighetsrätt (Uppsala, 2004), p. 155; and Carlsson, Laura, An Introduction to Swedish Real Property Law (Stockholm, 2008), p. 41. Also see the Swedish Code of Real Estate: Jordabalken (1970:994, as amended) 2:4. For discussion on common law practice on the subject, see Vinter Graham; Price, Gareth; Lee, David, Project Finance (London, 2013, 4 th edition), p Real estate on which the pipelines are built are typically areas of undeveloped real estate. 88

92 enters into a real estate lease agreement with the SPV concerning the areas where the compression stations are located and builds the stations on that real estate independently. As for the pipeline, it is built on real estate owned by third parties and the SPV acquires a right to use the real estate where the pipeline is located. In cases where the real estate lease agreement is transferable 7 to a third party, the construction company s leasehold interest could be entered in the real estate register alongside the ownership of the real property owned by the SPV. Thereafter, the construction company could grant a mortgage over its leasehold interest and use it as collateral for its project loan. The leasehold interest includes both the compression station(s) and the pipeline located on that leased piece of real estate. The construction company s lease agreement includes a right to use the SPV s leasehold interests in the third parties piece of real estate on which the pipeline is built. The construction company retains ownership of the pipeline until the construction price is paid in full. Upon completion of the compression station(s) and the pipeline, the construction company sells the stations and the pipeline to the SPV (in addition to the leasehold interest), and the SPV s leasehold interest and ownership interest are merged. 8 7 According to the Finnish Land Lease Act (258/1966, as amended), a lease of commercial real estate is transferable to a third party (30 ) (a provision to prohibit the transfer is not valid); a lease of other residential real estate is transferable unless a transfer is restricted in the lease agreement (53 ); and a lease of a so-called other real estate is transferable unless a transfer is restricted in the lease agreement (75 ). 8 See discussion from the project bankability's point of view Gatti, Stefano, Project Finance in Theory and Practice. Designing, Structuring and Financing Private and Public Projects (London, 2013, 2 nd edition), p

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