The global demand for natural resources continues unabated. As revenues increase and profits soar in the face of this demand, there has been a resurgence of “resource nationalism” with resource-rich host states seeking greater control or a larger share of the revenue generated from its resources.
Ernst & Young has recently ranked protectionism by governments through resource nationalism as the number one risk for mining companies in 2013. This alert looks at the impact of risks associated with resource nationalism on infrastructure projects and how those risks might be mitigated.
The relevance to infrastructure projects
While the main consuming markets are found in North America, Europe and increasingly Asia, the search for oil, gas, metals and minerals has shifted to emerging and developing countries with under-explored resources, such as in Latin America and Africa.
As a result, the global natural resources markets will reflect increasing dislocations between supply and demand. The distances separating production from consumption are vast and require financing, construction and operation of cross-border transportation infrastructure.
The revenue from natural resources plays a key role in the development of host states including the construction or renewal of key infrastructure such as roads, bridges, ports, harbours, airports, hospitals and schools.
So, in a very real sense, construction and engineering projects play a critical part in the changing global natural resources landscape, not only in respect of extraction and production, but also in the development of host states more generally.
Risk is effectively a cost, which needs to be managed
Such projects require significant investment and, particularly at the extraction and production stage, occur in geographically remote and technically challenging locations. This means increased complexity and critically, increased risk.
From a resource nationalism perspective, one of the particular dimensions of risk for those involved in such projects is the uncertainty as to how host states might apply their legal and regulatory regimes to the investments made in, and revenues generated from, those projects.
The debate on resource nationalism tends to focus on nationalisation or expropriation of foreign-owned assets or rights, but that is only part of the picture. In reality, resource nationalism can take numerous forms, such as the requirement to divest a certain share of a company to the host state; adopting measures which reduce the value of an investment; increasing the price of extraction licences; imposing new export taxes; or making projects more uneconomic by insisting that, say, metals and minerals be “beneficiated” (that is, processed) in-country prior to export.
The challenge is to identify, price and then try to control the risks whether through the construction and engineering contract or otherwise.
Responding to the risks of resource nationalism
While resource nationalism is seen as an externality when assessing the risk profile of a project, in fact, various methods, such as those set out below, can be employed to minimise the impact of risks on a project so as to protect the investment.
Choice of law
The choice of the law governing the contract and the forum for resolving disputes arising under it requires careful consideration. Ideally the governing law of the contract should be one based on a system of law which is well developed and predictable. Sometimes, however, there is no scope for agreeing a law other than that of the state in which the project is to be located.
In those circumstances, it is vital that local legal advice is sought as to how that law might deal with key rights and obligations under the contract, before signing-up. Decisions should be informed rather than based on an assumption that the law of one state will be the same or similar to that of another.
We will look at dispute resolution considerations below.
A stabilisation clause aims to prevent the host state from enacting subsequent legislation or taking administrative acts which may have a negative impact on the contract. This is done by agreeing that the terms of the contract entered into will not be varied by any change in law by the host state with which a party did not have to comply at the date of entering into the contract.
The aim of such a clause is to “freeze” a party’s rights and obligations in relation to the host state from the date of the contract for an agreed amount of time, in order to promote stability and certainty. Environmental or health and safety matters are normally exempted from the scope of such clauses.
An alternative to the traditional “freezing” approach is a provision that sets aside any new law which negatively impacts the economic balance of the contract, rendering the new law inapplicable to that contract. The benefit of this approach over the traditional approach is that it does not conflict with the legislative power of the host state, but rather grants the contract priority over the new law.
Adaptation clauses, which are sometimes referred to as economic equilibrium clauses, seek to preserve a degree of economic balance between the host state and a party after the host state has implemented a new law or executive act which negatively impacts on the economic balance of the contract.
Where this happens, the host state and the party are required to make best efforts to renegotiate affected terms of the contract so as to preserve the party’s original economic position, despite any changes in law. As opposed to the stabilisation clause, the new law or regulation still applies to the contract, while its effects may be mitigated. The mitigation methods include phasing in the changes, contributing to a party’s costs of compliance or modifying taxation or other fiscal requirements to offset the costs.
Termination provisions A host state may seek to avoid its obligations under a contract by alleging breach and invoking the termination provisions of a contract in order to secure a more lucrative deal. A party may also wish to terminate the contract where it has not been paid or measures have been introduced by the host state which renders the contract uneconomic.
Whatever the situation, a termination clause must clearly set out the process for termination (for example, the method and timing of relevant notices), how remaining payments are to be made and how to deal with on-site equipment belonging to the party. In the latter regard, demobilisation from site may take some time and be costly, so, detailed provisions on this must be set out.
Dispute resolution considerations
Considerations such as the forum and method of dispute resolution will need to be considered in detail in the light of the contract as a whole.
Parties must understand not only the available methods for dispute resolution, but also the impact of the local law on a dispute. For example, there may be a requirement that local remedies are exhausted before recourse to arbitration can be made. In this regard, a party should seek local legal advice in the first instance to ascertain whether adequate remedies, such as compensation, can be awarded for the host state’s breach. A party should consider the inclusion of an express provision in the contract dealing with compensation and how it is calculated, rather than simply relying on remedies available under the local law.
Where there is a chance that a host state may exercise resource nationalism, a party may not wish to submit itself to the courts of the host state, for fear that local courts will favour the state. This risk is heightened in the context of resource nationalism where vital resources or key infrastructure assets are involved.
Before agreeing to the jurisdiction of the local courts, local legal advice should be sought as to the available remedies in court and the timescales involved. Again, parties should not assume that cases, even straightforward debt collections, will be resolved in a matter of a few weeks or months.
International arbitration has been the preferred mechanism of dispute resolution for international commercial contracts, particularly in respect of contracts for infrastructure projects.
A party may mitigate the risk that the courts of a host state may not treat it fairly and impartially by seeking agreement that disputes be resolved by international arbitration. If it is not possible to agree on a party’s preferred governing law, parties to a contract are often willing to agree to “neutral” international arbitration.
An important consideration when agreeing to arbitration is the proposed “seat” or juridical location of the arbitration. This does not mean that meetings and hearings cannot take place outside the seat location, but the seat provides the applicable legal framework to support the arbitration. Further, the seat has an impact on the recognition of the arbitration agreement itself and the enforcement of any award.
The New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards concluded in 1958 (NYC) provides a regime for the enforcement and recognition of international arbitration awards within contracting states. The NYC requires all contracting states to enforce and recognise such awards rendered in conformity with its provisions. A particular characteristic of the NYC, which supports the international arbitration process, is the limited grounds upon which national courts may refuse to recognise and enforce an award.
To take advantage of the benefits offered by the NYC’s recognition and enforcement regime, a party should, before entering into a contract, ascertain the states in which the assets of its contracting counter-party are located and that the states are signatories to, and have ratified the NYC. Where this is the case, it should normally be possible to enforce an award in the courts of the host state or of another contracting state.
An important aspect of a state being a party to an international commercial arbitration is its ability to resist enforcement by invoking the public policy defence under the NYC. One such public policy ground is the defence of state or sovereign immunity, which may allow a host state to avoid execution of an arbitral award against its assets.
Under international law, a state cannot rely on the defence of immunity from execution in relation to property which is used for commercial purposes. This distinction appears straightforward, but it can be difficult to apply in practice, particularly in relation to transactions arising out of a state’s natural resources.
When agreeing to arbitration, a party should include provisions to cover the host state’s waiver of immunity, its submission to the jurisdiction of the seat and its consent to the enforcement and execution of the award. A party must also ensure that the waiver is sufficient, given that state entities, government officials or even particular departments may not possess the requisite power to bind the host state.
Bilateral investment treaties
An alternative method of resolving a dispute is through recourse to arbitration under bilateral investment treaties (BITs). BITs allow a party which enters into a contract with a host state or a state entity to pursue a claim thereunder, as long as that party falls within the definition of investor and the project is considered to be a covered investment. A BIT claim gives a party the opportunity to claim damages for breach of protection standards under the relevant treaty. The formulation of these standards depends on the terms of the relevant treaty, but may include standards of treatment such as no unlawful expropriation, fair and equitable treatment, non-discrimination and standards of compensation.
The claim would be made in arbitration and generally pursued under the rules of the International Centre for the Settlement of Investment Disputes (ICSID), provided the host state has opted into the convention establishing ICSID (ICSID Convention). The ICSID Convention sets out some sophisticated requirements for its jurisdiction, which have to be carefully considered at the drafting stage of the contract. This is because the purpose of the ICSID Convention is to create a forum for legal disputes rising out of investments and, therefore, only addresses disputes between states and foreign investors.
A corollary of this is that an ICSID tribunal will only accept jurisdiction over a claim from a “foreign” party that arises out of an “investment”. While the ICSID Convention does not define an investment, features that may be suggestive of an investment include performance of the project for a determined duration; existence of risk for the investor; a substantial level of financial commitment; and whether the operation is significant for the host state’s development.
The foreign criterion requires an investor to be a national of a contracting state and not the nationality of the host state. This is problematic where a party has entered into a joint venture with an entity from the host state or is required to incorporate a local company. The issue here is that, by reason of the joint venture relationship or local incorporation, a party’s foreign investor status would turn it into a local investor. The ICSID Convention does not cover disputes between states and its own nationals.
Therefore, if an investor wishes to have investment treaty rights, it is vital that careful thought is given to the structuring of the transaction and, in particular, to the nationality of the investment vehicle so that the foreign criterion is satisfied.
Energy Charter Treaty
The Energy Charter Treaty (ECT) is a multilateral investment treaty that establishes a legal framework and a binding dispute settlement mechanism for investor-state energy trade, transit and investment disputes.
Rather like BITs, the ECT sets out substantive protections for investors, which include national treatment, protection from unreasonable or discriminatory measures, expropriation and compensation.
The frequency with which disputes are brought by investors under the ECT is increasing, due in part to an increased awareness among energy investors and the legal community about the ECT.
The ECT not only provides a forum for parties and host states to settle their energy-related investment disputes, but also encourages signatory states to observe their ECT obligations and promotes a stable environment for investment in line with the aims of the treaty.
Political risk insurance
While commercial parties are well placed to evaluate commercial risk, political risk is more intangible and, therefore, much harder to measure. Political risk insurance provides against events such as expropriation, currency restrictions, political violence, civil war and breach of contract. Political risk insurance provides flexibility in that it gives a party the opportunity to negotiate and shape the precise scope and terms of the insurance coverage it requires, based on the project risk profile and the specific factors of the host state.
Infrastructure projects must be viewed within the context of its economic lifespan. So, it is important that a full risk profile of the project is undertaken to ensure that the policy covers the risks to which the insured is actually exposed.
On a practical level, political risk policies require that the insurers are kept fully informed of all relevant developments so that they are able to monitor the risk in question and be given the opportunity to be involved with any efforts to avoid, minimise or recover a loss.
While contractual provisions contribute to minimising the risks associated with the various expressions of resource nationalism, a party must ensure a positive dialogue takes place at all stages of the project with the government officials of the host state and the communities in the area where the project is located. Communication of the benefits of the project for the host state is imperative, as are the steps to align the interests of all stakeholders.
In practical terms, this may mean developing corporate social responsibility initiatives, supporting local entrepreneurship, investing in public services and infrastructure and collaborating with local companies. The latter point is important as the increased trend of resource nationalism has brought with it a requirement for greater local content. For many host states, the development of local expertise is an important strategic aim, including skills and experience transfer and the building of local industries able directly to benefit from the exploitation of the resources.
Host states are also increasingly stipulating that the award of a contract is accompanied by obligations to invest in the local infrastructure. The mining giant Anglo American has developed and made freely available what it calls a Socio-Economic Assessment Toolbox (SEAT) as a contribution to managing the socio-economic impacts of extractive, and other natural resources and industrial operations. SEAT is intended to help such operations to benchmark and improve management of their local, social and economic impacts and take a more strategic view of interactions with a host state.
Indeed, the World Economic Forum has stated in its responsible mineral development initiative that “Effective early engagement with communities, addressing concerns and providing support to governments where appropriate, will yield considerable stability benefits.”
Resource nationalism has become much more sophisticated and complex in the forms it takes, being not purely driven by nationalistic policies such as expropriation, but by wider political, social and environmental drivers, in addition to economic ones
Resource-rich host states and investors with the capabilities to exploit those resources clearly need each other. The key challenge for both is the creation of environments which deliver appropriate profit to investors, protect host states’ natural resources and provide other long-term benefits to the states and their people.
As set out above, effective risk-mitigation strategies will involve not only careful thought as to contractual protection, but also, and increasingly so, to effective early engagement with the host state and its communities to deliver the socio-economic benefits.
Client Alert 2013-132