Oil and Gas Revenue Management in Azerbaijan

Full text

Oil and Gas Revenue Management
in Azerbaijan
Policy Paper on Revenue Management in Azerbaijan
November 2013
Authors: Gubad Ibadoglu
Kamil Alasgarov
Galib Bayramov
Economic Research Center
Az1052, Baki, Azerbbaijan, A.Rajabli str. 5 A, apt. 82
Tel.: (99412) 465-18-41, (99412) 465-18-47, (99412) 465-60-19
E-mail: office@erc.az , web: www.erc.az

Acknowledgment
This policy paper was made possible by the financial and methodical support of the Revenue
      
           

The contents of the report are the sole responsibility of the Economic Research Center and do not
necessarily reflect the views of RWI.
The Economic Research Center (ERC) wishes to gratefully acknowledge the valuable input of
representatives from governmental and non-governmental institutions, including Tural Karimli
and Nushaba Aliyeva, the fellows of Summer Internship Program of ERC who contributed to the
development of this report. Special thanks to Andrew Bauer-Gador, economic analyst of RWI,
for providing his ongoing and remarkable recommendations on realization of this policy paper.

CURRENCY EQUIVALENTS
(as of 01 November 2013)
Currency Unit

New Azeri Manat (AZN)
$ 1.00
=
0.7845 AZN
ABBREVIATIONS
ACG
Azeri-Chirag- Guneshli
BTC
Baku-Tbilisi-Ceyhan
EITI
Extractive Industries Transparency Initiative
SOCAR

State Oil Company of Azerbaijan Republic
SOFAZ
SWF

State Oil Fund of the Republic of Azerbaijan
Sovereign Wealth Fund
RROR

Real Rate of Return
RWI

Revenue Watch Institute
ACG

Azari-Chirag-Gunashli
PSA

Production Sharing Agreement
NOTE
(i) In this report, "$" refers to US dollars.

Table of Contents Page
Executive summary 
Introduction
1. 
2. Problem description
a. Sustainability (over spending)
b. Volatility (poor spending)
c. Lack of transparency & accountability
3. .27
a. Rules not followed
b. Lack of rules
4. Policy recommendations
5. 

Executive summary
This policy paper is an assessment of the current situation in management of oil revenues
in Azerbaijan in order to find solutions for improving it. This policy paper is the result of
research conducted by the research team of Economic Research Center with the financial support
of Revenue Watch Institute in 2013. In the paper, analysis was carried out on the
macroeconomic environment, fiscal rules and legal bases for the management of oil revenues in
Azerbaijan, policy of the management of oil revenues was evaluated, assessment was done on
participation of policy makers, especially national oil fund, in the decision making process on the
management of oil revenues, and their influences. In some instances the comparative analysis of
superior and inferior features of oil revenues management was done taking Kazakhstan and
Norway as the reference countries.
The main aim of this policy paper is to assess the current situation of management of
oil revenues in Azerbaijan, unfold its weaknesses and strengths, identify key problems and
prepare alternative policies for solution of these issues.
          
management system; the second part diagnoses the problems; the third part analyzes the
problems created by the inefficiencies in the legislative system; and the fourth part describes four
possible futures depending on the choices taken today.
This paper does not just diagnose the problem; it also offers solutions. It suggests
specific fiscal rules that could be adopted by the Government of Azerbaijan to reduce volatility
and improve the quality of public spending. It provides options for enforcing these fiscal rules.
And it makes recommendations on improving the credibility of fiscal policy through enhanced
transparency and accountability.
The readers of this policy paper will be informed about the outcomes of retrospective
analysis of oil revenues in Azerbaijan as well as various options in management of oil revenues
within the scope of current and perspective opportunities.

Key words: oil, revenue management, State Oil Fund of the Republic of Azerbaijan, volatility,
non-oil deficit, fiscal rules
Introduction
Few countries in the world are as resource-dependent as Azerbaijan. 92,6 percent of total exports
of Azerbaijan is composed of oil and oil products while 73,1 percent of its state budget is made
of oil revenues in 2012. At expected rates of production and given proven reserves, government
oil revenue collection will be 1,5 times more than the revenue that is accumulated till 2013 in
just 11 years if price of oil stays on the same stage as it`s now.
Research by the Revenue Watch Institute (RWI) on how countries have used oil or mineral
wealth to generate robust non-resource sector growth has identified several prerequisites for
economic diversification: relatively open trade and investment policies; investment in education;
political stability; private sector access to financing; government-private sector partnerships to
spur investment; prudent and stable macroeconomic situation; and a stable business environment.
While some of these prerequisites may be self-evident, why are prudent and stable
macroeconomic policy and a stable business environment required? In short, because exchange
rate, financial sector and government spending instability prevents both the government and the
private sector from accurately calculating risk and planning in advance, leading to overspending
on legacy projects and consumer goods in good times  in other words, poor investment
decisions  and painful cuts and under-investment in bad times. Three specific channels linking
oil revenue shocks (prices or production dramatically rising or falling) to ups and downs in
economic growth or output have been identified by econometric studies. First, revenue shocks
cause foreign capital to flow in and out of the country, which in turn causes the exchange rate to
appreciate or depreciate or inflation to increase or decrease. Since businesses that import or
export parts or final products must absorb the high cost of uncertainty and volatility, private
sector development and growth is harmed. Second, shocks cause the financial sector to lend
more or less as bank balance sheets expand and contract, harming private sector access to credit,
a necessity for private sector growth. Third, shocks cause the government to spend more or less

which affects the broader economy. These three channels combine to contribute to growth
volatility. In the long-run the result is lower growth and poor investment decisions.
This paper will present evidence that oil prices and production (hence revenues) are highly
volatile, which makes Azerbaijan particularly susceptible to shocks. It is therefore absolutely
crucial for Azerbaijan to control government budget and macroeconomic volatility if it is to
effectively diversify its economy. Furthermore, given the expected drastic decline in oil
revenues, macroeconomic policy must become more prudent. This means committing to a
credible long-term fiscal policy and prudently managing petroleum revenues.
             
talking about effective, transparent and accountable revenue management. For example, saving
and spending decisions should be governed by long-term credible and appropriate fiscal rules.
According to IMF and academic studies, fiscal rules can help contain political pressures to spend
surplus revenues in good times by keeping them out of reach of the political process. They can
also help maintain financial sector credibility when running budget deficits during downturns.
Thus, if the country has a sovereign wealth fund, its objectives should be clear, it should have
rules for which revenues must be deposited and how much can be withdrawn in any given year,
investment risk limits should be clear and domestic investments by the fund should be prohibited
in order to prevent bypassing parliamentary oversight. Management structures and
responsibilities should also be clear, managers and staff should be held to high ethical and
conflict of interest standards and there should be penalties for misconduct. Finally, there should
be public disclosure of fund activities, independent audits and formalized oversight to ensure that
the government is complying with the rules. Similar standards should apply to state-owned
      
its people  whether they thrive or suffer once oil is depleted  is dependent on whether these
rules are adopted and enforced.

I. Azerbaijan‟s Revenue Management System
The history of oil production of Azerbaijan dates back to ancient centuries. However, it is worth
to mention that the production of oil with mechanical methods launched at the end of 19th
century. So, Azerbaijan took the first place in the production and processing of oil in 1899 and
accounted for 50% of the global oil production. At the beginning of last century the oil sector of
Azerbaijan experienced the first boom of oil revenues. The oil production has had increased in
Azerbaijan during Soviet regime. In addition, Azerbaijan accounted for 75% of oil produced in
the Soviet Union during the Second World War.
After declaration of its independence Azerbaijan was able to implement oil production jointly
with foreign companies. In 1994, September 12 Azerbaijan took first step in this direction and
thus signed Production Sharing Agreement (PSA) with renowned world companies for joint
exploitation of Azari-Chirag-Gunashli (ACG) - the biggest oil well in the country. According to
PSA agreement, the first production of oil had occurred in 2006.
In November 1997, Azerbaijan began producing oil under the agreement on the Joint
Development and Production Sharing for the Azeri and Chirag fields and the deep water portion
of the Gunashli field in the Azerbaijan sector of the Caspian sea1. On the following figures oil
and gas production from 2000 till 2012 are given:
14 14.9 15.3 15 .4 15.5
22.2
32.3
42.6
44.5
50.4 50.8
45.4
43.4
0
10
20
30
40
50
60
2000 2001 2002 2003 2004 2005 2006 20 07 2008 2009 2010 2011 2012
Oil production, mln. tonnes

Figure1. Oil production 2000-2012, Azerbaijan
As it is shown on the figure1 oil production increased rapidly by 2005 and peak level of oil
production was reached in 2010. In this year, 50,8 million tons of oil were produced. After that
year we observe declining tendency in oil production, and according to the results of 2012, the
oil production has decreased and estimated 43,4 million ton
Figure 2. Gas production 2000-2012, Azerbaijan
According figure 2 after 2004 we observe positive trend at the level of gas production, and the
biggest growth happened in 2007, the level of growth was 86,7 %. However, the highest amount
of gas production was observed in 2012, that was 26,9 billion cubic meter.
According PSA contract profit oil revenues are divided between Azerbaijan and companies,
State Oil Company of Azerbaijan Republic (SOCAR) also take parts as company in this
contract. Calculations on covering expenses (exploitation and capital) and sharing profit oil are
carried out on a quarterly basis. After the volume of profit oil is determined, the financial
indicator that was of importance to the contractor at the end of the previous quarter  Real Rate
of Return (RROR)  is calculated. If the preliminary oil scheme becomes a reality and the
overall transportation expenses are not higher than 3 US dollars per barrel, in this case profit oil
is divided on the basis of the table below, depending on the RROR
1
:
Table 1. Division of the profit oil based on RROR
1
The relevant method of calculation is shown in the contract
5642 5535 5144 5128 4995 5732
9080
16850
22800 23700
26349 25752
26908
0
5000
10000
15000
20000
25000
30000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
gas production, mln. m3

A
z
e
r
b
a
i
j
a
n

s
share
in profit
o
il
Contractor share
in profit
o
il
RROR
<16,75%
30
70
16,75%<=RROR
<22,75%
55
45
22,75%<=
RROR
80
20
Division of the profit oil was calculated accordingly to the first row (30/70) of table1 till the first
quarter of 2008. By the first half part of 2008 the second row (55/45) of the table1 was used for
division of profit oil. As in 2008 oil revenues covered its` expenses, and reached to zero level
the last row of table1 was taken for calculations of division, and also, now this correlation is
used. However according to our analysis correlation has to be 75/25 rather than 80/20 as we
calculated that transportation expenses are higher than 3 US dollars, it is, approximately, 6 US
dollars.
This was soon followed by profit oil collection and sale of this oil, generating billions of manat
for the government. But even before the oil money entered the country, International Monetary
Fund (IMF) and World Bank (WB) were among the first involved in discussions on the efficient
and transparent use of these oil revenues with the Government of Azerbaijan. They suggested
creating a separate non-budgetary fund which would make it easier to monitor the collection and
management of the revenues. Initially, the revenues from oil sales were collected in the accounts
of the National Bank (now Central Bank) and that made the public supervision of the revenues
almost impossible.
In 1999, December 29, the Presidential Decree #240 formalized the establishment of the State
Oil Fund of the Republic of Azerbaijan (SOFAZ). The main objective of the Fund is to ensure
the accumulation and effective management of foreign currency and other assets generated from
the implementation of oil and gas exploration and development agreements as well as from the
Fund's own activities, in the best interest of citizens and future generations of the Republic of
Azerbaijan.
The State Oil Fund in Azerbaijan was established as the legal entity with separate
management structure and not as special account in the central bank. This is one of the
            
and state budget is built only within bounds of summary revenues and expenditures of public
administration sector and pursues a goal of following a single macroeconomic policy. The assets
of the Fund could not be used for lending to state authorities, state and non-state organizations
and as guarantee for the liabilities of any subject.
According to the Statute, a Supervisory Board consisting of the representatives of relevant
government and public organizations is responsible for the general supervision of Fund
activities. The Executive Director, appointed by the President, carries out operational

management of activities. Currently, SOFAZ is headed by the Executive Director, who is
appointed and dismissed by the President of the Republic of Azerbaijan. The Fund's Executive
Director represents the Fund, carries out operational management of the Fund's activities,
appoints and dismisses employees of the Fund in a manner as determined by the legislation,
 
approved by the President of the Republic of Azerbaijan. 
an ann        
Republic of Azerbaijan for approval. Thus, the final decision regarding revenue spending and its
location was given by the president. The observation activity of SOFAZ is of formal character.
The executive director of SOFAZ plays as a representative role.
Fund is an extra-budgetary institution, a legal entity which has a settlement account and other
accounts at banking institutions (all over the world), so the resources are deposited directly into

The source of revenues of Oil Fund is generated by the followings:
 Net revenues generated from the sale of the share of the Republic of Azerbaijan in
hydrocarbons;
 The bonuses paid by investors;
 Acreage payments;
 Dividends;
 Revenues generated from oil and gas transported over the territory of the Republic of
Azerbaijan;
 Revenue management;
 Grants and other inflows.
Data about volume of revenue and assets of State Oil Fund by 2001 to 2012 that was generated
through above mentioned sources can be found on the following table:
Table 2. Revenue and assets of State Oil Fund
Years
Revenue of State Oil Fund
(mln. AZN)
Assets remaining at the
end of year (mln. USD)
2001
248.0
492.0
2002
295.0
692.0
2003
364.0
816.0
2004
317.0
964.0
2005
660.0
1394.0
2006
986.0
1454.0
2007
1 886.0
2475.0

2008
11 865.0
11219.0
2009
8 177.0
14900.0
2010
13 089.0
22767.0
2011
15 628.0
29800.0
2012
13673.7
34129.4
Total
67188,7
SOFAZ has an independent budget. The expenditure items of the Oil Fu  ll
comprise the following:
 Expenditures to finance the projects in compliance with the main directions (program) of the
Oil Fund's assets utilization; The expenditure items of the Oil Fund's budget within the Fund's
asset utilization program shall envisage only financing of the most important nation-wide
projects, construction and reconstruction of strategically significant infrastructure facilities for
the purpose of the socioeconomic progress of the Republic of Azerbaijan.
 The Oil Fund's operational expenditures, including administrative (staffing), involving external
consultants and other expenditures.
Amount of withdrawals those were incurred to expenditure items of budget of State Oil Fund
from 2001 to 2012 is given on the following table:
Table 3. SOFAZ withdrawals January 01, 2001 – 2012
Expenditure items
Amount, mln.
AZN
Financing the participation of the Republic of Azerbaijan in Heydar Aliyev
Baku-Tbilisi-Ceyhan (BTC) Main Export Pipeline Project
297,9
Settlement of the problems of refugees and internally displaced persons
1 157.8
Construction of the Oguz-Qabala-Baku water supply system
779,6
Reconstruction of the Samur-Absheron irrigation system
895.5
Transfers to the state budget
35 085.0
Formation of the statutory capital of the State Investment Company
90,0
Financing "Baku-Tbilisi-Kars railway"
341.5
Financing "The state program on the education of Azerbaijan youth abroad
in the years 2007-2015"
54.8
Repayment of State Oil Company's share in the project on joint exploration
and development of Azeri, Chirag and Guneshli oilfields
87,6
Total
38702,1 AZN/
49254,4 USD

Production sharing agreement signed with the foreign companies for operat-Chirag-
            
implementation for 19 years. As of July 01, 2012, the Government of Azerbaijan earned 60618,4
million manats from this agreement. 56,4% of this amount has already been spent. 30457,5
million manats or 92% out of the spent 33109,3 million manats have come through January 01,
2008 to July 01, 2012 so that this means the spending of average 6768,3 million manats over the
last 4,5 years. According to the pred
budget for 2013-2016 years will comprise of 424379,3 million US dollars or 33367,5 million
manats per the rates of July 25, 2012. So, to the predictions, the average spending of the state oil
fund for the next 4 years will comprise of 8341,8 million manats. As seen, the predicted
spending of the oil fund are expected to be 1573,5 million manats or 23,2% higher than its actual
spending during the last 4,5 years. If both spending for the last 4,5 years and the predicted
spending for the next 4 years are assumed as a basis, it will be clear that the average annual
spending of oil revenues during 8,5 years comprises 7555 million manats. If the Government of
Azerbaijan will not make a change in its policy regarding its spending, then the expected oil
revenues in the amount of 145,3 billion US dollars could have been spent in 15 years based on
the calculated predictions in the rate of one barrel oil in 80 US dollars. Keeping on this policy
serving the balancing of the state budget in the next 15 years will make a serious problem with
the implementation of recommendations made by IMF on reduction of the share of non-oil
budget deficit in non-oil GDP. So, IMF recommended by 2017-2018 years the special weight of
non-oil budget deficit in non-oil GDP should decrease up to 20%. The current policy excludes
the major changes to happen to this direction. On the other hand, such fast spending of oil
revenues will lead to the break of inter-generational equity princ 

Besides, the implementation of spending through the budget of oil fund, which is not subject to
the recommendation by the Chamber of Accounts, and financial auditing, as well as
parliamentary debates will ruin the opportunities of supreme auditing and parliamentary control
and keep the decisions on spending again under monopoly of the executive power. Furthermore,
no representation of civil society organizations at Supervisory Board of the Fund, in case the
article 5.4 of the Regulations of the Oil Fund is not observed, will restrict the opportunities of
civic participation and social control over its management. The Supervisory Board will keep on
acting formally.
So, fast spending of oil revenues in preserved status quo condition will make impossible its fair
distribution among future generations, and meantime leaving aside the Chamber of Accounts,
Parliament and civil society organizations out of the process will lead in one hand to keeping
decisions on spending under monopoly of executive power, and on the other hand to the
increased transparency and no providing social control.
Despite of the Fund annually publishes its financial and audit reports. Apart from that, quarterly
numbers are disclosed in the press. All of those reports can be taken from the official website

easily. Once a year, external auditing is conducted the report of which is again available on the
website. But they are not enough for increasing transparency and accountabilities.
II. Problem description
a. Volatility
One of the biggest concerns in resource-dependent countries is revenue volatility, which
mostly originates from short-to-medium term price volatility of the commodity. As mentioned in
            -

drastically when revenues drop. In countless examples, resource-rich governments have treated
temporary rises in revenue as permanent, spending lavishly on ill-conceived legacy projects like
           
than saved or taken the time to plan public investments that will promote sustainable economic
development and serve the population for years. When oil prices have dropped, cuts have left
roads half-finished or buildings unmaintained. Since spending volatility and poor investment
decisions affect the private sector as well, the long-term effects are low non-oil sector growth
and poor investments even in the private sector.
Governments can adopt fiscal rules to deal with this volatility by reducing everyday
discretion and leading to more consistent and stable spending. A consequence of establishing a
fiscal rule is the creation of a Sovereign Wealth Fund (SWF) like SOFAZ which could
accumulate and release the resources whenever necessary.
Has the Government of Azerbaijan used SOFAZ to achieve the first objective, preserving
macroeconomic stability? To answer this question, we will ask specifically:
 Does the Government of Azerbaijan experience expenditure volatility over the very
short-term?
 Has the Government of Azerbaijan delinked expenditure volatility from revenue volatility
over the medium-to-long term?
 -dependent countries?
In order to understand these issues, it may be worth examining the path that oil revenues take
when they enter government coffers. While the SOCAR retains a share in the profit oil and gas,

the majority of profit oil (75% or 80% depending on the transportation cost) and gas collected
         ted directly into the SOFAZ.
After oil revenue reaches the SOFAZ, the government must divide it between expenditure and
saving, for which there is currently no specific rule or guidance.      -
term strategy on the management of oil and    
revenues reach to the ceiling more than 25 % of its portion is being directed to saving.
Nevertheless, the peak level of proceeds from oil and gas revenues is still controversial topic and
subject to discussion. Despite the fact that Azerbaijan obtained the highest revenues in 2010-
2013, however, the expenses were 78 percent in 2012. Similarly, this indicator is predicted to
reach 116 percent in 2013.
Withdrawals from the Fund are made through annual transfers to the state budget, for which we
have monthly observations, therefore government budget is the key to analyzing the volatility
issue and whether that is affecting (rather distorting) the economy. Of course, one should be
cautious with this, as the Fund has another way of injecting money into the economy via extra-
budgetary spending directly authorized by the President, but this is much smaller compared to
transfers to the budget, therefore we leave it aside and concentrate on the budget instead.
As Figure 3 shows, the quarterly budget revenues and expenditures are very volatile and pro-
cyclical which is mostly due to differences intra-annum. Considering that the sample size
(starting from the 2005 structural change in the economy) is not large for Azerbaijan, we had to
use a parametric method and derive the annual volatility (here meant to be standard deviation, as
in financial theory) from quarterly volatilities, which are 1,33 and 1,46 billion manat and taking
into account inter-temporal covariance  
per annum. From here, annual volatilities for revenue and expenditure parts are the same, but
comparing to the size of the budget itself, that is 25-35% of the budget. So, spending volatility is
high in terms of budget size.
Figure 3 . Quarterly budget volatility
Perhaps more concerning from a public policy point-of-view is the year-to-year variation in
public expenditures. After all, it is year-to-year changes that incentivize poor investment
decisions. As we can see in Figure 4

price growth. When oil prices have risen, government revenue has risen. When oil prices have
declined, government revenue has declined. This is unsurprising given the Azerbaijan
      
correlated with expenditures. There is basically no delinking of revenue from expenditure
streams. This seems to indicate that SOFAZ is not c     

Figure 4: Percentage changes in government revenues, expenditures and oil prices
-dependent countries,
either those considered to follow best practices (in our case, Norway would be the best example)
or those most comparable (Kazakhstan would be the best candidate because of our similar
history and reliance on oil)?
For starters, budget expenditure growth can be graphically compared in those three countries
which show that Azerbaijan has considerably higher budget volatility than Norway and slightly
more volatile budget growth than Kazakhstan (see Figure 3). Over the last decade, the standard
deviation of expenditure growth in Azerbaijan is 26 compared to 16 in Kazakhstan and 2 in
Norway. In some years (e.g. 2009), Azerbaijan had almost no budget growth while in others it
grew by 60 or 77 percent. Norway, on the other hand, has stabilized expenditure growth between
3-9% despite high revenue volatility on par with Azerbaijan.
How has Norway managed to delink expenditures from revenue volatility? The short answer is
that it has implemented a fiscal rule that says that the structural non-oil budget deficit should
equal             
percent per year. This rule essentially limits the expenditure growth rate to the growth in non-oil

revenues plus the interest on oil revenue deposited and invested in the sovereign wealth fund.
While this rule may be inappropriate for Azerbaijan given its public investment needs, it has
successfully mitigated expenditure volatility.
Figure 5. Comparative budget expenditure growth rate (national currencies; data from the
IMF)
While SOFAZ does not seem to be preserving budget stability, is it preserving other types of
macroeconomic stability? The Central Bank of Azerbaijan has fixed the exchange rate, which
ensures exchange rate stability, but is SOFAZ helping to mitigate inflation volatility? Figure 6
seems to indicate that it is in fact not helping to preserve this volatility either. Inflation is more
volatile than either Kazakhstan or Norway.

Figure 6. Average consumer prices in Azerbaijan, Kazakhstan and Norway
What is the consequence of all this volatility on the Azerbaijan economy and public
spending? While more research would need to be done to prove the link between in volatility and
low-growth and poor spending decisions in Azerbaijan specifically, based on the evidence
previously cited from large econometric cross-country studies and well-known anecdotal
evidence showing that spikes in oil revenues lead to spending on large projects with little
developmental value, it may be safe to claim that this volatility has severely hampered economic
growth and contributed to wasteful spending.
b. Sustainability (over spending)
2) Financing major national
projects to support socio-economic progress; and 3) Ensuring intergenerational equality with
             
generations. With regard to objective 2, Table 4 shows that, notwithstanding that these funds
have been appropriated without parliamentary oversight and that spending is generally non-
transparent, the objective has been more or less met. However objective 3  ensuring fair
allocation of oil wealth across generations  has been neglected so far. Priority has been given to
spending resources instead of accumulating or investing them for long-term growth.

Let us examine the figures. $34 129.4 mln. have been accumulated since the establishment of the
fund as of January 01 of 2013. Table 4 gives more detailed information about revenues and
assets of the Fund since 2001. From 2001 to January 01, 2013, Azerbaijan collected over $83,86
billion USD revenue (including management revenues) from oil and gas sales obtained from
PSA. Calculations show that 59.3% of petroleum revenue was spent during this period.
According to Table 4, in some years as much as 99.5% of petroleum revenues were spent. In
                
violation of the principle of saving a minimum o-

Table 4 . The level of spending of oil revenues by years
Years
Revenue of State Oil
Fund
(mln. AZN)
The level of
spending oil revenues
2001
248.0
0,3 %
2002
295.0
32,1%
2003
364.0
99,8%
2004
317.0
90,8%
2005
660.0
99,5%
2006
986.0
99,5%
2007
1 886.0
56,2%
2008
11 865.0
36,2%
2009
8 177.0
64,8%
2010
13 089.0
48,9 %
2011
15 628.0
61,4%
2012
13 721.8
78,4%
Spending a large percentage of oil revenues is not necessarily a bad thing. After all, oil is a finite
resource and, like any asset, it is worth depleting if (and only if) turning it into cash and investing
it leads to higher income in the long-run. The question in Azerbaijan is whether revenue is spent
on projects and in sectors that will lead to higher long-run national income. If not, it may be
worth saving a larger proportion of revenues. After all, if citizens will not benefit from long-
lasting roads, electricity, clean water, access to credit, education and health services, not to
mention a growing non-oil economy that floats all boats, then future generations should at least
benefit from the financial returns of investing oil revenues.
Unfortunately, according to the WB  rs, Azerbaijan invests relatively
poorly. In fact, the Government of Azerbaijan ranks in the 22nd percentile in terms of
government effectiveness. In comparison, Kazakhstan ranks in the 45th percentile and Algeria

ranks in the 34th percentile despite higher per capita income. Poor public investment would
justify higher savings and less public spending.
       that measures public financial
management practices across four stages (project appraisal, selection, implementation and
evaluation) ranked Azerbaijan 43rd out of 71 mainly low and middle-income countries. Among
the neighboring states, Armenia was ranked 8th, Kazakhstan 9th and Turkey24th. Azerbaijan
weak position in comparison with neighboring states indicates serious problems in
       
poor implementation of projects and inadequate assessment of their execution.
While high oil revenue spending is not necessarily a problem, dependency is. It is very difficult
to cut spending once it has risen so far so fast. Also, when oil production starts declining or
global oil prices decline, either the government will be forced to run a budget deficit or draw
more funds out of SOFAZ. These options are unsustainable; they could lead to a debt crisis,
which would lead to high costs and lower standard of living for future generations, or a return to
pre-oil levels of development and poverty. Even now with near record oil prices and with
Azerbaijan near peak production, government debt levels keep rising though they are still
manageable (see Figure 7). Public debt seems to rise with oil revenues. That said, it is hard to say
whether the increase in the debt is due to oil revenues or some independent trend since we only
have a 10 year sample. Further visual analysis is provided in the graph below (outlier is mostly
due to BTC opening).
Figure 7. Comparing oil revenues and public debt in Azerbaijan
Beyond borrowing and drawing money from SOFAZ, a third option would be to raise tax
revenue from the non-oil sector, but to date this has proven difficult since non-oil non-

government growth remains weak and non-oil tax revenue remains steady around 8,6 % of GDP,
much lower than the 30-45% in most developed countries. Table 5 shows that not only has the
government spent more than it has received, but the share of the state budget financed by
petroleum revenues has increased every year since 2007 from 9.7% to 60.5%. The Government
of Azerbaijan is now highly dependent on oil revenues.
Table 5 . Transfers from SOFAZ to the state budget (million AZN)
Years
Transfers from SOFAZ
to the state budget
(million AZN)
Growth rate
Share of the
State Budget
Share in the
expenses of SOFAZ
Budget
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
585
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
9203
55,6%
59,7%
92.6%
2012
9905
7,6 %
60, 5 %
93,7%
2013 (planned)
11.350
14,6 %
59,3%
Dependency is a particularly severe problem when oil revenues begin declining permanently.
      -Chirag-Guneshli and Shahdeniz deposits
will decrease from USD 13.1 billion in 2012 to USD 9.2 billion in 2024 (see Figure 3). Peak
income from the two fields is expected in 2015 (USD 16.1 billion). Using an average price of 80
USD per barrel for Azeri Light Crude, the Azerbaijan government will collect approximately $13
billion USD per year on average over the next 12 years from sales of profit oil from the Azeri-
Chirag-Guneshli field and gas sales from the Shahdeniz deposit. Oil revenues in 2024 will be
about 8 billion USD less than in 2015. Increased gas revenues will not cover the loss of oil
revenues. This means that, barring new large-scale discoveries, the government will be hard
pressed to finance recurrent or capital expenditures unless tax revenue is raised from other
sectors.
SOFAZ calculated forecasted revenues based on 3 scenarios. These calculations were carried out
in 2 directions: oil revenues acquired from ACG and gas revenues from Shahdeniz. The
calculations regarding to estimated oil revenues are presented in Table 6.

Table 6. Government revenue from the profit oil of ACG, years of 2014-2024. In billion
USD (oil price 80, 90 and 100 USD per barrel).
Years
$80
$90
$100
2014
12,1
14,0
15,9
2015
12,0
13,9
15,8
2016
10,3
12,0
13,7
2017
13,0
15,0
17,0
2018
12,9
14,8
16,7
2019
13,1
15,0
17,0
2020
12,4
14,3
16,1
2021
10,9
12,6
14,2
2022
9,5
11,0
12,5
2023
8,2
9,6
10,9
2024
7,6
8,8
9,9
Total
122
141
159,7
Average
11,09
12,81
14,5
This table demonstrates that the minimum amount of oil revenues projected by SOFAZ for 2014-
2024 on the basis of 3 scenarios is 122 billion dollar, whereas the average amount constitutes
141 billion and the maximum amount is 160 billion dollar. In other words, the average annual
amount of forecasted revenues for that period estimated as more than 11 billion dollar and less
than 14,5 billion dollar. Naturally, the level of revenues for this period will be dependent on the
world market prices along with production as well. It is worth to mention that the forecast of
SOCAR, which is the only source in this direction, is optimistic by each 3 scenarios. Although
information inquiries were submitted to alternative sources - BP and SOCAR, it is disappointing
to highlight that they did not desire to publicize their projections with us.
The calculations of SOFAZ based on the same scenario over the gas revenues gained from
Shahdaniz are depicted in Table 7.
Table 7. Government revenue from the profit gas of Shahdeniz deposits, years of 2014-
2024. In billion USD (oil price 80, 90 and 100 USD per barrel).
Years
$80
$90
$100
2014
0.545
0,749
0,831
2015
0,538
0,605
0,672
2016
0,546
0,613
0,680
2017
0,582
0,655
0,728
2018
0,638
0,718
0,798
2019
0,924
1,1
1,2
2020
1,2
1,3
1,4
2021
1,5
1,7
2,2
2022
2,0
2,2
2,4
2023
1,9
2,1
2,3

2024
2,0
2,2
2,4
Total
12, 3
13, 94
15,6
Average
1,12
1,26
1,41
The table clearly describes that the projected minimum total gas revenues estimated 12,3 billion
dollar for 2012-2024, in average it will reach to 13,94 billion dollar and the maximum amount is
15,6 billion USD. This allows us to forecast that the average gas revenues will be fluctuating
between 1,12 and 1,41 billion dollar.
The perspective analysis conducted in this direction leads to 3 significant outcomes:
Firstly, revenues obtained from oil in the future can exceed the incomes received until now.
Obviously, this process mainly depends on price factor.
Secondly, if the forecasted price level holds, then in this case projected gas revenues will
constitute maximum 10 percent of expected oil revenues. In a nutshell, this refutes the
assumptions made over gas revenues will replace the declining oil revenues in the future.
Finally, if the volume of expenditures transferred from SOFAZ to the state budget will continue
to be as in 2013 (in average 14 billion dollar), then expected oil revenues will be depleted in 10-
12 years. It is certain that during this period the increase of expenditures can be prolonged and its
decrease might be shortened.
Let is mainly focus on the latter outcome by taking into account its significance. Currently, it is
possible to find endless arguments in regard to the increasing pace of expenditures. Thus,
Azerbaijan is planning to spend more funds for establishment of sport infrastructure and meet the
demands of Olympia due to hosting 2015 First European Olympic games. Additionally, the
establishment of large-
also noted that the non-oil revenues is eligible to finance only 52 percent of current expenditures
from state budget in 2013 and the transfers from SOFAZ to state budget will be continuing until
the increase of non-oil revenues at least2 times. In this case, the relevance of the management of
the Fund's assets increases. Furthermore, SOFAZ was not able to acquire fundamental revenues
from this source until now and thus, the total amount of revenues gained from management of
assets since the management of oil revenues until now has not exceeded 2,3 billion dollar. This
means annually 2,85 percent or 328 million dollar revenues within 7 years. SOFAZ has realized
cautious investment policy till 2012 and directed its assets mainly towards low-risky and low-
income projects. However, it has gone to significant changes in investment policy since last year.
The new investment policy allowed SOFAZ to forward its 5 percent of assets to property market,
5 percent to gold market as well as the same percentage to the market of developing countries.
Consequently, SOFAZ purchased 20,5 ton gold in 2012 and simultaneously invested to property
markets of the United Kingdom, France, Russia, Luxemburg and Jersey islands. Apart from this,

the Fund allocated 444,19 thousand manat as to the banks of developing countries ( Turkey,
Ziraat Banka,           together with BNP
Paribas and Jefferies Bache banks. The deposits are hold as dollar, euro, fund sterling, Australian
0 percent of the
Fund are deposited as USD dollar, 40 percent Euro, 5 percent fund sterling and the remaining 5
percent as Australian dollar, Russian ruble, Turkish lira and Azerbaijan manat.
According to the information of 2012, SOFAZ has deposited its 24,12 billion dollar financial
assets mainly in the securities of foreign countries ( 45,6 percent), companies ( 28,45 percent)
and international financial institutions ( 23,07 percent).
In generally, it is also important to note that the asset management practices of the Fund clearly
do not exhibit a good track record. Rather, SOFAZ has made a small return on investment (Table
8), so asset management clearly is not an option when it comes to generating alternative revenues
economy.
Table 8. Comparative investment Policy of Oil Fund
Year

Billion. USD
Percentage investment return, %
Azerbaijan
Kazakhstan
Azerbaijan
Kazakhstan
2012
34,2
55,6*
2,2
2,8*
2011
29,8
43,7
0,8
1,4
2010
22,7
31,0
1,0
3,0
2009
14, 9
24,4
3,5
7,3
2008
11,22
27,4
3,8
-2,3
2007
2, 47
21,0
4,5
9,9
2006
1,39
14,1
4,2
8,7
2005
1, 45
8,1
-
3,3
Average percentage investment return,
%
2,85
4,26
Due to this reason, Azerbaijan gains less revenues coming from management of assets in
comparison with Kazakhstan. In other words, the Oil Fund obtained 4,5 % in 2007, 3,8 % in
2008, 3,6 % in 2009, 0,8% and 0,7 % in 2010 and 2011 profits respectively emanating from
management of oil revenues. However, the same indicator estimated 9,9 % in 2007, 2,3 % in
2008, 7,3 % in 2009, 3 % in 2010 and finally 2,4 % in 2011 in Kazakhstan. Given this, the
average percentage rate obtained from management of oil revenues based on above mentioned
years was 4,6 percent - 2 times more than Azerbaijan.

In summary, the government is highly dependent on oil revenues, more oil revenue is spent than
saved despite declining revenues in the near future, and the government invests poorly.
Specifically:
 59.3% of oil revenue was spent from 2001 to January 01, 2013. However in some years,
the government has spent 99.5% of oil revenues.
 The share of the state budget financed by petroleum revenues has increased every year
since 2007 from 9.7% to 60.5% in 2012.
 Oil revenues in 2024 will be about 8 billion USD less than in 2015.
 Even as oil revenues are increasing, are likely at their peak, and are expected to start
declining in 2016, public debt is increasing.
           ex of Public
Investment Efficiency, the Azerbaijan government is an extremely poor public
investor.
 The return on SOFAZ investments is between 0.75-4.5 percent, therefore the interest
does not compensate for significant public spending out of SOFAZ.
 Non-oil growth in Azerbaijan is high at 10%, but driven by government expenditure
rather than private sector investment and, with declining oil revenues in the near
future, is therefore unsustainable.
It is obvious from the evidence that there is overspending (relative to saving) and the current
level of expenditure growth cannot be supported by actual or projected revenues. Considering the
amount of petroleum remaining, slow growth in the non-oil non-government sector, and weak
non-oil revenue generation, the aggressive budgetary expansion in Azerbaijan cannot be
justified. Azerbaijan must learn from the histories of other countries with declining resource
bases, like Nauru and Yemen, that have faced tough public spending choices, debt crises and
conflict. Public finances must be put onto a sustainable path and public investment must
improve.
c. Lack of transparency & accountability
Transparency of management processes and the flow of resource funds  defined as clarity of
roles and responsibilities, public availability of information, and open budget preparation and
execution  can provide a number of tangible benefits to resource-rich countries. First,
transparency aligns public expectations with government objectives, builds public trust and
reduces internal conflict by creating a consensus around the role of extractives and their
revenues. Second, public disclosure requirements can improve the quality of data the government
gathers and maintains, thereby making the jobs of ministries and regulatory agencies easier. This
can improve the efficiency and effectiveness of government policies. Third, according to the
IMF, it can help to highlight potential risks, resulting in an earlier and smoother fiscal policy

response to changing economic conditions and thereby reducing the incidence and severity of
crises.
Finally, transparency can improve public accountability, which is the obligation of public
officials to explain and justify their conduct and make decisions based on a concept of public
service. A well-informed public with the capacity to act can engage in a constructive discussion
around policy formulation and government oversight of revenue management processes.
Through public scrutiny, officials can be deterred from acting unethically and held accountable
for abuses of power for private gain.
Accountability is critical to ensuring the sustainability of revenue management systems in
particular because it encourages adherence to rules and principles of efficient economic
policymaking and effective management o
tenure in power. That said, accountability can be both internal and external. For example, staff of
a sovereign wealth fund can be accountable to their managers such that the managers can verify
their conduct and take action against staff for poor conduct. Alternatively, staff can be
accountable to an external agent, like a public accountability committee or the judiciary.
Lack of transparency and accountability of the whole revenue management system of Azerbaijan
is a major issue of concern. The most important issue is about the management of state budget
public investments that draw on SOFAZ resources. Transparency is an issue both in the
accumulation of oil revenues (1), and spending of oil revenues (2).
Revenue Collection by SOFAZ and SOCAR:      
SOFAZ (1.1.) and SOCAR (1.2.). SOFAZ regularly shares the information on the receipt of oil
revenues to the Fund both as part of the Extractive Industries Transparency Initiative (EITI) and
with the public of its own initiative. SOFAZ also publishes this information annually as part of
EITI country reports. SOFAZ also organizes quarterly press conferences to disseminate
information on oil incomes and expenditures of the Fund to a wider audience and publishes its
            -page, and
official accounts on social media web-pages like twitter and facebook. Letters of inqury sent to
SOFAZ are answered adequately and on time.
  
wealth funds on the Truman Sovereign Wealth Fund Scoreboard that measures SWF governance,
transparency, accountability and behavior. SOFAZ is also the winner of 2007 UN Public Service
Award in the category of "Improving transparency, accountability and responsiveness in the
Public Service".

As regards SOCAR, general information on its income and expenditures are published in its
annual financial reports. SOCAR considers this disclosure as adequately satisfying transparency
requirements. SOCAR usually does not respond to inquiries for any information by civil society
organizations. Those requesting information are usually directed to its web-page, where little
information is available. SOCAR does not regularly hold press conferences to share information
on its financials.
Petroleum Revenue Spending: With regard to transparency on oil revenue spending,
expenditures are made by three separate entities: Some socio-strategic projects are financed
directly by the SOFAZ budget (2.1.) (see: Table 1), SOCAR spends directly on corporate and
social projects (2.2.), and there are state budget expenditures, the main source of which is
SOFAZ (2.3).
2.1. The vast majority of annual withdrawals from SOFAZ is the transfer to the state budget,
which is approved by the President every year. However SOFAZ also financed strategic project
directly, like construction of the Oguz-Qabala-Baku water supply system. There is no access to
any detailed information on these other expenditure items. All information on cost estimates or
tenders for these projects is secret.
2.2. There is only general information available on social expenditures by SOCAR in Azerbaijan
and abroad. Since there is no systematic access to detailed information, it is impossible to state
whether spending is efficient or effective.
2.3. With regard to the state budget, it is not possible to identify which expenditures are financed
by oil revenues. That said, we can make several general statements on budget transparency.
There is broad access to information on social, education, and health expenditures, average
access to information on governance expenditures, and limited access to information on defense,
law enforcement agencies, judicial power, prosecuting bodies and the investment budget. The
            
budget information publicly available), above Kazakhstan and Venezuela but below Georgia and
Russia.
The Parliament and Chamber of Accounts have failed to improve budget transparency. The
National Budget Group notes that the expertise of reviews of the Chamber of Accounts and
observation of procedural requirements during budget discussions revealed that the supreme
control body over the state budget is still conducting only a superficial analysis of the budget
figures. There is still no real control over the budget execution. Finally, in 2011, parliament held
its shortest debate yet on the state budget. Only two days of discussion on the budget in
parliament indicates an increased need for regulation of budget process in the Azerbaijan
Republic.

III. Diagnoses of the problems
a. Rules not followed
Several rules governing the management of SOFAZ have not been followed. These include:
 Rules of designing and implementing the annual incomes and expenses program
(budget) of State Oil Fund of the Azerbaijan Republic” approved with the Decree
N: 579 of the President of the Azerbaijan Republic dated on September 12, 2001:
               
            
observed since the establishment of SOFAZ. As seen in Table 5, the presidential decree
on the approval of budget of the Oil Fund was delayed even for 4 months to the third
month of the following year.
 “Internal Statute of the Chamber of Accounts of the Azerbaijan Republic” N: 269-
IIQ dated on March 05, 2002: The Chamber of Accounts should provide an opinion on
the Oil Fund budget. Article 12 of section 4 of the statute (state financial-budgetary
             
budgets of the state budget and the budget of the off-
one of the main supervisory responsibilities of the Chamber of Accounts.
 “Regulations on State Oil Fund of the Azerbaijan Republic” approved with the
Decree N: 434 dated on December 29, 2000:A-
           
              
discrepancy, highlighting that opinions and audit reports of the Chamber of Accounts
should cover all off-budget funds and the Chamber of Accounts should prepare and
disclose opinions on the budget of the State Oil Fund which is not done. As well, the
structure of the management board of the Fund also does not match the description in the
above-   
           
bodies and civil society organizations, also other persons in order to provide general
          
Advisory Board has no representative from civil society organizations. Sometimes, the
government authorities present the president of the National Academy of Sciences of the
Azerbaijan Republic, who is a member of the Advisory Board, and Deputy Speaker of the
Parliament, as the representatives from civil society. However, since the National
Academy of Sciences and the Parliament are fully financed by the state budget and a
dependent body on the government, they do not fit to the commonplace description of
civil society organizations.

Table 9. Approval dates for the Fund‟s budget
Year
The Decree of the
President of the
Republic of Azerbaijan
on the Approval of the
Budget of the State Oil
Fund of the Republic of
Azerbaijan
The Decree of the President of the
Republic of Azerbaijan on the
Amendments to the Budget of the
State Oil Fund of the Republic of
Azerbaijan
The Decree of the
President of the
Republic of
Azerbaijan on the
execution of the
State Fund of the
Republic of
Azerbaijan
2001
-
2002
-
1.11.2002 (25/11/2011
2003
(27/01/2003)
2004
(31/03/2004)
(01/10/2004)
2005
(01/03/2005)
(28/12/2005)
2006
(28/12/2005)
(07/06/2006)
2007
(28/12/2006)
(28/06/2007)
2008
(26/12/2007)
(11/07/2008)
(30/06/2009)
2009
(26/02/2009)
(07/10/2009)
(22/07/2010)
2010
(25/12/2009)
22/07/2010, 30/09/2010
(14/07/2011)
2011
(28/12/2010)
14/07/2011
(02.07.2012)
2012
(29.12.2011)
09.02.2012, 02.07.2012
[While important, these are considerably minor issues compared to what is happening with
withdrawals from the fund. According to strategy, when incomes from oil and gas revenues
peak, at least 25 percent of them shall be saved. But for the last few years we have seen the fund
spending more than 75% of the revenues which means that this important rule is not followed.
There are a few more rules which are not followed:
 when forecasting the amount of long-term expenditures from oil and gas revenues, the

set for these expenditures that are to be made within the period covered by the strategy 
we do not see any limits on any expenditures
 the regulations adopted for spending oil and gas revenues shall remain unchanged during
the effective period of the long-term strategy on management of oil and gas revenues and
the expenditure limits projected on the basis of the constant real expenditures principle
shall be observed – which is not the case here
 the volume of medium-term expenditures shall be determined based on the non-oil deficit
(the difference between revenues and expenditures of the consolidated budget of the

country, excluding the oil sector) and taking account of the long-term expenditure limit.
Sharp year to year fluctuations in expenditures are undesirable and the non-oil deficit
may not be abruptly changed  the non-oil deficit is around 40% which is not advised or
meant
 investment expenditures shall be made in the framework of the medium term State
Investment Program that is drafted annually  program is being changed multiple times in
a year and not much detail is available on the program to see whether the expenditures
are in line with it.]
b. Lack of Rules
Legislated or constitutional fiscal rules can help protect governments from political pressures to
spend or borrow unsustainably. By committing to a permanent revenue, expenditure, balanced
budget or debt rule, governments can essentially bind their own hands. Fiscal rules can have the
added benefit of improving fiscal policy consistency and credibility, reducing macroeconomic
instability and making Azerbaijan a more attractive place to invest. This is one reason why
Central Banks all over the world prefer rule-based monetary policy as opposed to discretionary
policymaking. Similarly, Germany, Switzerland and Poland have amended their constitutions to
prohibit over-spending. In fact, most advanced economy governments have enacted some fiscal
rule.
Although discretionary decision-making can be more flexible than rules, in general some
constraints may in fact make policymaking easier by constraining the number of decisions
needed to be taken and forcing a long-term vision onto public finances. As well, having a fiscal
rule can protect policymakers from criticism. Those in power are easy targets of public
judgment, especially where revenue management is controlled by a small group of people. This
means, even if  intentions are good, citizens always remember bad events, causing
embarrassment or worse for any government. A better option may be some sort of long-term
rule, which would relieve the people in power from direct responsibility.
The recent financial crisis proved that there are times when revenues can decline suddenly due to
price and other shocks (e.g. technological developments; terrorist attack). If the negative shocks
persist for some time, the government is forced to reduce expenditures. Thus the government

path, it will have to save less and this would contribute to debt or budget crises in the near future,
but if it cuts expenditures, the results are political or social unrest. Therefore it is better to have
some predefined rule, say, limiting spend to a percentage of oil wealth (the so-
             
subject to changes in case of environmental or social crisis.
These rules are especially important in oil-rich countries. Over the longer-run, oil and gas will
run out. Azerbaijan must plan for that inevitability if it wants to maintain its standard of living.
Otherwise, severe cuts and economic contraction will result.

Why do we need fiscal rules in Azerbaijan specifically?
Azerbaijan public finance decisions are very discretionary. As described in the previous sections,
budget transfers from the Fund every year are large and growing and Fund resources are spent
directly for specific projects without thorough public justification. Problems with the revenue
management system of Azerbaijan arise once revenues from petroleum sales are deposited into
the State Oil Fund of Azerbaijan (SOFAZ). From here, the funds are allocated between saving
and spending and among different expenditure items through an opaque process managed by a
small group of people. According to the statute of the Fund, Article 4.1, “The Fund's assets are
utilized in accordance with the main directions (program) approved by the President of the
Republic of Azerbaijan”. That is the only rule involving revenue allocation and there is no
specific rule which would stipulate how funds are to be withdrawn. The President of Azerbaijan
is therefore the sole person responsible for saving-spending decisions without internal or external
checks and balances.
There are three separate revenue management issues that must be addressed:
The first and foremost problem, as mentioned above, concerns the process of withdrawal from
             
accumulated. There is no rule or document that stipulates:
 What percentage of revenues can be withdrawn in any given year;
 What principles govern long-term saving-spending decisions; and
 Specifically which expenditure items can and cannot be financed from the Fund
(notwithstanding vague statements about mid- and long-term development goals).
As a result we have procyclical spending and overspending, as stated in the previous sections, in
addition to expenditures serving popular political purposes.
The second problem for Azerbaijan would be the lack of rules in the formation of the
government budget. Most governments set a fiscal envelope  the maximum they can spend in
any given year  prior to deciding on specific expenditure items. In most countries, this process
relies on stable forecasts of tax revenue. However resource rich countries must rely on more
advanced practices that estimate stable taxes separately from volatile resource revenues.
Azerbaijan seems to have completed lack of rules in this regard which results in huge and
volatile transfers from the SOFAZ to the budget. The draft budget is prepared by the Ministry of
Finances for approval by the parliament. Large investment projects are usually not detailed,
which is a point that Parliament has criticized. To improve efficiency of the budget process, the
Government of Azerbaijan may wish to consider:

 Proportional limits on resource revenue items;
 Limits on the non-oil budget deficit;
 Complete budget disclosure and justification of individual expenditures of all items not
involving national security
Public investment is a crucial component of the development process. After all, roads, electricity,
         -  
investment. However, the World Bank has noted that while budget implementation is working
well, prioritization and medium-term investment budget are lacking. Given the high cost of
public investment projects, the government must:
 Appraise all projects with a cost-benefit analysis that includes social and environmental
costs and benefits, not just financial costs and benefits
 Prioritize projects that will have the largest development impact as measured by a
sustainable rise in incomes and standard of living
 Monitor the construction of all projects to ensure quality delivery on cost and on time.
 Budget for operations and maintenance of investment projects.
The third 
huge actor in Azerbaijani revenue management system. In fact it is fast becoming the biggest
actor in the Azerbaijani economy in general. Therefore, there must be some rules guiding the
social expenditures of SOCAR so that spending supports national development aims rather than
a political agenda or that scare resource be wasted. There should be clear rules on what
expenditures SOCAR can finance, full disclosure of these expenditures and parliamentary

According to the foreign experience, the following fifth rules are used in revenue management
and budget balancing:
1) Budget balance rule- Recurrent expenditures      
primary non-oil balance. This rule is applied in following countries: Ecuador, India,
Mexico, Nigeria, Pakistan, Peru, Switzerland.
2) Expenditure rule- Limit on total or recurrent expenditure in absolute terms, in terms of
expenditure growth, or as a percent of GDP. This rule is applied in following countries:
Argentina, Botswana, Brazil, Costa Rica, Israel, Japan.
3) Debt rule- Limit on public debt as a percent of GDP. This rule is applied in following
countries: Argentina, Australia, Ecuador, New Zealand, Peru, Sri Lanka

4) Revenue rule- Floor or ceiling on revenues entering the budget. This rule is applied in
following countries: Ghana, Mexico, Nigeria, Timor-Leste
5) Withdraw rule – Limit on withdrawals of accumulated capital of fund . This rule is
applied in research reach countries and appreciated highly. The following formulas are
considered measuring the level of limits:
 Permanent Income Hypothesis
2
;
 Absolute variable transfers (Due to Norwegian experience, the revenues gained
from management should be spent up to 4 %)
 Transfers based on fixed level with variable diapasons (Due to Kazakhstan
experience, the average annual transfers should be 8 billion USD +/-15 %)
 Constant transfers updated periodically (this indicator is calculated as following:
current year, 5 past and 5 upcoming years
3
).
 Transfers related to non-oil GDP growth rate (The relationship between non-oil
|GPD growth and the level of oil revenues).
4
2
According to the calculations of World Bank, the permanent expenditures should be in average 5,9
billion dollars as 2008-2012 with constant prices of 2007.
3
According to the calculations of experts of the Economic Research Center made on the basis of this
methodology, the amount of transfers should be 9684 milion manat for 2014.
4
The increasing pace of non-oil sector in 2011 was 9,4 and in 2012 it reached to 9,6 percent.

IV. Policy Recommendations
Based on the findings of research the following policy suggestions were developed:
4.1. For resolution of over spending and pro-cyclical fiscal policy problems:
           
objectives: Saving for future generations and stabilizing short-to-medium term fluctuations in
oil revenues entering the budget.
 A fiscal rule should be enacted that limits petroleum revenue spending to 4% of petroleum
wealth (the net present value of all proven reserves plus the value of SOFAZ). This is known
as the Permanent Income Hypothesis (PIH) rule.
 A fiscal rule could be adopted that a maximum of 30% of a 11-year average of hydrocarbon
revenues can be deposited into the State Budget in any given year. The remaining amount
would be directed to SOFAZ for stabilization and savings purposes. Revenue projections to
determine the 11-year average would be determined by an independent agency. Exceptions
may be made to the rule if parliament declares an emergency (e.g. environmental
catastrophe; violent conflict).
 The non-oil budget deficit should be reduced over the near term until it reaches 4%.
 The government should only borrow to finance public projects with a net positive real
financial return; all other projects should be financed out of government oil and non-oil
revenue
4.2. For resolution of poor spending problem:
 SOFAZ should be prohibited from directly financing public projects; all appropriations
should be directed through the normal budget process and approved by parliament;
 All public investment projects should be subject to public and competitive tendering;
auditing of financial-budgetary examination should be conducted by the Chamber of
Accounts, and social auditing by civil society organizations;
 [Investment projects financed by the Oil Fund should be implemented within interim Public
Investment Program, which is designed per each year, and reports should be given to the
public on their implementation;]
 The government should appraise all projects with a cost-benefit analysis that includes social
and environmental costs and benefits, not just financial costs and benefits, prioritize projects
that will have the largest development impact as measured by a sustainable rise in incomes
and standard of living, monitor the construction of all projects to ensure quality delivery on
cost and on time, and budget for operations and maintenance of investment projects. All
these documents and budgets should be made public on government websites.

 The Chamber of Accounts should prepare recommendations on financial operations of the
Oil Fund, and those recommendations should be discussed at the Parliament
         -transfer to the state
budget-cost ratio; SOCAR should transfer more revenues to the state budget, retain less
revenue and be subject to more parliamentary oversight
 SOCAR should publish all activities and financial information; SOCAR should be subject to
same level of disclosure as a publicly held traded stock company
4.3. For resolution of „no compliance with the rules‟ problem:
   -          
followed;
 
 Representatives of civil society organizations should be represented at Supervisory Board of
the Oil Fund;
 Recommendation should be provided by the Chamber of Accounts to the draft budget of Oil
Fund.

V. References
1 http://www.oilfund.az/en_US/hesabatlar-ve-statistika/son-reqemler.asp
2http://carnegie-mec.org/publications/special/multimedia/index.cfm?fa=swf&lang=en
3 http://www.revenuewatch.org/rwindex2010/pdf/RevenueWatchIndex_2010.pdf
4 http://www.iie.com/publications/briefs/truman4983.pdf
5 Rules on management of foreign currency assets of the state oil fund of the Republic of
Azerbaijan, http://www.oilfund.az/uploads/Investment%20Guidelines_nov3.pdf
6. Rules on the preparation and execution of the annual program of revenues and expenditures
(budget) of the state oil fund of the Republic of Azerbaijan, http://www.oilfund.az/uploads/4-
eng-programofrevenues.pdf
7. Information policy of the State Oil Fund of the Republic of Azerbaijan,
http://www.oilfund.az/en_US/metbuat-gusesi/informasiya-siyaseti.asp