MANAGING POLITICAL RISK
By Alan D. Berlin*

Note: This section is no longer being updated, but the archive will remain online for future reference.

Most of the authors in this section are now regular contributors to our online publications: OGEL (Oil, Gas & Energy Law Intelligence); TDM (Transnational Dispute Management); GPM (Global Pipeline Monthly) and A&AESB (A&A Energy Security Briefing).

One of the major considerations inherent in any international investment is the political risk represented by the host country. This is particularly true in industries such as the oil and gas or energy industries, which are high profile and often controversial in almost every country in which the energy industry has been privatized or in which private upstream petroleum operations exist. When evaluating a prospective investment in a foreign country, the investor must also evaluate and manage the potential political risk in addition to the geological and market risks. In other words, an oil company must be able not only to find hydrocarbons, it must also be able to develop and produce those hydrocarbons at a reasonable profit over time. Once the geologists have made their assessment of the geologic potential of a particular area, and the economists have evaluated the fiscal regime that the host country is offering, it is up to company management and their advisors to assess the political risk inherent in a particular new venture and determine if that risk can be managed in an acceptable way, given the returns that are likely to result if the first two assumptions are correct.

Political risk does not result from the type of political system in place in the host country. For example, western companies have operated successfully under all types of political systems, be they Marxist, capitalist, nationalist, socialist, monarchy, or democracy. Political risk stems from changes to the political and socio-economic conditions of the host country. Examples of this are the problems that Belco Petroleum Corp. faced in Peru and more

recently, Enron Corp. faced in India. In both cases, a change in the local ruling party resulted in a new government that adopted an anti-foreign investment attitude that differed significantly from that of the predecessor government (and in the case of Enron in India, apparently from that of the national government as well).

Furthermore, political risk is not confined to the third world. At various times, developed countries such as the UK, France and Italy have raised concerns about nationalization. If you broaden the definition of political risk to include "creeping expropriation" which stems from changes in legislation that affect the industry such as taxes, labor, environmental regulations and other economic measures, the United States itself may be considered to present somewhat of a political risk.

The degree of willingness to accept political risk varies from company to company. What one company finds acceptable, may be too risky for another company. In addition, there is usually a direct correlation between the degree of political risk that a company is prepared to accept, and the degree of geological potential of the proposed contract area.

In assessing¹ the degree of political risk in a particular country, the company will look to many indicators, e.g., the current activity in the host country that is affecting or is likely to affect the stability of the government (insurrection, rebellion, criminal activity), prospect for change of national or local government, past history of nationalizations/expropriations, experience of other companies in the country, political activity and trends in the region, the overall economic condition of the country, etc.

Assuming that a petroleum company determines that the geological potential is attractive given the fiscal terms being offered, how does the company manage the political risk? Political risk can be managed in two ways: either through actual political risk insurance, or through what I call de facto insurance. De facto insurance may be described as the protection that results from strategic partnering or planning. Actual political risk insurance is aimed not at preventing a loss, but rather at assuring the investor that compensation will be received for all or part of the investment if a loss does occur. De facto political risk insurance is aimed at trying to prevent a loss from occurring in the first place. Obviously, it is more effective against certain risks such as expropriation or nationalization, and less effective against others, e.g., currency inconvertibility, war risk, etc. These two methods are not mutually exclusive. They complement each other and in many instances are, used in tandem.

Types of Political Risk Insurance

Actual political risk insurance can be obtained either through private companies such as Lloyds, AIG, etc. or through national or multilateral government insurance programs e.g., OPIC or MIGA. Countries offering some form of political risk insurance to their nationals include Australia, Belgium, Canada, Denmark, France, Germany, Japan, the Netherlands, Norway, Sweden, United Kingdom and the United States. The extent and scope of coverages offered will vary by country. The United States Overseas Private Investment Corporation ("OPIC"),² is probably one of the best known of the national government companies.

In addition to the national companies, which only offer protection to their own citizens (for example, in the case of OPIC, a corporation must be 50% or more owned by United States citizens, or if a foreign corporation, it must be at least 95% owned by a qualified United States entity), the Multilateral Investment Guarantee Agency ("MIGA"), which is an agency of the World Bank, offers protection to corporations which are incorporated and have their principal place of business in a country which is a member country, or which is majority owned by nationals of member countries. Approximately 97 countries have signed the MIGA Convention and of those approximately 71 have ratified the convention. Ratification is required in order to participate in MIGA's programs.

Types of Coverage and Measure of Loss

Two of the most important sections of a political risk insurance policy are those which set forth the events that give rise to a loss i.e., what constitutes an event of loss, and the measure of damages in the event a loss occurs. The determination of when an event of loss occurs, and the measure of damages will be a function of the type of coverage that is being purchased. It is important, therefore, to understand the types of political risk insurance coverages that are available. These generally include expropriation, currency inconvertibility, war and civil disturbance and breach of contract, each of which will be examined more closely.

1. Expropriation coverage protects against partial or total loss of the investment as a result of actions by the host government which may reduce or eliminate the insured's ownership of, control over, or the exercise of its rights with respect to its investment. Coverage can also be obtained against so-called "creeping" expropriations i.e. a series of actions which, over time, have the effect of depriving the investor of its ownership, control or rights to its investment. The amount of the loss is generally the net book value of the insured investment.
2. The concept of book value appears repeatedly throughout this discussion when discussing the measure of loss under a particular form of coverage. The definition of book value can be very important in determining how much will be recovered in the event of a loss. For example, whose book value is to be utilized, the foreign entity or the parent company? The two can be quite different and produce dramatically different results. If the parent company wants to protect its investment in the foreign entity as reflected on the parent company's balance sheet, it should think very carefully about this question. In the U.S. for example, there are two generally accepted methods of accounting for drilling results. An oil company can either use the successful efforts method of accounting under which dry hole costs are written off in the year incurred, or the full cost method of accounting whereby all drilling costs are capitalized and written off over the economic life of the reserves. The two methods can produce dramatically different results. This was at the core of the dispute that Belco had with its insurers in the case of the Peruvian expropriation. Therefore, it is important to try and negotiate a definition of net book value that will produce the most favorable financial result for the insured.

3. Currency inconvertibility coverage protects against losses arising from an investor's inability to convert local currency into the foreign currency specified in the policy, which is usually United States dollars, or the investor's home currency, for transfer abroad. Specific acts covered usually include excessive delays (usually expressed in terms of a stated time period), adverse changes in local laws or regulations, and an adverse change in the conditions governing the conversion to foreign exchange. Devaluation of the local currency is not a risk that is covered. The investor should, however, be sure that the date of the loss is considered to be the date when the request for transfer of funds was denied, and not the expiration of the stated waiting period, so that the risk of devaluation is on the insurance company and not on the investor. Typically, the investor will be required to pay over the blocked currency to the insurance company in exchange for the foreign currency that is guaranteed under the policy.

4. War and civil disturbance coverage protects against losses resulting from damage, destruction or disappearance of assets as the result of acts of war or civil disturbance in the host country. Covered acts usually include revolution, insurrection, coup d'etats, sabotage and terrorism. There may also be a business interruption feature whereby if the investment becomes a total loss as a direct result of any of the foregoing actions interrupting the conduct of the business, an event of loss will be deemed to have occurred. Thus, the assets need not actually be damaged or destroyed for a claim to be made, but the investment must be considered a total loss. In such event, the measure of the loss will be the investor's net book value of the investment. In the case of damaged or destroyed property, the measure of the loss will be the investor's book value for the assets that have been destroyed, the insurance company may also want to include a provision giving them the option to replace the destroyed item, or in the case of damaged property, the reasonable cost of repairing such damaged item.

5. Breach of contract coverage protects against a host country's breach or repudiation of the investor's contract. A recent example of this type of event is the repudiation of Enron's contract to build a power plant in India. This type of policy will usually require that the investor's contract provide for arbitration or other dispute resolution procedure whereby the investor can obtain an award of damages. Once such an award is final, if it is not paid after a stated period of time, an event of loss will be deemed to have occurred the investor can then seek payment for the net book value of its investment under the policy. The loss of future profits is not covered, however.

Differences Between the Private and Government Insurers

In deciding whether to choose a private or government (national or multilateral) policy, some of the factors that should be considered are:

1. The private company will not have a nationality requirement other than that the insured not be a citizen of the host country.

2. The private insurer will insure existing as well as new investments, where as the government insurance companies will usually only insure new projects, or the expansion of an existing project. This is because the underlying rationale of the government companies is the promotion of foreign investment. It is important to remember that if you think you might want to consider a government type policy for a particular project, you should register that project with the government company at an early stage of negotiation.

3. The government companies will usually write a policy for a fifteen or twenty year term, while the private sector will write a shorter term usually on a three year basis which can be renewed at the end of each year for an additional year, so that unless renewal is denied by the carrier, there is always a three year term remaining.

4. The cost of government insurance is usually cheaper than that offered by the private sector.

5. With a private company, there is more flexibility and opportunity to negotiate the provisions of the policy. The government companies are usually not willing to alter the provisions of their standard form of policy.

6. Under government policies, the host government is informed of the coverage. Private sector policies often prohibit the investor from disclosing the fact of the coverage. In fact, disclosure can nullify the policy. This dichotomy of approach is an example of the de facto principle at work. The government companies feel that a foreign government will be less likely to take expropriatory action if they know it will lead to a direct claim by and potential conflict with the other government.

7. In the event of a loss, the investor may find that it is easier to collect from a government insurance company than from a private one. Some private companies are known to be aggressive in underwriting risks, and equally aggressive in avoiding the payment of any resulting claims.

De Facto Political Risk Insurance

As noted above, actual political risk insurance is aimed at compensating an investor for a loss once it occurs. If a company wants to achieve a degree of political protection against expropriation and breach of contract, and does not want to pay the cost of political risk insurance, then one approach that a company may take, is to look at the geopolitical situation of the host country and enter into a joint venture with a local company and/or a strategic investor. The theory is that a particular host country would not expropriate the operations of an investor that is a national of a country with which the host country has close political, economic and/or military ties. This umbrella of protection will then extend to the other investors as well.

Another form of de facto political risk insurance involves having one of the multilateral institutions such as the World Bank (IFC) or Inter-American Development Bank (IIC) become an investor in the project. Obviously,a host country might think twice before nationalizing a company or project in which an agency of the World Bank has a financial interest. As noted above, this reasoning is the basis for disclosing that OPIC or MIGA has written a policy, and is a marketing tool for these companies in selling their insurance policies.

Conclusion

Unless a company follows a strategy of complete risk avoidance and stays solely within its national boundaries, it will be faced with the need to consider political risk when investing outside its home country. The challenge therefore is to manage the political and other risks that are unavoidable in the industry. How well these risks are analyzed and managed will often be key to a project's success. Classic political risk in the form of expropriation and nationalization remains a threat, although it is not as prevalent as it once was. Remember, that expropriation or nationalization does not in and of itself violate international law, provided there is prompt, fair and adequate compensation to the investor. Risks of contract repudiation such as was experienced by Enron in India, and so-called "creeping nationalization" as evidenced by punitive taxation, burdensome labor and environmental regulations, price and monetary controls, pose a greater and probably more likely risk today.

While political risk can be managed through insurance, strategic alliances and partnering, it can also be minimized, by taking some actions, which may seem obvious, but are too often ignored. Effective techniques include keeping a low profile, maintaining close relationships with the host government, anticipating change and working with it, avoiding geographical concentration, being a good corporate citizen and utilizing local suppliers and personnel to the greatest extent possible so as to create an economic link with the host country that establishes a national constituency with a stake in your continued political survival.

One final caveat. No form of political risk insurance can protect a company if it engages in bribery or corruption, or pollutes the environment. Keep in mind that such actions would probably void any political risk insurance that was obtained.

* Alan Berlin is a partner in the international law firm of Aitken Irvin Berlin & Vrooman, LLP. He is an international negotiator with over 25 years of experience in the upstream petroleum industry. Mr. Berlin provides legal and negotiating advice to both foreign investors and host governments in Latin America, Central Asia, Canada and the Caribbean. Mr. Berlin was formerly President of the international division of Belco Petroleum Corp., an international independent petroleum company and is an associate of the Centre for Petroleum Energy and Mineral Law and Policy at the University of Dundee, Scotland. You may contact Mr. Berlin at 914-694-5717 or at aberlin273@aol.com

¹ Economists use various methodologies such as the expected monetary value theory to quantify political risk. A discussion of these quantification methods, however, is beyond the scope of this paper. For more information on this subject, see Johnston, International Petroleum Fiscal Systems and Production Sharing Contracts, PennWell Books (1994).

²In addition to OPIC, the EXIM Bank also offers protection for US equipment which is sold abroad.

Alan D. Berlin
Aitken Irvin Berlin & Vrooman, LLP
2 Gannett Drive
White Plains, NY 10604
Tel. No. 914-694-5717
Fax No. 914-694-1647
mail: aberlin273@aol.com