Looking beyond the Dabhol debacle: examining its causes and understanding its lessons.

• Author: Kundra, Preeti
• Position: India

ABSTRACT

This Note analyzes foreign direct investment in India, looking into the investment troubles surrounding the Dabhol power project, India's largest foreign investment project to date. After providing an introduction to the mechanics of project finance and a backdrop to the Dabhol power project, the Note considers whether the Indian government's actions, specifically the use of the Indian legal system, constituted "total expropriation" and violations of international law. Additionally, this Note considers what systemic changes India can make in order to create a more investment-friendly environment in the post-Dabhol context.

TABLE OF CONTENTS I. INTRODUCTION II. THE MECHANICS OF PROJECT FINANCE III. INDIAN ECONOMIC REFORMS IV. BASIC OVERVIEW OF THE DABHOL POWER PROJECT V. RELEVANT PROJECT DOCUMENTS VI. DIFFICULTIES EMERGE IN 1995 VII. DIFFICULTIES REEMERGE IN 2000 VIII. INDIAN JUDICIAL ACTIONS IX. EXPROPRIATION ANALYSIS X. LOOKING AHEAD XI. CONCLUSION I. INTRODUCTION

Dabhol, India's largest foreign investment project to date, continues to be surrounded by litigation and controversy over fifteen years after its inception. Following India's solicitation of foreign investment to strengthen its electrical power capacity in the early nineties, a group of foreign investors formed an Indian company to develop, construct, and operate a two-phase, project-financed power plant and related facilities. (1) Indian financial institutions, overseas lenders, and export credit agencies contributed approximately $2 billion in secured loans. (2) Unfortunately, an alleged series of actions by Indian national and state officials and agencies hindered the project, causing multibillion-dollar losses to investors and project lenders. (3)

The Overseas Private Investment Corporation (OPIC), a U.S. government agency created to promote U.S. private investment in developing countries and areas, subsequently paid out over $110 million on political-risk insurance policies covering the Bank of America, Bechtel, Enron, and General Electric (GE) against the risk of expropriation. (4) Pursuant to an investment guaranty agreement between India and the United States, the U.S. consequently initiated arbitration of OPIC's claims for approximately $110 million plus compound interest against the Indian government. (5) While India and the United States recently reached a successful settlement regarding these claims, (6) the domestic resolution of Dabhol continues to remain a contentious issue within India.

After providing an introduction to the mechanics of project finance and a backdrop to the Dabhol power project, this Note considers whether the Indian government's actions, specifically the use of the Indian legal system, actually constituted "total expropriation" and violations of international law. Understanding the parameters of expropriation is especially useful given the continued increase in foreign investment in the context of potentially unstable host country economies. Additionally, this Note considers what systemic changes India can make in order to create a more investment-friendly environment in the post-Dabhol context.

2. THE MECHANICS OF PROJECT FINANCE

   Infrastructure development is a priority for many emerging economies as they attempt to compete in the international economic system. Traditionally, the state has assumed the responsibility of funding infrastructure projects through taxpayer financing, especially in the areas of telecommunications services, public electricity, and transportation systems. (7) The role of private sector participation has been limited not only because these projects have been perceived as public works projects, but also because the costs of participation have been relatively high due to large initial capital outlay requirements, slow expected rates of return, and high risks of unprofitability. (8) However, governments have been forced to seek alternative means of funding for these projects in the face of large financial deficits and poor economic conditions. (9)

   A wave of privatization and deregulation in the 1980s and 1990s coincided with a strengthening of capital markets and a sudden availability of commercial lending for larger-scale projects in the category of hundreds of millions of dollars. (10) Accordingly, there has been a marked increase in the funding of infrastructure development projects through private sources of capital in the past several decades. (11) Specifically, project financing has become the most significant legal and financial means by which this shift to private participation in infrastructure development has occurred. (12) Financing is especially important in the context of developing countries attempting to accelerate their industrialization processes and foreign developers seeking to invest in emerging economies with high profit potential. (13)

   Project finance is a debt finance technique where the repayment of borrowed funds is primarily dependent upon the revenue generated by the project itself (14):

   It is the financing of a particular economic unit in which the lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as a collateral for the loan. (15) Additionally, the financing generally consists of two portions: equity and debt capital. (16) The sponsors or developers of the project are usually a group of large investors, both domestic and foreign, that make equity contributions to the project in the range of 20% to 25%. (17) The lenders are generally large international commercial banks and multilateral lending agencies. (18) Because of the large amount of funding required for infrastructure projects, debt is usually obtained in the form of syndicated loans with the participation of more than one bank. (19) Given the increased risks associated with this type of financing structure, project lenders are able to charge higher interest rates. (20)

   The process of setting up a project financing usually begins with the sponsors forming a project company for the purposes of constructing, owning, and operating the project facility. (21) The sponsors own and manage the project company, which is established as a corporation. (22) Significantly, the project company, rather than the sponsors themselves, borrows funds from the lenders for the benefit of the project; accordingly, the transactions have no direct impact on the sponsors' balance sheets or general creditworthiness. (23) Under this arrangement, the lenders look to the assets and cash flow of the project as the security interest for the loans. (24) By protecting against potential threats, contractual agreements play an important role in helping lenders achieve both their expectations of continuous operation of the project and constant cash flow. (25) Similarly, the sponsors seek guarantees from the host government on maintaining smooth operation of the project. (26)

   Project finance is a very attractive investment technique for developers for two primary reasons. First, if the project is unsuccessful in meeting its loan obligations, the lenders' only recourse is obtaining the assets of the project corporation itself. (27) Second, despite investing in a long-term project that borrows millions of dollars in frequently unstable developing countries, the parent corporation's credit rating is unaffected because the project corporation acts as the borrower. (28) However, there are also significant risks associated with project finance for both sponsors and lenders, often in the form of currency-related issues, risks of government default on payment guarantees, and possibilities of political and legal instability in the host nation. (29) Accordingly, project sponsors and lenders attempt to mitigate these risks by involving international agencies that provide credit enhancement programs such as political risk insurance in addition to the obtained host-government guarantees. (30) An appreciation of the mechanics of project finance, as well as the risks associated with this type of finance technique, provides the necessary background for understanding the Dabhol power project. The following Part discusses the economic climate in India leading up to the development of the project.

3. INDIAN ECONOMIC REFORMS

   Following decades of unsuccessful socialist-oriented policies aimed at achieving self-sustainability in all sectors of the economy, India embarked upon an economic liberalization plan in the early 1990s that moved the economy away from its traditionally protectionist policies and toward policies that actively encouraged foreign direct investment. (31) Specifically, the Indian government adopted a variety of structural reforms, including the de-licensing of industry, the adoption of full currency convertibility, the reduction of trade barriers, and the welcoming of foreign investors and multinationals, in order to alleviate a balance of payment crisis and spur much needed economic growth. (32) One of the key economic reforms pursued by the government involved opening infrastructure sectors to private companies, which included power, telecommunications, air transport, and roads sectors. (33)

   Recognizing that India's industrial growth depended substantially on the availability of reliable electric power, the government focused on bringing additional power capacity on line throughout the 1990s as a central component of the country's overall growth plan. (34) It was estimated that many of India's industries could operate at only half their capacity because of a lack of electric power, with analysts projecting that India urgently needed to double its capacity to maintain growth. (35) Virtually all of India's power was generated and managed by state-owned electricity boards (SEBs) that suffered from chronic managerial, financial, and operational problems. (36) Not only did government-run power...