The oil industry in Azerbaijan is one of the oldest in the world, and the country has been a major oil producer since the late 19th century. The country’s production levels have varied over the years, influenced by factors such as global oil prices, investment in the sector, and the development of new fields. The Azeri-Chirag-Gunashli (ACG) field and the Shah Deniz gas field are among the largest and most significant fields in Azerbaijan. The country’s reserves are a mix of both onshore and rich offshore fields.

According to the June 2021 BP Statistical Review of World Energy, at the end of 2020 its oil reserves of 7 billion barrels (1 Mt) accounted for 0.4% of global reserves.

Azerbaijan holds 35 trillion cubic feet (Tcf) of proven gas reserves as of 2017, ranking 25th in the world and accounting for about 1% of the world’s total natural gas reserves of 6,923 Tcf.

In Azerbaijan, the exploration and exploitation of oil and gas resources are governed by two primary regulatory frameworks i.e., General Regulatory Regime and PSA Regime:

• General Regulatory Regime, which is the Same for Both Onshore and Offshore

Regulatory regime established under the Law on Subsoil of the Republic of Azerbaijan, dated February 13, 1998 (the “Subsoil Law”) and the Law of the Republic of Azerbaijan on Energetics, dated May 31 May, 2021 (the “Energetics Law”) (the “General Regulatory Regime”).

The Subsoil Law regulates relations concerning the study of the subsoil (search, exploration), its efficient use, protection and safety of work performed during subsoil study and use (the “Subsoil Activities”). This Subsoil Law and other current normative-legal acts of the Republic of Azerbaijan establish the regulatory regime which applies to the Subsoil Activities, including exploitation of oil and gas reserves.

According to the Subsoil Law, the relations of subsoil use related to energy are regulated by special rules determined by the relevant legislation of the Republic of Azerbaijan. The Energetics Law regulates the types of activities in the field of energy¹, the placement, construction and operation of facilities for the implementation of these activities, energy conservation, efficient use of energy resources and energy efficiency, as well as measures to prevent or reduce the negative impact of Energy Activities on the environment.

We should note that no separate regulations on the tender and direct negotiations for oil and gas industry been adopted yet and in practice, for major projects, SOCAR is authorized to hold direct negotiations subject to the relevant order of the President of the Republic.

• PSA Regime as “ad hoc” regimes established by specific production sharing agreements (the “PSA Regime”)

To date the most important investments in the oil and gas sector have involved foreign investors such as BP, and SOCAR acting as Azerbaijani contractual party. PSAs are considered as “sui generis” legal instruments and established as laws in their own rights ratified by the Milli Majlis.  In general, the companies acting under the PSA enjoy a distinct legal and tax regimes rather than relying to any extent on general provisions of Azerbaijani law.  Under such legal instruments, the state commercial interests are represented by SOCAR who, acts as a market participant on behalf of the State.  In practice, for any important projects in oil and gas sectors, the President of Azerbaijan has issued a special decree authorizing SOCAR as the domestic state-owned investor to grant the necessary rights and guarantees described in a typical project.

Each PSA sets out an ad hoc regulatory regime for oil and gas activities carried out on the specific field developed under the PSA. In particular, the PSA regulates:

• Ownership of mineral resources and assets;
• Health, safety and environmental compliance;
• Taxation;
• Import/export operations;
• Profit sharing mechanisms.

Footnotes:

¹ According to the Energetics Law, activity in the field of energy means activities related to the exploration, development, production, processing, storage, transportation, transmission, distribution and use of energy materials and products (energy resources) (the “Energy Activities”).

A. Energetics Law

The relations of subsoil use related to energy are regulated by Energetics Law (as discussed in response for question 2). According to the Energetics Law, in the cases provided for in Licenses Law, activities in the field of energy are carried out on the basis of a permit.

The exploration, development, production of hydrocarbon reserves, the transportation of oil and gas through export pipelines, the management of the electricity distribution network, the gas distribution network, and gas storage facilities, as well as other cases determined by laws regulating various sectors of the energy sector, are carried out based on a contract concluded between the “energy entity” that has obtained permission for such activity and the body determined by the relevant executive authority. Relevant executive authority is determined as following:

• Ministry of Energy and the State Oil Company in relation to the exploration, development, production, and transportation of hydrocarbon reserves through export pipelines;
• Ministry of Economy in relation to the management of the electricity distribution network, the gas distribution network, and gas storage facilities.

In accordance with the ‘Environmental Impact Assessment’ Law, for obtaining permission for types of activities in the energy sector, EIA and the opinion of the state ecological expertise on that document are also required. If these documents are not provided, decision on permission will not be granted.

B. Licenses Law

In the list of permits granted for entrepreneurial activities in the oil and gas sector, according to the Law of the Republic of Azerbaijan on Licenses and Permits, dated March 15, 2016 (the “Licenses Law”), are the following:

• Certificate on the application of a special economic regime for oil and gas activities intended for export;
• Registration of the list of equipment and materials to be imported to the Republic of Azerbaijan for obtaining concessions for oil and gas activities intended for export (import list);
• Permit for the exploration of oil and gas fields;
• Permit for the development and production of oil and gas fields;
• Permit for the processing of oil and oil products;
• Permit for the transportation of oil and oil products through pipelines;
• Permit for the production and processing of natural gas;
• Permit for the transportation of gas;
• Permit for the distribution of gas.

Given that the Law on Energetics was adopted recently there has been no established practice of implementation of the provisions of the law into the industry. It may also be argued that lack of express regulations under the Law on Energetics would complicate the application of the law to general industry.

Currently, Azerbaijan is not engaged into the exploitation of unconventional hydrocarbon resources like shale gas. Consequently, there is no separate regulatory regime specifically tailored for the exploration and extraction of unconventional hydrocarbons in the country.

To date, the upstream oil and gas industry is overseen by two ministries as follows:

Ministry of Energy of the Republic of Azerbaijan plays a central role in formulating and implementing state policy in the oil and gas sector. It oversees the exploration, production, processing, and transportation of oil and gas resources. The Ministry of Energy is also responsible for international cooperation in the energy sector.

Ministry of Ecology and Natural Resources of Azerbaijan is responsible for environmental regulation in the oil and gas sector. It ensures that exploration and production activities comply with environmental standards and regulations, focusing on minimizing the environmental impact of these activities. The Ministry of Ecology and Natural Resources can restrict the use of oil and natural gas products, as well as other types of fuel which pollutes the atmosphere upon their use.

In practice, one can still observe certain unclarity in roles of the Ministry of Energy, Ministry of Ecology and Natural Resources and SOCAR acting the contracting party on behalf of Azerbaijani Government on major oil and gas projects although the Presidential Apparatus and the Ministry of Economy keep strong hand of the state in the contractual issues over such projects.

The government of Azerbaijan is directly involved in the upstream oil and gas industry, primarily through SOCAR. SOCAR is the government-owned oil and gas company established in 1992. It plays a central role in the exploration, production, processing, and transportation of oil and gas in the country. SOCAR represents the Azerbaijani government’s interests in the oil and gas industry and is involved in various joint ventures and alliances with foreign oil companies.

Under PSA regimes, it acts as the contarcting party on behalf of the State as to development major oil and gas reserves in tandem with international oil companies. It also plays a significant role, especially in managing the country’s oil and gas reserves and in negotiating production sharing agreements with foreign investors.

Under the Land Code, lands cannot be allocated for ownership of foreign legal entities (only lease).

Otherwise, there are no statutory restrictions that are specifically applicable to foreign investments, including any restrictions on participation in the upstream oil and gas industry by foreign oil and gas companies. Also, there are also no restrictions on having foreign shareholders in an oil and gas company registered in Azerbaijan as well as on acquisition of shares in a company registered in Azerbaijan by a foreign shareholder. In this context, it should be noted that under certain tendering procedures, bidding commission give preferences to local companies with local participation when selecting successful bidder.

The local environmental regulations envisage, inter alia, the following requirements in respect of environmental protection and liabilities:

 A. Environmental Protection

• The Energetics Law stipulates broadly that any person working in the field of energy, as well as using energy materials and products, must protect the environment from pollution.
• Environmental Impact Assessment. Upon developing projects on the search, exploration, development, production and transportation of hydrocarbon the EIA shall be conducted for the purpose of implementing measures to find out possible adverse impact on the environment and human health, assessment of their scale and intensity, and its elimination or reduction of such impact.

• State Ecological Expertise. The EIA document (i.e., a report about assessment of impact to environment and human health) will also be subject to a state ecological expertise, to be conducted by the Ministry of Ecology and Natural Resources.
• Users of natural resources. A user of natural resources (including soil and minerals as well) shall obtain a permit in respect of its activities.
• Environmental quality standards. Entities are required to comply with environmental quality standards, which include, inter alia, permissible ultimate limits of the number of harmful substances which can be released and discharged into the environment.
• Environmental monitoring. Legal entities as the users of natural resources are also obliged to conduct a production monitoring of the environment, record and reporting of the environmental impact of their environmentally hazardous activities.
• Subsoil use. For the purpose of effective use and protection of subsoil, a pollution of subsoil and environment must be prevented upon use of the subsoil, as well as storage of oil, gas and other substances and materials underground, or discharge of waste water. In cases when there is a risk of pollution of the places of mineral deposits and underground works, industrial and domestic wastes should not be disposed in places where there are mineral deposits and underground works are carried out.
• Water use. Discharge of waste water containing pollutants more than the permissible norm into water bodies should not be allowed upon use of water.
• Atmosphere protection. For the purpose of regulation of emission of harmful substances into the air the government introduces technical norms and permissible limits in respect of such discharge. Discharge of harmful substances into an atmosphere is allowed only based on a special permit issued by the Ministry of Ecology and Natural Resources, which provides for permissible limits and other terms in relation to emission of such substances.
• State register. Entities, which hold the source of harmful substances released into the atmosphere and adverse physical effects on it, will be subject to the state registration, by indicating the amount and composition of harmful substances released into the atmosphere, including greenhouse gases, substances which destroy the ozone layer, and physical effects, and the types and extent of harmful physical effects.
• Entities which hold the source of harmful substances released into the atmosphere and adverse physical effects on it shall also carry out an inventory of harmful substances released into atmosphere, and sources of physical impact on it.
• Production control. Entities having sources of harmful chemical, biological and physical effects on atmosphere will carry out production control in the field of atmosphere protection and appoint a responsible person for such purpose and/or organize an environmental service.

B. Environmental liability

• Any legal entity bears the responsibility for the efficient use of energy, energy materials and products, compliance with the rules for the effective use of energy resources, and for not allowing excessive waste. This responsibility applies also to the design, installation and operation of power units and facilities in oil and gas industry.
• Entities which caused damage to the environment, human health, property of companies, citizens and the state as a result of breach of the environmental protection legislation shall compensate such damage in accordance with the legislation in force. Compensation of damage caused as a result of violation of environmental protection legislation shall be paid voluntarily or based on a court decision.

Thus, a company that violated environmental protection laws and caused damage as a result of such violation will be held liable in respect of such violation and be required to reimburse such damage.

The taxation regimes applicable to the subsoil users in Azerbaijan can be broken down to the following regimes:

• Special Tax Regime established in PSAs (“PSA”), and
• Statutory regime established under Tax Code of the Republic of Azerbaijan, dated July 11, 2000 (“TCA”).

Under the most of PSAs, parties to such agreements enjoy simplified tax regime and pay withholding tax on services provided at established rates. The PSA regime prescribes the basis for taxation, procedure for tax calculation, and accounting and reporting requirements.

Under a typical PSA, an individual contractor is subject to profit tax payable at the rate established by the PSA. The taxable income is usually comprised of all income received during a calendar year from sales of the commercial product under the PSA. Profit tax rate is usually within the range of 25% and higher.

Under a typical PSA, foreign sub-contractors of contractors are subject to a fixed withholding tax which must be deducted by the person making the payment. In order to apply the relevant withholding tax to the appropriate payments, the foreign sub-contractors must notify the local tax authority and obtain their approval for applying such withholding tax.

Under a typical PSA, each contractor, the operating company and their sub-contractors are exempt with from VAT in connection with conducting the activities encompassed by the PSA. In order to be exempt, the relevant entity needs to obtain a VAT exemption certificate from the local tax authority.

TCA regime

A. Profit Tax

Under the TCA regime, resident enterprises are subject to profit tax, at a rate of 20% of taxable profit. Taxable income of residents encompasses also income received through their permanent establishments outside Azerbaijan, as well as dividends, interest, royalties received outside Azerbaijan (except for non-taxable revenues). Non-resident entities are subject to profit tax in respect of revenues attributable to their permanent establishment in Azerbaijan.

B. Mining tax

The tax rates for oil and gas extraction, set at 26% for crude oil and 20% for natural gas, are applied to their respective wholesale prices.

C. Withholding tax applied to royalties, interest payments and dividends

Under the TCA regime, payment of dividends and interests to non-residents is subject to 10% withholding tax at the source of payment. Income from royalty received from an Azerbaijani source is subject to withholding tax at the rate of 14%. The tax is withheld by the tax agent in Azerbaijan making the indicated payments to the foreign non-resident entity.

A. Value added tax

Under the TCA, any business engaged in commercial activities in Azerbaijan where revenues exceed AZN 200,000 (approx. USD 117,647) in any 12-month period is required to be registered for VAT purposes and charge VAT on its sales, at the tax rate of 18%. For VAT purposes, taxable base includes provision of goods, performance of work, provision of services in and taxable import to Azerbaijan.

B. Excise tax

Excise duty is applied at different rates on the sale and manufacture or import of certain products, including petroleum products.

C. Property tax

Azerbaijani resident legal entities (other than the state, government authorities and agencies and residents of industrial parks), and foreign legal entities operating in Azerbaijan through permanent establishments and owning fixed assets, are required to pay property tax, at the rate of 1% applied on the average annual value of the fixed assets.

There are no special tax deductions or incentives offered companies operating in development of oil and gas reserves other than special tax treatment of operating companies working under the PSA as well as PSA related contracting parties.

Under the Energetics Law, for satisfaction of the national demand, the state has the right of priority as to purchasing energy materials and products manufactured under the energy development and production agreements at world market prices.

With regards to export restrictions, the law provides for an extensive list of products which are subject to an “export control”. Import and export of such products is subject to obtaining a special permit from the relevant state authorities. Such products include, among others, oil and gas, missile fuel, military aviation fuel, metallic fuels, etc.

The local content requirements in respect of the personnel of the contractors and subcontractors are set under the PSAs. These requirements specify, inter alia, preferences in relation to the employment of the citizens of Azerbaijan, SOCAR’s role in selection of the personnel and the target manning levels of employees among Azerbaijani citizens.

According to the Energetics Law, each energy contract must contain a plan for the restoration of an area that has become unusable as a result of a contractor’s activities. A contractor must carry out restoration works until the expiry of the term of the energy contract.  

A contractor shall restore the contractual area, that is no longer required for use in respect of the contractual activities, within a reasonable period of time, if technically feasible.

A contractor must also renew its preliminary restoration plan regularly, and approve the final restoration plan one year prior to expiration of the contractual term or other period stipulated by the energy contract. The final plan shall also be produced to the Ministry of Energy and SOCAR.

A separate fund should be created to finance the restoration works which cannot be carried out by the contractor.

A former contractor will be entitled to dispose its immovables only after conducting the above indicated restoration works.

The regulatory regime for the construction and operation of both offshore and onshore oil and gas pipelines in Azerbaijan is governed by General Regulatory Regime and PSA Regime.

Under the Law of the Republic of Azerbaijan on Technical Safety, dated November 2, 1999, oil and gas extraction industry (including main oil and gas pipelines) and geological exploration are considered as potentially dangerous (hazardous) objects (facilities). Potentially dangerous objects are subject to the state registration, carried out by the Ministry of Emergency Situations. Also, technical equipment and facilities produced and used in potentially dangerous objects must be certificated in terms of their compliance with the technical safety requirements.

For construction, expansion, reconstruction, technical modernization, conservation and termination of potentially dangerous facilities an expert opinion on technical safety must be obtained in respect of the project documents.

Given that main oil and gas pipelines are also deemed as potentially dangerous construction facilities, and facilities built in Caspian Sea water area are construction facilities having the state importance, construction of such facilities will also be subject to obtaining a construction permit, for which the additional requirements must also be observed (e.g. installation of an alarm system in pipelines and maintenance of protection zones on the right and left sides along main pipelines, etc.).

Furthermore, transportation of oil and oil products by main pipelines, as well as transportation, storage and distribution of natural gas through pipelines are considered as activities carried out by natural monopoly subjects, and are regulated by the various regulatory authorities in specific manner.

As of the latest publicly available information available, there are no active LNG liquefaction and receiving terminals in territory of Azerbaijan. The General Regulatory Regime including provisions of the Law on Energetics would be applicable to LNG liquefaction and receiving terminals in Azerbaijan, in those aspects where it is relevant and can be appropriately applied.

In Azerbaijan, the regulatory regime for gas storage (excluding LNG) is governed by the Law on Gas Supply of the Republic of Azerbaijan (the “Law on Gas Supply”), dated June 30, 1998. It specifically addresses the regulation of underground gas storage facilities. This law stipulates that the operation, construction, and exploitation of underground gas storage facilities can only be conducted based on energy contracts. Additionally, a special permit must be obtained beforehand for the enterprise and its gas installations.

According to the Decision № 94 of the Cabinet of Ministers of the Republic of Azerbaijan dated May 10, 2001, underground gas storage facilities are classified as objects with potential hazard. This classification mandates strict compliance with safety and operational standards.

Azerbaijan operates two primary underground gas storage facilities: Karadagh and Kalmaz. These facilities are integral to the country’s energy infrastructure, playing a vital role in ensuring a stable and reliable supply of natural gas.

The gas transmission and distribution infrastructure in Azerbaijan is primarily owned and operated by SOCAR.  The operation of the gas transmission and distribution system is regulated under the Law on Gas Supply. This law outlines the legal framework for the import and export of natural gas, which are conducted based on specific contracts.

According to the Law on Gas Supply, agreements for gas transportation services, including those involving third parties, come into effect only with the approval of the relevant executive authority. This approval is granted when the agreements are in compliance with energy contracts and existing legislation.

The law stipulates that if the relevant executive authority does not respond with a refusal to a written request for approval within one month, the approval is considered granted. This provision facilitates third-party access to the gas transmission system under certain conditions, ensuring that the process aligns with regulatory standards.

The level of competition and privatization in Azerbaijan’s downstream gas market is limited. The market has traditionally been under the control of government-owned suppliers, with SOCAR being the main entity in the sector.

In terms of customer choice, end-users in Azerbaijan typically do not have the option to choose their gas supplier. The supply is generally managed and controlled by the incumbent state-owned suppliers.

The primary regulatory authority for the downstream gas market in Azerbaijan is the Ministry of Energy. This ministry is responsible for formulating and implementing energy policies, including those related to natural gas distribution and sales. Additionally, SOCAR plays a significant role in the operational aspects of the market.

Recent changes in Azerbaijan’s government policy and regulation, particularly in the energy sector, have been significant. The previous Law on Energetics, dated November 24, 1998, has been replaced by a new, more modern law enacted on May 31, 2021. This new law aligns with contemporary standards and focuses on efficient use of energy resources.

Additionally, the Rules on implementation of state control in the field of efficient use of energy resources and energy efficiency, dated July 17, 2023, have come into force. These rules regulate various aspects of energy management and efficiency. Key areas of focus include mandatory energy audits, adherence to energy management systems, calculation of energy consumption, and the implementation of obligations for energy producers regarding efficient use of energy resources.

In response to the Russia/Ukraine conflict, there has been a significant shift in European energy supply dynamics. Europe has been actively seeking to diversify its energy sources away from Russian gas. Azerbaijan, with its substantial natural gas reserves has become an increasingly important alternative supplier. In 2022, Azerbaijan increased its gas exports by 18% to 22.3 billion cubic meters (bcm), with shipments to Europe reaching 11.4 bcm, a 39% increase from the previous year.

Until recently, Azerbaijan, its economy based on oil and gas, has paid little attention to the growing worldwide wave of renewable energy sources — wind and solar among them. Energy Minister Parviz Shahbazov announced in November 2021 a “road map” of potential offshore wind power development as well as discussions on production of “green” hydrogen – using renewable resources as a base – and green ammonium. Development of renewable energy is a key pre-condition to enabling Azerbaijan to play a role in the clean H2 economy.

While experts agree that Azerbaijan has an advantageous geographical position and climatic conditions, making renewable energy a viable and attractive option, questions must still be resolved in terms of establishing a realistic and reasonable domestic tariff and conditions to encourage domestic companies to choose renewable energy projects. A number of new projects are now under consideration. But analysts and industry specialists say further direction – largely from the government – will be needed on construction, the establishment of fair electricity tariffs and advantageous conditions for local companies.

As part of ongoing efforts in the field of renewable energy, the Renewable Energy Sources State Agency was established under the Ministry of Energy by the Presidential Decree No. 1159 dated September 22, 2020. Azerbaijan has adopted laws and normative legal acts to develop the renewable energy sector and improve the legislative environment in this field. This includes the Law of the Republic of Azerbaijan on the Use of renewable energy sources in electricity production dated May 31, 2021, No. 339-VIQ.

“Azerbaijan 2030: National Priorities for Socio-Economic Development” document approved by the Decree of the President of the Republic of Azerbaijan dated February 2, 2021 includes climate change and green growth strategies. Azerbaijan aims to strengthen the use of renewable energy sources and apply green economy principles across all sectors.

The government is actively working on various projects and initiatives to increase the use of renewable energy sources. This includes collaborations with international organizations and foreign companies to develop large-scale renewable energy projects. As part of its contribution to global climate change mitigation efforts, Azerbaijan has set a target to maintain greenhouse gas emissions at 35% below 1990 levels by the year 2030.