Emerging markets are influencing the energy landscape in terms of both supply and demand. On the demand side the BRIC countries (Brazil, Russia, India, and China) alone consume 30 percent of the world’s fossil fuel sources. In 2010 China overtook the US as the world’s foremost consumer of energy resources. On the supply side, many emerging and pre-emerging (or frontier) markets, such as Brazil and a number of African countries, provide opportunities for new sources of energy supply to meet growing global demand.
In energy projects, that are typically characterised by high initial capital expenditure and realisation of return on investment over long terms, political and economic stability is essential. This article provides an overview of political risk mitigation instruments to support investment in emerging and pre-emerging markets.
Types of Political Risk
Political risks include:
Direct loss of assets due to host government expropriation; e.g., recent decision in Argentina to renationalise YPF SA by expropriation of Repsol’s 57% shareholding;
Arbitrary cancellation of government licences and concessions/production sharing contracts;
Government imposed changes to exchange controls preventing extraction of profits from host country; and
Government enactment of new legislation which adversely affects investment returns.
Investors in emerging markets will usually require that any long term investment contract (e.g., a project development agreement or production sharing contract) with a host government include a stabilisation clause to help insulate the project from adverse changes to the legal and fiscal environment. Through a stabilisation clause a government party accepts that the exercise of its legislative and administrative powers will not have the effect of adversely modifying the rights of a private investor. However, whilst a stabilisation clause provides an investor with a contractual remedy against a government party, it is only as good as that government’s willingness to honour its contractual undertakings. In the context of emerging markets where a host government has a poor record of political stability, an investor is likely to seek to enhance its protection under a stabilisation clause with political risk insurance.
(ii) Legislative Protection
Many emerging markets have unstable legal regimes with vaguely drafted or non-existent laws. Consequently an investor will usually require that its investment contract or concession with a host government, setting out the tax and other fiscal terms for a project, is “ring fenced” and given force of law in the host country. “Ring fencing” helps protect the rights of an investor from subsequent legislative changes in a host country which might otherwise adversely affect the investor. In addition, investors in emerging markets may require that special decree laws are enacted for a project. However, legislative protection itself is subject to political risk: the then-existing government may change the law, and subsequent governments may overturn existing laws.
(iii) International Arbitration
Investors will also usually insist that their contracts with a host government provide for dispute resolution by international arbitration in order to limit potential undue influence of a government party in local courts, and to avoid possible state immunity from the jurisdiction of foreign courts and arbitral tribunals. As a practical matter, the ability to enforce an offshore arbitration award in an emerging market may be limited.
International Investment Treaties
When assessing political risk associated with an emerging market country, an investor should consider whether a bilateral investment treaty (BIT) exists between its home government and the host government. Emerging-market countries in Latin America, Asia, and Africa are active participants in international investment treaties as they are seen as inexpensive means to mitigate risk and encourage foreign investment. Where a BIT does exist it will usually give an investor the following protections: (i) protection from expropriation; (ii) protection from cancellation of licences/concessions; (iii) guarantees against foreign exchange controls; (iv) “most favoured nation” protection; and (v) dispute resolution by neutral international arbitration for disputes between governments and private investors - usually ICSID. Generally BITs (unlike tax treaties) don’t have “limitation of benefits” so a parent company in a non-BIT country can get the benefit of a BIT by incorporating a subsidiary in a contracting state.
The Energy Charter Treaty (ECT)
The ECT provides certain protections against political risks to investors from ECT member countries investing in another ECT member country. The Treaty provides the following protections and assurances: (i) the protection of foreign investments, based on the extension of national treatment or most-favoured nation treatment (whichever is more favourable) and protection against key non-commercial risks; (ii) non-discriminatory conditions for trade in energy materials, products, and energy-related equipment based on WTO rules, and provisions to ensure reliable cross-border energy transit flows through pipelines, grids, and other means of transportation; and (iii) the resolution of disputes between participating countries, and in the case of investments between investors and host countries.
Although some emerging-market countries, such as China, Egypt, and Nigeria, hold ECT “observer” status, many emerging-market countries are yet to become ECT member countries and therefore ECT protection is not available.
Political Risk Insurance
Higher levels of investment in emerging markets has increased the demand for political risk insurance, and this has resulted in the development of new political risk insurance products and the emergence of a growing number of private providers of political risk insurance. Although obtaining political risk insurance coverage increases an investor’s project costs, it is seen by many investors and lenders as a pre-requisite to investing in high risk environments.
The US government’s Overseas Private Investment Corporation (OPIC) and the World Bank’s Multilateral Investment Guarantee Agency (MIGA), both “public” entities, offer political risk coverage to private investors in emerging markets (OPIC insurance is only available to US investors). For lenders, insurance is also available from export credit agencies (ECAs) and multilateral development banks (MDAs). MDAs in areas with high political risk have recognised that they can attract investment to their region, by offering creative products that provide wide coverage. The Asian Development Bank in particular has developed a range of creative guaranty products.
Political risk insurance is available for (i) political violence (e.g., revolution, insurrection, civil unrest, terrorism, or war); (ii) governmental expropriation or confiscation of assets; (iii) governmental frustration or repudiation of contracts; (iv) wrongful calling of letters of credit or similar on-demand guarantees; (v) business interruption; and (vi) inconvertibility of foreign currency or the inability to repatriate funds. However, there are limitations in the scope of political risk coverage and inevitably investors will be required to “self insure” some political risks. For example, generally political risk is not available for government breach of contract, although insurance is available for a dispute resolution clause where it calls for international arbitration. In addition, in energy infrastructure projects a government party is often a stake holder. Political risk insurance does not protect foreign investors from a government party being an unreliable partner.