Consequences for Firm Behaviour, Innovation, Value Creation and Framework Conditions on the Norwegian Continental Shelf

Paper presented at the PetroBank User Group Meeting, Petrodata AS.
Haugesund 10 September 2003.

That knowledge and technology create progress and cause major shifts in the economy’s functionality aren't news. By covering basic needs more efficiently, we have been able to release resources to produce more advanced goods and services, moving through several industrial revolutions.

Changes have been driven by major discoveries and inventions like controlled fire, the wheel, the steam engine, the incandescent light bulb, the assembly line, fossil energy, the transistor and so on. Such innovation did not only introduce new products, but caused major quantum leaps because they opened opportunities for improving all production.

Political conditions, have, however, been just as important. It is not accidental that the development was very slow through millennia of isolated and warring nations governed by omnipotent kings, emperors and priests, but sped fabulously ahead in the 20th Century and in those parts of the world where liberal and open political systems were implemented - the sector of time and space often called ”the mainspring of human progress”.

Few doubt that the changes have caused enormous improvements for most people, but change is also demanding. Those failing to acquire and make use of new knowledge fall behind. Business empires crumble, and the learned are forced to rewrite textbooks. More often than not; such change takes time and is met with fierce resistance.

Now all of this is happening again, only more forcefully than ever, since technological and political changes take place simultaneously, reinforcing each other and for the first time affecting almost the entire world within the same time period.

The main technological drivers are of course new instruments for collecting, storing, processing and communicating information and knowledge. The political drivers are globalisation, economic integration, the breakdown of communism and other centralized power systems and the termination of the Cold War.

We have already for some time been discussing the post-industrial society characterized by the emergence of a large information and communication-handling sector. The expectation was that this new quartiary sector would make a strong inroad in the relative distribution of production factors, just like secondary and tertiary sectors had done earlier, and made possible by more efficient production in the older sectors. Industry provided better tools for agriculture and service industries facilitated industrial production. Still, it wasn't hard to distinguish between a food producer, an industrial enterprise and a service provider.

The current change does all of this, but even more. Firms in the old sectors do not only purchase ICT tools. Collection, processing, communication and certainly creation of new knowledge are being integrated in production processes and products by advanced firms in all sectors. In a manner of speaking, such firms are becoming ICT companies themselves, at least in the sense that knowledge is emerging as the main production factor of the 21st Century.

This is the most dramatic change. Earlier, economic activities could without serious error be described as interaction between the three classic production factors, labour, capital and natural resources. All of these can with reasonable accuracy be defined, measured and evaluated. This made it possible to work with definable parameters in business economy and social economy; in accounting, annual reports and tax rules.

Granted, it has been known that innovation and new knowledge are sources of societies’ increasing value creation, but is has been assumed that most sources of new knowledge have been outside the commercial sphere, so-called exogenous, and that whatever might be created within firms at best can provide temporary advantages before leaking out, and therefore only cause minor market imperfections compared to how firms are expected to perform based on the three ”old” production factors alone. Hence it could be ignored as a production factor.

One could have believed that the Internet and other rapid knowledge dispersion systems would work to confirm this: That knowledge indeed would be made easily available to everybody. If so, economic theory would not need to be revised, but become even better at describing and predicting economic activities. But this has so far been proven quite wrong. Proprietary knowledge has become much more profitable and allowed leading firms to continue to create new knowledge faster than the leaks. Indeed, specialized knowledge is required to find and assimilate knowledge even from the public domain.

The complete cycle however ensures that also knowledge in the public domain is growing and rapidly dispersed, providing a strong feedback to primary knowledge creation. But its main impact is probably in the political sphere. While early predictions told us that the computer would become a powerful tool in the hands of “Big Brother”-societies, the opposite turned out to be the case, certainly combined with the Internet: It is now extremely difficult for anybody to monopolize news and other politically relevant information. The new technology has strengthened the individual and no doubt contributed to opening up earlier closed societies, another strong feedback to the economic sector.

I will not bother you by repeating the extensive evidence that knowledge indeed is emerging as a fourth and very powerful production factor, and has been doing so for the last two or three decades. This audience represents the pioneer industries, and you will of course simply smile to a claim that firms do not create knowledge and that knowledge doesn't create value in firms. For the old mainstream of analysts, planners and economists, even for many commercial actors, this is however a strange and, for some, a frightening novelty. But there is no escape any more. Textbooks must be rewritten, and firms must change their behaviour.

The interesting point is that knowledge as a production factor behaves quite differently from the three others, and that even different kinds of knowledge behave differently.

There is already an extensive literature on the knowledge economy, also called ”innovation economy” or simply “new economy”. It has developed from early studies about how firms can become more efficient by better employee management programs like education, incentives and participation, and about how better organization can release more creativity and enhance efficiency. This led to coining of the term ”human capital” that focused on the knowledge embedded in the individual.

The concept of ”human capital” didn't, however, seriously challenge classic theory, since it could be seen as just a new name for labour as a production factor. Assuming that employees would take out all value created from human capital through their wages, you could still use the old models for firm behaviour.

When we realize that companies can develop knowledge over and above what is attributable to individuals, however, the concept ”human capital” has to be extended. Most modern knowledge economists today combine ”human capital” with “structure capital” and ”relation capital”, adding all three up to “intellectual capital” or IC (also often called ”intangible capital” or ”knowledge capital”) as the fourth production factor.

In theory, a comprehensive balance sheet could now look for example like this:

This takes care of the possibility that some of the knowledge capital, notably a large part of the human capital, may be leased or purchased from others, and that some acquisition costs will have been written off. It is a common misunderstanding that it is not necessary to take account of knowledge capital, since acquisition costs (R&D, internal, education) may be deducted.

So can, however, acquisition costs for all kinds of capital. The whole point is that capital is acquired because it leaves a value creation capability over and above acquisition costs, reflected as equity capital on the liabilities side. In fact, there is every reason to believe that knowledge capital generates much more incremental value creation capability than tangible asset capital.

This naturally gives rise to many questions about how such a balance sheet can be implemented in practise, to which there are so far only insufficient answers. If time and interest, we can return to this, but for our purpose now, it is more interesting to look at how the increasing importance of IC affects firm behaviour, since it certainly does and will do all by itself, notwithstanding immature abilities to describe it.

In the old business model, asset capital was the dominant value creator. Since most (asset and human) means of production were rival (could only be used for one purpose at the time), advantages of scale were mostly limited to shared overhead costs. Markets were subject to the law of diminishing returns, as increasing investment from many suppliers would push prices down to the level of lowest acceptable rate of return. A firm would invest or reinvest where expected returns were seen to be good and reasonably compatible with the business concept, which could mean in any direction. This would often lead to a large variety of product lines and a large and diverse organisation that also would include many in-house staff and supply functions.

The emergence of IC as the dominant value creator changes all of this. IC means per definition proprietary knowledge, i. e. knowledge not readily available on the market for everyone. Hence, a competitor cannot easily copy the product or the internal production and marketing processes, and the producer can have a captive market for his unique product and obtain a good price for a while. This grace period is dependent on how quickly the knowledge leaks out. Knowledge embedded in the product leaks more quickly than knowledge in internal procedures. So-called tacit or informal knowledge leaks more slowly than knowledge that easily can be communicated in writing or over distances. Some knowledge is clearly non-rival, that is, possible to implement many times and in many places simultaneously with no or very low costs, other kinds of knowledge is very rival because it is embedded in for example company culture, tacit know-how, experience, unique personalities, customer and supplier relations, brands, networks etc.

With all these heterogeneous properties of IC, it is clear that IC management is highly demanding, but also very rewarding, and that it is going to be much more difficult to model and predict firm behaviour than in the old world with fairly homogenous factors.

But in the market, adjustment will take place whether actors or observers understand it or not. We can only begin to compare empirical and theoretical observations, but some mainlines do emerge.

When you have a product where a significant part of its utility is non-rival knowledge (typically software or hi-tech equipment), you will want to maximize profits by selling it in as large volumes as possible until it leaks out to competitors. This requires a worldwide production and marketing organisation with excellent internal communication that enables efficient dispersion and implementation. This will give you good profits that can be reinvested in developing the next generation product or new products that can allow you to remain ahead and continue the cycle. It also requires a highly creative and adaptive organisation with good leadership functions.

Hence, it is becoming less interesting to look outwards for markets where somebody seems to make high profits, and more important to look inwards to where you have your own core competence. This is where you must focus your resources.

It looks like an ideal situation is to have unique non-rival products that are developed and marketed by a large, but highly specialized organisation based on rival knowledge. This is, of course, an accurate description of Microsoft and other successful ICT companies, something you know all about.

It is, however, also typical for the best oil companies and many advanced companies within the supply industry, after restructuring through the last decade. The mantra among major oil companies has been mergers and outsourcing, creating organisations larger in volume and geography, but narrower in product lines. They have core competence as what we could call orchestra leaders. This includes choosing and guiding suppliers and R&D institutions, managing financing and risk, understanding political and social conditions in host countries, selecting projects, project leadership etc. Such competence is based on extensive experience in time and space, intensive networking and so on, and hence very hard to copy for outsiders. Maintaining it requires development and implementation of advanced information and communication systems.

Many will say that the merger process was driven by other factors, such as acquisition of resources by financially strong companies in a period where many independents suffered under low oil prices. This may be so, but it certainly didn't hurt that the combined merger and outsourcing processes also represented a powerful adjustment to the knowledge economy.

There is also specialization among oil companies. Most majors, many independents and some niche companies retain exploration as a main activity and hence geo-disciplines as core competence. Interpretation of seismic data and other tools for discovering resource potential are disciplines fitting very well to the profit opportunities of the knowledge economy. This competence is strongly embedded in groups of humans with experience, specialized knowledge, creativity and imagination, making each company's geo-culture unique and protected by the dependence on a lot of tacit knowledge.

This is also the area where we can see the most spectacular applications of information and communication technology, such as when geologists located at opposite ends of the world walk together ”exploring” in a virtual underground reality. Using such tools, the rival IC embedded in the company's combined geo-brains creates a product - finding oil and gas - that is non-rival in space and low-rival in time, but still not part of the sold product that would make it exposed to copying. And the orchestration part has many similar properties.

Other oil companies are not primarily explorers, but specialists in marginal fields or tail production, requiring correspondingly specialized IC. The most recent addition to the family is small companies that are not orchestra leaders at all, but have all focus on the early exploration phase and prefer to sell off a defined prospect even before it has been drilled.

But the properties of the knowledge economy become even more complicated. Few are able to create and maintain the desirable knowledge edge through internal resources only. All experience shows that networking, synergy and cluster effects become even more important in a knowledge economy. All of the above means sharing knowledge with others. To make full use of a supplier, or do your best for a customer, you need to show cards. To revitalize your own organisation, you need to hire qualified people from others, and accept that your own brains go to work elsewhere. To fertilize creativity and imagination, you need to allow your people to meet other professionals. Participants in networks or clusters can receive more than they lose, improving everybody's potential.

It isn't even clear that it is very important to protect your proprietary knowledge by formal means, like patents, confidentiality or limitations on your employees' rights to take other employment. Sometimes proprietary knowledge is even released freely to increase markets or influence standards, facilitating sales of the next product. This is far from the rule, but another example of how knowledge that starts as proprietary later moves around and that we therefore have little need to worry about lasting monopolies abusing consumers.

A good example of the technology cycle is horizontal drilling. Hydro came up with the concept because it could be a solution to the problem of how to recover oil from the narrow oil layers in Troll. Several suppliers did the actual technology development, in particular Halliburton, which retained the technology rights, since Hydro never had any interest in owning that kind of technology. For a while, it was a unique Halliburton product until it was understood and implemented by others.

Similarly, new ideas, new IC and new products are continuously created in interaction between partners, competitors, suppliers and customers. Tacit IC is still best exchanged among actors in physical vicinity; hence related firms tend to get together in clusters.

Cluster building is considered particularly demanding for small countries; hence they should take good care of those they have. Torger Reve et al have identified the petroleum industry including suppliers, the maritime industry, the ICT industry and the fishing and fish farming industries as genuine Norwegian clusters, with the petroleum cluster as the strongest.

The Norwegian cluster is considered one of the world's three truly advanced petroleum clusters. A recent study by Akademisk Forskningsfond (AFF) at NHH indicates that the GoM cluster with centre in Houston is the IC leader, with Norway and UK both at approx. 80% of that:

These clusters support and compete with each other. The strong Norwegian position is easier to understand when we remember that revolutionary new technologies like horizontal und other advanced drilling, subsea completion and floating production all were developed in Norway.

Again, ICT plays a vital role both by facilitating such processes and as contents in the products.

Hence, we should expect that the Norwegian ICT industry's proximity to one of the world's leading petroleum clusters would represent a strong advantage. The petroleum industry represents the most important group of customers for the ICT industry, and valuable ICT products have been developed in the interface between these two Norwegian clusters. Adding the Norwegian maritime cluster we have a group of clusters with strong interdependence and IC exchange.

I am far from an expert on ICT, but I would imagine that it would be hard for a Norwegian ICT industry to reach up towards the levels of the world's main ICT clusters without strong partners like this. I also used to believe that this advantage would be limited to specialized applications relevant to the strongest local customers, but I have been told that this is in fact wrong and that we can be pretty good at more generic applications as well, as one leads to the other.

The interesting question is of course how new ICT quantum leaps are likely to change the rules of the game again. Will virtual reality improve person-to-person communication to the point that geography does not matter and even tacit knowledge may be dispersed everywhere? Would that mean farewell to clusters and differences between countries and regions? Will networking become so efficient that firms will downsize and prefer to work in loose and short-term coalitions, even more specialized? Will it be increasingly difficult to shield information, making even new knowledge instantly available to everybody like in the old theory- after all? Or will the sheer enormity of available information provide additional protection because it becomes even harder to find and absorb what can be used - making absorption capability the dominating IC factor? I don't know. Of course there will be more changes, but probably of a kind we cannot even predict today.

In the meantime, we can conclude that IC is here and likely to remain with us for along time. My final point will therefore be about what this tells us about political framework conditions.

One major line of argument is well known: IC based industries tend to create more value for society than is absorbed by the producers, because of knowledge dispersion and many other secondary effects. This can be seen as a positive externality, the opposite of for example harmful environmental effects that are seen as negative externalities, destructing value for others. But since society is very concerned about correcting the negative externalities through regulations, taxes and quota markets, shouldn't it also be concerned about encouraging the positive externalities through favourable treatment of IC intensive industries? This is a long debate that has included such issues as IT Fornebu, shipping taxation and how to distribute public R&D funding. The counter-argument, still relevant, is that selective ”pick-the-winner” policies may turn out erroneous and reduce capital market efficiency.

Less attention has been given to the opposite problem, that tax rules could in fact punish IC companies. The petroleum tax study group under Kon-Kraft recently showed that the petroleum tax system indeed causes knowledge rent to be taxed at the high 78% as if it was resource rent.

The point here is that both financial (asset) capital and IC contribute to a firm's total bottom line, but since IC doesn't appear in the balance sheet, the illusion is created that all of it is return on the invested financial capital. Under normal circumstances, the rate of return on invested capital will therefore seem to be high. The petroleum tax system is a progressive income tax system with limited shelters against the high bracket (the special tax).

The 2000 Finance Ministry petroleum tax study (”Bjerkedal committee”) made a proposal streamlining the system according to neoclassic Capital Value Theory. Only ”normal” returns on depreciated asset capital would now be sheltered. The theory, not acknowledging IC as a production factor, assumes that all above ”normal” must be ”extraordinary” or ”clean profits” that by necessity must have been created by natural resources or monopolies, and hence taxable at any very high rate without influencing investment behaviour. ”Normal” returns are defined as risk-free rent (stale bonds) plus a risk premium that the study group managed to eliminate, ending up with a shelter of 6% only.

This can be quite devastating for exploration and development incentives. If we look at a hypothetical model where an immature and unprofitable project is gradually improved by repeatedly substituting two units of asset capital with one unit of IC, we see that the project’s pre-tax economy may grow strongly while the post-tax economy deteriorates. IC is here treated as real capital for the taxpayer but no allowance is made for it in tax:

The Bjerkedal proposal wasn't sent Parliament, but the current system is not very different. Also, the Ministry of Finance continues to believe in its theory, and, also in 2000, it argued that a similar Capital Returns Allowance system should be the foundation of a new generic Norwegian company tax system. The Skauge committee proposed a modified version where returns above ”normal” are taxed when received by a shareholder as dividends.

The Kon-Kraft group, representing the oil industry, its suppliers, the shipping industry and the trade union LO, has documented that the special tax will cause erosion of the petroleum industry, i. a. because knowledge rent is taxed as resource rent and there is inadequate allowance for total risk. The current petroleum tax system is therefore also directly dangerous to all partner industries. But by the same argument, the Skauge committee proposal, or any other proposal including progressive taxation on company profits or dividends, is equally dangerous to all IC intensive businesses, and of course in particular to the ICT industry. Hence, these industries also have strong common interests related to fiscal frame conditions and what kind of theory to use for tax design.

Ramm Energy Partner, PO Box 104 Stovner, N-0913 Oslo, Norway.
Tel +47 21902000 or +47 92805015
(Former name Ramm Kommunikasjon).

This page last updated 17 October, 2010.