Public Finance Monitoring Center Managing the national oil fund in Azerbaijan: asset management and transparency Kenan Aslanli (Senior economist, Public Finance Monitoring Center) kenan@pfmc.az; kenan.aslanli@yahoo.com Baku, Azerbaijan 31 October 2012

Structure SOFAZ’s history, mission and general governance SOFAZ’s asset management process SOFAZ’s revenue management and state budget SOFAZ’s durability in global financial turmoil Accession to EITI and the role of civil society International principles and indices Main conclusions and findings

SOFAZ’s history, mission and general governance The State Oil Fund of the Republic of Azerbaijan (SOFAZ) was established in accordance with the decree of the President of the Republic of Azerbaijan dated December 29, 1999 "On Establishment of the State Oil Fund of the Republic of Azerbaijan“. Mission of the SOFAZ is to ensure collection and effective management of foreign currency and other assets that are generated from the implementation of agreements signed in the field of oil and gas exploration, and development, as well as from the SOFAZ's own activities, in the interest of citizens and future generations. SOFAZ's activities in the field of assets accumulation and spending are overseen by a Supervisory Board (7 members), but daily management is vested with the Executive Director (board members and executive director appointed by and accountable to the President).

SOFAZ’s asset management process (1) The Fund’s assets form on the account of the following sources: revenues generated from implementing agreements on exploration, development and production sharing for oil and gas fields; as well as other agreements on oil and gas exploration, development and transportation entered into between the State Oil Company of the Republic of Azerbaijan (SOCAR) and investors; net revenues from the sale of hydrocarbons falling on the share of Azerbaijan; oil and gas agreements signature or performance bonuses paid by investors to the SOCAR; acreage payments due to the SOCAR from investors for the use of contract area in connection with oil and gas exploration and development; dividends and profit participation revenues falling on the share of Azerbaijan in connection with oil and gas agreements implementation; revenues generated from oil and gas passing over the territory of Azerbaijan by means of the Baku-Supsa, Baku-Tbilisi-Ceyhan and Baku-Tbilisi-Erzerum export pipelines; revenues generated from the transfer of assets from investors to the SOCAR within the framework of oil and gas agreements; revenues generated from the placement, management, sale or other utilization of the Fund's assets and revenues from asset revaluation and other related revenues; grant and other free aid.

SOFAZ’s asset management process (2) The purpose of management of the SOFAZ foreign currency assets is to hold foreign currency assets securely and to generate revenues by effective management. The Fund is an extra-budgetary institution. Outside the country, the current accounts of the SOFAZ open with banks rated by reputable international rating agencies such as Standard & Poor's, Moody's and Fitch with a long-term credit rating not lower than: "AA-" - as defined by Standard & Poor's, Fitch or "Aa3" - as defined by Moody's. The Fund's counterparties at international financial markets are institutions with long term credit ratings not less than BBB (by Standard and Poor's), BBB (by Fitch) or  Baa (by Moody's). The Fund's assets under management are placed in investment grade rated banks and instruments.

Funding and withdrawals SOFAZ budget – part of consolidated budget Revenues Asset management revenues Expenditure Operational Expenditures Directly financed strategic projects Transfers to the State Budget SOFAZ’s investment portfolio USD 32.36bn (as of 31.03.2012) (35% saving – 2011) Surplus Oil Receipts Includes: Revenues from sales of oil and gas Bonus payments Royalties (acreage fees) Transit fees

SOFAZ’s asset management process (3) The maximum weight of one financial institution or one investment in the investment portfolio of the Fund is set at 15 per cent of the total amount of the investment portfolio. 50 per cent of the Fund’s total investment portfolio is to be invested in assets denominated in US Dollars, 40 per cent in assets denominated in Euro, 5 per cent in assets denominated in British Pounds. Up to 60 per cent of the Fund’s investment portfolio can be managed by external managers. The assets given to an individual external manager cannot exceed 15 per cent of the total investment portfolio. Geographically the assets of the SOFAZ are distributed as follows: 73.66 per cent are placed in Europe, 10.82 per cent in North America, 8.04 per cent in international financial institutions, while 4.31 per cent are invested Asia and others. 1 October 2010: SOFAZ’s assets are amounting to a total $21,720.8 billion.

SOFAZ’s transfers to state budget (1USD = 0.8 AZN) Years SOFAZ’s transfers to state budget (million AZN) Growth dynamics Share in state budget Share in SOFAZ’s expenditures 2003 100 -- 8.2% 41% 2004 130 30.0% 8.6% 77% 2005 150 15.4% 7.2% 70% 2006 585 290.0% 15.6% 59.6% 2007 0.0% 9.7% 55.1% 2008 1100 88.0% 35.3% 88.5% 2009 4915 346.8% 40.4% 92.8% 2010 5915 20.3% 51.4% 90.5% 2011 6480 9.6% 53.7% 94.9%

SOFAZ’s projects financing (from creation to midterm period of 2010) Financing of the participation of Azerbaijan in “Heydar Aliyev BTC Main Export Pipeline Project” (the project's financing closed in 2006) – 372.5 million $ Settlement of the problems of refugees and internally displaced persons – 866.25 million $ Construction of the “Oguz-Qabala-Baku” water supply system – 825 million $  Reconstruction of the “Samur-Absheron” irrigation system – 593 million $  Transfers to the state budget – 17.4 billion $ Formation of the statutory capital of the State Investment Company (implemented in 2006) – 112.5 million $ Financing "Baku-Tbilisi-Kars” railway – 63.75 million $ Financing "The state program on the education of Azerbaijan youth abroad in the years 2007-2015" – 17.5 miilion $ Repayment of SOCAR’s share in the project on joint exploration and development of Azeri, Chirag and Guneshli oilfields – 109.5 million $

SOFAZ’s durability in global financial turmoil The global financial crisis affected the activities of SOFAZ regarding its reduced income. Profitability of SOFAZ’s assets fell down to the 3.79 % annually in 2009. The yield from SOFAZ funds managed by foreigners aside from the World Bank treasury was close to zero in 2009. The volatility of the Dollar and the Euro since early 2010 has affected the amount of SOFAZ’s assets.

Moving to new investment strategy Rationale Higher level of return is necessary to ensure the realization of SOFAZ`s mission Grounds The long-term investment horizon of SOFAZ enables us to invest in riskier asset classes to benefit from more diversification and higher returns Implementation New asset classes New currencies (e.g. Turkish lira and Russian ruble)

Accession to EITI and the role of civil society Azerbaijan has already joined the Extractive Industry Transparency Initiative (EITI) in 2004 and is actively working under this framework. Recent assessments have revealed that SOFAZ’s reporting is relatively consistent with all principles of EITI – therefore country became the first full EITI member. EITI is one of the few platforms where active interaction between government, companies and NGOs has concrete positive results.

International principles and indices Linaburg-Maduell Transparency Index

Revenue Watch Index 2010

Open Budget Index 2010

Linkage between transparency and national income

Main conclusions and findings Transfers from SOFAZ to the state budget aren't limited by government, but it should not exceed 20-30 % of the total assets. SOFAZ invests the assets mostly to low-profit and guaranteed bonds in order to avoid open market risks. The Fund actively joined the EITI transparency process which is important for long-term institutional building. It would make a sense if the SOFAZ was subordinated to the Parliament as collegial body instead of the President. SOFAZ’s activities should be regulated by law instead of regulatory acts. The government doesn’t create adequate opportunity for civil society organizations to be elected to SOFAZ’s Board. There is fragile linkage between SOFAZ’s asset management policy with general fiscal and macroeconomic policy.

Many thanks for attention..! E-mail: kenan@pfmc.az