Combating the short-term approach

15.12.2010
Economic considerations are crucial when deciding to pursue major petroleum projects. But government and companies can disagree on their profitability. In popular terms, this can be seen as a fight between social economics and “quarterly capitalism”.
  • Eldbjørg Vaage Melberg and Emile Ashley (photo)

Benvenutta Henriksen

Benvenutta Henriksen is a discipline coordinator and has worked on petroleum economics and cost-benefit analysis at the NPD since 1993.

 

The concept of social welfare is important for understanding how the NPD pursues its cost-benefit analyses of resources on the NCS – not least for developments. Economist Benvenutta Henriksen has been doing such assessments at the agency for 17 years.

 

What is social economics?

This subject deals with the way we manage our resources – be they natural assets, labour or means of production – in the most efficient possible way. They’re in short supply, and we want to get as much as possible out of them.

The market is normally an effective instrument for such allocation. But the best solution from a company’s perspective is not always optimum for society.

To exaggerate a little, we can say that instead of “the invisible hand” contributing to the best outcome for the community, the market can help “the invisible foot” to trip us up.

The government must then correct company proposals and ensure that these coincide with society’s best interests. Cost-benefit analyses are one way of setting efficient and sensible priorities for the community’s resources.

 

“All petroleum activity on the NCS will have spin-offs on land, which can be substantial. We try to clarify these as best we can in the costbenefit analyses if they are important for the decisions to be taken. But it is not certain that they should be included in purely numerical terms in the specific economic calculation.”

(Benvenutta Henriksen)

 

 

Is this why the NPD carries out such analyses?

Several considerations are involved here. First, the ministries and their subordinate agencies, like ours, are required to conduct such analyses.

They’re carried out for projects, studies, regulations, reforms and measures as well as in connection with White Papers and propositions (Bills) to the Storting.

This demand for cost-benefit assessments is enshrined in an official instruction in order to ensure good preparation and control of official measures.

Moreover, the best financial solution for companies may not be optimum for society. When perspectives differ, economic decision-making criteria can also be at odds.

The government, for instance, usually has a lower required rate of return than the industry. This means that it finds more petroleum projects profitable than the companies.

That differential can be particularly wide for long-term projects with high initial capital outlays and revenues which first flow well into the future.

This is reinforced by “quarterly capitalism” [as some have dubbed the short-term business accounting procedures applied by many companies].

It can encourage managements to take a very short-term view rather than concentrating more on longterm developments. And it can unfortunately encourage the oil industry to think a little too often of immediate returns only.

In addition, differing equity holdings may prompt companies to behave strategically in ways which open big gaps between cost-benefit and commercial considerations.

An investment decision on the NCS usually has implications for other existing projects and sometimes for developments still at the planning stage.

The financial consequences for a company will also often depend on the outcome of various commercial negotiations between the partners in different projects.

That can give rise to difficult conflicts of interest, which in turn create a gap between a commercial and a cost-benefit interpretation of optimum project utilisation.

 

Can you provide any practical examples of this?

Take the case of an oil field with associated gas being developed as a satellite to an existing producer, where the gas must be sent through the pipeline network to a European buyer.

This field has to pay tariffs – or rent – for processing oil on existing installations and for transporting gas. Some of the satellite licensees are also partners in the producing field.

The value of the new development will accordingly depend on the processing and transport tariffs charged and the holdings of each licensee in the various sub-projects.

In economic terms, the best social welfare solution will not necessarily be optimum for licensees with the decision-making power in the production licence.

 

“Quarterly capitalism can unfortunately encourage the oil industry to think a little too often of immediate returns only.”

(Benvenutta Henriksen)

 

 

How are such cost-benefit analyses carried out?

A normal approach is to start by describing all relevant effects in order to value them as far as possible in krone. This valuation is then used to weigh the significance of the various impacts against each other.

If the calculated value of all the effects of a measure or a project add up to a positive sum, we say that it is profitable in social welfare terms.

Even if the overall economic benefit may outweigh total costs, however, this is not necessarily the same as saying that the measure/ project will be desirable for the community.

Several considerations could underlie such a judgement, including our inability to measure the overall impact adequately in kroner at all times or possibly unfortunate distributional effects of the project.

As a general rule, the less significant the distributional effects, the more impacts can legitimately be priced in kroner and the fewer ethically difficult questions raised, the better the effects of a measure can be summed up in terms of socioeconomic profitability.

As a result, cost-benefit analyses can’t unreservedly provide a clear answer to the question of whether a measure is desirable for society as a whole.

This means that the assessment should also account for and assess relevant considerations which have not been assigned a numerical value in the analysis.

 

Have you any specific examples of impacts which are hard to value?

Where environmental measures are concerned, only certain impacts have be valued in money terms. Other effects can be hard to measure except in physical units.

We can conduct an analysis in such cases based on the benefits and costs we feel can be valued acceptably in economic terms. However, the other effects – such as spin-offs from a project – should be described and included in an overall assessment of the measure.

 

It can be difficult to explain that spinoffs are not always included in costbenefit calculations. Any comments?

That’s very understandable. All petroleum activity on the NCS will have spin-offs on land, which can be substantial.

We try to clarify these as best we can in the cost-benefit analyses if they are important for the decisions to be taken. But it is not certain that they should be included in purely numerical terms in the specific economic calculation.

For spin-offs to be incorporated in the actual calculation, they should contribute to net value creation and not simply cause a redistribution of that value.

Such reallocation could occur, for instance, if increased activity on the northern NCS reduces work in the Stavanger or Bergen regions.

It might also be the case that operations in the petroleum sector are boosted at the expense of other industries which compete – at least in the long term – over the same scarce resources, such as labour.

If the value of enhanced activity in one area or within one industry is equal to the decline in other areas or industries, the overall value of the project won’t be changed. It should accordingly be excluded from the calculation.

This distributive effect could nevertheless be significant for the assessment of a project by decisionmakers, and should accordingly be covered as well as possible in the analysis.

That’s also usually done in government assessments. Generally speaking, however, strict standards must be set for the empirical study in order to incorporate spin-offs in a cost-benefit analysis.