Looking at a sovereign wealth approach

Walker administration proposes a radical rethink of how to channel Alaska’s oil revenues and the use of the Permanent Fund

ALAN BAILEY

Petroleum News

As part of Gov. Bill Walker’s team investigating how to deal with the state of Alaska’s perilous fiscal situation in the light of low oil prices and declining oil production, Alaska Attorney General Craig Richards has written a report, recommending a major change to the way in which state revenues are generated. Essentially, in an approach that Richards terms the “sovereign wealth model,” revenues would be decoupled from oil prices and Alaska oil production levels by channeling all oil and gas royalties and taxes into the Alaska Permanent Fund and then generating state revenues from Permanent Fund earnings.

The proposed model could support a sustainable state budget while also preserving oil wealth for future generations, Richards says.

The current system

Earnings from the Permanent Fund’s investments are accounted as an earnings reserve, with the fund’s principal, which generates the earnings, being constitutionally protected from fund withdrawals. The level of the permanent fund dividends, paid annually to Alaska residents, is calculated using a formula which is based on the average earnings of the fund over the previous five years and which uses half of those earning for dividends. Only “realized earnings,” rather than the changes in asset values, count in this formula. And dividend payments have to come from the earnings reserve fund.

Although the fund principle is protected by the state constitution, the state Legislature has discretion over the use of the earnings reserve. Money in the earnings reserve not used for permanent fund dividend payments is typically paid back into the fund’s principle for inflation proofing the fund or as a special appropriation.

Sovereign wealth

However, were an equivalent to the permanent fund dividend to be paid directly from 50 percent of royalties, rather than from the earnings reserve, with the remaining royalties going into the Permanent Fund along with oil and gas taxes, the sovereign wealth mechanism could potentially generate at least $3.1 billion in sustainable revenues for the state, Richards says. Under this approach the state would come closer to meeting its revenue needs but the Permanent Fund Dividend would become linked to oil price volatility and Alaska oil production levels.

Withdrawal mechanisms

Under an endowment fund model, a set percentage of the fund’s total value would be transferred each year into the earnings reserve. The concept behind this type of arrangement is that, by setting an appropriate withdrawal rate, allowing for long-term expectations for fund growth and the eroding effects of inflation, an income from an endowment fund can be achieved while also preserving the fund’s long-term value.

Although this approach would insulate fund-derived state revenues from the vagaries of oil price movements, the annual payout from the fund would be susceptible to the ups and down in financial markets. So, to smooth out what could otherwise be a choppy ride, Richards suggests using a five-year moving average of the annual fund value for calculating the annual fund payout.

However, with the possibility of a withdrawal from the Permanent Fund principle being needed in years when the earnings reserve holds insufficient assets to cover the entire payout, a full-scale endowment approach would require a constitutional amendment to allow the fund principle to be tapped. An alternative would limit withdrawals to whatever is available in the earnings reserve, accepting that in some years it will not then be possible to withdraw the full amount that the endowment calculation requires, Richards says, commenting that this more limited approach might only provide a short-term solution to longer-term budgetary issues.

Another possibility might be to withdraw a fixed amount, say $2 billion, each year. This approach would provide a steady and predictable state income but would suffer from the risk of overdrawing on the fund at times when returns from financial markets are poor.

Endowment model

Based on a projected Permanent Fund Dividend payout of $1.4 billion in 2016, using the current dividend algorithm, about $1 billion would go into the General Fund, thus bolstering state finances while also preserving the value of the Permanent Fund, Richards says. But this level of revenue would be less than that from the sovereign wealth approach.

Overall, Richards suggests that Alaska should adopt investment practices that increase the earning of its assets over time. He suggests that the state could use more debt to optimize its capital structure, using the debt to earn higher returns but not to increase state spending. Moreover, there are several billion dollars spread across several state funds, managed by the state’s Treasury Division or held by Alaska public corporations that could be used in an endowment model for state income, he says.

And Richards recommends the formation of an investment management board, consisting of three state officials and four outside experts, to oversee the state’s investments.

Standard & Poor’s lauds proposal

“Publication of the report itself is a favorable development because it illustrates to state lawmakers how a pathway to a more sustainable fiscal structure for Alaska’s general fund is possible,” the agency said in a Nov. 2 statement.

The administration’s report, prepared by state Attorney General Craig Richards, proposes channeling all oil and gas revenues into the Alaska Permanent Fund and then using earnings from the fund as a primary source of state revenue. Permanent fund dividends that are paid annually to state residents could either come from fund earnings or from a portion of oil and gas royalties.

Standards & Poor’s notes that Alaska will need to find some way to address its current fiscal imbalance if the state is to prevent its credit quality from slipping — the state’s 2016 budget shows a deficit of $3.1 billion, about 55 percent of general fund expenditures, the agency says. A significant reform such as the one outlined in the attorney general’s report will be needed, the agency says.

The agency does, however, point out that the proposed reform would not fully close the state’s fiscal gap and that some combination of spending cuts, reduced oil industry tax credits and new revenue sources, such as the introduction of a new broad-based statewide tax, would be needed. And the proposed sovereign wealth reform comes with some financial risk, given that the calculated revenues from the reform assume a 6.73 percent rate of return on the state’s assets.

—ALAN BAILEY