THE R&D CLAUSE AND FOSTERING TO RESEARCH AND DEVELOPMENT IN THE OIL, GAS AND BIOFUELS SECTOR Elias Ramos de Souza, Analia Francisca Ferreira2, João Henrique Lima do Nascimento3, Marcos de Faria Asevedo4, Fabiana da Silva Dutra5, Alzir Antonio Mahl6

Copyright 2012, Brazilian Petroleum, Gas and Biofuels Institute - IBP
This Technical Paper was prepared for presentation at the Rio Oi & Gas Expo and Conference 2012, held between September, 1720, 2012, in Rio de Janeiro. This Technical Paper was selected for presentation by the Technical Committee of the event according to the information contained in the final paper submitted by the author(s). The organizers are not supposed to translate or correct the submitted papers. The material as it is presented, does not necessarily represent Brazilian Petroleum, Gas and Biofuels Institute’ opinion, or that of its Members or Representatives, nor the ANP’s institutional opinions. Authors consent to the publication of this Technical Paper in the Rio Oil & Gas Expo and Conference 2012 Proceedings.

The nature and impacts of the R&D Clause that is present in contracts signed between the Brazilian National Petroleum Agency – ANP and licensed companies for exploration, development and production of oil and gas is addressed as a key component of the Brazilian System of Innovation for the oil industry. The innovative nature of the underlying public policy is then unveiled. The R&D Clause is unique around the world in the sense it constitutes an obligation rather than a mere fiscal incentive to undertake research and development. Because R&D expenditures can be accounted as costs of production, companies can benefit from special participation and taxes deductions. In the period 1998 - 2011 cumulative financial resources generated by that agreement clause were above US$ 3.5 billion and they might triplicate in the 12 years to come. As at least 50% of the financial resources must be applied in R&D projects carried out inside universities and research institutions it has strengthened the Brazilian competence to develop new technologies for the oil and gas industry.

1. Introduction
Much attention has been paid to the study of Innovation Systems (IS) in the oil and gas sector as Hatakenaka et al. (2006) report in their studies concerning the strategies adopted in the North Sea oil capitals following the oil and gas discoveries in the 1980’s. Indeed the development of the Innovation System (IS) concept (Freeman, 1995; Johnson, Edquist and Lundvall, 2003) is closely related to catching up strategies aimed at promoting economical development of countries, regions or industry sectors. The IS approach can be useful for the analysis of such systems at different levels in different sectors and economies. Initially, such systems have been addressed in a national perspective and were later developed for the study of regional, local and sectoral systems of innovation (EVANGELISTA et al., 2002). Freeman (2002) applies the term even within a continental perspective, including the importance of studying the interactions between sub-systems that comprise a larger system. According to Carlsson et al. (2002) a system is defined as a set of interrelated components working toward a common goal. In this sense, the systems consist of components, relationships and attributes. The components are the

Ph.D, Physicist – National Petroleum, Gas and Biofuels Agency – ANP. On leave of Federal Institute of Bahia – IFBA Economist – National Petroleum, Gas and Biofuels Agency – ANP 3 Chemical Engineer – National Petroleum, Gas and Biofuels Agency – ANP 4 Architect – National Petroleum, Gas and Biofuels Agency – ANP 5 Economist – National Petroleum, Gas and Biofuels Agency – ANP 6 Master, Economist – Federal University of Bahia - UFBA

Rio Oil & Gas Expo and Conference 2012 parts of the operating system and can be represented by actors or organizations, as individuals, companies, universities, research institutes and public agencies. The relationships are the connections between the components. The properties and behavior of each component influence the properties and behavior of the system as a whole. The attributes characterize the system and are, in fact, the properties of components and relations between them. The function of an innovation system is to generate, disseminate and use technology. Innovation systems are seen in this approach as an institutional design par excellence that is associated with the existence of broad institutional support for technological innovation including universities, government funding programs, and corporate labs. They include sectoral innovation systems as a delimited part of a regional, national or international one. In the approaches of Freeman and Lundvall innovation is taken in a broader sense than usual. It is seen as a continuous cumulative process that involves not only radical and incremental innovation, but also the diffusion, absorption and use of innovation. Innovation and learning processes are essential in the development of systems. The literature on innovation systems emphasizes that the technological performance of national economies cannot be explained only by examining the performance of firms. It takes into account other factors and actors that favor the spread and economic exploitation of knowledge, such as the presence of networks, financial institutions, technical agencies, public infrastructure, education and training for specific skills, as well as the presence of appropriate innovation policies (EVANGELISTA et al., 2002). Sectoral IS are confined to specific fields of technology (generic technologies) or manufacturing sectors. Both technological systems and sectoral systems of innovation (Malerba, 2002) belong to this category. However, the significance of a particular sector is not clearly evident and the specification of industry boundaries is particularly difficult when considering sectors that face radical changes in technology. The spatial or sectoral - or both - boundaries of an innovation system depend on the object of study. Different approaches can be valid if applied to suitable purposes or objects studies. The concept of sectoral system of innovation comes from three intellectual and theoretical traditions (Malerba, 2002). The first one is related to change and transformation in sectors and in broader analysis of long term evolution of industries one can find in Schumpeter. The second tradition is concerned with boundaries between sectors. Such boundaries change over time and should include interdependencies and links among related industries and suppliers. The dynamic complementarities between these actors provide force and trigger mechanisms of growth and innovation as introduced in the notion of development blocks by Dahmen (1989). The third tradition, the innovation system approach considers innovation as an interactive process among a wide variety of actors. Accordingly, firms do not innovate in isolation. Rather, in the innovation process firms interact with others firms as well as with non-firms organizations such as universities, research centers, government agencies, and financial institutions. This approach emphasizes collective processes and has put learning as a key determinant of innovation. The notion of sectoral system of innovation complements other concepts such as those of regional, national, international or technological system of innovation. In technological systems the focus is mainly on networks of agents for the generation, diffusion and utilization of technologies. They usually focus on generic technologies and are delimited by a technological field or to a productive sector. The non-excludable nature of knowledge provides an incentive problem when profit-motivated firms are the main driver of technological change and several institutions have been used to solve this incentive problem (Verspagen, 2006). Because of that, sectoral IS are in particular concerned with incentive policies to generate and diffuse technological knowledge as a key attribute. David (1993) distinguishes three general forms of institutions to meet the need of incentive policies that are known as the three P’s: Property rights, Patronage and Procurement. Property rights include patents as their main form and also comprise, among others, copyrights and trademarks. Patents accounts for a legal monopoly for the use of a specific piece of knowledge to be awarded to a firm, person or organization that first develops the knowledge and is willing to apply it in a commercial way. Property rights are a typical kind of incentive to in house R&D made by private companies although other strategies such as trade secrets are also adopted. Patronage refers to a mechanism in which government use tax income to finance the development of new knowledge by means of a publicly financed system of research that is aimed at generating and diffusing new knowledge. Universities and other public or nonprofit research organizations are the main example of such a system. Procurement refers to a situation in which the development of a specific piece of knowledge is the topic of a contractual agreement between the producer of the knowledge and an organization that is particularly interested in the knowledge, and hence is willing to act as a financer and procurer in the contract. Such an arrangement is used, for example, in the defense industry, where a ministry of defense may procure new weapon systems (Verspagen, 2006). In the last decades industry has funded and performed a growing share of R&D mainly in more developed countries, e.g., countries with greatest per capta GDP. Private share of R&D funding in these countries are typically of the order of two thirds of the total R&D investments. However the knowledge that results from R&D is often intangible and may benefit its users without fully compensating its producers. In such cases private incentives for R&D are diminished resulting in levels of R&D that may not maximize potential economy wide or social benefits. Because of that policy tools that stimulate industrial R&D have gained increased importance owing to the role of R&D in economic 2

Rio Oil & Gas Expo and Conference 2012 growth. Fiscal policy tools include government direct funding, such as grants or contracts, and indirect incentives, such as taxes credits or allowances (Moris, 2005). Tax credits are usually subject to specific rules that establish in which conditions firms could benefit from tax deductions as they perform R&D. Industrial R&D departments have been introduced by firms from the 1870’s following caching up national strategies (Freeman, 1995). From that period on some industry sectors, mainly in Germany and in the United States, realized that it could be profitable to put the business of research for new products and processes on a regular, systematic and professional basis. However the need of specific institutions aimed at consolidating national systems of innovation lead to public policies including intellectual property rights, tax credits, and grants among others. Brazil has a well established set of institutions concerned with incentives to research and development. Intellectual Properties Rights are regulated by the Industrial Property Law (Brazil, 1996). The Innovation Law (Brazil, 2004) sets government fostering to innovation in industry and service companies and to cooperation between those companies and research institutions. It was in this Innovation Law that the possibility of direct government funding of R&D in private companies via grants was first established. It also establishes additional rules dealing with intellectual property rights arising from government-funded research. Among other things, it gives universities and research institutions intellectual property control of their inventions. Also it allows to inventors a share of the earnings that its research institution has with the transfer of the patented knowledge. Indirect funding through tax credits is also legally established (Brazil, 2005) and allows firms to benefit of tax deductions to carry out research and development. A general view of the Brazilian funding and incentive programs is given by the National Association of Research and Development from Innovative Enterprises – ANPEI (www.anpei.gov.br). Besides general institutions concerning incentives for R&D the Brazilian Innovation System also comprises institutions aimed at fostering technology development in specific sectors. Because the discoveries of large oil and gas reserves in the pre-salt put Brazil in a more favorable scenario to boost economical and social development, specific incentives for R&D in the oil and gas industry are addressed here as a key component of its Innovation System. Among other institutions, the R&D Clause, a contract clause in the contracts for exploration and production of oil and gas plays an important role as an innovative public policy around the world. In order to have a better understand of this public policy, this work aims to: (1) analyze and discuss the nature of the funds that have been made available for R&D as a result of this agreement clause, (2) evaluate the results obtained by this model of funding since it was established in 1998, and (3) provide prospective studies on the rules for potential investments in the years to come. The paper is organized as follows. Section 2 is concerned with methodological issues. The R&D Clause statement and nature along with some results and prospects are presented in Section 3. In Section 4 we analyze and discuss the Brazilian policy for the R&D funding in comparison with other countries related policies. Finally, some conclusions are highlighted in Section 5.

2. Method
R&D incentives and funding in the Brazilian System of Innovation are described and analyzed as they appear in the legislation and in the related regulatory institutions. Laws and rules are available over the internet. The Brazilian Presidency of Republic makes available the legislation for patenting, innovation fostering, R&D fiscal incentives and for the oil and gas industry. Concerning specificities of the oil and gas sector, the Brazilian National Petroleum Agency – ANP is the source for rules and agreements concerning the exploration, development and production of oil and gas and the regulatory instruments on tax payment and deductions. Data concerning the financial resources generated from the R&D Clause and prospects for resources to be generated in the next years are also obtained from publications issued by ANP and obtained at the Agency web page (www.anp.gov.br). Comparisons of incentive institutions in the Brazilian oil and gas sector with those of other countries are made possible with the analysis of regulatory institutions from abroad.

3. The R&D Agreement Clause
Besides general institutions concerning incentives for R&D, the Brazilian Innovation System has specific legislation and regulatory institutions for the oil and gas sector. It is settled in the Petroleum Law (Brazil, 1997) that 25% of the portion of royalty value exceeding 5% of production shall be distributed to the Ministry of Science and Technology for the financing of programs supporting scientific research and technology development applied to the petroleum, natural gas and biofuels industries (Brazil, 1997; Brazil, 2005a). It results that a share of about 12.5% of the royalties are distributed to the National Fund for the Scientific and Technological Development – FNDCT to fund R&D in the oil and gas sector and in others transversal related research programs. As reported by FINEP – the Brazilian Agency for Innovation – in 2010 the royalties distributed to the FNDCT amounted to about R$ 1 billion (approximately 3

Rio Oil & Gas Expo and Conference 2012 US$ 550 million). However the share of these royalties directed to finance projects in the oil and gas sector was slightly above R$ 120 million (approximately US$ 66 million). However, following the pre-salt discoveries a new legal framework was introduced mainly through a sharing contract system (Brazil, 2010) for exploration and production of oil and gas in the pre-salt and strategic areas. In the this new framework there is no more portion of royalty nor special participation generated from pre-sal areas distributed directly to the Ministry of Science and Technology. Instead these financial resources will be distributed to a Social Fund created to boost the social and regional development through programs and projects devoted to overcoming poverty and develop education, culture, sports, public health, science and technology, environment issues and mitigation and adaptation to climate changes (Brazil, 2010). Petroleum Law (Brazil, 1997) also created the National Petroleum Agency – ANP with the objective, among others, of stimulating the research and the development of new technologies for exploration, production, refining and processing. This objective is later broadened to include the biofuels industry (Brazil, 2005a). As a result, this legal statement reflected in the agreements for oil and gas exploration and production through a contractual obligation concerning investments in research and development. Following the regulatory Brazilian institutions for oil and gas exploration and production, in the concession system established by the Petroleum Law (Brazil, 1997), companies pay up to 10% of the gross revenue as royalties plus, for the oil fields with extraordinary production, up to 40% as special participation – SP. From 1998 on, the Concession Agreements (Brazil, 2008) establish that in case special participation is due for a given oil field the licensee company is obliged to undertake R&D expenditures equivalent to 1% of the gross revenue for that field. At least 50% of such expenses must be done via universities or R&D organizations previously accredited by ANP. The licensee company may direct the remaining funds to in house R&D projects or even to projects developed in collaboration with supplier companies. Further the R&D Clause was introduced in the Onerous Cession Agreement that was signed with Petrobras in order to capitalize the Brazilian company. However this contract establishes the obligation of investments correspondent to 0.5% of the gross revenue that must be fully applied in universities or research institutions. Also the R&D Clause is expected to be in the new Sharing Agreements to be signed up for the new pre-salt areas. It is worth to note that in addition to the R&D Clause statements it is established in the ANP Ordinance 10/1999 (Brazil, 1999) that the companies can include the 1% invested in R&D as costs of production before calculating the special participation and other federal taxes. As a result the real expenditures with R&D accomplished by companies are less than the apparent expenditures for a share of those financial resources are recovered as the deduction of both special participation and taxes. This mechanism of tax deduction is illustrated in the Table 1 for a hypothetical in which the gross revenue is US$ 100,000.00 and the royalty rate is 10%. When due, the special participation rate is greater than 0% and less or equal to 40% and we consider it is 20%. In such a case, the 1% of the gross revenue obligation for R&D is US$ 100.00 and the oil company will readily benefit of US$ 20.00, that is, 20% of the R&D expenditure, as SP deduction. The company can also benefit from some taxes deductions such as deduction on Corporate income tax, IRPJ, and on Social contribution tax on profits, CSLL. Taking all of these reductions together, for an apparent R&D expenditure of US$ 100.00, the real expenditure of the oil company is US$ 52,80. The remaining financial resources, that is, US$ 47,20, come from government contribution through special participation and tax deductions. Some other possible tax deductions resulting from R&D expenditures such as PIS and COFINS as well as incentives given by Law 11.196 (Brazil, 2005b) are not considered here. Table 1. Shares of company and government R&D expenditures in a hypothetical oil field with gross revenue of US$ 100,000.00 and special participation rate of 20% B. With R&D C. Without R&D Clause (US$) Clause (US$) 100,000.00 100,000.00 Gross revenue (1,000.00) (1,000.00) (10% of royalties) 9,000.00 9,000.00 Intermediate income (100.00) (0,00) (Costs of production)* 8,900.00 9,000.00 SP** basis of calculus (1,780.00) (1,800.00) (SP ≈ 20%) 7,120.00 7,200 Profit after SP (2,420.80) (2,448.00) (IRPJ, CSLL ≈ 34%)*** Net Profit 4,699.20 4,752.00 *For simplicity, we consider here just R&D costs as costs of production. **Special participation ***Corporate income tax (IRPJ) and Social contribution tax on profits (CSLL). A. Income / (Expense) B – C (US$) 0 0 0 (100.00) (100.00) 20.00 (80.00) 27.20 (52,80)

Special participation and taxes deductions for different SP rates following R&D obligation are shown in Fig. 1. The share of SP deduction equals its rate. Increasing SP rate leads to a decrease in taxes deductions. Effective SP rates 4

Rio Oil & Gas Expo and Conference 2012 due by all companies, from the 2nd quarter of 2011 to the 1st quarter of 2012, are shown in Table 2. Although the SP rate can lie between zero and 40%, in the 1st semester of 2012, it ranged effectively from 0,28% to 30,66%. Figure 1. Special participation and taxes deduction for different SP rates. 70 60 Deductions (%) 50 40 30 20 10 0 5 5% 32 31 29 27 26 24 22 20

10 10%

15 15%

20 20%

25 25%







Special Participation Rate Special Participation Taxes (IRPJ and CSLL)

Table 2. Effective special participation rate, by oil and gas field, from the 2nd quarter of 2011 to the 1st quarter of 2012.

Special participation rate  Field  Marlim Sul   Roncador   Marlim   Jubarte   Marlim Leste   Barracuda   Albacora   Leste do Urucu   Albacora Leste   Cachalote   Rio Urucu   Carmópolis   Canto do Amaro   Caratinga   Lula   Manati   Pampo   Espadarte   Frade  
Source: ANP 5

2  quarter  2011 


3rd quarter  2011 

4th quarter  2011 

1st quarter  2012 

28.00% 30.11% 27.23% 15.07% 22.13% 15.07% 8.65% 6.42% 4.48% 3.52% 6.42% 5.27% 4.49% 4.95% 0.00% 0.00% 0.00% 0.00% 0.16%

27.72% 29.86% 23.81% 17.05% 20.13% 17.59% 9.35% 7.03% 4.58% 3.30% 6.45% 5.37% 4.61% 4.73% 0.00% 1.73% 0.00% 0.00% 3.91%

29.04%  29.57%  25.93%  22.07%  19.15%  17.15%  10.07%  6.94%  5.12%  2.84%  6.51%  5.32%  4.59%  4.29%  2.42%  2.57%  1.45%  0.00%  3.05% 

30.66% 28.73% 25.61% 22.80% 17.62% 17.53% 9.37% 6.95% 6.60% 6.09% 6.07% 5.32% 4.46% 4.33% 3.64% 3.33% 1.62% 0.40% 0.28%

Rio Oil & Gas Expo and Conference 2012 The yearly financial resources generated from the R&D Clause (Chambriard, 2012) evolved from US$ 1 million in 1998 to US$ 537 in 2011. The accumulated resources in this period amounted to approximately US$ 3.5 billion. Between 2009 and 2011 above 100 research laboratories were opened in Brazilian universities and research institutions. The ANP forecasts indicate that cumulative R&D investments from 2012 to 2020 will be close to US$ 9 billion. These prospects also show that from 2017 on the yearly resources will reach above US$ 1.0 billion. In the last 14 years 98,6% of the funds originated from the contracts signed up with Petrobras while the remaining 1.4% were generated through 11 others companies. The prospects for the next 12 years show a new scenario in which Petrobras will be responsible for 75% of the resources while 25% of such funds will be shared by 17 others oil companies.

4. Analysis and Discussion
Research and development (R&D) funding in the oil and gas sector across the world are usually characterized by the prevalence of major business investments combined with small government investments. According to ThuriauxAlemán et al. (2010), investments made by large International (IOC) or National (NOC) oil companies in 2009 ranged from US$ 1,500 million to US$ 300 million. The data were reported in a survey where PetroChina, Shell, ExxonMobil, Total, Petrobras, Chevron, BP and Statoil appear in decreasing order of investments. Business investments also have substantial resources from companies that supply goods and services to the oil and gas chain. In this case, investments were made by Schlumberger, Baker Hughes and Halliburton in 2009 lied between US$ 800 million and US$ 300 million. Concerning IOC, in the period of 2003 to 2009, Chevron had a medium 18% R&D investments growth followed by BP (17%), Shell (12%), ExxonMobil (9%) and Total (4%). For NOC, in the same period, PetroChina, Petrobras, and Statoil investments growth was, respectively, of 31%, 23% and 11%. In contrast to high business investments, public funding of R&D has generally been much smaller. In 2007, according to a report of the National Petroleum Council of the United States, the U.S. government investments for R&D projects in the oil and gas sector were estimated at only US$ 60 million (United States, 2007). In Brazil, investments in R&D in the oil and natural gas sector also have allocations of corporate and government resources. On the business side, it can be highlighted the investments made by Petrobras, particularly from the creation of Cenpes, the Petrobras Research Center, in 1968. On the other hand, the Brazilian government has allocated funds to research institutions to develop R&D in the oil and gas through the CT-Petro sectoral fund, whose funds originate from royalties paid by companies that produce oil and natural gas. These public funds amounted to approximately US$ 66 million in 2010. Along with general incentives and funding policies and strategies, the oil and gas sector may benefit of specific regulatory institutions and programs designed to boost sectoral technological development. Oil and gas production has experienced a transition from easy to hard recoveries as it happens in Brazilian pre-salt basins and in the Arctic ocean. In the years to come value creation will be more technologically demanding and knowledge intensive than is the case today. Competitive strategies have led to higher company investments in R&D. Also specific public policies have been designed in order to take advantage of new discoveries or to improve oil and gas recoveries. In Brazil an innovative public policy for fostering technology development was introduced via the R&D agreement clause in the concession contracts for exploration and production of oil and natural gas. Besides being an obligation for the licensed oil companies, the R&D Clause has raised large amounts of financial resource and could serve as a potential tool to take the country to a leading position in this industrial sector. The R&D Clause is, to our knowledge unique across the world. In the North Sea, the Stavanger region on the southwest coast of Norway and the Aberdeen region in northeast Scotland developed into oil capitals in strikingly similar circumstances from the discoveries of large oil reserves in the 1980’s. Yet the development of local technological and industrial capabilities followed different paths in the two locations without leading to different levels of international competitiveness. Hatakenaka et al. (2006) suggest that although Stavanger and Aberdeen are characterized by very different local innovation systems, outcomes have been similar along significant dimensions of industry performance. In Norway, the OG21 – oil and gas in the 21st.century – was established on the initiative of the government in 2001. It is organized in a board, whose composition is defined by the Ministry of Petroleum and Energy, and a secretariat. Government programs funded by the Research Council of Norway are intended to contribute to attaining the goals identified in the OG21 strategy. Government sponsored petroleum research has an emphasis on environmental issues (Norway, 2010). Concerning R&D funding, a strong public policy managed by the Norwegian Petroleum Directorate – NPD encourages the licensed companies to invest in R&D. But differently from the Brazilian R&D investments obligation, the Norwegian government established an incentive policy. It is up to the companies to decide whether they will invest in R&D or not. Yet the government income in the Norway oil and gas industry equals 78%. Moreover, although the R&D investment is an option the company can benefit from tax incentives only in case its R&D project is previously 6

Rio Oil & Gas Expo and Conference 2012 approved by the NPD as long as it fits the government guidelines and strategies concerning technology development in the Norwegian Continental Shelf. In Canada section 45 of the legislation for offshore exploration and production states that expenditures should be made for research and development to be carried out in the province of Newfoundland and Labrador as well as for education and training also provided in that province. It seems to be closer to the Brazilian model in the sense licensed companies must to apply for R&D and Education and training proposals in the phases of exploration and production. Here tax deduction is also subject to a previous approval of the R&D or Education and Training project. As in Norway, projects are analyzed and approved by the Newfoundland and Labrador Offshore Petroleum Board as they fit guidelines and strategies settled by the regulatory body. The Brazilian rules for investments in R&D following the agreement levy are settled by ANP (BRAZIL, 2005). Differently from Norway and R&D projects are not previously approved by the regulatory body unless they comprise laboratorial infrastructure or human resources education or training. The licensed companies decide about the projects A debate on this matter was raised in the occasion in which the contract for the 11th. bid round was subject to a public hearing. But it was not concluded.

5. Conclusions
The R&D agreement clause was analyzed as a key component of the Brazilian System of Innovation (SI) for the oil and gas industry. The System and Innovation approach seems to be a powerful tool for studying the Brazilian oil and gas industry development for two main reasons. First the historical development of the concept of System of Innovation has been associated to caching up strategies for the development of countries, regions and sectors. Also, this approach emphasizes collective processes and has put learning as a key determinant of innovation. A broader study on the SI perspective could meet fundamental challenges such as taking the country to a leading position following the presalt discoveries through a catching up strategy along with local content development focusing on learning and domestic capacity creation. In this work the uniqueness of the research funding based on the R&D Clause is unveiled as an innovative public policy. The financial resources raised are much more significant than public funds applied in other countries with a leading position in the oil and gas industry. However, neither guidelines for the application of the resources nor previous approval of projects are considered. The innovativeness of fund raising should be closely connected to a more coordinated process headed by the regulatory body.

6. Bibliography
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