Stabilization Design: Learning from Alberta’s Woes

Province needs "clarity of mission".

November 9, 2010

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story_images_oil_gas_miningI read quite an interesting C.D. Howe Commentary this morning by Stuart Landon and Constance Smith entitled, “Energy Prices and Alberta Government Revenue Volatility.” If you’re interested in understanding how governments can manage resource volatility, this is a must (and quick) read.

Basically, the authors look at the various options for stabilizing “Alberta’s wild revenue and spending path.” However, the fundamental principles discussed are generalizable to any government dependent on resource revenues for spending. Here’s the premise of the piece:

“For Alberta, as for the governments of other energy-producing jurisdictions, adjusting to large revenue movements typically involves economic, social, and political costs.”

Fact. And so the authors list off some options at the disposal of these resource dependent governments and, in addition, highlight their failings. Indeed, the paper’s value is in showing many of the limitations of these alternative approaches and, as a result, it helps to explain why so many governments are resorting to stabilization funds:

“One commonly proposed method to reduce the volatility of revenues is tax base diversification, through the use of, say, a sales tax. We show, however, that this approach would have a relatively small effect on overall revenue volatility since Alberta’s resource revenues are such a large share of own-source revenues. Other alternatives, such as revenue smoothing using futures and options markets, can be expensive, are associated with significant political risks, and cannot eliminate all revenue volatility. Movements of the exchange rate are another source of revenue stabilization, since the Canadian dollar tends to appreciate when energy prices rise and to depreciate when they fall, but this effect is relatively small.”

So, what to do?

“An effective approach to address revenue volatility is to establish a resource revenue stabilization fund with fixed contribution and withdrawal rates.”

Now, you may be thinking to yourself, Alberta’s already got a SWF! That’s true, but this is really the point the authors are trying to make: It’s not sufficient to have a generic savings oriented SWF:

“…the Alberta Heritage Savings Trust Fund’s ability to stabilize revenues is quite limited: when the fund was established, it received a fixed percentage of resource revenues each year, but this practice was ended in 1987, although the fund has received ad hoc contributions from general revenues in several recent years…In a report commissioned by the Alberta Minister of Finance, Tuer (2002) proposes that the AHSTF be redesigned to stabilize the impact of volatile resource revenues on the province’s budget, but this has not been done. There is also the Alberta Sustainability Fund, created in 2003 and designed to stabilize revenues but it, along with the AHSTF, has been subject to considerable discretion in terms of contributions and withdrawals.”

In short, the AHSTF is not designed to properly immunize the economy from resource volatility and price shocks (at least according to these authors), which is why they are calling on the Alberta government to set up a new special purpose vehicle to achieve this objective. Indeed, the authors suggest that for a fund to be successful at the specific task of protecting the economy from the volatility of resource prices, it needs to have a fit-for-purpose design:

“The two key design elements of the stabilization fund we propose are the commitment of a fixed percentage of volatile current resource revenues to the fund, and the withdrawal – the transfer to current government revenues – of the long-term real earnings of the fund and a fixed percentage of the total assets in the fund…The stabilization fund we describe here would not be a “rainy day” fund, as extra funds would not be withdrawn when there was a negative disturbance to revenues. Rather, the fund would smooth revenues by weakening the link between current resource revenues and current budgetary revenues. Further, the proposed fund would not require the government to identify the conditions under which contributions and withdrawals should be made. An added benefit of fixed contribution and withdrawal rates is that they likely would limit discretion, which can contribute to revenue volatility. As well, this type of fund would be transparent and easy to understand.”

And so, this returns us to a fundamental governance principle: “clarity of mission”. I’ve said it a number of times, for a fund to be successful it needs to have a well-defined objective. Alberta’s woes offer an interesting case study in this regard.

Chart for SWF

This post originally appeared on the Oxford SWF Project website.

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