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An Oil Fund for Scotland: Taking forward our National Conversation

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3 The Purpose of an Oil Fund

Chapter Summary

  • An oil fund is intended to transfer a share of the wealth generated from oil and gas production to a separate fiscal account where it can be saved and invested over the long-term rather than consumed immediately.
  • A variety of public policy objectives can be served by an oil fund, these include:
    • long-term fiscal sustainability;
    • inter-generational equity;
    • macroeconomic stabilisation;
    • efficient resource allocation within the economy;
    • promoting industrial diversification;
    • providing local benefits; and
    • developing sustainable energy.

3.1. Having large reserves of oil and gas presents an economy with considerable opportunities over the short and long-term. Experience has shown that these assets also create considerable challenges to a country's economy and political system.

3.2. Unlike other sources of a nation's wealth, oil and gas reserves are non-renewable. By their very nature, once a barrel of oil or cubic metre of gas has been produced, they cannot be re-produced in the future. To a certain extent, current production levels can be maintained by exploring for, discovering and developing new reserves previously unknown or deemed un-profitable, but ultimately, with continued production, a point will be reached when all oil and gas reserves have been exhausted.

3.3. The general principle behind the creation of an oil fund is to transfer a share of the wealth generated from oil and gas production to a separate fiscal account where it can be saved and invested over the long-term rather than consumed immediately. This requires a conscious decision by policymakers to forgo a proportion of possible current consumption in favour of long-term investment. This is not straightforward. Current needs and demands on the public finances are typically more clearly defined than future needs.

3.4. This chapter discusses:

  • first, the public policy rationale for creating an oil fund; and
  • second, how an oil fund could generate future income.

Public Policy Rationale for an Oil Fund

3.5. There are a variety of public policy objectives which could be served by an oil fund. This Chapter discusses how an oil fund could help achieve these aims:

  • long-term fiscal sustainability;
  • inter-generational equity;
  • macroeconomic stabilisation;
  • efficient resource allocation within the economy;
  • promoting industrial diversification;
  • providing local benefits; and
  • developing sustainable energy.

3.6. In practice, and with the correct design, an oil fund can be used to help achieve several of these policy objectives simultaneously.

Long-term financial sustainability

Oil funds can facilitate the creation of renewable wealth from a non-renewable and finite resource.

3.7. In most cases, the key motivation behind the creation of an oil fund has been to provide a vehicle for sustainable resource management such that the returns from non-renewable oil and gas revenues can be converted into a renewable financial pool of wealth.

3.8. Oil and gas reserves represent an important element of a country's asset stock. Investing a share of the revenues received from oil and gas production in financial assets such as equities and bonds, leads to the creation of a new asset - financial wealth. Unlike oil and gas reserves, returns from such assets can provide a permanent income stream. Provided that the underlying principal of these financial assets is maintained, equities, bonds and cash holdings are able to generate income flows year on year, via interest payments, dividends and rising asset values. An oil fund, by converting the temporary wealth generated by oil and gas production into financial assets, can therefore lead to the creation of a permanent source of revenue which would continue to generate income beyond the point when oil and gas reserves have been exhausted. The theoretical principle of permanent income streams is discussed in more detail in Box 1.

Box 1: Permanent Income Streams 36

The constant permanent income stream which could be provided from oil and gas production, after accounting for inflation, is determined by equation 1 below. M is the annual income received from oil production, y is the number of years of investment, r is the real return received on the investments and X is the real revenue stream raised.

[Equation 1]

As a simple stylised example, suppose that £100 million in tax revenue (in real prices) is collected from oil and gas production for ten consecutive years and the real return received on investments ( r) is 5 per cent. Further, suppose that at the end of year 10, oil and gas reserves have been exhausted.

Using these figures it is possible to estimate how much would need to be invested to maintain a constant revenue stream from year 1 and for all subsequent years, including the period after all reserves have been exhausted.

In this example, the permanent income stream ( X) would be £39 million a year in real prices.

[Equation 2]

To obtain this, a government would be required to invest £61 million of oil and gas revenues into the fund (£100 million less £61 million = £39 million) each year for the ten years oil and gas is in production. By doing so, this would mean that from the first year when oil and gas tax revenues are received, and in each subsequent year, the value of the principal and the returns generated would be sufficient to return £39 million in revenue each and every year going forward in real terms.

After year 10, the income earned on the investments and the underlying principal would be sufficient to continue providing £39 million a year in revenue indefinitely.

diagram

Inter-generational equity

Oil funds can provide a mechanism to save some of the temporary windfall from oil and gas revenues and allow the benefit of a country's natural resources to be shared across generations.

3.9. The most obvious motivation behind the creation of an oil fund is to provide a transparent mechanism to save a proportion of the temporary financial windfall from oil and gas production for future generations.

3.10. Oil and gas reserves are potentially very lucrative with the ability to earn billions of pounds for countries fortunate enough to have them located in their jurisdiction. As with any one-off financial 'windfall', many countries have found it prudent to 'lock- away' a proportion of these returns in 'rainy day funds' or 'heritage funds'.

3.11. Saving an element of this windfall ensures that future generations can share in the benefit from a country's natural resources. Of course, if this saving comes at the cost of increased borrowing in the general budget, future generations would inherit debt and savings simultaneously. Ensuring that the former does not dominate is critical to this benefit being achieved.

Macroeconomic stabilisation

Oil funds can help to stabilise the macro-economy, limiting any inflationary effect on demand when oil and gas prices rise sharply, and helping to cushion demand when oil and gas prices fall.

3.12. In addition to assisting in the development of sustainable wealth creation and providing a mechanism for inter-generational saving, oil funds also have the opportunity to act as a short-term stabilisation mechanism. This can be especially important in small economies where oil and gas production contribute a significant amount to the government exchequer.

3.13. As illustrated in Figures 4 and 6, oil and gas tax revenues are typically subject to variability as a result of fluctuations in underlying commodity prices and hence in the profitability of the operating companies and the taxes that they pay.

3.14. Faced with such volatility spilling over into the general government budget, oil funds can act as a stabilising mechanism, transferring relatively higher levels of the fund's wealth to the government budget in lean years and relatively lower levels in good years. This could ensure predictability in the budget process and in the setting of policies and spending programmes. Thus while the funds do not stabilise commodity prices themselves they mitigate against commodity price volatilities translating into wider macroeconomic (particularly fiscal) instability.

3.15. Furthermore, the funds can, in theory, be used to assist the wider economy during lean economic years, finance automatic stabilisers and facilitate growth. For example the Norwegian Government announced in January 2009 that it would use a proportion of its oil wealth to fund a £2 billion fiscal stimulus package 37. In contrast to other countries, Norway has been able to implement these measures without relying on large increases in government borrowing. The Norwegian Government projects that it will run a budget surplus of 7.4 per cent of mainland GDP in 2009, higher than any other country in Europe. 38 It is important however, to ensure that appropriate checks and balances are in place so that such transfers are made only in times of genuine need and that they are re-paid during better times.

Efficient resource allocation within the economy

Oil funds can prevent negative spill-over effects from the oil and gas sector impacting upon other sectors of the economy.

3.16. A common concern faced by many small economies with substantial natural resources, particularly developing countries, is the impact that the sector's success can have on the development of other aspects of the economy. In small countries with significant oil and gas reserves, academic evidence has shown that in certain cases, these economies have actually performed relatively poorly when compared to apparently similar countries who do not have oil and gas sectors; this is often referred to as the 'resource curse' 39. There are a number of possible explanations for this phenomenon, including the overvaluation of exchange rates (often referred to as 'Dutch Disease'), high unit labour costs, lack of sufficient incentives to invest in human and physical capital stocks relevant for other sectors of the economy and general instability spilling over from fluctuations in oil and gas prices. These effects mean that the non-oil and gas producing sectors in the economy can be squeezed, resulting in a loss in competitiveness and long-term decline in economic growth.

3.17. By enhancing stability in the economy and providing a transparent mechanism for investment, oil funds can be used to mitigate the effects of any negative spillovers from natural resource extraction.

Promoting industrial diversification

Oil funds can be used as a mechanism to assist in economic diversification.

3.18. Oil funds can also be used as a transparent funding mechanism to assist in the diversification of a country's economy into areas of economic activity other than oil and gas production. This can ensure economic and social development continues at a pace once oil revenues have been exhausted. By having a diversified economy a country can also avoid being overly exposed to sector specific shocks.

3.19. Furthermore, international evidence clearly demonstrates that investment in capital, both public and private, and research and development are essential drivers of productivity, competitiveness and long-term economic growth. Increased productivity - that is, more or higher quality output per unit of labour input - represents an efficiency gain that lowers average production costs.

3.20. The development of these assets can be assisted by allocating a proportion of not only the direct tax revenues from oil and gas production but also the returns from the fund to finance additional investment. Such ring-fencing of withdrawals from the fund can lead to a higher level of investment than would otherwise have been the case and assist any transition in the economy toward an age where the importance of the oil and gas sector is more limited.

3.21. Once more, appropriate checks and balances are often desirable to ensure that this is undertaken in the best possible manner. In practice, designing rules that govern the magnitude and composition of spending have proved useful in many countries.

Providing local benefits

Oil funds can provide a mechanism to ensure that local communities benefit from the extraction of natural resources in their area.

3.22. In practice, the majority of the financial benefits from oil and gas extraction are captured by residents outside the area in which the reserves are located (i.e. shareholders of oil and gas producing companies and general population). Establishing an oil fund can be used as a mechanism to ensure that local people benefit from the extraction of natural resources in their area by effectively ring-fencing a share of the revenue windfall for residents most directly affected. Many countries have found this desirable, especially if the extraction of the resource imposes an environmental or social cost on local residents. For example an oil fund was established in Shetland during the 1970s using a levy on oil passing through Sullom Voe harbour. The fund is now estimated to be worth £180 million and has provided £200 million in funding for the island 40.

Developing sustainable energy

Oil funds can use some of the wealth generated from oil and gas production to facilitate the development of renewable energy sources.

3.23. In addition to providing a source of revenue to both the private and public sectors, oil and gas currently meets the majority of most countries' energy demand. However, energy demand will undoubtedly need to shift toward alternative and low carbon energy sources.

3.24. However, relative to oil and gas processes, many alternative energy sources remain in development. An oil fund's income and capital can in theory be channelled to assist the advancement of new techniques and technologies in alternative sources of energy creation, providing benefits not only in terms of economic sustainability but also in the sustainability of a country's energy supply. It could also be used to invest in the infrastructure which will be required to deliver low carbon energy systems in the future.

3.25. One area where this has significant potential is carbon capture. Carbon capture is especially relevant for the oil and gas sector as it can replace water and natural gas and other technologies for promoting enhanced oil recovery. There is therefore a double benefit - increased oil output plus reduced carbon emissions. Development of the relevant technology and expertise will take time and require financing, creating investment opportunities in which an oil fund can invest.

How an Oil Fund Generates Future Income

Past opportunities

3.26. An interesting historical illustration is to estimate how much a hypothetical UK Oil Fund would have been worth had the UK Government invested a proportion of oil tax revenue over the past three decades.

3.27. Given the assumptions required, such analysis is purely illustrative but does give a useful indication of the potential value of a fund had the UK Government chosen to create one.

3.28. Figure 10 highlights the potential value of a UK Oil Fund had 10 per cent of North Sea revenues been allocated to an oil fund from 1980 onwards. Note that to best capture the level of investment each year, the analysis assumes a transfer of just 10 per cent of nominal revenues. As discussed above, the value of such a fund would depend on both the returns achieved on the investments and the proportion of the fund withdrawn in a given year. Assuming that no revenue was withdrawn from the fund, annual nominal returns of 3 per cent would have meant that such a fund could have been worth £24 billion in 2008-09. If nominal rates of return of 5 per cent and 7 per cent had been achieved, the value in 2008-09 would be worth approximately £33 billion and £47 billion respectively 41. This would mean that the value of the fund could be at least twice as large as the total amount of revenue raised in 2008-09 from the North Sea.

Figure 10: Hypothetical Value of a UK Oil Fund - Investing 10% of Nominal North Sea Revenue Annually (1980-81 to 2008-09)

Figure 10: Hypothetical Value of a UK Oil Fund - Investing 10% of Nominal North Sea Revenue Annually (1980-81 to 2008-09)

Source: HMT and Scottish Government calculations

3.29. Table 2 highlights the hypothetical value of the fund in 2008-09 if transfers of 10 per cent, 20 per cent and 30 per cent of North Sea revenues had been invested each year into the fund.

Table 2: Value of Oil Fund in 2008-09 with an Annual Nominal Return of 3%, 5% and 7% (£ Billion)

Annual Investment
(% of total revenues)

Annual Return (£ billion)

3%

5%

7%

10%

£24

£33

£47

20%

£47

£66

£94

30%

£71

£99

£141

Future opportunities

3.30. This section sets out the potential value of an oil fund for Scotland under various hypothetical scenarios. Forecasting the potential value of an oil fund is subject to a variety of uncertainties. Some factors are determined by policy choices, such as how much is invested into the fund each year and for how long, while others, such as the rate of return received on the fund's investments each year, depend upon general economic conditions in the future. The analysis conducted here is illustrative and simply attempts to highlight the potential gains from establishing an oil fund.

3.31. Two illustrative examples are given below:

  • one-off investment of a fixed amount; and
  • repeated investment over time of a fixed amount.

One-off investment

3.32. Figure 11 demonstrates the future value of a one off investment of £1 billion, if this money was invested over the long-term. Assuming that an annual real return of 3 per cent a year could be achieved and that the annual returns were re-invested year on year, this initial investment would be valued at approximately £1.3 billion in year 10, rising to £2.4 billion by year 30 in real terms. If the fund was able to achieve a real return of 5 per cent, it would be valued at approximately £1.6 billion in real terms in year 10 and £4.1 billion in year 30.

Figure 11: Hypothetical Oil Fund Value - One Off Investment of £1 billion

Figure 11: Hypothetical Oil Fund Value - One Off Investment of £1 billion

Source: Scottish Government calculations

Repeated investment

3.33. In practice most funds receive repeated investment each year as oil and gas reserves are depleted, as set out in Chapters 4 and 5. By adding to the fund on a regular basis, this can allow a fund's value to grow even more rapidly. For example, panel 1 in Figure 12 illustrates that if £1 billion (in real terms) was invested annually for 10 years, with an annual real annual return of 3 per cent being achieved and no withdrawals being made, the fund would be worth £11.5 billion in real terms at the end of the 10 year period. This could provide a permanent annual income stream of £344 million in real terms from year 11 onwards as illustrated in panel 2.

Figure 12: Hypothetical Oil Fund Value - Investing £1 billion a year for 10 years with no withdrawals

Figure 12: Hypothetical Oil Fund Value - Investing £1 billion a year for 10 years with no withdrawals

Source: Scottish Government calculations

3.34. The amount of income which an oil fund could generate depends on the amount invested, the returns achieved and the number of years for which the investments are made. The tables below illustrate how much a fund would be worth over different time periods and different levels of return if £1 billion, £2 billion or £5 billion was invested annually. For example, if £2 billion was invested annually and achieved an annual real return of 3 per cent, it would be worth £22.9 billion in real terms after 10 years and £53.7 billion after 20 years.

Table 3: Value of Investments with an Annual Real Return of 1% (£ Billion - Constant Prices)

Number of Years Invested

Annual Investment (£ billion)

£1

£2

£5

5 years

£5.1

£10.2

£25.5

10 years

£10.5

£20.9

£52.3

20 years

£22.0

£44.0

£110.1

Table 4: Value of Investments with an Annual Real Return of 3% (£ billion - Constant Prices)

Number of Years Invested

Annual Investment (£ billion)

£1

£2

£5

5 years

£5.3

£10.6

£26.5

10 years

£11.5

£22.9

£57.3

20 years

£26.9

£53.7

£134.4

Table 5: Value of Investments with an Annual Real Return of 5% (£ billion - Constant Prices)

Number of Years Invested

Annual Investment (£ billion)

£1

£2

£5

5 years

£5.5

£11.1

£27.6

10 years

£12.6

£25.2

£62.9

20 years

£33.1

£66.1

£165.3

3.35. The above examples assume that no income is withdrawn from the fund during the initial investment period. Alternatively, while preserving the real value of the fund, a proportion of the income received from the fund's investments may be withdrawn from year 2 onwards. This would serve to reduce the value of the fund and ultimately the level of future income that the fund would be able to generate. This is illustrated in Figure 13. In this example, the fund's real return is withdrawn each year and the remaining returns are reinvested to ensure that the real value of the fund is not eroded by inflation. Under this scenario, the fund would be worth £10 billion after 10 years and could provide a permanent annual income of £300 million in real terms from year 11 onwards.

Figure 13: Hypothetical Oil Fund Value - Investing £1 Billion a year for 10 years with Withdrawals

Figure 13: Hypothetical Oil Fund Value - Investing £1 Billion a year for 10 years with Withdrawals

Source: Scottish Government calculations

3.36. The tables below provide a range of examples to illustrate how much a fund could be worth, and the cumulative amount which would be available for spending, over different time periods and with different levels of return. For example, if £5 billion was invested annually with a real return of 3 per cent, and the real returns withdrawn each year, then after 10 years the fund would be worth £50 billion and £6.8 billion would have been available over the period to fund government programmes.

Table 6: Value of Investments & Total Income Withdrawn with an Annual Real Return of 1% (£ Billion - Constant Prices)

Number of Years Invested

Annual Investment (£ billion)

£1

£2

£5

Value of Fund

Total Income Withdrawn

Value of Fund

Total Income Withdrawn

Value of Fund

Total Income Withdrawn

5 Years

£5.0

£0.1

£10.0

£0.2

£25.0

£0.5

10 Years

£10.0

£0.5

£20.0

£0.9

£50.0

£2.3

20 Years

£20.0

£1.9

£40.0

£3.8

£100.0

£9.5

Table 7: Value of Investments & Total Income Withdrawn with an Annual Real Return of 3% (£ Billion - Constant Prices)

Number of Years Invested

Annual Investment (£ billion)

£1

£2

£5

Value of Fund

Total Income Withdrawn

Value of Fund

Total Income Withdrawn

Value of Fund

Total Income Withdrawn

5 Years

£5.0

£0.3

£10.0

£0.6

£25.0

£1.5

10 Years

£10.0

£1.4

£20.0

£2.7

£50.0

£6.8

20 Years

£20.0

£5.7

£40.0

£11.4

£100.0

£28.5

Table 8: Value of Investments & Total Income Withdrawn with an Annual Real Return of 5% (£ Billion - Constant Prices)

Number of Years Invested

Annual Investment (£ billion)

£1

£2

£5

Value of Fund

Total Income Withdrawn

Value of Fund

Total Income Withdrawn

Value of Fund

Total Income Withdrawn

5 Years

£5.0

£0.5

£10.0

£1.0

£25.0

£2.5

10 Years

£10.0

£2.3

£20.0

£4.5

£50.0

£11.3

20 Years

£20.0

£9.5

£40.0

£19.0

£100.0

£47.5