local content solutionsseries5

8/12/2019 Local Content SolutionsSeries5

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Unpacking Local Content Metrics and MeasurementDr Michael Warner, November 2010

Summary

Which is b et ter, to a c h ieve 30% Loc a l Conte nt me a sured b y ac tua l eco nom ic va lue re ta ined

wi th in the d om est ic ec onom y, or 50% Loc a l Co ntent m ea sured b y expe nd i tu re w i th na t iona lly -

reg istered sup p liers? The m a nd a tory d ef in it ion s a nd rep ort ing req uirem entsof sta te reg ula tors,

a nd the vo luntary me t ric s an d rep or ting stand a rd s of c om p anies, vary wide ly ; f rom c rud e

m ea sures suc h a s the c oun try a dd ress on a n invo ic e, to ve rif ied c ert if ic a tes p ro ving tha t go o d s

a re o f do m est ic or ig in. This a rt ic le unp a c ks the c om p lexit ies of d i fferent m etr ic s for rep o rt ing

Lo c a l Co nten t a nd a ssesses their p ro s a nd c ons. Co m p a rison is m a d e b etw ee n Bra zil a nd

Ka za khstan reg a rd ing a p p lic a t ion o f Rules of O rig in. The a rt ic le d ra ws a tten t ion to som e

impor tant m issing m etrics.

Introduction

Whether for reasons of compliance orreputation, oil, gas and mining companiesand government regulators increasinglycommunicate their performance in LocalContent, and like to demonstrate how thefigures and trends are ever upwards. But justhow much credibility should be placed inthese figures, and on these trends?

This article investigates different metrics fordefining and reporting on Local Content,and contrasts each for their accuracy,comprehensiveness and ease ofadministration.

But let us begin by laying to rest a myth orthree about Local Content reporting.

Myths of Local Content Reporting

The most obvious myth associated withreporting Local Content is the presumptionthat the higher the level of Local Contentrecorded, the better. The question here isbetter for whom? In prac tice, higher levelsof Local Content may well impact theinterests of other stakeholders. For example,

higher levels of Local Content can,depending on circumstances, lead to:

the erosion of commercial value forinvestors and developers and/or greaterrisks to project delivery and operationalperformance.

a fall in levels of inward investment andtechnology transfer by internationalsuppliers and contractors;

a decline in the internationalcompetitiveness of domestic industry;

loss or delay in the accumulation ofnational (State) revenues;

unsustainable dependency of a localeconomy on the oil, gas or miningcompany for jobs and orders books.

These trade-offs are discussed and

modelled in other articles in this seriesi. Incontrast, this paper focuses solely on theimpact of Local Content reporting p er se.

There are two particular myths assoc iatedwith the reporting of Local Content statistics,which deserve attention.

The first is that reporting higher levels ofLocal Content necessarily means thatperformance is improving. In practice, ahigh level of reported Local Content, be

that at the local community level orregionally or nationally, can simply be a

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Clarity in the Reporting of Local Content


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Figure 1 Inherent Variability in Local Content

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US$Millions

Years

Capital expenditure Operational Expenditure

Local Content % Linear (Local Content %)

An a p p a ren t upw a rd s

line a r tre nd o ve r t im e

m a y ac tua lly re f lec t no

m ore tha n the d if fe ren t

leve ls of Loc a l C ont ent

ab le t o b e a c h ie ved in

c a p ita l ve rsus o p e ra t io na l

expend i tu re

reflection of the type of metric beingdeployed.

To illustrate, it seems likely that in Kazakhstan,application of the current formula forreporting Local Content in the purchase ofgoods of domestic originii(which requires acertificate proving such origin) will lead to afall in the reported levels. Until the formulawas introduced, subsoildevelopment companieswere reporting LocalContent using their ownformulae. Invariably thesemetrics did not require acertificate proving theorigin of goods or services.

Further, some companymetrics were based oncommitted expenditure,not actual expenditure asrequired under the new formula, ie on theplanned value of goods and services, notthe actual value of goods ordered orservices delivered.

Lastly, the regulatory effort involved incertifying goods and producers is asignificant bureaucracy hurdle, and may

well result in a period of under-reportingwhilst the system of certification matures.(This last error can of course be removed ifthe Local Content data reported arederived exclusively from that sub-set ofexpenditure for which such certificatesexist).

Taking these considerationstogether, a developer whoreported 45% aggregateLocal Content in 2008 for the

purchase of goods, and twoyears later under the newreporting regulations reported23%, may have actuallyachieved a higher level ofLocal Content in 2010, notlower. In summary, whenmetrics are undergoingrevisions, to simply report theheadline figures for LocalContent without explainingthe context, carries a

significant potential for error.

But what about trends? Surely, even ifrevising a metric introduces ambiguities overtime, an increasing or decreasing trend inLocal Content using the same metricshould be reliable. Again, however, this isnot necessarily so, and leads us to thesecond myth: that an averaged linear trendin Local Content is a reliable indicator ofperformance.

The problem is that thedevelopment andoperation of oil, gas andmining concessions arecharacterised by periodsof elevated capitalexpenditure. Thus anapparent upwards linear

trend over time mayactually reflect no morethan the different levelsof Local Content able to

be achieved in capital versus operationalexpenditure.

Figure 1 shows a typical flow of capital andoperational expenditure across a twentyfour year concession. Plotted against theseflows is the headline Local Content figure forall expenditure on bought-in goods and

services (capital and operationalexpenditure combined). In this scenariothere is no assumed increase in thecapability or competitiveness of domesticsuppliers over time. In other words, the realrate of improvement in performance is zero.

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Figure 2 Real vs Inherent Trends in Local Content

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YearsCapital expenditure

Operational Expenditure

Local Content %

Local Content with 5% annual increase

Linear (Local Content %)

The apparent upwards average linear trendseen in Figure 1 is a consequence of bothproportionately less expenditure going todomestic suppliers during periods of capitalinvestment, and this capital spend begincommitted early in lifespan of theconcession. As is common in theseindustries, especially in emerging economieswith undeveloped manufacturingcapacities, during periods when capitalprojects are being executed, a higheroverall share of annual expenditure will goon equipment and materials purchasedfrom specialist foreign suppliers, such asrotating equipment, long-lead items thatrequire the manufacture of parts tospecification, and exotic materials anddrilling and excavation equipment where

the supplier market is limited.

Figure 2 presents a modified scenario. Itshows what happens if Local Contentperformance improves by 5% year-on-yearas a result of vendor developmentprogrammes delivered by the developer,lead contractors and State agencies. Notethat the real trend in Local Contentperformance here is the variance betweenthe two averaged trends, and that in Figure1 the real trend is actually flat.

A final observation on trends is tounderstand how scale can affect results.From years five to six in Figure 1 we see a

significant jump in Local Content from 21%to 42%; and in contracts in years fourteenand fifteen, a dramatic fall from 44% to 18%.

These trends, apparent only when looked atfrom a medium-term perspective, have littleto do with how successful the company,local industry or state agencies might be inbuilding industrial capability andcompetitiveness. The initial rise in years fiveto six is simply a consequence of shiftingfrom a project delivery to operationalmode, with a relatively higher proportion ofexpenditure subsequently going on localsite-based services and orders for locally-produced materials.

Likewise, the sharp fall across years 14 to 15

results from the onset of a new period ofcapital investment, with early expenditure

by the developer onexpensive long-leadequipment and exoticmaterials, procureddirectly from foreignmanufacturers.

With regard to both ofthese myths, what can beconcluded is that to report

Local Content is more thansimply the reporting of thefigures themselves. It isabout understanding, andabove all explaining,precisely what it is that themetric is measuring, andwhat is happening in thewider economic orbusiness environment thatmight be influencing thefigures and trends.

A Typology of Local Content Metrics

Tables 1a/1b and 2a/2b present a typologyof Local Content metrics. These metrics arecurrently used, or being considered, byregulators and companies in the oil, gasand mining sectors. The inventory is non-exhaustive, but includes some of the morecommon metrics, as well as those withpotential to influence other regulatorsaround the world in the future, such as the

certification-based metrics being adoptedin Brazil and Kazakhstan.

inherent +real trend

inherent trend

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Table 1a A Typology of Local Content Metrics


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Table 1b A Typology of Local Content Metrics con t i nued


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Table 2a A Typology of Supplier Development Input Metrics


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Table 2b A Typology of Supplier Development Output Metrics


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Table 1 lists metrics that measure LocalContent. Table 2 lists metrics to measure thedevelopment of local suppliers through on-the-job training, management supervisions,quality control, investment, education etc.

Each table classifies the metrics under threeheadings:

in-house, meaning the workforce on thepayroll of the development or operatingcompany;

services and goods, metrics that can beapplied to either the provision of servicesor supply of goods, and

specific metrics that apply only to oneor the other of goods or services.

The inventory of supplier developmentmetrics in Table 2 is further classified intoinput metrics, such as training hours andcapital investment, and output metric, suchas improvements in labour productivity andprice competitiveness.

The inventory of output metrics in Table 2covers only a narrow set, but this includessome important examples along with two

new metrics that the author considers arebeing overlooked and yet should form acentral part of any companys or authorityslong-term reporting on Local Content (seelater in this paper). For a morecomprehensive list of outcome metrics, thereader is referred to a report by the WorldBusiness Council for SustainableDevelopment prepared by the Dalbergconsultancy firmiii.

A comparison of selected metrics from the

two tables follows, analysed from thefollowing perspectives: their key feature; thestage of procurement at which they apply;the relevant expenditure categories;confidence in the data; simplicity toadminister; and economic ac curacy.

In-House Local Content :Hea dc ount vsWage Va lue

A simple measure of Local Content within adevelopment or operating company is the

number of nationals employed as aproportion of total full time equivalent (FTE)employees. Such a metric is common in

concession agreementsiv to define LocalContent targets for national professionaland non-professional staff. The targetsderived from this metrics may includeanticipated performance over time, forexample 70% of nationals in managerialpositions in year one of the concession, and90% in year five. A variant on headcount isto report the proportion of total manhours ofwork undertaken by national citizens indifferent job types or grades.

With headcount metrics, ambiguity canarise in the definition of both nationals andemployees. One rule of thumb is toinclude individuals who have nationalcitizenship and are on the company payroll,thus including full and part-time agency

staff.

An alternative to headcount as a measureof in-house Local Content is to measure theactual value paid by the company toemployees and other pay-rolled staff. Mostusual is to use a gross wage or gross salarymeasure. This metric combines base salary,associated social taxes paid by employeeand employer, and employee benefits andexpenses, including pension contributions,housing, personal and vehicle allowances,

and bonuses.

Both headcount and gross wage metricsare relatively simple to administer,calculated as they are from informationalready collected by human resources andfinancial accounts departments. As such,confidence in these data should also bereasonably high.

These attributes are important, but asreliable measures of economic value

contributed to the domestic economy, bothmetrics are prone to a number ofinaccuracies as follows.

Headcount, when used to report LocalContent in expenditure on human resourcesin a company that uses expat labour, canbe particularly misleading. For example, itwould not be unusual for the headcount ofnational citizens in an oil and gas operatingcompany to be 85% across all grades, butassume only 15% of the total payroll bill (plus

social taxes and benefits).

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Rep ort ing Loc a l Co nte nt

a s g ro ss w a g e s tona t io na l c it ize ns a nd

ig no ring e xpa t sa la rie s is

likely to c a rry ma te ria l

ina c c ura c ies. In one

stud y the in-c o untry

a llow a nc es a nd soc ia l

t a xes p a id to a nd on

b eha lf o f exp a ts w a s

three tim e s the g ro sswa ge s p a id to a ll

na t iona l em p loyees.

The common answer to this problem is toreport gross salary paid to national citizens,as introduced above. But this too can bemisleading. Although expatriate basesalaries are often paid into foreign bankaccounts, and thus accumulate overseas,expat allowances for housing, transport andpersonal expenses, as well as expat socialtaxes, will accrue to the domestic economy.

These expenditures should not beunderestimated. In one anonymouseconomic assessment of Local Content inthe upstream oil sector undertaken by theauthor, the in-country allowances and soc ialtaxes paid to and on behalf of expatriateswere three times the totalgross wages and socialtaxes paid to and on behalf

of all national citizens in thesame companyv.

When discussing in-housemetrics for Local Content,an important distinctionneeds to be drawnbetween the mining and oiland gas developmentsectors. Whereas a fewhundred to a thousand FTEemployees would be

typical in an oil or gasdevelopment or operatingcompany; in the miningsector, these figures can beten times larger, dependingon the extent to which labour to operatethe mines is in-house or sub-contracted.

Defining Local Supplier?

Regarding the reporting of Local Contentwithin procurement expenditure, a

controversial topic is what is meant by alocal suppliervi. Common definitionsinclude: the address given in vendor registration

information; the address on a purchase order or

invoice; the share of equity owned by nationals,

eg > 50%; whether the supplier is incorporated in-

country; whether the supplier is tax-registered in-

country, eg for corporate tax orwithholding tax;

whether the supplier is a producer orprovider of goods or services ofdomestic origin (see later).

With regard to regional or communitysuppliers, more refined definitions caninclude: regional/local address in vendor

registration; regional/local address on invoice suppliers and contractors who source

the majority of materials or labour fromthe province, district or localcommunities located closest to theoperation.

In establishing suchmetrics, the regulator or

company is then left withthe choice of whether torequire reporting of thenumber of such suppliersor the $ value ofexpenditure.

Probably the most timeconsuming such metric todefine, and most prone toerror, is to where a localsupplier is described by

the proportion of equityowned by nationalcitizens. In theory,information on equityshare is readily

forthcoming through investigation of annualfinancial accounts, web-sites and the stateoffice of company incorporation. Yet, inpractice few operating companies arewilling to invest the resources involved toundertake this type of detailed research.

Furthermore, there are few opportunities forshort-cuts here. For example, it cannot beassumed that a supplier who is incorporatedwithin the country is necessarily majority-owned by nationals; and nor can it beassumed that a supplier incorporated in aforeign country is not majority owned bynationals. In general then, such realitiesprohibit regulators from accurate reportingto politicians the extent to which nationallyowned firms are participating inprocurement.

Measuring Local Content as equityparticipation is far from being the only

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Figure 3 The Misleading Nature of Certain Local Content Metrics

0% 20% 40% 60% 80% 100%

...to supplier vendor registered with in-country

address

...to suppl ier with in-country address on invoice

...to supplier > 50% national equity

...to supplier incorporated in-country

...spent on goods of 'domestic origin'

...actual ly added to the domestic economy

100%

0%

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100%

42%

100%

100%

100%

100%

0%

22%

Local

Contentas%ofPurchaseAgreement...

Scenario #1 - Local Import Agent

Scenario # 2 - Foreign OEM + Local Fitting and Testing

source of potential error in this class ofmetric. Defining a local supplier byapplying the company address in vendorregistration information, or from a purchaseorder or invoice, is administratively simply,but carries even greater potential forinaccuracy, if intended to convey howmuch expenditure is retained in thedomestic economy.

Inaccuracies in using the office address ismore likely when reporting on the purchaseof goods than the contracting of services.With goods, especially finishedmanufactured equipment and materials, alocal address on aninvoice may simplyreflect the office

location of an importingagent. These agents(the so called Mr 10%s)are often whollyindigenous and reliablesuppliers of equipmentand materials, but thegoods involved areessentially imported. Theproportion of the salesprice retained in thedomestic economy

comprises only thecommission paid to theagent and the importduties. Even if the importagent offers additionalservices, such as storageand in-land freight, a company reporting100% Local Content for these goods on thebasis that the suppliers office is located inin-county, is reporting information that ispotentially misleading.

To illustrate how misleading such reportingcan be, Figure 3 compares how LocalContent might be reported for ahypothetical purchase of spare parts andtheir fitting and testing.

In the example, a purchase order for US$4million has been raised for the supply ofmachine spare parts under a call-offcontract. Two scenarios are compared. Inthe first, the suppliers main office is locatedin-country. This supplier imports goods that

are already finished and packaged. Heprovides a storage facility, and transportsthe parts on demand to the end user. Fitting

and testing services are performed througha sub-contract between the agent and theforeign original equipment manufacturer(OEM).

In a second scenario, the suppliers mainoffice is located overseas, but he has maderecent investment in local capability tostore, transport, fit and test the parts. Thesein-country capabilities contribute 42% of theactual total purchase agreement. Thegoods are deemed by regulators to be ofdomestic origin because more than 40% ofthe value of the sales has originated in-country.

Figure 3 clearly shows how inaccuracies canarise from reporting Local Content usingsimple metrics such as country address onkey documentation. In both scenarioseach scores 100% Local Content with

respect to the in-country location of thesuppliers main office as recorded in thecompanys vendor registration data-base.But with regard to using the address on aninvoice, the supplier in scenario #2, who isinvoicing from its overseas office, recordszero percent Local Content, whilst the localimport agent in scenario #1 scores 100%.

The same inverse relationship occurs withequity ownership, where the supplier inscenario #1 is 100% owned by nationals,and in scenario #2 is 100% foreign

ownership.

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Dif fe rent Loc a l C ont ent

m et ric s c a n ge nera te , no t

o nly re la t ive ly d if fe re ntre sults, b ut lea d to

d ia m etric a lly op p osite

c o nc lusio ns.C ruc ia l the n

is fo r the sta te m ents

c om m unic a t e d a ro und

these d a ta to b e a t rue

a nd fa ir in te rp re ta t ion of

the m et ric in q ue st io n

And the ambiguities run deeper still. Withrespect to measuring Local Content in termsof goods of domestic origin, in scenario #2all of the purchase agreement value iscounted as Local Content because theproportion of this agreement assumed to beof domestic origin is greater than thethreshold of 40%. This is so, despite only 42%of the actual purchase agreement pricestaying in the domestic economy.

In contrast, in scenario # 1, although 22% ofthe contract value stays in the domesticeconomy as a combination of commissionto the agent and payment for storage andfreight costs, Local Content is reported aszero percent because 22% is below the 40%threshold for goods to be defined as being

of domestic origin.

Importance of Description and Context

Figure 3 demonstrates how different LocalContent metrics can generate, not onlyrelatively different results, but lead todiametrically opposite conclusions. What iscrucial then is for thestatements andmessagescommunicated around

these data to be a trueand fair interpretation ofthe measurement inquestion.

To illustrate, the followingstatement: We spent$950 mil l ion on

p ro c urem en t this yea r, of

which 47% was local

c o n t e n t is notaltogether uncommon in

company reports. Thestatement is, however, rather meaningless ifreported without clarity on the definition ofLocal Content being used, and what ismeant by the term spent. Reportingaggregate figures for Local Content in thisway also raises the question of how the 47%figure is spread between operational andcapital expenditure and across differentexpenditure categories.

Table 3 below gives the actual information

upon which this generalised statementmight have been based.

Table 3 Illustrative Data on Local Content

Year 2010

US$mtotal

US$ spent withsuppliers tax-registered in-

country (US$m)

LocalContent

%

Committed Expenditure (contrac t awarded)

Services $700m $425m 61%

Goods $250m $22m 9%

Total $950m $447m 47%

Actual Expenditure (invoiced)

Services $450m $280m 62%

Goods $130m $55m 42%

Total $580m $335m 58%

These data are sufficient to support a farmore meaningful statement than in theprevious communication, for example:

In 2010, $950m wa s c om m itted forexpe nd itu re o n g oo d s a nd services, of

wh ich $447m (47%) was awarded to

sup p lier s ta x-registered in-c ou ntry. Of this

$447m , $425 is fo r the future p ro vision of

lo c a l servic es, an d $22m for the future

sup p ly of go od s f rom loc a l

sup p lie rs. The rela tively low

f ig ure of $22m is exp la ined

by the per iod o f cap i ta l

re furb ishment ant ic ipa ted

for 2011. A m o re ro ut inef igure for standard

opera t i ons wou ld be

a round 40%, as ev id enc ed

by ac tua l expend i tu re

a g a inst invoic es from lo c a l

ta x-re g iste red sup p lie rs in

2010.

When reporting LocalContent, it is far safer andclearer to precisely

communicate the metricbeing applied, and, where necessary,provide context so that the real trends aretransparent. As a rule of thumb: avoid usingthe term Local Content when reportingLocal Content, and instead just say what it isthat you mean.

Rules of Origin and Local Content

A suite of more complex metrics for LocalContent derive from Rules of Origin. Rules

of Origin are the principles applied todetermine whether a product is eligible forpreferential treatment in trade. These rules

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As a rule o f

thum b , avo id

using the te rm

Loc a l Co n ten t

w hen rep o rt ing

Loc a l Co n ten t .

Inste a d , just sa y

w ha t it is tha t

yo u mea n

are now being applied bysome regulator to design LocalContent targets and reportingrequirements. The same ruleshave also informed the LocalContent metrics used in theinvestment criteria of nationaldevelopment banks, forexample, the 60% LocalContent requirement of theBrazilian national developmentbank BNDES - for extendingfinance for fixed investments inmachinery and equipmentvii. In turn theseinvestment criteria have influenced LocalContent reporting regulations, most notablyin Brazil and Mexico.

Rules of Origin have and continue to bedebated at length by the World TradeOrganisation, the European Union, NAFTAand Governments in bi-lateral tradeagreements and negotiations. A commonpoint of contention are the methods andthresholds for determining whether animported product has undergone what istermed a substantive transformation in-country, such that the good is eligible fortrade preferences.

One such determinant is the level of valueaddition achieved in the exporting country.Generally the methods for calculating valueaddition are one of two types: build-upmethods and build-down methods. Thedistinction here is important, and lies at theheart of much of the current discourse onthe ambiguities and administrativecomplexities of Local Content reporting.

Build-up methods aggregate, piece-meal,the value added to the domestic economy

from in-country industrial activity, essentiallythe cost of labour and direct manufacturingcosts, but excluding the cost of importedmaterials.

If one applies the logic of build-upmethods to the gross salary metric reviewedearlier in this paper, this would suggestadding the base salary of nationals, toemployer and employee tax contributionsand employee benefits of nationals, andthen also adding in the allowances and

benefits paid to expat (but excluding expatbase salaries and bonuses). In other words

the figure for Local Content isbuilt up from the individual localcomponents.

In contrast, build-downmethods seek to identify the non-originating foreign content,then deducting this from theoverall transaction price.Continuing with the aboveexample, a build-down methodapplied to measure in-houseLocal Content would take the

entire employee wage bill and all taxes andbenefits as the starting point, and thendeduct that portion paid to expats as basesalary and bonuses. This would theoreticallyleave the originating value being

contributed to the domestic economy, iethe proportion that is Local Content.

Under Rules of Origin for trade preferences,there then takes place a critical secondstep. A threshold is applied to theoriginating portion (whether this be derivedfrom a build-up or build-down method). Thisthreshold is the point at which a good isconsidered to have undergone substantivetransformation in-country. The critical ruleis that trade preferences are then applied to

the entire transaction value of the exportedgood, not only the proportion that is ofdomestic origin.

The significance of this second step inreporting Local Content in oil and gasexpenditure is demonstrated by thedifferent ways in which examples offormulae from Brazil and Kazakhstan haveutilised Rules of Origin methods (refer to

Table 4). In the Brazil example, both steps inthe process are followed as a build-down

method to calculate Local Content ingoods and servicesviii. In the Kazakhstanexample, the formula for reporting LocalContent applies the first step of calculatingdomestic origin, but not the second step,with a build-up method used for goodsand a build-down method for servicesix.

It is not altogether clear why in the Brazilexample the formula uses the two stepprocess applicable under Rules of Origin.Since there is no tangible trade advantage

to achieving some arbitrary threshold ofsubstantive transformation, there is no

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Table 4 Metrics to Measure Goods and Services of Domestic Origin - Examples from Brazil and Kazakhstan

An example from Brazil An example from KazakhstanStep 1 Calculate % Loc al Content in Goods and ServicesScreening o components for Evaluation

Sub-set of components subjected to evaluation, based on Paretos80/20 rule (inputs ranked by value) with remaining 20% and c ertainbulk materials assumed to be 100% Brazilian without need forevaluation

Build Down Method - Nationalisation Index for Goods (INB)

Value of direct and third-party imported components as CIF (cost,insuranc e, freight) or FOB (free on board) plus foreign freight andinsurance; including import duties, IPI (tax on industrial products)

and ICMS (state VAT)__________________

Sales price

Correction factorto take ac count of overheads incurred outsideBrazil

Build Down Method - Nationalisation Index for Services (INS)

Imported human resources (value o f foreign man hours) +Imported capital goods used to provide services (rental, leasing) +

Intermediary imported goods/consumables________________________

Service price

Build Down Method - Local Content metrics for Goods(used incalculation of CT-KZ Certificate o f Origin)

Cost of the foreign raw material and o ther components__________________________

Sales price

This metric is only applied in the context of calculating the %Domestic figure in prepa ration of a CT-KZ Certificate confirmingthat goods are produced in the Republic of Kazakhstan.

Build Up Method - Local Content metric for Services

(CT-KZ % in goods used to provide services)+

(share of salary fund by citizens of Kazakhstan pursuant to primarycontract)

+

(value o f sub-c ontracts performed by legal entities of RoK with >95% nationa l citizens)

________________________Service price

Step 2 C lassification of Local Content as Goods or Services of Domestic Origin

Goods and Services Origin Verification

GoodsIf INB > 40%, then goods are 100% Brazilian, and total sales pricecounts towards Loca l Content targets

ServicesIf INS > 80% then services are 100% Brazilian, and total service price

counts towards Loca l Content targets

Goods of Origin Certification

Goods

% share of Kazakh content in goods, as specified in the C T-KZCertificate

If there is no C T-KZ Certificate of Origin, Kazakh Content is 0%,

regardless.

Und e r Rule s o f O rig in,

t ra d e p re fe renc es a re

a p p lied to the en t ire

t ra nsa c t ion va lue of

the exp o rted g oo d ,

not o n ly the p rop ort ion

tha t is of d om est ic

o rig in. Ap p lying this

log ic to rep ort ing Loc a lCon t e nt c a n be

mis leading.

obvious reason for assuming that goods thatare over 40% domestic origin should bereported as 100% Local Content. Indeed,other formulae used in the Brazil oil and gasindustry forego this second step.

Arguably, the central tenet of reportingLocal Content in procurement expenditureis to communicate the value beingcontributed by this expenditure to the

domestic economy. Assuch, the single stepapproach being adoptedin Kazakhstan would seemmore credible.

With regard to the choiceof build-up versus build-down methods, in bothBrazil and Kazakhstanreporting regulationsrequire use of a build-

down method to calculateLocal Content in goods. InBrazil, the metric involves

deducting the CIF IncoTerm (costinsurance, freight) dollar figure from thesales price, along with import taxes andoverseas overhead costs. In Kazakhstan, thesame principles are at play, but the precisemetric remains unclear.

The main difference in choice of methods isin the calculation of Local Content for thecontracting of services. In Brazil, the

method is to build-downwards, ie to deductthe foreign labourcomponent from the totalcontract price. InKazakhstan, at the time ofwriting, the applicablemethod was to identify thegross salary and benefits ofnationals utilised in contractdelivery, and add this to thetotal value of sub-contracts

awarded to those nationally-registered service providerswith greater than 95% of

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national employees, by headcount. Inother words, a build-up method.

IncoTerms and Local Content

International Commerce Terms (IncoTerms)

are published by the International Chamberof Commerce and widely used ininternational transactionsx. The coreIncoterms relevant to calculating the non-originating component of procurementexpenditure on goods under a build-downmethod are FOB (free on board) and CIF(cost, insurance, freight).

In calculating Local Content, if a supplierhas paid for goods FOB, then thesubsequent port-to-port freight costs and

associated insurance would need to beadded to the FOB price before deductingthis from the total sales price. This explainswhy CIF is favoured as the metric forcalculating Local Content under a build-down method, since CIF includes the non-originating costs up to the port of entry.Figures 4a and 4b below compare how FOBwith CIF can be used in the calculation ofLocal Content.

Figure 4a Goods Paid as FOBxi

Figure 4b Goods Paid as CIFxii

The attraction of using a build-downmethod to calculate, especially if derivedfrom FOB or CIF IncoTerms, is their relativeadministrative simplicity. FOB and CIF

information is identifiable in the buyersinternal documentation, and can readily bededucted from total sales price to generate

a reasonably accurate figure for LocalContentxiii. This said, there is a noninsignificant drawback to using Incoterms tocalculate Local Content. Invariably,reporting Local Content using FOB and CIFmeans suppliers are asked to disclose theresults of their price negotiations with sellers,information which can be commercialsensitive. In Brazil, this limitation is beingaddressed through an independent third-party system of certification, with LocalContent reported on an aggregated basis.

Measuring Supplier Development

With reference to the first myth discussed inthe introduction of this paper, higher levelsof Local Content do not necessarily imply

that a country or regions industrial base isbecoming stronger or more competitive.Whilst it may indeed mean that more directand indirect jobs are being created, andlocal order books look more healthy, thesedata say little about whether nationalemployees or local suppliers and servicecontractors are developing their capabilitiesand capacity and as a result wining morework and growing as long-term viablebusinesses.

Metrics that measure the development oflocal suppliers are as equally diverse asthose available to measure content.

These metrics can be divided into twocategories: input metrics and outputmetrics.

Inp ut M etric s for Me a suring Sup p lier

Deve lopmen t

Input metrics are essentially proxy indicatorsfor measures of outcome or performance.

For example, a development or operatingcompany would expect the future earningpower of employees who have receivedvocational training, or the future growthprospects of community-based basedsuppliers who have benefited from vendordevelopment programmes, to be at leastequal to the cost of providing the training ordelivering the programmes.

Likewise, levels of capital investment in localsuppliers to build capability made by an

operating company, or leveraged frominternational contractors or third-partyfinancial institutions, can also be claimed as

FOB Free On Board Freight/Ins Freight/Ins

Foreign Content Local Content

CIF Cost, Insurance, Freight Freight/Ins

Foreign C ontent Local Content

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The re is a simp le r

a lte rna t ive to c ond uc t ing

re so urc e -inte nsive m a rket

surve ys to m ea sure

w he the r lo c a l sup p lie rs a re

be c om ing m o re

c om p e t itive . This is fo rc om p a n ies to rep ort on

the tre nd s in lo c a l sup p lie rs

b e ing a wa rde d c on t ra c t s

o n a n inte rna t io na lly

c om p et it ive b a sis

a proxy indicator for the growth-potential ofthese suppliers.

These are the most simple supplierdevelopment metrics, and, as is discussed inSolutions Briefing # 3 of this series, may havea role to play in the evaluation of tenders asa means to incentivise lead contractors tosupport and developmentlocal suppliersxiv.

O utp ut M etr ic s for

M ea suring Sup p lier

Deve lopmen t

Output metrics to measurelocal supplier developmentare more meaningful, but

to-date companies havehad difficulty in identifyingmetrics that are sufficientlyrobust and yet simple andresource-efficient toadminister.

Most robust would be thosethat measure actualimprovements over time in the coreparameters of firm competitiveness, forexample: supplier costs, delivery times, labour productivity, quality, volume capacity, and HSE performance,

To ca librate performance, these resultsobtained would need to be benchmarkedagainst international norms. Such metricscan be applied, but require a significantcommitment of resources in order to

undertake the necessary surveys at the levelof individual suppliers. One efficiencymeasure here would be to combine thistype of survey with conventional markettesting, for example, when preparing for anew capital project.

Other useful output metrics, equallydependent on local market surveys, are toinvestigate what new contracts localsuppliers have won as a result of beingcontracted by, or supplying to, the oil, gas

or mining company in question, and howtheir revenues have grown over time as aresult. Positive trends in these two metrics

would be meaningful since theydemonstrate whether local suppliers arebecoming more competitive and growing.However, confidence in the results wouldneed to be predicated on a clear cause-and-effect linkage between the newcontracts being won and the vendorsupport programmes of the company and

its lead contractors.

Believability in the datawould be less whereevidence that localfirms are becomingmore marketable andexpanding theirbusiness is only partiallylinked to having been

contracted to thecompany in question,ie where the bulk ofnew revenues haveactually come fromcontracts or ordersexecuted for clients inthe wider place.

The Missing Metrics

These are not inconsequential limitations,

and there is clearly a need for simplermetrics that negate the need for resource-intensive surveys or proof of a cause-and effect linkage. One set of alternatives is forthe oil, gas or mining company to report ontrends in the number and type of localsuppliers who: make it through pre-qualification

processes; are selected for tender lists, and are awarded contracts on an

internationally competitive basis.

These three metrics can work well asindicators of successful local supplierdevelopment, but only if there is an openlycompetitive tendering processes inoperation and no anti-competitivepreferencing of local suppliers (for examplethrough cost advantages or excessivetargets. In such cases a positive trend in thenumbers and value of local suppliers makingit through pre-qualification or beingawarded contracts on an internationally

competitive basis, would be solid evidencethat local industry is becoming morecompetitive.

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These would seem to be helpful andadministratively efficient metrics. Yet fewregulators require companies to reportagainst them, and few companies disclosethis information on a voluntary basis. Thesemissing metrics can be summarised asfollows:

1. Competitive Pre-Qualification:% of ve nd o rs in m aster sub -c ont ra c to r lists

a nd tend er lists tha t c om p rise nat iona l ly-

reg iste red sup p liers (by d ifferent

p rocu rem en t c a teg o ries)

Data source:Co mpany tender tracking system, eg

PROCON

2. Competitive Contract Award# and $ va lue o f con t rac ts aw arded to

nat ion al ly-reg istered vend ors on a n

internationa l ly c om pe ti tive b a sis

Data source: Contrac ts Plan/ Company vendor register

Conclusion

This paper has sought to demonstrate thatthe choice of metrics for measuring andreporting Local Content in oil, gas and

mining expenditure is large and thepotential ambiguities involved in theirapplication, many.

Some of the emergent principles foraccurate and efficient reporting are asfollows:

Report both relative and absolutefigures, to avoid communicatingmisleading information.

If there are ambiguities due to changingmetrics, report two setsof data using theold and new metrics

As far as possible disaggregate theinformation reported, so that low or highlevels of Local Content are not hiddenwithin aggregate figures

Accurately describe the metrics beingused to generate the reported figures,and not only the figures themselves.

Report the total data population that isthe basis for reporting, alongside theproportion of expenditure not includedin this population.

Beware applying Rules of Originwithoutadaption, these were designed for adifferent purpose

iWarner, M (2010) Local Content Optimisation: Mod e l li ng the Eco nom ic Imp ac t o f Loc a lCo ntent on Co mm ercia l Interests a nd Pub lic Industria l Pol icy, Solutions Briefing # 4; Warner, M (2010) Are Local ContentRegulations a Pa thwa y to C ompetitiveness or a Road to Protec tionism?; a p resentation for Menas Assoc iates, London,

September 27th, 2010iiRepublic of Kazakhstan (September 2009), General Provisions: Single Methodo logy to Ca lculate Kazakhstani Content

Pertaining to Purchased Goods, Works and ServicesiiiSee WBCSD (forthcoming 2011) A Framework for Dialogue on Na tiona l Market Participation and C ompetitiveness,Geneva: World Business Counc il for Sustainable DevelopmentivIn this paper the term conc ession agreement in its general sense to mea n any agreement made between a Stateand company for the exploration or development of mining resources (metals, minerals, oil or gas) in which the Stateoffers incentives, such as exclusivity to seek profit, reduc ed tax or royalty rates, cost rec overy or production sharing

arrangements etc, in exchange for long-term capital investment in the country".vRefer to author

viUnless otherwise indica ted, in this paper the term supplier is used in its general sense to describe all types of vendors,including suppliers of goods under a purchase order or agreement, and suppliers of services under contrac t.viiRobert, S. (2007) Na tiona l Development Banks in Sustainable Financing: Addressing Market Failures, Competition

Commission and the University of WitwatersrandviiiSource: Brazilian Local Content Requirements, undated (assumed 2009)ix Ibid. Republic o f Kazakhstan (September 2009)xFor a full description of IncoTerms see: http:/ /en.wikipedia.org/wiki/Incotermxiadapted from Wikipedia: ibidxiiibidxiiiassumes that the proportion of sales price for foreign overheads is not material.xivWarner, M (2010) Lo ca l Conte nt in the Formulat ion o f Inv i tat ions to Tend er and Tend er Eva luat ion for Ma jor Co ntrac ts,LCSSolutions Briefing # 4

Author:Michael Warner, Direc tor, Local Content Solutions (a trading a rm of SNSI Ltd) 2010 all rights reserved

Acknowledgement:Mike Oakey, Direc tor, CMC LtdContact: [email protected];Tel:+44 (0) 1491 830421; Website:www.loc alcontentsolutions.com

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