Espiritu Santo and its attempt to take advantage of the current oil price boom

This blog was written by Oswaldo López and Vittorio Boscheti.

The current global economic recovery has brought a new boom in oil prices, which already shows a 45% increase in 2021, as measured by the Brent benchmark. For oil-exporting economies, these price increases have always resulted in important policy dilemmas for their leaders, who are torn between using these windfall gains to meet the urgent needs of the population, or saving them, so that they are available to future generations. The advisability of injecting these funds into the economy, via public investment, or sending them to a countercyclical mechanism that reduces budgetary volatility is also often discussed.     

In Brazil, these discussions also include the subnational levels of government, keeping in mind that the states receive about 60% of the taxes imposed on the oil sector. Espíritu Santo belongs to this group, and is the third largest oil producing state in the country, with production close to 250,000 barrels per day. Espiritu Santo’s oil profits have a great impact on its public finances, which receive an average of USD 504 million annually in royalties and special oil interests (about 40% of their total current transfers) during the last decade.

Although the lack of funds is a development limitation for many states, the windfall revenues, as is the case with oil taxes, may also paradoxically lead to failed public management, given the problems it causes in terms of budget planning orincentives to lack of accountability and corruption. Evidence found for municipal governments in Peru, Colombia, Argentina and Brazil itself suggests that availability of larger funds, in these cases coming from a commodity, leads to greater public spending. However, it is not clear whether this increase in expenditures results in improvements in government management indicators, better quality of public goods provided or greater transparency in public accountability.

Specifically, the Espiritu Santo government’s oil revenues have shown a fluctuating behavior (linked to international crude oil prices) and have been declining in recent years (due to decreased production). To cope with these income swings, the state government chose to follow the old recommendation from the biblical parable of Joseph to store up during years of plenty for use in times of scarcity. This is how the Espiritu Santo State Sovereign Fund (Funses) emerged, an initiative created by the state government in June 2019 and regulated in November 2020.

At least 40% of the royalties and 15% of the transfers for special oil shares received by Espiritu Santo are transferred to Funses, which represents its main source of income. These rates could be halved if the state were to enter a liquidity risk scenario, e.g. a real fall in available treasury balance from the previous year.  

The fund was designed with a two-fold purpose: 1) serving as an intergenerational savings tool and 2) promoting sustainable economic development for the state. Between 2019 and 2022, the savings component will be very important for Funses, accounting for 40% of the total funds received. Over the years, this percentage is expected to drop to 20%, starting in 2027.

To execute this dual purpose, Funses relies on BANESTES, a mixed bank in the state of Espiritu Santo, which is responsible for managing the generational savings fund, under the premise of making investments with a conservative approach, while trying to maintain a return above the basic SELIC interest rate. BANDES (Espiritu Santo State Development Bank), on the other hand, will be the financial agent in charge of promoting sustainable economic development, through an innovative equity private company investment scheme (private equity and venture capital), in addition to other types of structured investments, regulated by the Brazilian Securities Commission. For business development activities, companies must have a tax domicile in the state.

If the Espiritu Santo government is able to retrieve funds kept in Funses, mainly to mitigate fiscal risks, it could only do so for a sum equivalent to the previous year’s returns and when the fund balance exceeds R$ 1 billion (USD 178 million). At the end of 2021, Funses had a capitalization of R$ 628 million (USD 112 million), with a projection of R$ 2 billion (USD 357 million) for 2022,

Although discussions on the rational use of oil tax revenues are long-standing in Brazil, interest on the part of state government leaders in addressing this issue is relatively recent. Along with Funses, other savings funds are already in operation at the municipal level, such as the Niterói-RJ municipality Income Equalization Fund (2019), the Maricá-RJ Sovereign Fund (2017) and the Ilhabela Prefecture advanced Sovereign Fund project in São Paulo. In total, the monies managed by these funds total about R$ 1.3 billion (USD 236 million).

This is how Brazilian state and municipal governments are leading a discussion about political economy which is typically reserved for national governments. At a global level there are few experiences one could share regarding subnational sovereign wealth funds (9 in the U.S., 3 in Canada and 1 in Australia), with the Alaska Permanent Fund standing out in terms of the magnitude of funds managed (USD 70 billion). In most cases, the endowment model predominates, where the returns generated by the fund are used to finance priority public expenditure, similar to the model used by Funses.

The challenge is greater in the case of Funses, not only since it is an intergenerational sovereign savings fund, but also because of the creation of the venture capital investment agency, which is already expecting to receive R$ 250 million (USD 44 million) to purchase a minority stake in innovative local companies. While this investment scheme is widely used by sovereign wealth funds in Asian and Middle Eastern countries, it would be an unprecedented model for existing funds in Latin America and the Caribbean.

However, one difference this Funses Investment Agency has with respect international trends is its bias toward investing in companies located within the Espiritu Santo state, which involves important challenges. The legitimate intention to develop the local economy might be threatened by making poor investment decisions. In this regard, safeguards that limit the mismanagement of funds and corruption should be put in place, such as rules endorsed by the local legislature to prevent conflicts of interest in capital investments.

International experience generally indicates that successful sovereign wealth funds are those that are established in sound institutional environments and that have an orderly set of fiscal policies. An adequate fiscal rules framework might contribute to the fund’s purpose of “parking” a portion of volatile oil revenues, until they can be used more efficiently. Fiscal rules could also prevent distortions, such as the potential lack of coordination in parallel budgets (of the state and sovereign wealth fund) or the weakening of public responsibility

The creation of sovereign wealth funds by subnational governments in Brazil represents an important step in the paradigm shift towards a fiscal policy with a long-term vision. The use of oil revenues in an intergenerational savings scheme and a productive Funses investment agency is an example of this. It is therefore worth following this fund’s progress in the coming years, with CAF—development Bank of Latin America—being not only an institutional ally for the state of Espiritu Santo, with the links created through the credit operation for the “Complejo de Salud Norte” hospital, but also as a soundboard to replicate this experience in other subnational contexts throughout the Latin American region.

The authors appreciate the comments and contributions from Alexandre Viana Gebara, Deputy Manager of the Espiritu Santo Sovereign Fund.