Foreign investment contracts in the oil & gas sector: A survey of environmentally relevant clauses

The oil and gas industry faces increasingly strict environmental standards in developed countries. However, the majority of the world’s proven oil reserves are in developing countries and economies in transition, which often lack sophisticated regimes for environmental protection. Even when legislative frameworks are well developed, there are often deficiencies in capacity and an unwillingness to monitor and enforce environmental regulation.

This article shines a light on a poorly understood domain of environmental regulation:  the foreign investment contracts signed between international oil companies (IOCs) and host states, which allocate rights to explore for and exploit hydrocarbons within an area of land (or an offshore block) over a fixed period of time. In a 1994 monograph, Zhiguo Gao noted that environmental issues had “not received enough attention” in the oil and gas contracts he had reviewed.[1]  His conclusion raises the question of whether environmental issues have received greater attention in more recent oil and gas contracts (i.e. those negotiated and signed in the last fifteen years).  This question is difficult to answer, not least because foreign investment contracts generally are not disclosed to the public. Many governments’ model agreements are publicly available, but these models may be substantially altered or ignored altogether in the negotiation of actual contracts.

In this article, sample clauses from forty-one upstream oil and gas contracts (both onshore and offshore) covering thirty-five countries and the period 1994-2008 were reviewed. Fourteen of the contracts were models.[2]  Given the small number of contracts that were reviewed, and the great variety of clauses that were encountered, nothing can be extrapolated from this preliminary survey about the frequency with which any particular type of clause is likely to appear in oil and gas contracts. Furthermore, in any given situation, a contract should be considered within the broader context of a country’s petroleum law, environmental law, and other domestic legislation. The purpose of the article is not to provide a full picture of environmental regulation of petroleum operations in individual countries, but instead to draw attention to how contracts can either bolster or undermine environmental protection efforts.

Domestic environmental law

Some reference to domestic environmental legislation is clearly desirable from a public policy perspective. Domestic standards have been developed (in most cases) under a democratic system of rule, have often been designed with local environmental conditions in mind, are familiar to the agencies that are tasked with monitoring and enforcement, and are in the public domain. However, as noted previously, in many developing countries environmental regulation of the oil and gas sector is still in its infancy and it may be inadequate in some situations. As such, reference in contracts to domestic legislation alone may be undesirable. In any event, it would appear that parties rarely adopt this form.  A contract from Peru[3] and one from Algeria[4] were the only contracts in the sample that referred solely to domestic environmental legislation.

In several of the contracts in the sample, the parties instead included a reference to international industry standards and failed to mention the application of domestic environmental law. The advantage from an environmental perspective of referring to international industry standards is that in some cases, they may be higher than, or cover specific issues not addressed in, domestic legislation. Furthermore, reference to international standards allows some scope for change and evolution of the environmental management regime of an investment over time, thus providing a way around a contractual requirement for stability, as will be discussed below.

However, there are serious problems with referring only to industry standards, given their inherent ambiguity. The terminology “good oilfield practices” or “good production practices” is frequently employed in environmental standards clauses, as well as in other types of provisions discussed further below, but these phrases are seldom defined. It is not at all clear where exactly one should look for “generally accepted standards” as there are a multitude of potential sources.

Stabilization Clauses

Stabilization clauses come in various forms. In their most basic form, they “freeze” the law that applies to the investment at the time the contract is signed. A more nuanced version is often referred to as an “economic equilibrium” clause, which requires the government to restore the balance of risks and rewards established in a contract when it is upset by a new regulation or tax. A stabilization clause can be strictly circumscribed to only cover very specific issues, or the parties to the contract can explicitly “carve out” areas such as environmental protection from its application. For example, in a 1997 contract from Kazakhstan, the stabilization clause contains the caveat:

provided, however, that no amendment to this Agreement shall be required hereunder as the result of (i) changes to Laws concerning health, safety or environmental protection that cause such Laws to be consistent with international standards for health, safety or environmental legislation and are applied on a non-discriminatory basis . . . .[5]

As Lorenzo Cotula notes, this provision is weakened by its ambiguous reference to “international standards,”[6] but it is still far preferable to the stabilization clauses found in many contracts and even in model agreements that are worded in such a broad manner that they can stifle any future regulation that might be perceived to undermine the profitability of an investment, including efforts to address corruption, to safeguard human rights (including labor rights), and to protect the environment.

Environmental Impact Assessment Clauses

Environmental Impact Assessments (“EIAs”) and corresponding management plans have become a staple requirement for investment projects in many sectors. Unfortunately, a recent survey of environmental governance in petroleum producing countries commissioned by the World Bank found that “much of the emphasis of the EIA process appears directed towards the approval of oil and gas projects, rather than to a life cycle approach for minimizing environmental and social impact.” [7]

An EIA is typically mandated to be completed after a contract with the state has been signed and most of the contracts reviewed for this article contained some reference to the need for an EIA. However, the form of the EIA clauses varied widely across the sample from a simple note of the existence of a requirement,[8] to detailed specifications of what the EIA should cover, who should prepare it, when it should be submitted, and so forth.[9]

Clauses on Access to Protected Areas

Petroleum operations are particularly contentious when they are located, even partially, within wildlife reserves, parks, or areas of cultural or biological significance. NGOs have long argued that such areas should be off limits to the extractive industries, but most governments are not ready to forgo the potential economic opportunities that the exploitation of these areas offer. This is evident in several of the contracts in the sample. For example, Article 37.6 of Madagascar’s 2006 Model Offshore PSC states:

In the event that a portion of the Contract Area is located within a natural reserve area, the Operator shall deploy the necessary efforts in order to minimize the negative impacts on these natural reserves, in accordance with generally accepted environmental practices in the international petroleum industry.[10]

This is an incredibly weak provision. A 2004 PSC from Uganda is similarly permissive, but it also contains a bizarre caveat:

In the event of protest from responsible concerned third parties within or outside Uganda regarding the conduct of Petroleum Operations in any National Park or Game Reserve and the consequent effects upon the environment or wildlife, the Government and Licensee shall meet to determine what if any action should be taken.[11]

Given that this clause provides nothing more than an obligation for the investor and the government to meet, it is questionable why the parties bothered to include it at all.

Clauses on Access to Water & Other Natural Resources

Petroleum operations require natural materials in their construction phase, and significant amounts of water and electricity throughout their operation. While many operations are self-sufficient in terms of energy supply, other natural resources may need to be obtained from within or outside the contract area.

From an environmental and community rights perspective, as well as from an economic-development perspective, it is disturbing that many governments appear to focus solely on the potential revenue that they can obtain from petroleum production and are willing to simply give away other valuable natural resources under the terms of oil and gas contracts. For example, Article 27.8 of Mozambique’s 2007 Model concession contract provides for the right of the investor “to drill for and have the free use of water and impound surface waters.”[12]

Some of the contracts in the sample were completely silent on the issue of access to natural resources, and a small number had more nuanced provisions than those quoted above. For example, a 1994 contract from Ethiopia states that the contractor shall “have the right, subject to the approval of the Minister, to use water in the Contract Area for operational purposes, but the Contractor shall not deprive any land, domestic settlement or livestock watering place of the water supply to which they are accustomed.”[13] A 2008 Model PSC from Bangladesh goes a step further by requiring that the contractor pay for the natural resources, such as water, that it utilizes.[14]

Clauses on Gas Flaring

The World Bank estimated in 2004 that the volume of associated gas being flared and vented globally every year was about 110 billion cubic meters—enough fuel to provide the combined annual natural gas consumption of Germany and France.[15] Although some short-term flaring during testing or in cases of emergencies is accepted as standard practice in the industry, the flaring of more substantial amounts of gas is only practiced in poor countries with limited infrastructure and weak regulatory institutions. Aside from being incredibly wasteful, flaring has a significant impact on local air quality and also makes an appreciable contribution to climate change.

Many oil and gas contracts, even recent models, appear to be lenient on the issue of flaring.  For example, the Bangladesh 2008 Model PSC notes in Article 15.3 that:

Any Associated Natural Gas as is not used under Article 15.1 or Article 15.2 and which Contractor does not consider possible to recover economically shall be offered to Petrobangla without any payment to Contractor but at Petrobangla’s cost at the well-head or field facilities in the Production Area.  To the extent that Petrobangla does not so take any of such Associated Natural Gas, Contractor may flare such Associated Natural Gas provided that such flaring is included in the Development Plan submitted under Article 8.10.[16]

Although this clause gives priority to utilization of the resource, there is no requirement for the gas to be re-injected into the ground if it is not taken by the state-owned enterprise, and economic concerns clearly trump environmental ones. Other contracts, such as a 2000 contract from Belize[17] and a 1998 contract from Angola,[18] allow for flaring only if it is authorized by the government. A Ugandan contract from 2004 also follows this model, but includes the caveat that the government’s consent “shall not be unreasonably withheld or delayed.”[19] The most stringent clauses, found in only a few contracts in the sample, restricted flaring to cases of an emergency or for safety reasons.[20]

Clauses on Responding to Emergencies and Accidents

In 2008, thirty-two companies in the International Association of Oil and Gas Producers reported 2,978 spills greater than one barrel in size, resulting in the release of 18,266 tonnes of oil into terrestrial and marine environments.[21] In many of the oil and gas contracts in the sample, the parties have recognized that spills and other accidents and emergencies have the potential to occur and should be planned for.  As such, as a part or separate from an EIA, an emergency response plan is often required from the contractor.

Some oil and gas contracts also cover three additional elements in respect of emergencies:  notification, response, and consequences for failure to respond.  In the oil and gas contracts reviewed, notification was limited to the contractor apprising the government of the situation, but not the local community or the broader public. In terms of response, the requirements were often vague (e.g., “take prudent steps”) or simply provided reference to good oilfield practices.[22] However, some of the contracts in the sample did additionally stipulate that in the event that the contractor did not act promptly to respond to an emergency or accident, the government had the right to mount its own response and charge the contractor for expenses that it incurred in doing so.

Clauses on Liability, Indemnity, & Insurance

Issues of liability for environmental damage can be complex, especially when multiple parties, including state-owned enterprises, are involved in petroleum production. Contracts, therefore, should have provisions that are explicit about who is to be liable for what and to whom. The issue of “who” depends somewhat on the form of contract, but generally it is the contractor or concessionaire (the IOC) who will be liable, except in cases where fault can be directly attributed to the state or state-owned enterprise. If there is more than one contractor involved in the project, then there will likely be a clause that stipulates that they are jointly and severally liable.

The issue of “what” concerns the types of harms (e.g., only death or injury or also “damage to the environment”), the period in which the harms were caused (i.e. no liability for prior environmental damage established in a baseline assessment), and the legal form of the liability (fault, strict, or absolute).[23] Finally, on the issue of to “whom” the contractor is liable, there are typically two separate issues covered in contracts:  liability to the state and liability to third parties. In the latter case, the issue is not directly one of liability—contracts cannot affect the rights of third parties under national law—but rather one of indemnity. Through indemnity clauses, IOCs commit to compensate states for any costs incurred resulting from a third-party liability suit.

Most contracts in the sample made specific mention of “pollution” or “environmental damage” in liability/indemnity clauses and adopted a strict liability approach.[24]  However, a 2002 Cambodian[25] contract provided only for fault liability. The most developed liability/indemnity clause in the sample was from a contract signed by Belize in 2000, which required that the contractor contribute one tenth of one percent of the value of the gross annual production to a fund managed by the government “for the sole purpose of indemnification against any or all environmental damages cause during the petroleum operations.”[26]

An additional issue closely related to liability and indemnity is the requirement for contractors to have insurance coverage.  These clauses often specify that insurance should cover “pollution” or “environmental damage.”[27] One potential problem with both liability/indemnity and insurance clauses is that the term “pollution” is quite narrow and does not cover all of the various environmental impacts from oil and gas operations.[28] Even references to “environmental damage” could be subject to interpretation if not defined in the contract.

Clauses on Decommissioning & Remediation

When an oil operation reaches the end of production, a number of costly activities must be undertaken. The extent to which decommissioning is dealt with in contracts depends somewhat on the contractual relationship between the parties and the expected life of the project. Under some arrangements, states retain ownership over production facilities and may continue operations after the termination of the contract. However, even in such instances, there may be contractual provisions covering decommissioning of installations that are not destined to be taken over by the state.

Clauses on decommissioning and remediation found in contracts in the sample were generally lacking in detail.  For example, a 1997 PSC from Benin states:

At the end of the Contract, in any other situation than the abandonment case, the Contractor must take the measures according to the Good Practices of the Oil Industry to restore the environment and the sites where the Petroleum Operations have been performed to their original state on the Effective Date of the Contract, taking into account the rules of the abandonment procedure.[29]

Although this provision appears quite strict, as it suggests that sites should be restored to their “original state,” it is weakened by the generic reference to good oilfield practices. In addition to an absence of guidelines, there are obviously strong incentives for some companies to “cut and run” or to conduct only superficial remediation to minimize costs. One method for ensuring that decommissioning and remediation are carried out to plan is to use a financial mechanism such as a performance bond or reserve fund. Tanzania is an example of a country that has set up such a regime in its 2008 Model PSC.[30]

Conclusions

The small sample of contracts reviewed in this article indicates that a significant number of clauses covering a variety of issues—from baseline environmental assessments all the way through to environmental remediation—can be found in modern contracts. Given the monumental increase in environmental awareness and the intense scrutiny that the industry has come under in the two decades, this is unsurprising. What is remarkable is that a handful of contracts still resemble those that Gao criticized for having only a token mention of environmental protection, and that references to ambiguous terms such as “good oilfield practices” remain so pervasive.

Author: Kyla Tienhaara is the Co-Director of the Climate and Environmental Governance Network and Research Fellow at the Regulatory Institutions Network, Australian National University.

Lengthier versions of this article were published in the online journal Oil, Gas and Energy Law Intelligence in September 2010 and the Spring 2011 edition of the journal Sustainable Development Law and Policy.