New Local Content Approach

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GRATA International

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General overview of Kazakhstan in World Mineral Industry
Kazakhstan Energy and Natural Resources
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[General overview of Kazakhstan in World Mineral Industry.

Kazakhstan ranks second only to Russia among the countries of the CIS in its quantity of mineral production. It is endowed with large reserves of a wide range of metallic ores, industrial minerals, and fuels, and its metallurgical sector is a major producer of a large number of metals from domestic and imported raw materials. The economy of Kazakhstan has been growing owing to the state policy of attracting foreign investment into its extraction industries. Kazakhstan was the first CIS country assigned with investment sovereign rating, and the World Bank has listed Kazakhstan among the 20 most attractive countries for investment.1 More than US $140,7 billion was invested in Kazakh economy since 1994 to 2009.]

1. Introduction

What a potential investor deciding whether to buy a profitable oil and gas or solid minerals assets in Kazakhstan should know? Before the middle of 2010, the rules of entry into the Kazakh subsoil market were rather simple. Except for political concerns in rare cases, potential investors should estimate planned expenses and income, decide the question where necessary operational funds will be taken from, make relevant technical and legal due diligence, buy the asset, resolve the staff issues and commence working.

But since mid 2010 investors faced the new important state factor which should be taken very seriously.

In June 2010 Kazakhstan adopted a new Law on Subsoil and Subsoil Use (the "Subsoil Law"), which replaced the Subsoil Law 1995.

Since adoption of this Law a new trend appeared in relationships between subsoil users and regulatory authorities. Subsoil users found out that... they cannot spend income derived from their investments on operational activity in the way they would like. After the new law has been introduced, if a subsoil user wants to buy certain equipment, or hire a subcontractor for drilling, processing or other subsoil-related activities, he is obliged to follow the Procurement Rules2, approved by the state. It may be therefore possible that the investor may have to choose a different contractor from the one he originally intended to hire; it will be the one who offers the lowest bid from all other contractors.

What is this new trend connected to? Why did it appear? What are the roots of such regulation of subsoil users' procurement process by the state?

The answer is simple. Kazakhstan decided to follow other countries' experience in order to develop the local content.

This articles will shortly describe the main points relating to this issue.

2. General overview

During the recent one and a half year one could notice a sharp increase in the interest of subsoil users and their contractors related to the issue of Kazakh content in the procurement of goods, works and services. In the first instance it was connected with changes to subsoil and subsoil use legislation, as well as with toughening of the Kazakh government's policy with regard to development of Kazakh content.

It is worth noting that at the international level the term which has a similar meaning to "Kazakh content" has already been known among subsoil users for several decades as the "local content". In general, this term refers to use and development of local production and labour force, as well as technology transfer. Such development is ensured through creation of legal mechanisms obliging subsoil users to use local goods, works and services in their operations, as well as to increase proportion of local employees among their staff and their contractors' staff. Let us see how specifically the "local content" provisions are applied in the Republic of Kazakhstan.

3. History

Strictly speaking, the term "Kazakh content" was first introduced to the subsoil legislation on 1 December 2004 together with the terms "Kazakh manufacturer" and "Kazakh origin" (goods, works and services of Kazakh origin). However, until the adoption of the Law on Amendments to Some Legislative Acts on Kazakh Content, dated 29 December 2009 (unofficially called "Kazakh Content Law"), this term did not raise much attention, since the Kazakh content provisions were essentially declaratory by nature.

In particular, despite the fact that the rules for purchasing goods, works and services ("GWS") by subsoil users were first approved by the Kazakh Government Decree in the summer of 2002, the majority of subsoil users did not actually apply these Rules and kept purchasing GWS at their discretion.

However, since the enactment of the Kazakh Content Law the rules of the game between the Government and subsoil users changed dramatically. Such a change is, for instance, reflected in the fact that since the second half of 2010 until now, almost all subsoil users have been and procuring GWS under the state-regulated procedure.

We would like to give our view with respect to causes of such developments. It is not a secret that total investments of subsoil users in Kazakh economy amount to a significant sum. E.g. the volume of registered investments into procurement of GWS in 2010 was KZT 691 billion (approx. US $4,7 billion), for 2011 – KZT 1,227 billion (approx. US $8,3 billion)3. In the meantime, the Kazakh mass media for the last 5-7 years repeatedly gave examples that some subsoil users procured GWS from abroad at prices several times higher than the cost of similar GWS at the local market. It turned out that such subsoil users benefited from above procurement several times.

First, they got the opportunity to purchase GWS from foreign companies, which were often registered in the same country as the subsoil users (i.e. the funds went to development of foreign economies). Second, all such expenses were considered as execution of investment commitments under their contracts. (All subsoil users in Kazakhstan have to reach an annual minimum level of execution of investments obligations, otherwise they may face the risk of unilateral termination of their subsoil use contract by the state.) And thirdly, after commencing production operations, such subsoil users had the opportunity to avoid paying higher taxes for the investments. Accordingly, subsoil users had a direct interest to overstate their expenses in many possible ways at the exploration stage. In our view, the main purpose of all amendments introduced to the subsoil use legislation was to prevent this trend. Another supporting reason was the impact of the world economic crisis which causes countries to introduce measures to protect their population and economies by all possible means.

4. Basic Concepts

Let us see at the structure of relationships between subsoil users and the state, constructed to stimulate increase of Kazakh content by subsoil users.

4.1. Notions

Firstly, we shall get acquainted with the notions related to Kazakh content, implemented by the Kazakh Content Law, specifically:

  • registry of GWS used in subsoil operations;
  • Kazakh content in works, services;
  • Kazakh content in staff;
  • goods of Kazakh origin;
  • Kazakh provider of works, services;
  • Kazakh manufacturer of goods; and
  • Kazakh content in goods.

Almost all these concepts have "migrated" unaltered into the current Subsoil Law, except for the concept of "Kazakh content" introduced in 2004. The latter term as a matter of fact was defined in the Subsoil Law depending on the area of application, whether it means goods, works (services), employees, status of an individual or legal entity as a manufacturer of goods or works (services).

4.2. Registry of GWS used in subsoil operations

Since 1 October 2010, all subsoil users shall not only procure under the Procurement Rules, but shall also download all information about forthcoming procurements (advertisement, tender documentation) and results of the tenders held, resolutions on choosing a contractor onto the on-line registry of GWS used in subsoil operations.

The authorities by imposing such obligations onto subsoil users passed the obligation to oversee compliance of subsoil users with the Procurement Rules to potential contractors. Now, if the authorities receive a claim from a contractor that a certain subsoil user violated the Procurement Rules, it is a matter of several hours to visit the on-line register, review the advertisement, tender documentation, draft procurement agreement and results of the tender to adopt a relevant resolution.

In addition it shall be noted that together with placing information onto the registry, the subsoil user are also obliged to place advertisements about forthcoming purchases and their results in periodicals, distributed on the territory of the Republic of Kazakhstan at least three times a week, in the Kazakh and Russian languages.

All other notions are used widely when calculating Kazakh content either in GWS or staff, or at determining whether a potential contractor may be entitled to a 20 percent conditional discount at subsoil use procurement tenders, which will be discussed in more detail in section 5 (Calculation of Local Content Percentage) below.

4.3. Legislative importance of Kazakh Content provisions

We shall note that Kazakhstan introduces new amendments into subsoil use legislation with great precaution for those subsoil users who have concluded their contracts before enactment of new amendments. Majority of subsoil use contracts have special provisions that amendments to legislation made after conclusion of a subsoil use agreement shall not apply to such agreement, that is, they shall not be retroactive. Even now courts of Kazakhstan when there is a collision between the subsoil use contract concluded 5-10 years ago and current legislation, usually take the subsoil user's side, save for several exceptions set forth by legislation.

Pursuant to Article 30 (Guarantees of Subsoil Users) of the Subsoil Law the rights of subsoil users are protected from any amendments to the legislation, except for amendments to (1) national security, (2) army and defence, (3) environmental safety, (4) healthcare, (5) taxation and (6) customs regulation.

However, Article 129 (Transitory Provisions) of the Subsoil Law stated that in respect of subsoil use contracts concluded before the amendments the parties shall be obliged to comply with the Kazakh content requirements established by the Subsoil Law.

By virtue of the above Article, the relevant competent authority (Ministry of Oil and Gas of Kazakhstan for oil and gas contracts or Ministry of Industry and New Technologies of Kazakhstan for ore mining contracts) starting from the second half of 2010 proceeded to sign respective additional agreements with subsoil users. According to the addendums, the terms related to the Kazakh content were introduced into the conceptual framework of all contracts. Moreover, the subsoil users were forced to undertake certain obligations to increase the percentage of Kazakh content separately for goods, works, services, and staff as well as to liability for their non-compliance.

For example, a subsoil user may undertake to achieve a percentage of not less than 15 percent of Kazakh content in goods, 60 percent of Kazakh content in works, 70 percent in services and as for staff: 90 percent of local content among qualified employees and middle-level specialists and 70 percent among high personnel. The method of calculation is described below. The user also undertakes a certain percentage of liability for non-achievement of the above parameters.

Consequently, the retroaction established by the above Article 129 regarding the obligation of subsoil users to rely on the Kazakh content requirements of the Subsoil Law can be considered as a kind of additional exception from subsoil users' guarantees provided by the state.

In our view this is another indirect confirmation of the serious approach of the state to Kazakh content issues.

5. Calculation of Local Content Percentage

How is the Kazakh content calculated? The authorities have adopted a special Uniform Method of Kazakh Content Calculation[4] (the "Uniform Method").

5.1. Regulated scope

The Uniform Method is applied to calculation of Kazakh content when GWS are purchased:

  • by the state authorities according to Kazakh Law on State Procurement5;
  • by companies where 50 percent or more of its shares are directly or indirectly owned by "National Welfare Fund "Samruk-Kazyna" JSC (the biggest state holding with Kazakh Government as sole participant, controlling $78 billion in assets, or nearly 56% of GDP6);
  • by subsoil users under the Procurement Rules;
  • by companies where GWS procurement shall be subject to Kazakh content monitoring in accordance with the list approved by the Government of the Republic of Kazakhstan; and
  • by concessionaires.

As can be seen from above, it is not only subsoil users who shall raise the Kazakh content in their procurement, but also other major players of the Kazakh economy.

The Uniform Method looks somewhat difficult with its complicated at the first glance formulas of calculation, however, its practical application is not of any particular difficulty.

5.2. Kazakh content in goods and Kazakh manufacturer of goods

For instance, the Kazakh content in goods will be zero, if in respect of a particular product there is no CT-KZ certificate of Kazakh origin. And in case of availability of the latter the Kazakh content will be equal to the percentage indicated in the certificate.

A CT-KZ Certificate is issued by the Technical Regulation and Metrology Committee to Kazakh manufacturers of goods for a period of one year. This certificate gives the right for the conditional 20 % discount to suppliers when participating in a tender. The procedure for obtaining such a certificate is quite simple.

Consequently, if a subsoil user has obligation of 15 % of Kazakh content in goods, to avoid contractual responsibility for non-achievement of limits related to Kazakh content, he is directly interested in procurement of goods with CT-KZ Certificate.

5.3. Kazakh content in works and services

Kazakh content in services is equal to the share of salary fund of Kazakh personnel in the general salary fund of employees of the supplier and its subcontractors (if applicable). For reporting purposes, the share of salary fund of Kazakh personnel in the general salary fund of employees of the supplier is determined by the supplier itself and is indicated as a percentage on the official letterhead with the certified director's signature and the company's seal. Similar requirements apply to subcontractors, if any. In fact, such a certification can be regarded as a kind of analogue of CT-KZ Certificate in respect of services and works.

As an example, if a servicing contractor has 100 employees with 90 percent of Kazakh workers, and the salary fund of Kazakh workers represents 75 percent, then a contractor has 75 percent of Kazakh content in services.

Kazakh content in works where goods are used is equal to the sum of Kazakh content in goods and Kazakh content in services calculated using the above methods.

Consequently, if a subsoil user has an obligation to ensure 60 percent of Kazakh content in works and services, to fulfil his contractual obligations, he is encouraged to procure goods and services from companies with high Kazakh salary fund rather than from foreign companies.

5.4. Kazakh provider of works, services

One should distinguish the notion of "Kazakh content in works and services", calculated as above and the notion of "Kazakh provider of works, services". The latter is understood as either citizens of Kazakhstan or Kazakh legal entities, where employees-citizens of Kazakhstan exceed 95% in the staff list. Such status as the status of Kazakh manufacturer of goods, also entitles a contractor to a conditional discount of 20% when participating in a tender.

6. Incentive Measures

Let us consider other measures applied by the state for encouraging subsoil users to increase the share of Kazakh content.

6.1. Non-acceptance of investments made in violation of the Procurement Rules

The first and primary weapon of the state is implementation of Article 70.6 (Purchase of Goods, Works and Services for Oil Operations) of the Subsoil Law, whereby it is expressly stated that the a subsoil user's expenditures for purchasing GWS made in violation of the Procurement Rules or on the basis of the tender held outside Kazakhstan shall be excluded by the competent authority for the costs, accounted as performance by the subsoil user of its contractual obligations.

In other words, if, for example, a subsoil user which has investment obligations under the contract for the respective year of US $10 mln has acquired a part of GWS for the amount of US $3 mln in violation of the requirements established by the Procurement Rules, the Competent Authority shall be entitled to exclude this amount from the expenses of the subsoil user.

Accordingly, this exclusion causes the failure to perform contractual obligations of the subsoil user which automatically entails the risk of early termination of the subsoil use contract by the Competent Authority.

This is the main statutory provision which caused the subsoil users to change their view to legislative procurement rules in force since 2002 and start procuring GWS under such rules since the mid 2010.

6.2. Limitation on attraction of foreign labor force

The state established limits to issuance of work permits for foreign employees. Since 1 January 2012, issuance of such permits for high level managers is limited by 30%, and for mid-level managers, specialists and qualified workers - by 10 % of the total number of the company employees.

It should be noted that these statutory limitations do not apply to subsoil users of Karachaganak, North Caspian (Kashagan) and Tengiz Projects, as well as to their operators, contractors and subcontractors until 1 January 2015. These three projects are called "Three Wales" in Kazakhstan, because they absorb around 50 percent of GWS procured by all Kazakhstan subsoil users.

6.3. Procurement Rules

Thirdly, as mentioned above, taking into consideration the above discussed risk of non-execution of investments obligations if procurement of GWS are made in violation of the Procurement Rules, almost all subsoil users now procure GWS through one of the following mechanisms stipulated by the Procurement Rules: (1) through open tender with a minimum 30 days prior notification of potential contractors, (2) by request for bid proposals, (3) from single source under specified grounds, (4) through e-purchasing system or (5) through commodities stock exchange.

The main criterion for choosing the winner is the price. The contractor who proposed the lowest bid or if his bid together with above-mentioned discount for Kazakh manufacturer of goods or Kazakh provider of works, services is the lowest one, receives the order at stake.

6.4. Results of campaign and nearest plans of the Government

In general, according to the official data, the number of violations of Procurement Rules by subsoil users significantly declined in 2011 compared to 2010. Thus the amount of purchases with violation was reduced from 25,4% in 2010 down to 17,8 in 20117.The state has adopted a special program on development of Kazakh content in Kazakhstan for 2010-20148, whereby the targets of Kazakh content for subsoil users to be achieved in 2014 are the following:

  • Kazakh content in goods shall be up to 16 %;
  • Kazakh content in works and services shall be up to 85 %;
  • Percentage of Kazakh staff involved in subsoil users' projects:
  • For high-level managers, not less than 70 %;
  • For mid-level, technicians, specialist and workers, not less than 90 %.

For comparison reasons, the parameters of Kazakh content in GWS procurement by subsoil users for 2011 comprise9:

  • Kazakh content in goods – 12,2 % (KZT 43 billions or approx. US 0,3 billion);
  • Kazakh content in works – 58,0 % (KZT 516 billions or approx. US 3,5 billion);
  • Kazakh content in services – 69,1 % (KZT 668 billion or approx. US 4,5 billion);

Total 1,227 billion or approx. US $8,3 billion.

7. Conclusion

One should note that in general most subsoil users have already been purchasing GWS under the Procurement Rules for several quarters with provision of the respective quarterly reporting to the authorities. Thus, practical experience resulting in common understanding of the rights and obligations of parties in the area of subsoil use has been accumulated with respect to Kazakh content.

We should also mention some challenges faced by subsoil users while increasing the share of Kazakh content in GWS and personnel. They include:

  • absence of some required goods in Kazakhstan;
  • poor quality of domestic goods, which do not comply with international standards and safety requirements, as stated by many subsoil users;
  • use of Kazakh mediators as GWS suppliers instead of domestic manufacturers;
  • lack of employees of respective qualifications.

However, provided the state would proceed to implement Kazakh content development policy and the subsoil users retain high interest in continuing operations in Kazakhstan, we believe that all these issues would result in mutual benefits for both parties.

Footnotes

1 http://en.wikipedia.org/wiki/Mineral_industry_of_Kazakhstan

2 The Rules for Procurement of Goods, Works and Services for Subsoil Operations approved by Kazakhstan Government Decree dated 28 November 2007 No. 1139, as amended

3 http://camng.kz/ru/6-2/356-45.html (Rus)

4 Uniform Method of Kazakh Content Calculation by Companies when Purchasing GWS, approved by the Governmental Decree dated 20 September 2010 No. 964

5 dated 21 July 2007

6 http://www.imf.org/external/pubs/ft/scr/2011/cr11150.pdf

7 http://camng.kz/images/attachment/prezent_otchet_2011.pdf (Rus)

8 Approved by Kazakh Government Decree dated 29 December 2010 No. 1135

9 http://camng.kz/ru/1/360-65.html (Rus)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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