Indonesia. 1 Indonesian Constitution 1945, Chapter XIV (Social. 2 Constitutional Court No. 002/P44-I/2003 dated 15. December 2004.

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1 12.15 Indonesia Introduction In considering the system of regulation of hydrocarbons in Indonesia, the starting point is the Indonesian Constitution of 1945, year of the country s Declaration of Independence, which states: Land and water and natural riches shall be controlled by the state and used for the greatest possible prosperity of the people. 1 The Indonesian archipelago is resource rich. Control of the exploitation of these resources has the potential to be a politically sensitive issue. In 2001, a new Indonesian Oil and Gas Law was introduced, Law No. 22 of 2001 (2001 Law). This law plays a pivotal role in the current system of regulation of this sector in Indonesia. Although it may have been assumed that the above provision of the Constitution was simply a general expression of intent of little ongoing relevance to the shape of the law, this assumption was challenged in late 2004 in a case heard in the Constitutional Court. 2 The current system of regulation based around the 2001 Law amounted to a fairly far-reaching reform and reshaping of the system. Persons opposed to the 2001 reform argued to the Constitutional Court that the 2001 Law was unconstitutional being in violation of various provisions of the 1945 Constitution. In all material respects, the challenge was unsuccessful and the 2001 reforms were confirmed to be constitutional. Nevertheless, the Constitutional Court was required to measure the provisions of the 2001 Law against the guiding principles of the Indonesian Constitution, including that stated above Indonesian legal system: an overview Before discussing the system of regulation, it is worth commenting briefly on the nature of Indonesia s legal system. Indonesia s legal system follows key aspects of the civil law tradition. Thus, the rules of the system are to be found in legislative sources. Previous court decisions, which are not systematically published or readily accessible, do not offer any binding precedents as to the manner in which these sources should be interpreted and applied. In addition, legislation is often expressed as relatively general principles or concepts, rather than the detail and minutiae more often seen in common law systems. There is a hierarchy of legislative sources in Indonesia starting from the 1945 Constitution. 3 Currently, the 2001 Law is the primary specific source relating to the regulation of hydrocarbons. Further to that there are Government Regulations enacted under the 2001 Law. Primary legislation, in this case the 2001 Law, usually acts as a framework and leaves a significant amount of detail to be filled in by implementing regulations. These implementing regulations often follow some years after the primary legislation. In relation to the 2001 Law, the key implementing regulations were enacted only in Therefore, at the time of writing, the application of various aspects of these implementing regulations remains to be tested. An issue that can sometimes cause difficulties in Indonesia is the inconsistency between rules contained in different sources. It is not uncommon that new rules 1 Indonesian Constitution 1945, Chapter XIV (Social Welfare), art. 33 subpara. 3. Please note that Indonesian laws and regulations are enacted in the Indonesian language. English translations of the wording of Indonesian laws and regulations contained in this Article are unofficial. 2 Constitutional Court No. 002/P44-I/2003 dated 15 December Law No. 10 of 2004 concerning Legislation, art. 7. VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 833

2 NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY are enacted without expressly addressing the status of previous rules, which may not be directly contradictory, but deal with matters in the same area. In addition, as discussed further below, additional powers have been granted in recent years to regional governments in Indonesia under legislation providing for a system of regional autonomy. The operation of these powers in the oil and gas sector has led to complaints of a lack of coordination in the regulatory position. In Indonesia, an Official Elucidation is published together with legislation, and can provide additional information on the meaning of principles often expressed in general terms. The 2001 Law was a relatively far reaching reform and reshaping of the system of regulation of hydrocarbons in Indonesia. The system in force prior to the 2001 Law was based on laws and regulations mostly dating from the 1960s and 1970s, 4 which marked the start of modern, commercial oil and gas exploitation in Indonesia. The 2001 Law broadly divides the oil and gas industry into upstream and downstream business activities (as defined in the 2001 Law), and reshaped the system for regulation of both. Previously, in upstream activities, Pertamina, Indonesia s national oil and gas company, had regulated and controlled exploration and production in a quasi-governmental role. In particular, Pertamina had acted as the government party in oil and gas mining concessions in the form of production sharing contracts. The 2001 Law removed that role and provided that a new government agency would be created to deal with these matters. Downstream business activities had been a state monopoly in the hands of Pertamina. The 2001 Law was the first piece of a new regulatory system for downstream business activities, enabling private companies to participate in processing, transportation and trading. Under a Government Regulation of June 2003, 5 Pertamina became a state-owned limited liability company (or Persero). This change had been provided for in the 2001 Law. 6 Previously, Pertamina had been deeply involved in regulatory and policy aspects of the oil and gas industry in Indonesia. Pertamina s role is being transformed by establishing new regulatory bodies, removing Pertamina as the government party in production sharing contracts, and removing its monopoly position in downstream activities. In due course, it is intended that Pertamina will simply be one commercial operator in the sector. The 2001 Law establishes the framework for a regulatory system in downstream activities. The law had not previously contemplated private investment in this area. The new system is based on government granted business licences for the carrying on of downstream activities. Whilst Pertamina continues substantially in the position of an incumbent in downstream businesses, it is starting to feel the impact of competition in its market. As the most visible example, Shell has now started trading from various petrol retail sites in and around Jakarta. The 2001 Law was enacted in the years following the collapse of the previous long-standing political regime in Indonesia under General Suharto. The collapse of that regime gave new life to the political ambitions of the various regions within the massive Indonesian archipelago. The 2001 Law followed relatively soon after certain laws, 7 which became effective on 1 January 2001, aimed to address these ambitions. These laws provided for greater regional autonomy and greater sharing of tax and revenue between central and regional governments. These developments were particularly relevant to the oil and gas industry, since many of the oil and gas fields are in outlying areas; the changes are recognized in the 2001 Law. Under the 2001 Law, regional governments are granted various consultation and other rights in relation to upstream activities in their area, and the Chapter of the 2001 Law on state Revenues 8 provides for revenues to be payable to regional governments as well as central government. As discussed below, this has been a contentious issue, which has not yet fully played out, and remains an issue of concern for investors in the industry Supervision of the oil and gas sector Under the 2001 Law, three principal government institutions are to be involved in supervising the oil and gas sector in Indonesia. Directorate General of Oil and Gas, a section of the Department of Energy and Mineral Resources. While many of the functions previously held at this level have now been transferred to BPMIGAS (Badan Pelaksana Minyak dan Gas Bumi, see below), the government, through this Directorate General (Migas), 4 In particular, Law No. 44 of 1960 on Oil and Natural Gas Mining; Law No. 15 of 1962 on Domestic Market Obligations; Law No. 8 of 1971 on State Oil and Natural Gas Mining Companies. 5 Regulation No. 31 of Law No. 22 of 2001, art See note Law No. 22, Chapter VI of ENCYCLOPAEDIA OF HYDROCARBONS

3 INDONESIA retains certain high level functions and broad responsibility for policy and coordination in the sector (where the 2001 Law refers to the Minister, these matters are in practice carried out through this body). In upstream activities, the Minister is still stipulated as the source of various decisions and approvals, which include determining and offering working areas, approving the initial plan of development for a working area and giving government approval for the transfer of interests in production sharing contracts by contractors, as well as having a broader supervisory function. 9 In downstream activities, the Minister retains a general regulatory function. Implementing body for upstream business activities or BPMIGAS. This is a state-owned, non-profit agency set up by Government Regulation in July 2002, 10 based on the provisions of the 2001 Law contemplating the creation of such a body. BPMIGAS now has an extensive role in the regulation of upstream activities. These include acting as the government party to production sharing contracts, supervising the implementation of production sharing contracts, 11 and input to various ministerial decisions. Regulatory body for downstream business activities or BPHMIGAS. BPHMIGAS (Badan Pengatur Hilir Minyak dan Gas Bumi) is a government institution set up by Presidential Decree in December 2002, 12 based on the provisions of the 2001 Law. Its remit is based around the regulation and supervision of national fuel-oil supply, important in the Indonesian domestic context (fuel-oil is described as fuel derived or processed from crude oil, including gasoline, diesel and kerosene), 13 and distribution and transportation of natural gas by pipe. Responsibilities include ensuring availability of fuel-oil throughout Indonesia, as well as increasing domestic use of gas. 14 To some extent, these are two sides of the same coin given that Indonesia is currently engaged in a push to diminish reliance on oil in favour of an increased use of gas. The increased transportation and use of natural gas is a looming challenge for Indonesia. Today, the network for the transportation of gas by pipe in Indonesia is not extensive Upstream business activities Definitions Upstream business activities are defined in the 2001 Law as business activities focused or based on exploration and exploitation. Exploration is defined as activities aimed at obtaining information about geological conditions to find and obtain an estimate of the oil and natural gas resources in a specific working area. Exploitation is defined as a series of activities aimed at producing oil and natural gas from a specific working area, consisting of well drilling and completion, the construction of facilities for the transportation, storage and processing through separation and purification of oil and natural gas in the field, and other supporting activities. 15 In October 2004, the provisions of the 2001 Law in relation to upstream activities were supplemented by the enactment of Government Regulation No. 35 of 2004 concerning Oil and Natural Gas Upstream Business Operations (Upstream Regulations). The remainder of this section discusses the principal features of the upstream activities regime under the 2001 Law and Upstream Regulations. Oil and natural gas remain assets controlled by the state through the government as the holder of the mining authority. 16 Exploration and exploitation of these assets by other parties (i.e. upstream business activities) are therefore to be conducted through concessions in the form of Co-operation Contracts 17 with BPMIGAS, a body established by the government in its capacity as the holder of the mining authority. Under the 2001 Law, co-operation contracts can take the form of a Production Sharing Contract (or PSC) or other form of co-operation contract that meets the requirements of the 2001 Law, including the requirement that it be beneficial to the state and maximize the people s prosperity. 18 Since its introduction in the 1960s, the PSC has formed the basis for upstream activities in Indonesia. As elsewhere, PSCs were perhaps felt to offer advantages in the political context, both for the government, as they recognized Indonesia s permanent sovereignty over its assets, and for an industry worried about unpredictable change in a less stable political environment. Furthermore, it provided a contractual document with the government setting out the law between the parties (to use the basic description of the effect of contracts contained in the Indonesian Civil Code), 19 and thus, in theory, isolated from shifts in the general legal regime. 9 Government Regulation 2004 No. 35 ( GR 35 ), arts. 5, 95, 86 et seq. 10 Government Regulation 2002 No GR 35, arts. 24 and Presidential Decree 2002 No Law No. 22 of 2001, art. 1.4 and Government Regulation No. 36 ( GR 36 ) of 2004, art GR 36, art. 7; Law No. 22 of 2001, art. 46.2; see also Government Regulation No. 67 of Law No. 22 of 2001, art. 1 paras. 7, 8 and Law No. 22 of 2001, art Law No. 22 of 2001 art Law No. 22 of 2001, art Indonesian Civil Code, art VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 835

4 NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY Under the regime in force prior to the enactment of the 2001 Law, in some cases, contractors were granted rights under forms of contract other than PSCs. These contracts were derived from PSCs and linked to Pertamina s position with respect to its own fields (rather than those for which it simply acted as a representative of the government). Depending on the circumstances, these comprised joint-operating agreements (and joint-operating bodies), technical assistance contracts, and enhanced oil recovery contracts. The PSC is the mainstay of upstream activities and, although other forms of contract could be accommodated by the 2001 Law, it is expected that PSCs will be the universal or near-universal model. A number of examples of the other forms of contract referred to above remain in force. However, for the purposes of this Chapter, reference is made only to PSCs. Existing PSCs (i.e. those in place prior to the 2001 Law taking effect) are expressly confirmed by the 2001 Law to remain in force until the expiration of the relevant contracts. 20 The principal of sanctity of contract is observed, and the terms of the existing PSCs remain unchanged (save that rights and obligations of Pertamina are transferred to BPMIGAS). 21 This means that some of the changes brought about by the 2001 Law, such as the extension of domestic market supply obligations to gas as well as to oil, are not thought to apply to existing PSCs. However, as discussed elsewhere, where an extension to a PSC is sought, which is an increasingly common occurrence, the terms and conditions of the extension appear likely to take into account developments and changes in the regime. For PSCs created after the enactment of the 2001 Law, both the law itself and now the Upstream Regulations stipulate a list of matters to be addressed in PSCs 22 and a number of specific positions to be reflected in certain provisions of PSCs. Except where specified, for the purposes of this Chapter, PSCs should be taken to mean PSCs reflecting the 2001 Law and Upstream Regulations. It should be recalled, however, that PSCs for existing, producing fields in Indonesia will have been entered into under the previous regime. Most of the core provisions are largely the same, although the standard terms of PSCs have been altered from time to time historically to deal with policy or legal changes, and to give effect to government incentive packages for oil and gas investment. PSCs are an important tool in the government s control of upstream activities, ensuring it can control such activities through contractual conditions, as well as through applicable laws and regulations. 23 A brief summary of some key aspects of PSCs under the 2001 Law and Upstream Regulations follows. Production Sharing Contracts (PSCs) Parties A PSC is entered into by a contractor with BPMIGAS. A contractor can be either an Indonesian incorporated entity, which can in theory include a foreign owned Indonesian company although this is not an option used in practice to date, or an entity incorporated in another jurisdiction. A contractor can have an interest in only one working area, and thus separately incorporated entities are needed to hold interests in several working areas under common control. 24 Validity period, extension and relinquishment A PSC has a maximum period of (and is normally granted for) thirty years. This comprises an initial exploration period of six years (extendable on one occasion only for a maximum of an additional four years, provided that the contractor has fulfilled the minimum requirements to date), and the exploitation period. At the end of the exploration period, the working area is relinquished and the PSC terminates if the contractor has not discovered oil and/or natural gas in quantities that can be produced commercially. If such discoveries have been established, the contract will continue into the exploitation period. 25 A PSC can be extended for up to twenty years in each extension. The application for extension is made to the Minister through BPMIGAS. This application can be made at the earliest ten years and at the latest two years before expiry of the PSC. 26 The need to secure extensions significantly in advance of expiry has been an issue in certain projects that require large amounts of funding, in particular the large Tangguh LNG project. Perhaps partly in recognition of this, the limit on the earliest date to apply for an extension (i.e. ten years before expiry) is excluded if the contractor is bound by a natural gas sale and purchase contract. 27 Whether this exception will prove to be suitably expressed as the LNG market and natural gas market in Indonesia change remains to be seen. 20 Law No. 22 of 2001, art. 63 s. c). 21 Law No. 22 of 2001, art. 63 s. a). 22 Law No. 22 of 2001, art. 11.3; GR 35, art. 26, art Law No. 22 of 2001, Official Elucidation to art Law No. 22 of 2001, art GR 35, art. 27; also Law No. 22 of 2001, Official Elucidation to art GR 35, art GR 35, art ENCYCLOPAEDIA OF HYDROCARBONS

5 INDONESIA Another issue with PSC extensions is the terms and conditions that will apply. Although not specific on this particular point, the Upstream Regulations provide that the provisions or form of contract in the extended contract should remain profitable for the state. 28 This provision is not specific about where the line will be drawn, but suggests that as part of an extension the government may require changes in the terms and conditions reflecting more recent developments, notwithstanding the terms of the existing PSC. This appears to have been the government practice. A PSC will provide for specified percentages of the working area allocated initially to be relinquished in stages. 29 This is aimed at reducing the problem of contractors sitting on assets that are not used. Commonly, at the end of the relinquishment schedule, the contractor will hold only a fraction of the initial area. Domestic Market Obligations (DMO) In accordance with the 2001 Law and Upstream Regulations, a contractor is obliged to provide a maximum of 25% of its share of oil and natural gas to meet domestic demand. 30 Under PSCs entered into prior to the 2001 Law, the domestic market supply obligation does not extend to natural gas. At the time of writing, the future impact of DMO remains unclear and an issue of potential concern to investors. Under the 2001 Law, it is stated that the implementation of DMO will be further regulated by Government Regulation; the Official Elucidation states that this will cover basic matters including provisions on price and the policy of providing incentives. 31 It is unclear whether the provisions in the Upstream Regulations on DMO are intended to represent these Government Regulations on DMO referred to in the 2001 Law. The provisions of the Upstream Regulations related to DMO contain little regarding specifics. In particular, they contain no stipulation on price. The picture is further confused by the Constitutional Court ruling referred to in the opening section of this Chapter. Although it upheld the main provisions of the 2001 Law, the Constitutional Court did identify several provisions of the 2001 Law, which it considered did not meet the requirements of the 1945 Constitution. Perhaps the most significant provision was the reference to DMO being based on a maximum of 25% of production. The Constitutional Court felt that a maximum without a minimum did not guarantee sufficient benefit for the state and thus prescribed the deletion of reference to a maximum. Therefore, it appears that the 2001 Law would then provide for a flat 25% to be caught by DMO. It is not an established role of the Constitutional Court to amend a law in this way (as opposed to striking down provisions), and subsequently it has been indicated that the Indonesian Parliament may amend the 2001 Law to deal with the Constitutional Court s finding. At the date of writing, no such amendment appears to have been enacted. It would seem arbitrary to provide a flat percentage for DMO that may not match reality. Indeed, if DMO were to be applied to major new gas projects in Indonesia, in the current circumstances, infrastructure to accommodate the gas supplied may be insufficient. A PSC will stipulate expenditure for a fixed work programme for the initial years of the exploration period. 32 Ownership of oil and natural gas remains with the government until it passes the point of delivery, and sharing of production is effected at this point. 33 This is distinct from the approach sometimes taken under licence based systems whereby ownership is held by the licensee even before mining. PSCs can be in Indonesian or English, and are commonly in the latter. PSCs are subject to Indonesian law. 34 Handling of Production As the name suggests, the provisions of PSCs dealing with how the oil and natural gas produced is to be allocated comprise an important part of the system. These provisions are also relatively complex and affected by numerous variables. What follows is an attempt to summarize common elements of the basic approach. The 2001 Law and Upstream Regulations refer to the general concepts involved, but also contain few specifics in this area. The detail is found mainly in the terms and conditions of the PSC and, to some extent, the practices of BPMIGAS. The basic scheme for the allocation of production under a PSC will be along the lines of the following. First tranche petroleum. Before deduction for recovery of investment credits and operating costs, a percentage of production typically 20% in previous cases is taken as first tranche petroleum. In the past, this first tranche petroleum had been split between the contractor and the government party (now BPMIGAS), in accordance with their relevant sharing 28 GR 35, art GR 35, art. 7.1; also Law 2001 No. 22, art Law No. 22 of 2001, art. 22; GR 35, art Law No. 22 of 2001, art and Official Elucidation, art GR 35, art Law No. 22 of 2001, art. 6.2; GR 35, art GR 35, arts. 37 and 38. VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 837

6 NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY splits. In more recent rounds of PSCs signed, there have been examples of PSCs in which first tranche petroleum is taken entirely by BPMIGAS, and is thus part of the state s revenue effectively a form of royalty. Cost recovery. After first tranche petroleum, the contractor is entitled to recover its operating costs from production. Operating costs recoverable in a year comprise of current-year non-capital costs, current-year depreciation for capital costs, and any recovery permitted for unrecovered costs of previous years. Only certain categories of costs will be permitted as recoverable, and amounts are linked to approved budgets and work plans. Costs related to oil and costs related to natural gas are treated separately. The implementation of the cost recovery regime is overseen by BPMIGAS, and is one of the key areas in which contractors deal with BPMIGAS on an ongoing basis. Ultimately, amounts to be recovered must be agreed with BPMIGAS. Alongside cost recovery, as part of various previous incentive packages designed to encourage investment in oil and gas assets, the contractor may also be entitled to take amounts representing certain investment credits. These are defined percentages of identified capital investment costs. Remaining production. After cost recovery, the remaining production is split between BPMIGAS and the contractor, according to specified sharing splits or equity shares. The application of these splits depends on a number of variables, including the nature of the field and the level of production. A standard sharing split for conventional areas (i.e. not for frontier production) to date would be for oil: BPMIGAS 85%, contractor 15%; for gas: BPMIGAS 70%, contractor 30%. These percentages reflect the position after tax, the contractor being subject to Indonesian income tax. The precise pre-tax percentages, specified in the PSC, will differ accordingly and, therefore, will show the contractor as receiving a somewhat greater percentage. DMO. As noted above, the contractor may be required to make a percentage of its share available to satisfy domestic market obligations. This will be taken from its equity sharing split of remaining production. Where it is applied, DMO will operate differently to the other parts of the production sharing mechanism, since it will in fact comprise sales of oil and/or natural gas by the contractor from its share. It will, nevertheless, affect the return of the contractor and the production available to it for its own purposes. Production bonuses. For completeness, over the course of the PSC, the state may also receive certain bonuses based on the achievement of specified cumulative production levels. The sharing of production is effected at the point of delivery. 35 As standard practice, BPMIGAS can appoint the contractor to sell the state s share of oil and/or natural gas. In that case, the contractor is authorized to transfer ownership of the state s share at the point of delivery. 36 Transfer of interests in PSCs Under the Upstream Regulations, a transfer of part or the whole of a contractor s rights and obligations or participating interest under a PSC requires approval from the Minister. 37 In practice, obtaining this approval is dealt with through BPMIGAS and, in accordance with the Upstream Regulations, takes into account the considerations of BPMIGAS. In addition, the terms of the PSC itself will require BPMIGAS s consent, as a party to the PSC, for such a transfer. Notably, there is no requirement for consent from the Minister or BPMIGAS regarding the change of control of a PSC contractor. Since PSC contractors are commonly special purpose vehicles (indeed, the 2001 Law stipulates that an entity can have an interest in only one working area), in substance, a transfer of ownership of the contractor itself can provide an alternative means to transfer a participating interest. The Upstream Regulations also introduce a new, and potentially restrictive, provision in this area. Where a contractor transfers the whole of its participating interest to a non-affiliated company (not further defined), and that is not currently a partner in that working area, the Minister may request the contractor first to offer to national companies. 38 No further details are provided as to how such an offer will occur. This provision, to the best of our knowledge at the date of writing, remains to be tested in practice. Approval of first development plans The approval of a development plan for the first production from a working area has particular significance for a number of reasons. First, approval of the first development plan is sometimes viewed as important to ensure that a PSC continues into the exploitation period after the exploration period. Although there is no reference to the approval of the first development plan as a condition of the PSC continuing beyond the end of the exploration period the reference, as noted above, is simply to the discovery of commercial quantities of oil 35 GR 35, art GR 35, art GR 35, art GR 35, art ENCYCLOPAEDIA OF HYDROCARBONS

7 INDONESIA or natural gas 39 there is no other formal confirmation of this continuation, and approval of the first development plan can be viewed as ensuring that this requirement has been satisfied. Secondly, the first development plan needs approval from the Minister subsequent development plans for a working area are approved by BPMIGAS. 40 Thirdly, the Upstream Regulations (and typically the PSC itself) provide that as of the approval of the first development plan, the contractor shall offer a 10% participating interest to a Regional Government owned business enterprise and, failing take up of that offer within sixty days, to national companies. 41 Again, there is no detail on the operation of this provision although requirements for Indonesian participation have been part of PSCs in the past. This is expected to be an area of increased activity in coming years. Role of the operator and taxation In many PSCs, more than one contractor holds a participating interest. Each of the contractors will hold a percentage of the entire interest. In that case, one of the contractors will be the operator of the asset. It is worth noting that in these cases, BPMIGAS, in administering the regulatory system, will generally deal only with the operator. Therefore, for example, where one of the other contractors needs to obtain consent to transfer its participating interest, the process of obtaining this consent will be dealt with through the operator. Taxation is beyond the scope of this Section. Nevertheless, a few general comments in this area can be made. Where a contractor is foreign incorporated, by entering into a PSC it becomes a permanent establishment taxable in Indonesia. A contractor is obliged to pay taxes as part of its obligation to pay state revenues. 42 Historically, a largely special tax regime has been applicable to upstream oil and gas activities. Currently, greater emphasis is being placed upon the application of general tax laws and regulations for upstream activities, although this remains a contentious area. The 2001 Law and Upstream Regulations specify that state revenue in the form of tax comprises taxes, import duties and other levies on import and excise and regional taxes and regional retributions. 43 The latter item remains an area of some difficulty as discussed further below. Notably, contractors now have the option under the 2001 Law and Upstream Regulations to stipulate in the PSC that the obligation to pay taxes will be determined in accordance with either the provisions of the tax laws and regulations prevailing at the time of execution of the contract or the provisions of prevailing tax laws and regulations. 44 The aim is to allow contractors flexibility to make their own assessment for the purposes of business feasibility given the nature of upstream activities as a long term investment, involving commitment of significant capital and significant risk. 45 This concept provides a specific example, embedded in legislation, of the sanctity of contract principle for PSCs: the contractor can choose to fix in the PSC the tax regime that will apply for the duration of the contract Enviromental law and regional autonomy Environmental Law Clearly, many areas of the general law in Indonesia will apply to the oil and gas industry as to other industries. Although this Chapter does not aim to cover all areas of the general law relevant to upstream oil and gas operations in Indonesia, at the current time it would seem incomplete to review the regulation of upstream activities without briefly covering two particular areas of concern, environmental law and the impact of regional autonomy. The primary law in Indonesia relating to environmental matters is Law No. 23 of 1997 on Environmental Management (Environmental Law). There are a number of related laws and regulations in place, including some regulations made under previous environmental laws, which have not been repealed and are applied in practice to the extent not directly contradicting the Environmental Law. This is an area where precisely identifying the prevailing legal position can be difficult for the reasons outlined above. The Environmental Law deals with a number of requirements regarding specific issues affecting the environment. These include: obligations to treat waste, a specific regime for hazardous and toxic wastes, and requirements to meet discharge and environmental quality standards in water and air. 46 Each of these will be of relevance to an upstream oil and gas project. 39 See note GR 35, art. 95, art 90 s. d). 41 GR 35, arts. 34 and Law No. 22 of 2001, art and 2; GR 35, art. 52 paras.1 and Law No. 22 of 2001, art. 31.2; GR 35, art Law No. 22 of 2001, art. 31.4; GR 35, art Law No. 22 of 2001, Official Elucidation to art National standards for water and air are contained in Government Regulation No. 82 of 2001 and No. 41 of 1999 respectively. Requirements for various types of emissions are set in a number of other specific regulations. Regional Governments have also enacted environmental standards that, if more strict, may supersede the national standards. VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 839

8 NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY An overarching element of the regime in the Environmental Law is the use of the environmental impact analysis process (AMDAL, an acronym based on the Indonesian). AMDAL comprises preparation of terms of reference and, on the basis of the terms of reference, an environmental impact assessment, an environmental management plan, and an environmental monitoring plan. Only business activities considered to have a significant impact on the environment need to go through the AMDAL process. Suffice to say, oil and gas upstream operations are required to comply with the AMDAL process. The purpose of the AMDAL is to arrive at a specific set of requirements for that business which will ensure compliance with applicable environmental standards. The fulfillment of the AMDAL process, comprising of each of these elements, must be approved by the central or regional government. Allocation of responsibility in this area depends on the application of recent changes to the regional autonomy regime, the implementing regulations for which have not been enacted at the date of writing. The prevailing view, at least in central government, is that this remains a matter for central government. In oil and gas projects, performance in accordance with the AMDAL is monitored, 47 a task carried out by an office of the Ministry of Energy and Mineral Resources or the regional government (depending on the allocation of responsibility as referred to in the preceding paragraph). This comprises supervision of the implementation of the environmental management plan and monitoring plan, as comprised within the AMDAL. Of note in this context is the regime for treatment of hazardous and toxic waste the so-called B3 wastes contained in separate Government Regulations. 48 Oil and gas upstream operations are identified in these regulations as a source of particular categories of B3 waste (drilling mud, oil sludge, used active carbon, other sludges and drill cuttings). This regime sets out particular requirements for management of these types of waste. As an industry-specific supplement to these matters, a Regulation of the Ministry of Mines dating from 1973, 49 which still appears to be in force, expressly prohibits discharge of oil, drilling mud, or other toxic mud into the sea. This also requires that an oil and gas project have in place an emergency plan, approved by the Director General of Mining, containing mitigation measures to address pollution issues arising from activities. It can be assumed, in any event, that such discharges and pollution would breach other provisions of current environmental laws and regulations in Indonesia. In mid-2006, hot and foul smelling mud started to erupt from near the site of an exploration well being drilled onshore in East Java. It is alleged that this is the result of an incident and loss of control during drilling. The impact on the surrounding area and population has been enormous, displacing thousands of people and disrupting business and industry. There is no sign yet of the mud flow abating and the story looks like having several yeas to run. Both in the short term and longer term it can be anticipated that this may give rise to changes in regulation and practice in these areas. In recent years, the environmental issue of abandonment of installations has attracted significant attention in other jurisdictions. In Indonesia, the legal position of contractors with respect to abandoned installations remains somewhat piecemeal. The ultimate ownership of oil and gas installations rests with the government. 50 Neither the 2001 Law and Upstream Regulations nor the Environmental Law, that spell out an obligation of contractors to deal with installations after their operations. Under the current system, the existing obligations appear more likely to arise under the terms of the PSC. The Upstream Regulations provide that a contractor should allocate funds for post-operation activities and that the procedure for use of this fund be stipulated in the PSC. 51 Both in the Upstream Regulations and the 2001 Law, post-mining operation obligations are listed as one of the items for inclusion in a PSC. 52 Neither the Upstream Regulations nor the 2001 Law specify exactly what the post-operation obligations of the contractor should be. Notably, the standard form of PSC used since 1995 contains provisions in this area. It allows for accumulation of funds for post-operation activities and sets out several post-operation obligations to be fulfilled. These are expressed in somewhat general terms and focus on obligations to prevent further damage to the environment from old wells. They do not go so far as to spell out an obligation to remove or otherwise deal with disused installations, although this may be implied. Given the periods involved, the application of these provisions has not yet been tested. Further developments may be needed in this area in due course to provide greater clarity about the obligations falling on contractors. It can also be 47 Law No. 23 of 1997, art. 22; see also Government Regulation No. 27 of Government Regulation No. 18 of 1999 concerning Management of Hazardous and Toxic Waste Materials. 49 Ministry of Mines Regulation No. 04/PM/pertamb/1973 of GR 35, art GR 35, art Law No. 22 of 2001, art. 11.3; GR 35, art ENCYCLOPAEDIA OF HYDROCARBONS

9 INDONESIA queried whether it will be appropriate on an ongoing basis to try to deal with an issue of this magnitude, which has attracted public attention in other jurisdictions, in what is ultimately a private contractual document. Regional autonomy Two important regional autonomy laws were enacted in 1999, which were relevant to the regulation of upstream oil and gas activities. 53 These came into effect on 1 January Following amendments in 2004, the relevant laws are now Law No. 32 of 2004 on Regional Autonomy; and Law No. 33 of 2004 on Fiscal Decentralization. The Regional Autonomy Law grants authority to regional governments to deal with a variety of consultation and other rights in connection with upstream oil and gas investments made within their regions. Under the 2001 Law and Upstream Regulations, there are various rights provided to regional governments, such as consultation rights in relation to the determination of working areas to be offered, 54 and with respect to approval of the first development plan in a working area. 55 The Upstream Regulations also contain some generally expressed provisions concerning the obligation of contractors with regard to the development of the local community. 56 These provisions refer vaguely to potential aspects, such as improving the residential environment of the community so as to bring about harmony between the contractor and the surrounding community, 57 and benefits in-kind in the form of physical infrastructure and facilities. 58 There is no detailed discussion of what is needed to fulfill requirements in this area. The Upstream Regulations provide that in activities to develop the local community, a contractor co-ordinates with the Regional Government. 59 In some cases, regional governments, apparently under the aegis of this provision and the Regional Autonomy Law, have negotiated directly with contractors with regard to benefits for the locality. The Fiscal Decentralization Law contains provisions for increased tax and revenue sharing between Indonesia s central government and the regional governments. Again, this principle is recognized in the 2001 Law and Upstream Regulations. Part of the contractors obligation to pay state revenues comprises regional taxes and retributions. 60 The operation of these aspects of regional autonomy has been a key concern in recent years for investors in the oil and gas sector. Investors are now required to deal with regional governments as well as central government. The regional governments, de facto, have the ability to restrict or impede their operations. Investors are concerned by the lack of coordination of the overall position. Consultation and other rights (and in particular, the right to levy taxes and negotiate other local benefits) can be exercised in an apparently haphazard and inconsistent way. Indeed, the central government has reportedly revoked numerous over-reaching regional government bye-laws over recent years in an effort to improve this aspect of the investment climate. At present, the problem remains Downstream business activities Background Downstream business activities are defined in the 2001 Law as business activities focused or based on the following: Processing. Activities of refining, obtaining derivatives, enhancing the quality and increasing the added value of crude oil and or natural gas, excluding field processing. Transportation. The activity of transferring crude oil, natural gas and/or the products of their processing from the working area or from the collection and processing area, including the transport of natural gas through transmission and distribution pipelines. Storage. Activities of receiving, collecting, gathering and/or releasing crude oil and/or natural gas. Trading. Activities aimed at purchasing, selling, exporting or importing crude oil and/or the products of its processing, including the trading of natural gas through pipelines. 61 In October 2004, provisions of the 2001 Law were supplemented with the enactment of Government Regulation No. 36 of 2004 concerning Oil and Natural Gas Downstream Business Operations (Downstream Regulations). Downstream activities in oil and gas were previously the exclusive preserve of Pertamina as a government monopoly. The 2001 Law, now supplemented by the Downstream Regulations, introduced a new regulatory system based on the grant 53 Law No. 22 of 1999 on Regional Autonomy and Law No. 25 of 1999 on Fiscal Decentralization. 54 Law No. 22 of 2001, art. 12; GR 35, art Law No. 22 of 2001, art. 21.1; GR 35, art GR 35, Chapter VIII. 57 GR 35, art GR 35, art GR 35, art Law No. 22 of 2001, art. 31.2; GR 35, art Law No. 22 of 2001, art. 1 paras. 10, 11, 12, 13 and 14. VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION 841

10 NATIONAL REGULATION OF THE HYDROCARBONS INDUSTRY of business licences for specific downstream activities. There are opportunities now for private participation in downstream activities although lack of or limited precedent is still tending to slow the bureaucratic process farther. Private companies are gradually having an impact, however, most visibly retail petrol stations in an around Jakarta mentioned above, although there remain structured impediments in the broader retail market. In many respects, the rules and regulations applicable to downstream activities are those generally applicable to business activities in Indonesia (many or most of which involve the grant of business licences for the relevant activities). Certainly, downstream activities are not regulated by the special PSC-based system as described for upstream activities or any equivalent. Downstream business activities can only be carried on by business entities incorporated in Indonesia, pursuant to a business licence issued by the Minister. 62 As with upstream operations, the Minister is, in practice, represented by the Directorate General of Oil and Gas. Although only Indonesian incorporated entities can hold such licences, these can be Indonesian subsidiaries of foreign investors. Regulation and supervision Regulation and development of downstream activities are overseen by the Minister with input from BPHMIGAS and other related agencies, and downstream activities generally are supervised by the Minister. 63 BPHMIGAS is responsible for regulation and supervision of fuel-oil supply and distribution, and transportation of natural gas by pipe. 64 As these activities are part of the general scope of downstream activities, they are to be carried out by entities holding business licences granted by the Minister. A business licence will only cover one type of downstream activity (except in certain cases where transportation or storage, or, in more limited cases, trading are considered as a continuation of or support to another activity, in which case they will also be covered by the relevant licence for that principal activity). 65 A single business entity can be granted more than one downstream business licence. 66 An entity that is a contractor in a PSC cannot also hold a licence for downstream activities. 67 The regulation of processing to produce lubricants and petrochemicals is done jointly by the Minister of Energy and Mineral Resources (through the Directorate General of Oil and Gas) and the minister in charge of industry. 68 Distribution and transportation of natural gas Increased domestic use of natural gas is an officially acknowledged target in Indonesia. At present, there is very limited gas infrastructure in Indonesia. It is hoped that the ability of private companies to carry on the business of gas transportation as part of downstream activities may play a role in developing this infrastructure. A number of special provisions in the 2001 Law and Downstream Regulations relate to the distribution and transportation of natural gas. In order to transport natural gas by pipe, a business entity must hold a Special Right as well as a business licence. 69 A Special Right is granted by BPHMIGAS and gives the recipient the right to carry out transportation of natural gas by pipe in an identified area of a transmission network or distribution network. 70 These areas will form part of the National Natural Gas Distribution and Transmission Network Master Plan, expressly provided for in the 2001 Law and the Downstream Regulations. This is established by the Minister and is an evolving document, which is envisaged to change over time. 71 A business enterprise transporting natural gas by pipe must give access to other parties to use the facilities it owns to transport natural gas with due regard to technical and economic aspects. 72 The tariff, which can be levied, is to be determined by BPHMIGAS with due regard to the economic calculation of the business enterprise s, users and consumers interests. 73 Although some of the relevant concepts appear to be contemplated, these provisions do not provide the level of detail that has been necessary elsewhere to successfully establish and operate open-access gas transmission and distribution networks. At the date of writing, it remains to be seen whether these provisions can be used successfully in the development and operation of gas distribution and transmission networks in Indonesia. 62 Law No. 22 of 2001, art. 23; GR 36, arts. 2 and GR 36, arts. 3, 4 and GR 36, art. 7, Presidential Decree No. 86 of 2002, art. 4; Government Regulation No. 67 of 2002, art Law No. 22 of 2001, art. 23.2; GR 36, art. 16.1, art and art Law No. 22 of 2001, art Law No. 22 of 2001, art GR 36, art GR 36, arts. 9.1 and GR 36, art. 1.14; Presidential Decree No. 86 of 2002, art. 6; Government Regulation No. 67 of 2002, art Law No. 22 of 2001, art. 27.1; GR 36, art.1.11, art GR 36, art GR 36, art ENCYCLOPAEDIA OF HYDROCARBONS