Cover Story (#12 December 2016)

Bespoke Law

Balancing the geopolitical state of play, political ambitions and economic realities, national energy policy is, perhaps, the most sensitive subject of the overall reforms circle. Its becoming obvious that the sector could be re-launched by capital intensive investments. Minding its interests, the state has the fundamental task to restore trust in it as a reliable partner and suggest good incentives for investors. Albert Sych, EY partner, law leader for Ukraine, who was a trusted advisor of the first huge foreign inbound investments, has given a fair explanation of the business mindset of industry majors.

UJBL: Our state quite frequently changes conditions for oil and gas exploration and production. How are these constant changes in regulations perceived in the market by its main players: both by external investors and by domestic operators?

Albert Sych: On the one hand, it is true that there are a lot of changes in some areas and on some matters. Sometimes there are too many of them, which is undesirable. At the same time, there are areas in the energy sector, including the oil and gas industry, where changes should have been introduced a long time ago and where they are highly anticipated. Regrettably, they still have not been made. I would like to highlight several aspects. First, taxation changes in the industry. The most obvious example is royalties (or using the Ukrainian law terminology rental payments for exploration and production of oil and gas). Its a sensitive subject. It was very hot a year and a half ago. Then there were changes at the end of 2015 that reduced to their previous level the tax rates that had been significantly increased earlier. This returned everything to a kind of status quo. At that time, many market players believed that the state tried to fill in the state coffers at the expense of the industry, which the state, admittedly, must have thought to be rather well off. We tried to understand ourselves whether there was any proper rationale underlying the raise, and whether some international experience had been taken into account or necessary case studies and calculations for our country had been made. We had not seen that, or if there was indeed such an elaborate approach we did not know about it. So it just looked like a fiscal measure. Naturally, such an approach and changes that occurred quite abruptly, without any preparation and explanation that is what you cant take positively, whether you are a local producer or foreign investor. Second, there are many issues in regulations that should have been addressed in Ukrainian legislation, often on the basis of international experience. Now there are a number of draft acts pending their adoption, starting with the seemingly ill-fated Natural Resources Code. Its a long process. Importantly, Ukrainian players understand to a certain extent the market and country realities and have already got used to working under these conditions. For new foreign investors who wanted to come to Ukraine for large and long-term projects in the oil and gas industry (unfortunately, I have to mention this in the past tense), much of what we view as normal for us was a red light and no-go. Because, in fact, when they look at Ukraine, they compare it with all other countries where they already work. And, as trite as this may sound, the stability of legislation is one of the fundamental principles that are most important to them. And this is a good illustration of why foreign investors are interested in instruments that provide such stability and make it possible to be safe from the risk of legislative changes. A production sharing agreement is a great example. It is one of the few mechanisms in Ukraine that still contain a so-called stabilization clause (or grand-fathering clause). It allows freezing, fixing Ukrainian legislation, for example, at the date of agreement conclusion to protect investors from these changes.

UJBL: You have already partially touched upon the subject of instruments currently at the disposal of investors to work in the oil and gas industry. What instruments are the most suitable? How do you assess the practice of production sharing agreements (PSA)? What alternatives to PSA actually exist in practice?

A. S.: We were directly involved in working with many instruments that had just appeared or had been tested for the first time in Ukraine, specifically for large scale projects with major international oil and gas players. Notably, different instruments may be needed to address the needs of local producers and foreign investors. And the approach to these projects may also differ. For example, if we are talking about Ukrainian producers, in many cases a standard mechanism is assumed getting a special permit. But in practice it turned out to be quite different. These permits were and could be very difficult to get. There were all sorts of risks. For example, if a company got an exploration license, then there was a risk that it would not get a production permit. Sometimes some interesting fields were already in use by someone else, who in fact did not exploit them effectively, but at the same time did not want to give away a permit. Also, there always was an issue with royalties. The tax burden when working under a standard mechanism using a special permit was quite heavy, especially for large-scale greenfield projects. Stand alone permits were not always the most effective and workable instrument and one had to resort to alternative mechanisms. The most common alternative is joint activity (JA). It was necessary to be able to attract a partner to work with. Because of the existing legislative prohibition on transfer of a special permit, in most cases you cannot just sell it. So, one had to use contractual mechanisms for joint exploration and production. The practical application of JAs has shown both their positive and negative sides. Alas, there were many cases of abusive practices. But there were also positive examples, when, in fact, in 2006 it was the only mechanism through which one of the worlds major players could have some kind of a joint project with a Ukrainian state sector enterprise. A lot of issues arose, starting from taxation, with different approaches: how to impose taxes on joint activity as such, especially in the oil and gas industry; who should pay royalties joint activity itself, as a separate payer, or only a permit holder...

A more tailored instrument is a production sharing agreement. Undoubtedly, this mechanism is not for every day use not for each project, not for each field, and not for every situation. But it is an instrument that really allows you to apply quite drastically different rules of the game, which are more suitable for large-scale projects. These rules are by their nature focused on being most attractive for an investor willing to make very significant and very often risky investments. Opponents of PSAs often argue that this agreement provides unwarranted privileges. However, it could be so only if the state chose the wrong investor or, in the long run, agreed to manifestly discriminatory conditions under the agreement. In my experience, the state has always minded its own interests. Perhaps now may not be the right time, not the right situation in the market, not the right price for oil and gas, to talk about large-scale projects, as those that were planned in Ukraine. But if you still aim at such projects, a PSA would be the most appropriate instrument for them. But I would like to stress that this mechanism can, of course, be used for smaller projects, which still require a lot of resources and financing and would be unsustainable if you worked under a general regime. As there are too many issues with joint activity, it seems to be promising and interesting to convert a joint activity agreement under already issued special permits into a production sharing agreement.

UJBL: Does this conversion practice exist?

A. S.: This practice is very limited. As far as I know, only one agreement was converted in Ukraine. But this topic is quite relevant, we are discussing and considering it with a number of market players, both in the private and public sectors.

UJBL: Why, then, is this conversion not used? Investors are probably not aware that there is basically such a possibility.

A. S.: If we see an interesting instrument that could be more effective, of course we are always ready and happy to propose it to our clients. We held events and individually communicated with our clients to make them aware of such possibilities. To my knowledge, almost all major players are conscious of such instruments. Some of them even seriously considered them. Why have they not used them yet? There could be different reasons. The key one is that regulation of the conversion process is not complete enough, whether for converting a regular special permit or a permit used in joint activity. This legal ability to convert was introduced in the past to make major changes in the law on production sharing agreements, which we worked on actively. These changes allowed for this opportunity, but at that time it was not possible to specify all the necessary details that would ensure smooth conversion process. By the way, there is now Draft Act No. 3849 in Parliament that addresses the conversion process, among other things.

UJBL: How do you assess the prospects for the development of shale gas fields in our country? You are one of the pioneers in the field of PSA for unconventional hydrocarbons from which foreign investors withdrew in recent years. What prospects do you see in these projects?

A. S.: Indeed, we have worked on a number of unconventional hydrocarbons projects under production sharing agreements. There are several aspects. First, does Ukraine need or not need unconventional hydrocarbons? If such a resource is available, taking into account the whole situation with ensuring our energy independence, of course, for our country, it would be great to have its own source and its own production. So exploration and production in this area should be stimulated. On the other hand, given the current situation world markets and oil and gas prices, this resource is becoming rather expensive. When the price was above USD 100 per barrel, high costs were justified in many respects. This explains why many major international players looked at Ukraine as a source of unconventional hydrocarbons. We understand now that these are very difficult and very expensive ones. The state should weigh up all the pros and cons. Notably, all our regulatory rules that existed for quite a long time and turned out to be in current legislation were designed for traditional exploration and production. In many respects they were simply not designed for new methods of exploration and production, talking specifically about unconventional hydrocarbons, including shale gas. Thats why our laws must be adjusted. What is more, given the scale and complexity of such projects, the state might wish to take a more balanced and flexible approach in terms of taxation, including specifically royalties.

UJBL: What changes to existing legislation on production sharing agreements are needed to get investors to return? What kind of incentives to attract foreign investors to Ukraine should be taken into account?

A. S.: I have been working on legislation on production sharing agreements and the actual PSAs themselves since 2006. When investors came and we had to practically apply the On PSA Act of 1999, it became clear at once that those rules had never been tested in practice and did not cover all the necessary issues that needed to be regulated. This made it virtually impossible to continue with the PSA projects. The government and investors cooperated in an attempt to change and improve the law. It was not possible to draft everything from scratch and to create a perfect law. Still, we regularly had to work on and managed to significantly change and I hope very much improve the PSA rules in the field of special oil and gas regulation, other contractual regulation of these agreements, as well as in the sphere of currency control and taxation. However, unfortunately, some new changes are introduced that gradually undermine what has previously been achieved. And a good example is striking out low royalty rates under PSAs. When previous PSA projects were planned in Ukraine, there were fairly low rates, but this was justified. There were opponents who probably must have forgotten or ignored the fact that the primary principle of production sharing agreement states that if there is a tax reduction or even exemption under the agreement, the state gets all the same in return through in share of profit production, in cash or in kind. That is why low rates were just a very good incentive for investors. Cancellation of special rates, in fact, jeopardized one of the most important advantages for future agreements. Tax stabilization to freeze the lower previous rates is potentially possible only under already concluded agreements, but currently these do not, unfortunately, work. And this just further answers to your question why not many agreements are converted into PSA.

UJBL: Along with the international trend of strengthening legal practices of the Big Four companies, EY in Ukraine also strengthens its position in legal support of business. Has your legal practice in fact distinguished itself as a separate entity?

A. S.: Probably for an outside observer, EY Ukraines activity in the legal area is first visible as a structural separation of an individual legal entity. But, of course, theres much more behind it. Historically, if we talk about EYs legal practice in Ukraine, it has never ceased to exist, and continued along with other streams of our multidisciplinary practice. As for EY companies around the world, the situation differed depending on the jurisdiction. There were countries that, due to various regulatory restrictions, such as the Sarbanes-Oxley Act since 2002, at that time stopped or restricted the provision of legal services. But to date EYs worldwide legal practice is one of the most dynamically developing and prospective areas. It is truly global; it is backed with the full power of resources, infrastructure, and professional services experience of EYs global organization. We are really talking now about a fully-fledged global legal practice covering more than 75 countries. What is important to me is that we at EY address our clients issues in a manner different from that mono services firms. Yes, we do pay heed to narrow technical specialization, but also take a broader look from the perspective of a clients business and its industry. Often, real business issues are complex and multidimensional and we offer the same comprehensive solutions through bringing together for the client service different specialists. This is precisely the principle of a so-called multi-disciplinary practice. Yes, we fully operate as a legal practice; clients often come to us only as to their legal counsel. But where we see the main strength and benefit for our clients is our ability to provide a comprehensive solution. And the firm wouldnt be able to do this without lawyers either.

UJBL: Has the approach of your clients to risk management changed? After all, many investors began assessing how to change Ukrainian law and judicial practice to the point when it is possible to apply to court with these agreements.

A. S.: From my observations, I can say that risk management always depends on each individual player be it a local player or foreign company, or be it a global super major. Each of them may take a very different approach to risk and indeed have a different appetite for risk. Perhaps the most important risk in the oil and gas industry is whether we have a discovery or we find nothing. It is clear that all players already know how to assess, understand, compare all of these risks, put together their risk matrixes and then manage risks. For super majors, say, all this has already been tested in various countries. Indeed, country risk has a considerable importance among other risk factors. This is associated not only with the economic or political situation, but also with regulations, which can be quite complex and burdensome. Many players understand this and are willing to deal with these problems. But they want a guarantee from the state that legislation will be stable. They must see the economic substance, expediency and profitability of a project for themselves. If tax rates change several times, frustrating the whole economic model of a project, this is what discourages investors, without prejudice to any specific state. The same applies to fundamental legal principles. As trite as it may sometimes sound it is the possibility of objective dispute resolution and negotiability of the state, its ability to make and maintain arrangements and keep its promises, not trying to revisit them. It is clear that quite often a new government might not like its predecessors much. But is it a good enough reason to challenge a properly signed agreement? This is the question...

Going back to the risk matrix, it is the level of risk that guides future investors on whether to come into this country or simply go to another country.

UJBL: What is your forecast regarding the development of industry and ensuring the countrys energy independence?

A. S.: The situation in the oil and gas industry is not as rosy as we would like it to be. I am an optimist, and I hope that the government will still introduce adequate and proper regulations, whether general or special, for instance on subsoil use or taxation. We have already knowledge and experience, often coming from investors. This should help to introduce new rules. And the state should start using and taking advantage of already existing instruments, like production sharing agreements more actively and without fear. Perhaps, this will not return super majors to the country now. They do not look at Ukraine primarily because of the market situation. But I am talking about those players who are in Ukraine or other foreign investors with a different profile. As to my personal sentiment, sometimes I regrettably observed how the state simply failed to seize an opportunity to continue with some pro- jects, even though a lot, even everything, was up to the state to fulfill. Regrettably, such things happened in the past. The state could do more, and now it must, at least, not lose the opportunities that are available.

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