Governments may contract with third parties, including private and state-owned companies, at different points during resource extraction. Such contracts need to secure full value for the host government and its citizens while at the same time providing the necessary incentives to attract investment and ensuring that exploration and production will be undertaken efficiently. Natural resource extraction is particularly contractually complex. There are numerous uncertainties regarding geology, costs, technology, resource prices and the capabilities of firms and local human capital.

Governments face a range of problems, from securing sufficient exploration and extraction activity on reasonable terms, to ensuring credibility and stability of contractual commitments while retaining some flexibility in the face of changing circumstances. Governments require a robust mechanism by which value and sufficient extraction can be achieved; competitive bidding and auctions are often the most desirable instrument for allocation of rights. However, they also face limitations, notably where the number of viable competitors is low; here, resource owners may wish to pursue alternative strategies.

There are several key principles that apply across the range of mechanism design, including competitive bidding, license-based regimes or negotiation-based systems of allocation:

1. Terms should be set in law or regulations to the greatest extent possible. Setting policy in law increases public input and support, enhances stability for the investor, ensures uniform treatment, and reduces opportunities for gaming and side-dealing. It may also enhance the return to government by reducing uncertainty.
2. As much information as possible should be made public prior to the awarding of contracts. Contracts themselves should be made public. This includes the fiscal regime under which firms will be operating. It also includes geological knowledge; publicly available findings of advanced survey work are likely to be beneficial in drawing firms into the bidding process. Social and environmental terms should be made public too. Robust and well-thought-through model contracts that have been subject to detailed legal review provide a sound basis for bids. Broadcast and open media access to the bid or auction event aids transparency and helps establish the legitimacy of the outcome, particularly where the development is of national importance. Social and environmental terms should be made public too.

Competitive allocation mechanisms are preferred in general for a number of reasons:

1. Government may be at an informational disadvantage, knowing relatively little about technical details and perhaps having little or no experience in the complex negotiations that are characteristic of the resource sectors. Through auctions and competitive bidding mechanisms, governments need not know the true value of the rights to secure full value for them. Competition between firms that are technically and financially competent has the potential to deliver maximum value to a government which may possess less expert information than the bidders.
2. The use of well-designed auctions can reduce opportunities for discretion by government officials that create opportunities for favoritism and abuse.
3. Sequential auctions can secure greater value for governments. Initial bidding rounds can reveal privately held information about the true value of neighboring plots

Competitive bidding can be achieved through the design of instruments to allocate rights or contracts. Auctions are one such instrument, but they can range from certain kinds of single buyer-seller negotiations through to competitive markets with many buyers and sellers. The prospects for delivering the benefits of competitive bidding are enhanced if a number of pre-conditions are met, including the provision of regional geological information, the presence of qualified bidders and physical security in the license area.

The process for government allocation of contracts amongst competing firms needs to be carefully designed. Technical competence, capacity and financial capability may be important criteria for careful and robust pre-qualification. The true beneficial owners of the firm should be known. There should be strong rules to prevent public officials steering business to firms in which they or their relatives and proxies may have a financial interest.

Where practical, auctions are generally the preferred mode, both on grounds of transparency and of securing maximum value. The design of the auction or allocation mechanism may differ across resource types and geological conditions.

During a strategic analysis of contracting options or the pre-bid process it may become clear that an auction process is unlikely to be successful, perhaps because the structure of the industry means that there are likely to be few bidders or because of particular local factors. In these cases a strategic partnership approach may be a legitimate option. However, without the discipline of an open competitive process, special efforts to ensure and demonstrate transparency and alignment of the interests of the contracting parties may be required.

The auction itself needs careful design, both in terms of selecting the bidding variables (e.g., royalty rate, production share, work program or profits tax) and the design of the auction process. Post-bid negotiations should be minimized; this is facilitated by clear and transparent bid terms, including well prepared model contracts.

1. Competitive bidding should take place over observable or verifiable bid variables. This ensures bids can be compared and assessed. Further, subsequent delivery on bid variables can be monitored and enforced. If bidding takes place over a domain of variables which are hard to measure and verify, there will be increased opportunities for gaming and abuse.
2. Competition need not simply be on price, but competition on too many variables erodes transparency, increases administrative costs and can lead to unintended consequences. For example if bidding takes place on a factor such as the production rate, it is decoupled from government influence on the subsequent rate of extraction and the associated economic impacts. In all cases competition should be on the basis of clear and transparent rules, thus minimizing the possibility of back-room deals and abuse of discretion.
3. Competition in bidding can be enhanced by good prior geological information. Governments need not allocate extraction rights prior to obtaining exploration information. Such activities can be directly contracted or undertaken as a public good. Donors can support countries in acquiring geological survey data prior to the allocation of extraction rights. Incumbency rights of those who have carried out prospecting or supplied geological information should be clear from the start of the process.

Competition and competitive bidding mechanisms have implications for different modes of allocation and for different actors involved:

1. Barter deals or tied sales should be allocated competitively and transparently to secure maximum value. For example, it is common, especially in low income countries, to include as part of the investor’s obligations requirements to provide social benefits, such as housing, education, health, training, or related infrastructure. As long as such requirements are made clear in regulation or the bidding process they should not prevent the government from realizing the benefits of competition. More difficult situations arise in the case of government-to-government deals for infrastructure which require that the host government give preferential access to the other country’s companies. Such transactions usually lack transparency and are difficult to value. Governments choosing this route need to carefully analyze both the benefits of the infrastructure and the value received for their resource to ensure that they are, on balance, ahead. A common pitfall is that the access to the resource is a firm commercial contract while the government-to-government element relies on high level undertakings that are not enforceable.
2. There may be advantage in unbundling the contract into separate parts. Certain activities, e.g., limited seismic acquisition and interpretation, could be subject to separate contracting from the letting of exploration rights. It should be clear from the start what the benefits of incumbency in any stage of a separated process are, so that they can be properly reflected in the competition between firms. In some mining jurisdictions competition between investors has historically taken place during the exploration or prospecting phase, with subsequent development governed by existing fiscal and other regulations. While this may be an acceptable competitive model where an adequate body of fiscal and other regulations exists, post-exploration one-on-one negotiation of terms with investors will not result in adequate transparency or competition.
3. Competition in downstream activities and procurement of upstream services is also important for achieving value and efficiency in the extraction process. This may include avoiding the allocation of resource outputs to the domestic market at a value lower than the international price. Governments should take steps to ensure transparency, open access and fair competition in procurement processes, which should also include the knowledge of the true beneficial ownership and the source of funds behind the companies that bid. Competitive rules should apply equally to private and state-owned companies.