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SUBSOIL AND SUBSOIL USE LEGISLATION: NEW CONCEPT

January 2016 - Projects, Energy & Natural Resources . Legal Developments by AEQUITAS.

More articles by this firm.

Dr. Olga Chentsova, Managing Partner

Natalya Braynina, Partner 

A quality subsoil and subsoil use legislation is of strategic importance for Kazakhstan.  Since the appearance of the first independent Kazakhstan's regulatory acts governing subsoil use relations and until nowadays, this legislation has undergone a huge number of changes, both conceptual and less important.  It was especially feverish in recent years.  Amendments adopted in December 2014 have perceptibly changed the situation and for the first time over the past 15 years there appeared a trend towards liberalization of legislation regulating the country's pivotal industry.

At the moment, Kazakhstan is considering the possibility to adopt the Subsoil and Subsoil Use Code (hereinafter, the Code).  The Draft Code Concept has been prepared involving experts from the KazEnergy Association, Kazakhstan Petroleum Lawyers' Association (KPLA), Association of Mining and Mining-and-Metallurgical Enterprises (AMME) and employees of the profile ministries.  As of today, the Concept of June 2015 presented by the RK Ministry of Investment and Development is available in the Paragraph Information System.

Based on the Concept analysis, one can expect that the Code, if adopted, will significantly change the legal regime of subsoil use in the country, such changes even likely to come up to investors' expectations.  Hopefully, the process of this legislative act development and adoption will maximally take account of all the amassed experience and embody the idea of establishing a subsoil use legal regime to ensure the balance of investors' and state's interests.

The New Subsoil Code Concept – Will the Investors' Expectations be Met?

Prerequisites for the Code Development and Adoption. To substantiate the need to adopt the Code, the Concept developers put forward a number of strong arguments, including the fact that the current Kazakhstan's subsoil legislation is segmental, contains lots of indistinct provisions covering key issues, while being at the same time extremely overregulated, leaving the subsoil user no opportunity to make prompt and effective decisions regarding its production activities, difficult for investor's apprehension and subject to frequent changes[1]. But most importantly, it does not conform to the phase of economic development the subsoil use is at, because it has been intended to regulate the relations in the process of development of earlier discovered fields/deposits, while now the key objective is to prospect and explore for the new ones.

We would add from ourselves that the subsoil legislation and environmental legislation are so repressive nowadays, that they pose incessant threat of bankruptcy or loss of business to the subsoil user, which, naturally, scares investors off.

General Evaluation of the Concept. The Concept, as of today, contains a whole number of provisions, which could be evaluated as definitely desirable for investors.  But some proposals – for instance, those to replace the exploration contract by license – are quite disputable.

However, in general, one can assert that, if the adopted Code assumes the key Concept's provisions, it would be a qualitatively new legislative act, as compared to the current Subsoil Law.  Ideally, the Code, if adopted, will change the methods of, and approaches to, the state administration of the industry, reducing the instances of applying the administrative-and-command method in its regulation; it will guarantee the stabilization regime for contracts and legislation applicable thereto, including tax stability; ensure open access to geological information for all potential investors; make the conditions of granting the right to exploration and its implementation more attractive; also changing the conditions of granting the right to production and its implementation to become less onerous and risky for investors, etc.

The Concept is also proposed to revise legal regulation over a number of matters and establish new subsoil users' rights not envisaged by the current legislation.  For example, it is proposed to completely change the approaches used in the course of preparation and approval of project documents; change the methodology and system of reserves calculation; change the legal status of national companies, stripping them of their privileges; provide for the possibility to conduct artisanal mining; provide for subsoil user's right to suspend exploration and production operations, for example, in connection with a significant drop in raw material prices to a limit that leads to production unprofitability, etc.  If everything happens as planned, it will bring about almost an "investment heaven."

We did not purport to review and comment in this article on all issues set out in the Concept and have focused on what we deemed most crucial.

When evaluating the content of the Concept, one should not forget that the document has to go through the legislative procedure, from the Concept development to the Code adoption.  The experience shows that adopted regulations may often significantly differ in their content and purport from what was planned.  This is understandable, because a considerable portion of Kazakhstan's budget is formed by subsoil user taxes, including signature bonus, which the Concept developers propose not to collect at all; many state's social objectives are attained at the expense of payments under different subsoil user's financial obligations, for instance, social sphere development charges.  Therefore, it is very likely that on its way to adoption the Code will face strong opposition on the part of governmental agencies, fiscal in the first instance.

A Law or a Code? The issue of whether to adopt specifically a Code, not a new Subsoil Law, has been discussed for quite a time, both from the perspective of legal theory, and from the practical standpoint.  We do not claim that it will be specifically the Code, not the Law, which, if adopted, will magically resolve all the existing problems – this will depend on its content and application practice.  Given the system of normative legal acts (NLAs) formed in Kazakhstan, adoption of the legislative act in the form of a Code will facilitate resolution of a number of issues, and here is why.

1) Codification of the subsoil legislation, if done with appropriate quality, will probably resolve the issue of contradictions between the legal acts of different level, provided that the adopted Code will contain clear-cut provisions regarding the area of its application and delimitation of coverage among the Codes in other branches of law.  Occupying a higher than laws position in the hierarchy of NLAs, the Code will legally prevail over the laws and any normative legal acts hierarchically lower than the laws.

2) Practically all other branches of legislation governing the use of natural resources are codified (Kazakhstan has the Land, Forest and Water Codes).  The recent years' codification rush yielded other Codes as well (for example, Environmental Code and Code on Public Health and Healthcare System).  Relations arising in the subsoil use area are no less important and complicated, so, from this perspective, it would be logical to have them governed by a Code as well.

3)Codification would allow overcoming to some extent the fragmentary nature of normative legal acts regulating relations in the subsoil use area, bringing the most crucial provisions of different legislative and subordinate acts together in one document.  In our view, it will be impossible to get rid of all the "bylaws"; however, this is not necessary, because it is reasonable to have many procedural and methodological matters regulated by subordinate legislation, as this is the case with other areas of legislation where Codes are adopted.

4) According to the Concept developers, adoption of the Code will add leverage to ensuring the subsoil legislation stability, because Codes are amended under a more complex procedure via at least two readings and consecutive consideration in different sessions of the RK Parliament.  In our view, this effect will be strengthened, if the rule to amend the Code not more than once a year (by analogy to the Tax Code amendment) is established legislatively.

Principles of subsoil use – an effective instrument or declaration? The Concept developers believe that the principles of subsoil legislation secured in the Subsoil Law need to be adjusted by filling them with the new content and adding new principles, previously unknown to the subsoil legislation.

For instance, it is proposed to introduce the principle of presumption of bona fide use of subsoil and its resources, which should be understood as a presumption that the subsoil user is using subsoil in good faith, until and unless otherwise proven by governmental agencies.

It looks that this principle, though not expressly provided for by the current legislation, is in fact effective.  Probably, given the level of industry overregulation and the great number of obligations and requirements imposed on subsoil users, the effect of this principle is not always traceable in practice, or it is being violated.

It is proposed to replace the existing principle of "transparency of subsoil use operations" by the principle of "transparency of governmental agencies activities and accessibility of information."  This principle implies the obligation of governmental agencies to ensure for persons concerned unimpeded access, including via relevant Internet resources, to information about subsoil use right granting conditions; information about fulfillment of the subsoil use right granting conditions under concluded contracts and issued licenses; decisions of governmental agencies regarding granting, changing and termination of subsoil use right; document based on which the subsoil use rights are arising; geological information that is not confidential and does not refer to state secrets; and reports on subsoil users' fulfillment of contract and license conditions.

It is supposed that introduction of this principle with the above responsibilities of governmental agencies will ensure a much greater degree of subsoil use transparency as compared with the currently effective principle of transparency, which is narrower in its content.

Besides, granting access to geological information will permit investors, including junior companies, which are so welcome on the market today, to make a preliminary investment decision regarding the prospects of investing in Kazakhstan's subsoil use industry based on the analysis of such available information.

It should be mentioned that simply securing in the Code the transparency principle would not resolve the issue of geological information accessibility, and it will be required to accordingly amend other norms regulating this matter, which is also mentioned by the Concept developers.

Changing the methods and approaches in the state administration of subsoil use. The Concept developers propose to exhaustively set out the powers and duties of governmental agencies performing regulation in the subsoil use area, which would maximally eliminate the possibility of the law being applied at the discretion of a governmental official.  The proposal is alluring, but it is not quite clear what mechanisms can help achieve this goal.

It is planned to utilize the so-called method of "index-based regulation" using which the state control in subsoil use area will not have to be focusing on subsoil user's performance or failure to perform certain actions, but will focus on subsoil user's attainment of certain results.

Using this method, the subsoil user will be able to independently decide in which manner exactly to conduct its activities and which of the recognized technologies, techniques and methods to use in order to attain the established indices, without the state's superfluous approvals, consents and instructions.  It is specifically mentioned that all this will be possible subject to complying with environmental statutory requirements and industrial safety rules and ensuring the rational and efficient use of subsoil.

It is expected that application of the proposed method will mitigate the currently existing risk of contract termination for any committed violation, because the state will be controlling only the final result.

Our practice comprises a very demonstrative case, where a subsoil user conducting activities based on a contract for combined exploration and production, having obtained approval of the reserves, production work program and other necessary documents, received, on the date of signing the last documents required to transfer to the stage of production, a competent authority's notice of contract termination in connection with failure to fulfill the financial obligations and the scope of exploration work.  The subsoil user managed to defend the contract with great difficulty, already at the level of the RK Supreme Court.  The competent authority did not take into consideration the argument that additional expenditures and work would be uneconomical, given that the aim of exploration had been successfully achieved without incurring further unjustified costs.

Hopefully, the proposed method of administration, specifically aimed, in our view, at achieving the economic results, will be duly reflected in the Code, and the norms establishing the relevant regulatory requirements will ensure the possibility of its use.

Stabilization of subsoil use conditions is presented as a separate Concept's provision and named as a measure making it possible to restore investors' trust in Kazakhstan.

Obviously, subsoil use is a capital-intensive industry, requiring significant (often huge) and most often long-term investments.  In view of that, it is extremely important for the investor to understand what conditions his activities will be conducted in and whether these conditions will remain stable.

In our opinion, stability in subsoil use can be viewed from the two aspects: a) as minimization of the number of amendments introduced into the basic legislative acts governing relations in the subsoil use area, and b) in the establishment of a guarantee not to apply legislation aggravating subsoil user's position to contracts entered into prior to such legislation enactment.

The Concept suggests that both these aspects should be taken into account when drafting the Code.

We have mentioned above the need to minimize as much as practicable amendments to subsoil legislation by way of adopting specifically the Code, not another subsoil law.

As to the guarantees of stabilization of subsoil legal regime, including tax regime, in respect of particular contracts, this is a very complicated issue causing the fiercest debate over the past ten or more years, therefore, we will dwell on this in more detail.

Originally, Kazakhstan was providing investors with broad guarantees of contract regime stability, including tax regime stabilization guarantee.  The Law on Subsoil and Subsoil Use of 27 January 1996 (its first version) set forth that "Subsoil user shall be guaranteed protection or its rights according to legislation.  Amendments to legislation aggravating Subsoil User's position shall not apply to Licenses and Contracts issued and entered into prior to such amendments" (Article 71).

Currently, the 2010 Subsoil Law sets forth that "amendments to legislation which deteriorate the results of subsoil user's entrepreneurial activities under contracts shall not apply to contracts entered into prior to the introduction of such amendments.  The guarantees established by this Article shall not apply to changes in the Republic of Kazakhstan's legislation in the area of ensuring national security and defense capacity, and in the areas of environmental safety, healthcare, taxation and customs regulation" (Article 30).

That is, the currently established guarantee applies not in case of any aggravation of subsoil user's position, but only in cases of deterioration of the results of subsoil user's entrepreneurial activities.  But even such curtailed guarantee contains exemptions relating to legislative amendments in the field of national security and a number of other areas.

It should be mentioned that the "elastic language" – such as "ensuring national security" or "environmental safety area" – allows covering thereby practically everything and extending over the previously concluded contracts any new regulations jeopardizing the interests of investors, especially, however paradoxical this may be, large investors.

In our view, the most illustrative example are the norms of the current Subsoil Law regarding changes to be made in the terms and conditions of contracts (including those previously concluded) for subsoil use at fields/deposits and subsoil sections of strategic importance upon the competent authority's, i. e., actually the state's, unilateral demand.  In order to substantiate such actions, the legislator is widely using such language as the "RK economic interests" and "threat to national security."

Verbatim, it says as follows: "If subsoil user's actions in the course of subsoil use operations in respect of subsoil sections or deposits of strategic importance lead to a change in the economic interests of the Republic of Kazakhstan that poses threat to the national security, the competent authority may demand to amend and/or add the contract conditions, including previously concluded contract, in order to restore the economic interests of the Republic of Kazakhstan."

But how can one, without violating the contract terms, work program, project documents, etc., carry out subsoil use in such a way as to pose threat to the national security?  And what should specifically be understood as the "RK economic interests" in this context?

If the subsoil user refuses to make the suggested amendments, or the parties cannot come to agreement, the competent authority has the right to terminate the contract.  By the way, in case of the above mysterious situation with a violation of the Republic's economic interests posing threat to its national security, and provided a relevant Government resolution is in place, the competent authority may terminate the contract even without suggesting its amendment, merely by a 2 month prior notice to the subsoil user.

We do not review in this article the issues of environmental and tax legislation, therefore, we do not dwell on the facts of how, on the pretext of protecting environmental safety, subsoil user is imposed threefold property liability for one violation, such draconian penalties requiring no proof of occurrence of actual damage.  This is a subject of a separate article and has been addressed more than once by us and other lawyers.

The result is: legislator's almost complete refusal to guarantee the stability of previously issued licenses and concluded contracts, inclusion into the legislation of provisions fraught with risks to lose all investments and making such provisions cover the previously concluded contracts have undermined investors' trust in Kazakhstan.  Restoration of the trust will largely depend on the state's readiness to once again provide to investors the guarantees of stability (including tax regime stabilization guarantees, especially in respect of production contracts) and ensure this regime preservation.  This will require not only legislative declarations of the contract legal stabilization regime, but also their correct and expanded reflection in the Code.

We are not calling to reject all exemptions from the stabilization regime in subsoil use, but the language used to describe such exemptions must be clear and understandable, expressly delimiting the scope of their application.

Replace the contract by the license – is it really necessary? Since 1999, the right to minerals exploration and production has been arising in Kazakhstan on the basis of a contract entered into between the subsoil user and the competent authority (this general rule having but a few established exceptions). The Concept developers propose to define the license as a ground for the arising of the right to explore for and extract solid minerals, common minerals, therapeutic muds, ground water and geothermal resources, to use underground cavities (man-made and natural) and useful components from state-owned technogenic formations and technogenic mineral formations, and to explore for hydrocarbons at poorly prospected and non-promising subsoil sections.  The key requirements to licensable operations are proposed to be set forth in the Code.

It is proposed to conclude contracts only for the exploration and production of hydrocarbons. The developers, however, do not clarify why the contract should be preserved for hydrocarbons.

In substantiating the appropriateness of introducing the licensing procedure, the Concept authors argument it by a significant reduction of the subsoil use right obtainment period.  Quickly obtaining the desired right is, of course, very good, but it is also possible to lose it quick in this case as well.  Because the license, at least as it is understood by the Kazakh legislation, is a public permitting document, which is issued and revoked by the state on a unilateral basis.

Under the licensing procedure, if the license is understood as an administrative act, not a document of contractual nature, investor's protection is insignificant, primarily because he has no possibility to discuss the license conditions and cannot provide for dispute arbitration, which, given the highly corrupt Kazakh courts, poses additional risks to lose the license (according to the Transparency International expert data, as of 2014, Kazakhstan ranked 126th by the global Corruption Perception Index). Moreover, unlike the contract, the license, being an administrative act (at least in the Kazakh legal environment), cannot be stabilized.

As to the foreign experience referenced by the Concept developers, in some countries work, even if based on a license, does not imply administrative relations between the state and the subsoil user.  For example, Norway has a concession-based system of subsoil use, albeit formally called licensing.  Essentially, the state enters with the subsoil user into a civil law contract, elaborating in detail its terms and conditions and tightly controlling their implementation[2].

If the Concept implies the above type of legal relationships, it is unclear why complicate the situation, create artificial contrived structures and introduce the license as a document of contractual nature where the country is currently regulating the license as a permitting document of public nature, especially given that the general legal apprehension of this matter coincides with that defined by legislation.

Kazakhstan had already attempted introduction of the licensing procedure for granting the subsoil use right (from 1994 to 1999), but licenses were in effect in conjunction with contracts, and it appears that was exactly because license has always been perceived as a permit (in the case under consideration – permit to enter into the contract on the basic terms and conditions defined by the license). The contract was to conform to the license conditions, revocation of the license entailing termination of the contract. This yielded nothing positive, as contract amendments most often required amendment of the license, the licensing and competent authority were not always the same agency, there was a period when licenses were amended only upon a special RK Government Decree, as a result, in practice, subsoil use was constantly conducted in breach of the license conditions, impending its revocation.  Eventually, licenses were abolished and everybody breathed a sigh of relief.

In view of all the above, a transfer from contract to license is likely to become another, most probably unsuccessful, attempt to utilize in Kazakhstan a legal instrument, which is used by other countries in their legal systems and which, in its content, nature and legal regulation, does not conform to the license legal regime under Kazakh law.  The question is: why try to establish a special license regulation in subsoil use, referring to Australia, Norway, Canada, etc., and every time prove that it bears a contractual nature, if the Kazakh legislation has a contract for these purposes?

We understand that a subsoil use contract, given the legal regulation and law application practice we have had over the past years, is not the most flawless instrument too.  However, in our view, legislation should be improved specifically by reinforcing the civil component of the subsoil use contract, not rejecting it in favor of the public document – the license.

As to the contract execution timeframes, which are longer than license issuance timeframes – the license, if all the terms and conditions contained therein will have to be approved, will not be issued in one day or in one month.

We do not exclude the possibility for some operations not requiring large investment and complex industrial production to be implemented based on licenses.  For instance, extraction of common minerals for commercial purposes may be license-based.  However, generally, in our view, given Kazakhstan's current realia, abolition of contract system in transferring to licensing can only be evaluated as a "step back."

How to make exploration and production legal conditions in Kazakhstan more attractive for investors? The Concept developers are right to mention that the exploration and production conditions currently existing in Kazakhstan are investor-hostile, and they offer a number of measures, which, in their opinion, can improve the situation.

Among other things, they are proposing to establish the general rules for conducting exploration and production, some of which are as follows:

· Exploration and production/extraction of any types of minerals to be carried out within the main groups of minerals: hydrocarbons, solid minerals and common minerals.  This rule will exclude uranium, ground water, therapeutic muds and geothermal resources, which will have to be explored for and extracted depending on the specific type of minerals, based on a special license;

· Payment of lease payments at annually increasing rates per one block;

· Unlimited scope of geological prospecting operations;

· No obligations to bear the region's socio-economic development, local personnel training, R&D and experimental design costs and other costs not directly related to exploration operations, in the period of exploration;

· Transfer to production without issuing a new license or entering into a new contract, i. e., conducting exploration and further production on a combined basis;

· No requirements to the scope and limit of production (based on the good field development practice), except for ground water, which will be subject to maximum water intake limit;

· Payment of the region's socio-economic development, local personnel training, R&D and experimental design costs in the period of production within the amounts established by the Code, etc.

It is proposed to provide for certain special conditions for the hydrocarbons exploration and production at poorly prospected and non-promising sections, as well as for solid minerals.

That is, it is proposed to maximally liberalize the subsoil use operation conditions, entitling the subsoil user to independently decide which operations and within what scope to perform, how much to spend on them, what and how much to extract, etc.  In order to ensure such possibility, it is proposed to proceed from the fact that the indices of project documents and work program are just the planned and forecast indices, allowing for significant deviations.

It is hard to say whether such high degree of liberty, again, given Kazakhstan's specific background, will be used for the good or for the bad.  Probably, all this is appropriate for "law-obeying" countries with long years of private business experience and traditions.  It is probably worth recalling that at the first stage of the Kazakh legislation development, there existed a fairly liberal regime of exploration and production, without today's " overregulation," where subject to approval were specifically the minimum work programs based on which the annual work programs were approved, deviating, as a rule, from the contract and license provisions; the project document issues were almost unregulated; control over subsoil use was exercised by local authorized agencies, etc. As a result, work at fields/deposits had not been conducted for years or was conducted within a minimum scope, and subsoil use rights had been repeatedly resold.  Hence, the industry did not show the expected development rates and the state started to "tighten the screws" and never managed to stop in proper time.  Since no one ever cancelled the "negation of negation" law, before going from one extreme to another and granting subsoil users an almost unlimited freedom, it is necessary to account for the past years' experience.

As a conclusion, we would like to specifically dwell on the issue of transfer to, or to be more precise, reinstatement of, the possibility to conduct combined exploration and production.

Before 2010 (adoption of the latest Subsoil Law), Kazakhstan had had such practice and it showed that the economic model of a contract could not be prepared for the period of production until the exploration had been fully completed and the mineral reserves approved, therefore, in any case, by the time of exploration completion and before transferring to the production stage the parties had to have the contract terms and conditions re-approved for the period of production.  Meantime, in case of combined exploration and production, the production contract already legally exists, which protects the investor conducting exploration and creates a guarantee of transition to production.

Under the currently effective regulation, a subsoil user who has discovered and assessed a field based on an exploration contract possesses an exclusive right to production, without tender, on the basis of direct negotiations.  However, the risk that the subsoil user and the competent authority will not reach agreement on the production contract terms and conditions and the contract will not be concluded stays.  Hence, the possibility to obtain the rights to combined exploration and production is much more desirable for the investor.

As to the impossibility to define the economic conditions of production before completion of exploration, these conditions may be determined optionally, by setting provisional indices in case of these of those results of exploration, which is used in the international practice.

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[1] We have been continually looking into the problems of Kazakh subsoil legislation at different stages of its development.  For instance, please see: Chentsova, O. I. New Subsoil Law of the Republic of Kazakhstan: New Regulations and New Issues, Petroleum magazine, 2010, No. 5; Chentsova, O. I., Braynina N. V.  Latest Amendments to the Kazakh Subsoil and Petroleum Legislation,  Nedropolzovanie i Pravo magazine, 2005, No. 2; Bassin Yu., Chentsova O., Hines Jonathan H. Kazakhstan’s Amended Legal Regime for Natural Resource Development: A Critical Analysis of the Key Changes.  Columbia University, The Parker School Journal of East European Law, 1998, Vol. 5, No. 4.

[2] Please see on this: Kokin, V. N. Subsoil Use: Theoretical and Legal Analysis. – M: Nestor Academic Publishers LLC, 2005, pp.131–132.