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Reforming Colombia's Extractive Sector Royalty Distributions: Key Changes and Coronavirus

Key messages:
  • In Colombia, royalties generated from hydrocarbons and mining are distributed to subnational governments for investment in local development. These royalties have represented an average of USD 2.7 billion for each biannual allocation since 2012.
  • Colombia's parliament will disucss a proposal to change the rules governing how these revenues are distributed today, 20 July, and should approve it before the end of August. It aims to overcome the shortcomings of the current distribution system, which is slow, inefficient, and low-impact spending, as well as a high risk of corruption in decision making. It also allocates a higher share of royalties to the municipalities and departments where extraction takes place.
  • Legislators could strengthen the proposal by rethinking and clarifying the decision-making mechanisms, explicitly including spaces for citizen participation and oversight, including mechanisms to promote economic diversification. Lawmakers should also review the cut in the percentage allocated to savings and stabilization. 
For almost three decades, Colombia, one of Latin America’s main petroleum and coal producers, has distributed royalties from hydrocarbons and minerals to its subnational governments: departments (middle-tier governments) and municipalities (local governments). Against the backdrop of the global coronavirus pandemic, the rules governing how these royalties are distributed are about to change significantly.

Royalties in Colombia have amounted to an average of USD 2.7 billion for each biannual allocation (10.1 trillion Colombian pesos) since 2012. This is money made available for subnational investment that could significantly contribute to local development. While this has not yet been the case, it could be achieved through reform of the distribution and use of royalties. However, the proposal to be discussed by parliament does not fully address the shortcomings of the current system. Indeed, it also raises new concerns. Since there is still space to contribute to the contents of the draft before it is discussed by parliamentarians (the executive has been open to receiving feedback from civil society), this article aims to highlight some critical areas for improvement to strengthen governance of these revenues.

The proposed new system seeks to address current deficiencies, such as inefficient and slow spending (in 2019, around COP 12 billion or USD 3.2 million were left unspent from the previous 2-year pool of revenues), while allocating a higher share of royalties to producing departments and municipalities. However, the proposal remains unclear about accountability and citizen participation mechanisms around decision making, threatening to weaken them. It also eliminates existing savings and stabilization mechanisms that have proved useful as a source of funding for emergency spending as the coronavirus crisis exploded in Colombia.

Colombia’s current royalties distribution system

The current distribution of royalties was established in 2011, through a reform that sought to distribute this wealth more evenly across the whole country, and not only to producing territories (prior to 2011, producing territories received 80% of total royalty revenues). It also created mechanisms for savings and stabilization and prioritized investment in technology and innovation. The current distribution includes small direct transfers to producing departments (less than 10 percent of total royalties), and is mainly made up of five funds: the Regional Development Fund, the Regional Compensation Fund, the Savings and Stabilization Fund, the Science and Technology Fund and the Territorial Pensions Fund. All departments and municipalities in the country can present public investment projects and, if deemed viable, receive resources from these funds.

The 2011 reform also created multi-stakeholder decision-making bodies, known as OCADs (Órgano Colegiado de Administración y Decisión – Collegiate Body for Administration and Decision-making), in charge of assessing and approving the projects to receive funding from royalties. Each municipality or department has its own OCAD made up of a representative of the national government, the governor (president of the department) and mayors in the area.

In 2019, less than a decade on from that reform, a constitutional reform was approved to allow for changes to the royalties’ management system in 2020. There was consensus that the system’s design reduced the royalties for the producing territories too much, that it was leading to slow and fragmented spending with low impact, and that there was evidence of corruption. A bill for a new system (the 2020 reform proposal) will be discussed in parliament today, 20 July, once the prior indigenous consultation is concluded, which is necessary for any legislation that affects their territories.

2020 reform proposal: principal changes

The objectives of the 2020 reform proposal are to increase efficiency in spending by “reducing the timeline and eliminating bottlenecks of the investment cycle” and to give a higher share of royalties back to producing areas. This change in objectives comes with a completely different distribution formula.

The largest change is the direct distribution of royalties to producing municipalities, which more than doubles, from 11 percent to 25 percent. The other two big allocations are to poor municipalities and an allocation for “regional-level investment”. In Colombia, there are six regions, which are territorial units defined by their natural characteristics, and made up of several departments. To achieve regional-level investment, since there are no “regional governments”, the royalties will be transferred to the departments, who will have to spend the money in projects with regional-level impact. The Savings and Stabilization Fund (a macro-fiscal stabilization tool) and the Territorial Pensions Fund (designed to cover the pensions liabilities of subnational governments in the next 30 years), become marginal allocations (less than 8 percent for both). Previously, these two funds together received more than 20 percent of royalties.

The other major change in the 2020 proposal is that it abolishes OCADs at the local and department level. However, it keeps the six regional OCADs that will decide about the allocation of 34 percent of royalties used for regional-level investment. Therefore, although departments receive the royalties for regional-level investments, the decision on which of the projects are viable and will therefore receive funding, will not be taken by the departments themselves, but by the regional OCADs. This would ensure that the projects developed by departments actually have a regional impact.

These changes in the formula achieve two seemingly contradictory results: they increase the money transferred to producing departments and municipalities without taking money away from non-producing ones. This might content subnational authorities but comes at the expense of savings and subnational pensions, which have proven useful in the COVID-19 crisis. As the effects of the pandemic became clear in March 2020, the Colombian government created the Emergency Mitigation Fund (FOME) for spending on the health sector and both the savings and subnational pensions funds were the main sources of funding

The reform proposal also prioritizes regional-level investment, which means larger-scale projects that could have a higher impact on subnational development. As mentioned, one of the weaknesses of the current system is that spending of royalties has been fragmented and spread out in small and low impact projects. This problem is a common across countries that distribute extractive revenues to subnational governments, like Peru and Bolivia, and is an important and relevant aspect of a reform.

Revenue governance in the coronavirus era: assessing the reform proposal

Our assessment of the proposal is based on two elements: recommendations based on best practices from NRGI’s research on revenue distribution, and the objectives of the reform itself. In other words, is the reform proposal meeting the objectives it set out to achieve and do these objectives align with good governance practices regarding revenue distribution to subnational governments?

Furthermore, none of these debates happen in a vacuum. The reform proposal is being debated in the middle of a global pandemic, which has caused a health, economic and social crisis in Colombia. In this context, royalty revenues are expected to decrease significantly following oil and mineral price falls. The Colombian Petroleum Association estimates royalties in 2020 could be 50 percent less than in 2019. And this comes at a time when spending needs across all levels of government are rapidly increasing.

This creates specific challenges for the new royalties system. The context highlights the need for efficient and impactful spending with a lower amount of total revenues available, the need for flexibility to spend royalties in projects that have to do with the health crisis, as well as the need for savings and stabilization mechanisms to smooth out revenues if these continue to fall.

Regarding the recommendations for good governance of revenues (the full list is set out in NRGI’s comparative study on revenue sharing), several are relevant to this reform proposal. First, revenue distribution systems should have clear objectives and align the system’s design with these objectives. The reform proposal complies with this recommendation, since the objectives of increasing efficiency in spending and giving a higher share of royalties back to producing areas effectively guide the new formula and changes to reduce the administrative burden that slows down spending, including the elimination of OCADs.

A second recommendation states that distribution systems should keep expenditure responsibilities in mind. This relates to the general principle of intergovernmental transfers that, ideally, revenue allocation to subnational governments should match their expenditure responsibilities. However, many countries choose to stray from this principle to transfer a portion of revenues to producing areas to compensate for extractive activities. This is the case of Colombia, as well as many others in Latin America, like Bolivia, Peru, and Brazil. Since one of the objectives of the reform is increasing compensation to producing areas, although it does not comply with the principle, it does follow its own objective of returning a larger portion of royalties to producing departments. Furthermore, Colombia has other subnational transfers from the regular budget, which relate to subnational governments’ expenditure responsibilities. Royalties have other specific purposes, including poverty reduction and regional development, which align with the allocation percentages in the reform proposal.

Increasing the revenue distribution to producing areas is part of a trend in the region to channel more money to producing regions with the assumption that this will lead to higher acceptance or “social license” for extractive activities from local populations. In Peru, where subnational transfers to producing territories are already high, there have been proposals to allocate a percentage of mining revenues directly to communities. This assumption, however, does not necessarily hold, as evidenced by the surge in conflicts in Peru in the producing areas that received the highest amount of mining and hydrocarbon revenues during the commodities boom period, and the persistent reluctance of other areas to engage in extractive projects, despite the potential flow of revenues.

Two critical concerns: the cut in savings and unclear mechanisms for decision-making and citizen participation

A further recommendation is that distribution systems should smooth fiscal expenditure and make spending predictable. They should also make revenue distribution transparent and formalize independent oversight. The reform proposal fails to follow these two recommendations.

As mentioned, the reform cuts the distribution to the savings and stabilization fund, as well as the subnational pensions fund. This therefore restricts the system’s ability to smooth out expenditure, withdrawing from the fund when revenues fall or saving when they rise. This cut is especially concerning in this context. The crisis has made it clear that having resources saved and available for these catastrophic events makes a huge difference for a country and its ability for a swift response. The savings and subnational pensions funds contributed COP 14.8 billion (around USD 4 billion) to the government’s Emergency Mitigation Fund immediately, at zero interest and without having to borrow externally and affect its credit rating. Regarding the allocation to subnational pensions, although this cut will have its impact down the line, it affects a sector of the population that has become even more vulnerable. Also, today’s spending needs could restrict the funds to cover pensions in the future.

Regarding formalizing independent oversight, the elimination of most OCADs and the lack of clarity about which citizen participation and oversight mechanisms will be implemented in the reform is concerning. OCADs have indeed been identified as a bottleneck, and as a space prone to “under-the-table” deals, with a high risk of corruption. However, the reform project is unclear about the new accountability mechanisms that will replace local and department OCADs. Returning to simple decision-making by the local authority should not leave aside the project cycle (formulation, presentation, verification, viability and approval, execution and follow-up, and evaluation) which aims to ensure approved projects have positive social impact and reduce the risks of corruption. In the current system, opportunities for citizen participation were made possible through the advisory committees, which are associated with the OCADs. In the proposal, these committees disappear. Even if the previous participation mechanisms were ineffective, the absence of specifications about participation spaces in the new system raises concerns about how decisions will be made and if citizens will be able to monitor them.

Another relevant issue is that the six regional OCADs would now concentrate the decision-making power regarding projects that benefit several departments. Though the rationale is to ensure that impactful projects are prioritized, it is not clear that taking decision making to a regional level will allow a more efficient operation than the current OCADs. The proposed system could also lead to patronage relations with the different departments and municipalities in each region, which will want to benefit from the projects funded by these royalties.

Investment in diversification and flexibility: two elements excluded from the proposal

A further aspect the reform proposal should consider is prioritizing spending on projects that bring about sustainable and inclusive development. One way to achieve this is to promote economic diversification, to reduce the territorial dependency on oil and minerals. The SGR's monitoring and evaluation system shows that only 3 percent of the resources have been used to strengthen agricultural, livestock and fishing productive capacity, while the rest has been used in transportation, road-network construction (43 percent), education (11 percent), drinking water and basic sanitation (8 percent). Although this spending can contribute to the enabling environment needed for diversification, the lack of diversification in past decades suggests that productive investment is also needed. The coronavirus crisis has demonstrated the dependency on the extractive sector as a source of fiscal revenues and economic growth, and how a fall in prices and production can cause a harsh economic slowdown. Therefore, investing in other sectors that can be a sustainable source of economic growth and development for the Colombian territories could be included in the reform as well.

Finally, and this relates directly to the context of the coronavirus crisis, the system should build in a degree of flexibility or allow for small adjustments to the formula, for instance, for changing economic conditions, such as those the country is experiencing now. This is not included in the reform proposal, since it was drafted in 2019, before the pandemic began.

While the reform proposal deals with some of the concerns regarding the current royalties system and is aligned with the objectives established, it leaves out crucial elements that could help improve governance of extractive revenues in Colombia. Concretely, it addresses the administrative burden that leads to slow, inefficient, and low-impact spending, as well as increasing the limited participation of producing departments and municipalities in total royalties. However, it is unclear on accountability mechanisms to replace OCADs, spaces for citizen participation and does not include mechanisms that can contribute to economic diversification. It could therefore increase the risk of corruption and bad expenditure decisions, going back to the problems that the 2011 reform tried to overcome, while leaving the country without savings for future crises.

Therefore, based on NRGI’s research on revenue distribution to subnational governments, we conclude that the proposal could be strengthened by rethinking and clarifying the decision-making mechanisms, explicitly including spaces for citizen participation and oversight, both of decision making and of project implementation, and including guidelines regarding prioritizing investment for economic diversification.

The coronavirus crisis represents a timing challenge for the reform – since, at its core, modifications sacrifice savings and stabilization to distribute more money directly to departments and municipalities. Civil society organziations are calling this aspect of the reform into question and lawmakers will likely scrutinize it in the debates in parliament. Careful revision of this aspect of the proposal is essential to ensure the long-term success of the reform.

Claudia Viale is Latin America senior officer at the Natural Resource Governance Institute (NRGI).