Journey to Sakhalin

Introduction The purpose of this report is to comprehensively analyze and assess the investment venture of Royal Dutch/Shell in the Russian Oil Industry, with specific focus on the Sakhalin II Investment project, operated through the subsidiary of Sakhalin Energy Investment Company (SEIC). This analysis will commence with a revision of the political risk assessment pertaining to Russia, and will continue from that platform by an identification of likely factors and situations of potential conflict.

Such information will then provide the basis for developing the risk avoidance steps that the company can take in order to protect itself from excessive exposure. In the first instance the report will seek to structure the necessary risk mitigation during the transitional aspect of taking further steps to the second phase of Sakhalin II. In the final instance the report will continue by formulating the measures required to reduce the impact of political risk, after the investment is fully undertaken. Conclusive premise(s) can then be provided to complete the report. POLITICAL RISK ASSESSMENT OF RUSSIA

Considering the reality of Russia’s political past, and its struggles encountered during the transitional period of the early 90’s towards democracy and free market system, it would be reasonable to project that a significant level of obstacles for business enterprises, particular foreign businesses exist. Analyzed from a political perspective, five factors may be suggested that when assessed can help to define the level (and perhaps more appropriately), the nature of the political challenges and risks that a foreign firm would face.

These five factors are: A. Historical Foundation – The political, as well as the related aspects of social, economic and even cultural experiences that Russia would have had for the years. (The period from the end of the Second World War could be used for a definitive time line). Assessment Reference IBS/July 2009/2_Donovan A. Moore_7558334

B. Social Instability – The present (referring to the time of the case, say mid 2003, and or dates previous to this when initial investment opportunities were being contemplated) level of discomfort that has, or potentially can, manifest itself in the populace reacting forcefully to real or perceived societal inequities C. Economic Condition – The health and condition of the Russian market, in terms of growth in productive output, the supply and demand for goods and services, relative to the ability of individuals to afford them.

D. Legal Platform – The body of laws that regulate the operation of business in general and that determine the operations of foreign entities within Russia in particular, and the extent to which these are relevant, enforceable, as well as facilitative or restrictive. Utilizing the five factors listed above, an attempt will be made below to rank these in terms of their importance, by giving them a numerical rating between one (1) and ten (10).

A number value will also be assigned to each factor between zero (o) and two (2), which intuitively defines the impact of that ‘political factor’ on the operation. It would be important to note the difference between what is coined as ‘rating’ and ‘value’ for the purpose of this analysis. Rating is the degree of importance assigned to the factor, where it is ranked generally, on a scale above. This weight affects the overall impact or result, which is the product of rating and value (the specific value of a factor as is extrapolated from case information concerning the state of affairs in Russia at that time).

Assessment Reference IBS/July 2009/2_Donovan A. Moore_7558334 TABLE A POLITICAL RISK ASSESSMENT TABLE FOR RUSSIA OF POLITICAL & ECONOMIC CONDITION 1999 TO 2003 FACTORS RATING VALUE RESULT REMARKS Historical Foundation 5 0.45 2.25 Rating assigned 5 out of 10 because though the country was moving away from a totalitarian regime, this factor still had significant residual effect - 45% subjectively Transitional Experience 7 0.3 2.1 Russia had limited experience in Western Business practices Social Stability/Instability 3 0.9 2.7 Populace of Russia considered fairly disciplined due to suppression in communist past Economic Condition 6 0.25 1.5As indicated by fall in GDP figures and rise in inflationary levels the economy was going  through 'withdrawal symptoms' as it sobers up To fuller exposure, coming from the protective effect of a somewhat controlled economy Legal Platform 9 0.1 0.9 The existence of business laws (or the lack of it), and the letter and spirit of these legislations would most profoundly affect the profit levels Total 30 2 9.45 viability of foreign entities, such as Shell

Hence from this an informational flow model can be designed which would show that on the singular basis of looking at Russia and considering that the maximum worst case result would have been that all the factors were at ten (10) keeping the values constant, the overall result would be 20 (the highest risk level. The diagram below indicates that Russia is close to the top of a medium political risk classification, based on the model below


Assessment Reference IBS/July 2009/2_Donovan A. Moore_7558334 The analysis above was done looking at Russia in an isolated case, but similar results could also be demonstrated showing that Russia compared to two hypothetical countries (the best –lowest political risk and the worst – highest political risk), using only the rating scale in the first analysis. The results again show that Russia fall in the medium range closer to the top of that range. Royal Dutch Shell approaching the investment, like a driver in his SUV would read an amber signal at the stop light – proceed but do so with caution. After the comparative table data is shown, the report will continue to explore how the company can do just that…navigate cautiously. TABLE B

Note - Country A could be a failed African state; country B could be Singapore

Assessment Reference IBS/July 2009/2_Donovan A. Moore_7558334

Now that the foundation has been solidly laid, the next step as suggested in the introduction will be to identify the likely areas of potential conflict. INDENTIFICATION OF POTENTIAL CONFLICTS The potential conflicts that the company may encounter based on the reality of the analysis above, falls into three major categories. These are as listed:

1. Conflict of the company’s policies, objectives and interests with the legal foundations of the federal government, in spite of the Production Sharing Agreement (PSA), in light of the legislative commitment to rationalize it as a prevailing legal contract

2. Ideological conflicts with the local authorities on the island of Sakhalin, as well as state agents and administrators of the bureaucratic system of both the local and central government. 3. Conflicts arising from opposition by other business entities, local enterprises or even potential competitors who may be jealous of any perceived lucrative gains Royal Dutch Shell (and its other business partners) may be able to enjoy in the future.

There is a fourth area which cannot be ignored, and that comes from the pressure of social groups and none governmental organizations that may have particular social and environmental concerns. In light of the general categories being provided, it would nonetheless be prudent for this report to outline with a little greater precision the areas of potential conflict that fall under one of the general categories above: The existence of conflicting legal premise and principles between the PSA and other legislative acts

Assessment Reference IBS/July 2009/2_Donovan A. Moore_7558334

The opposing presence of power brokers in business and government who are against the ‘spirit’ of the PSA The oppositions from persons with political seats in the Russian parliament. Even if favourable laws/amendments were to be drafted and tabled in the house, these persons would attempt to block their passage. Possible negative reaction from local groups in Sakhalin Island who may feel that their interest were undermined, or they were not represented adequately in an egalitarian distribution of benefits Concerns and variations on elaborate technical detail.

Could be used as a tactical maneuver by technical opponents to confuse decision makers in government, by overwhelming them with detail that they may have difficulty comprehending Social groups and NGOs (likely with international connections or affiliations) that purport social and environmental concerns regarding the impact of the project activity Of a certainty most of these can be neutralized or somewhat reduced if the latitude exist for developing and implementing mitigation measures. It should be recognized however, that with some political conflicts there is little that Royal Dutch Shell will be able to do to protect itself.

Assessment Reference IBS/July 2009/2_Donovan A. Moore_7558334 POLITICAL RISK MITIGATION MEASURES There are seven political risk mitigation measures that the company had already incorporated into its initial agreement and mode of operation: 1. Tax exemptions that offered some level of insulation from exposure to regulatory cost 2. Some level of guarantee of investment recovery built into the PSA contractual framework 3. Sourcing of funds from multiple international financial sources, that assist in diversifying the narrow identity of the company, to appear like a true international investor

4. Temporary ownership rights with pre-conditions for titled transfer to Russian Federal government 5. Fixed tax rate on profits allows for more structured and reliable business planning 6. Support of social development through education and infrastructural development on the island of Sakhalin – this does purchase some amount of acceptance both in the local and federal government

7. External third party mediator should the necessity of arbitration arise Regardless, there are other steps that can either solidify and or further compliment the set of political risk mitigation already in place: A. A request that the PSA document be amended to include a very clear and comprehensive outline of the methods and processes that will systematically facilitate the tax exemptions, as well as the means or instruments of refund, should any such regulatory cost be incurred B. (This one may be difficult, but is worth the asking) A request for the amendment in the PSA, providing a definitive clause that the legal substance of the PSA takes precedence above any Assessment Reference IBS/July 2009/2_Donovan A. Moore_7558334

and all other conflicting legal acts, specific only to the Sakhalin II development project. (This is simpler than other possible amendments proposals C. A clear commitment for agents of the state to honour and conform to the legal requirements of the PSA (to some extent more enforceable with the amendment suggested in (B.) ), with possible consideration of appropriate penalties for ignoring or violating its foundation. This may seem far fetched and difficult to sell as an idea. The legislators and higher ranking officials could be told however, that Russia has a vision to reach (or one could even say reclaim) its place as a dominant world power.

This cannot be done without the capital. In a sense Royal Dutch Shell and its partners are important players and partners in that vision in that they provide the capital – you should not make it difficult for a partner that supports the prime vision for your country, you should support them! When asked what interest would the company have for supporting such a vision, the negotiators should remind the politicians that the company is a set of business people seeking mutually beneficial business opportunities; the interest is not world politics – the interest is a symbiotic relationship.

Assessment Reference IBS/July 2009/2_Donovan A. Moore_7558334 D. In the same way that the company explores and identifies its alliance with persons in government and the supporting ministries and groups that appear to be on the side of SEIC, the company can develop a similar linkage chart which shows the opposition and how they are linked through the network of the government. A forum or a social function can then be arranged and these officials given special invitations so that their points of view can be understood, and the opportunity can be created to possibly re-align their thinking towards the project, and the company.

So supposing that the company arrives at the stage where the investment decision was already sealed and substantial financial investments were already made, and the project is now in progress. The report will as a consequence offer guidelines as to how political risks can be mitigated after such stages. HOW TO AVOID POLITICAL RISK AFTER THE INVESTMENT

The items below demonstrate some guidelines for avoiding political risk after the investment is undertaken: In regards to the political constraint of Russian Content, engage in strong negotiation for not only a clear definition of its measurement, but a protective clause which allows SEIC to source the input externally, should local providers fail to meet an established external benchmarked standard A dual structure that spans the geographic distance between

Moscow and Sakhalin, with automatic flexibility to shift the political management relationship smoothly should political changes necessitate the switch Submit a proposal for the identification and streamlining of specific government officials who would have the complete authority for granting approval for all the Assessment Reference IBS/July 2009/2_Donovan A.

Moore_7558334 technical, political and commercial details surrounding the project with clear outline of how the approval process would flow Explore ways of developing complimentary policies with the political, social and or economic objectives of the Russian Government Partner with the other internal entities (to reduce the cost impact) on social projects that have a wide scale and significant effect with potential for demonstration of good corporate citizenship If there are no issues of legal/official conflict, offer 5% of Royal Dutch Shares in SEIC to top government officials for sale at little below market value. (This is not a bribe they are paying for it; if they own it they care more about its success!) CONCLUSION

It is clear that this ambitious journey that Royal Dutch Shell has embarked upon with its business partners is a very challenging one that presents formidable political challenges. The secret to facing a significant opponent is to preferably be on the side of friendship and cooperation. However should the circumstances shift to a more turbulent ride then remaining flexible and nimble is the way to navigate the path to success. This report provides the some cardinal directions to stay the course, regardless of the challenges.