Confronting the obsolescing bargain: transacting around political risk in developing and transitioning economies through renewable energy foreign direct investment.

Author:Sieck, Daniel R.

    Access to a reliable source of energy is indispensable to the stability of all nations. (1) Beyond the requirements of domestic demand, energy access is a component of any national security program and can be a primary source of wealth in producing countries. Energy producers' ability to shut off world supply gives them a powerful bargaining position politically and economically. (3) Recent expropriations of foreign energy investments in fossil fuel producing countries demonstrate the vulnerability of international energy investments to government intervention. (4) As an alternative, some investors avoid the fossil fuel market altogether and instead choose renewable energy. (5)

    This Note argues that investment in renewable energy is an attractive method of mitigating political risk in developing and transition economies. (6) Part II introduces political risk and provides a brief description of the common methods of risk mitigation. (7) Part III examines expropriation through the lens of two high-profile case studies, Russia and Venezuela, and highlights the increasing global significance of renewable energy projects. (8) Part IV analyzes the attractiveness of clean energy projects in comparison to fossil fuel projects in light of the difficulties of arbitrating investor-state disputes. (9) Part V reaches the conclusion that by choosing renewable energy projects, investors can reach markets that would otherwise be closed to foreign direct investment (FDI) because of the expropriation threat, but cautions that renewable energy projects are not a panacea for political risk. (10)


    1. Increased Risks of Foreign Direct Investment

      Foreign direct investment presents a lucrative opportunity for the investors but also entails numerous risks, such as property loss if the political environment changes. (11) Developing and transition countries receive a large percentage of world FDI because of the confluence of three factors: inexpensive labor, market growth potential, and wealth of natural resources. (12) Political risk is an ever-present danger of FDI that is especially profound in the energy sector. (13) During an economic slowdown, political leaders may appropriate foreign assets to make up for the host country's losses. (14) When commodity prices rise, political leaders may be tempted to repudiate contracts that imposed ceilings on royalty payouts to host countries. (15)

      The 1962 United Nations Resolution on Permanent Sovereignty Over Natural Resources and the 1974 United Nations Declaration on the Establishment of a New International Economic Order, announced the principle that host countries are free to control their natural resources despite contractual agreements granting rights to foreign corporations. (16) Host countries eager to assert their independence utilize this principle to justify expropriating foreign projects once they reach the production stage. (17) This "obsolescing bargain" is particularly prevalent in developing countries and those in transition from planned to market-based economies. (18) Frequent regime changes in such countries often increase their leaders' reluctance to recognize that prior contracts remain binding on current administrations. (19)

      When investors operate in foreign legal regimes, they face an increased level of general business risk uncommon in domestic ventures. (20) Contract risk, specifically the risk of repudiation, increases when the counterparty is a foreign government entity. (21) Another example of the increased risk of FDI is currency risk, which includes the risk of currency devaluation, convertibility problems, and limitations on currency transfer from the host. (22)

    2. International Investment Protection

      1. Transaction-Based Risk Mitigation

        The importance of taking proactive dispute prevention measures before conflicts materialize cannot be overstated. (23) If the risk involved outweighs the benefit, multinational businesses generally abstain from investing. (24) When the risk is more reasonable, multinational businesses actively reduce expropriation risk through choice of legal entity. (25) Common entity structures include joint ventures, strategic alliances, and other types of cross-holdings between foreign and domestic stockholders. (26)

        Multinational companies also use general business tactics as defensive measures, such as staying in arrears on contracts and limiting assets held in the host country's jurisdiction. (27) Another common business measure is localization: both the reinvestment of profits in the host country and the employment of local workers. (28) In developing countries in particular, technology transfers and domestic training programs can sufficiently align interests. (29) Political risk insurance is another necessary proactive defense measure. (30)

      2. Legal Remedies

        Because of the imbalance of power involved in FDI, negotiation is often no longer an option once infrastructure improvements are completed and investors may only be able to resolve disputes with host countries through formal proceedings. (31) Legal recourse is seldom realistic in the host country, and arbitration proceedings must be initiated before the International Centre for Settlement of Investment Disputes (ICSID) or another arbitral body. (32)

        The Convention on the Settlement of Investment Disputes Between States and Nationals of Other States (The ICSID Convention), which established the ICSID, is the primary instrument of investment protection. (33) Under a traditional interpretation of The ICSID Convention, written consent from both parties is required before a claim may be filed with an arbitral body. (34) If consent is not given, the parties are forced to proceed before a national court in the host country. (35) The ICSID Convention also permits "arbitration without privity" that allows the host country to waive the need for its contractual consent to an arbitration agreement. (36) By forcing arbitration, Article 25 of The ICSID Convention reduces costs of individually negotiating every arbitration clause in each contract and increases investor leverage against host states by guaranteeing a legal remedy. (37)

        Bilateral investment treaties (BITs) are the primary vehicles used by industrialized countries to insure investment protection in other nations. (38) BITs typically address expropriation directly, and generally require the following: prompt and adequate compensation for a taking; treatment that is predictable, transparent, fair, and equitable; non-discriminatory taxation; license fees; visa restrictions; anti-monopoly regulation; and most favored nation status. (39) In addition, investors may be able to compel arbitration through multilateral investment treaties. (40) The 1994 Energy Charter Treaty (ECT), for example, requires that parties engage in conciliation negotiations first, and only if those fail may the investor choose the forum. (41) By permitting the investor to choose either a domestic court in the host country or an international arbitration tribunal, the ECT provides another method of invoking "arbitration without privity." (42)

        If the investor is able to win an arbitration proceeding, enforcement remains a problem in the current arbitration system. (43) Even when an aggrieved investor wins an arbitration decision, a host country can avoid paying damages if it has not waived sovereign immunity from enforcement. (44) If the host country waived sovereign immunity for enforcement, it may still seek to set aside the arbitration decision during the enforcement proceedings. (45)


    1. Modern Expropriations

      1. Russia Reclaims its Oil and Gas

        Some of the world's largest fossil fuel energy reserves lie in the Russian subsoil. (46) After the Soviet Union collapsed, multinational oil and gas companies received their first real Russian investment opportunities as the country shifted from a planned to a market-based economy. (47) Eager to replace outdated infrastructure, Russia encouraged foreign investment during this period. (48) In the early 1990s, Russia responded to perceived instability in its market for foreign investment by enacting the 1992 law "On Subsoil," and then in 1996 the Federal Law "On Production Sharing Agreements" (PSAs).

        During the 1990s, an investor-friendly market was created in Russia by low oil prices and increased access to new resource deposits through PSAs. Today, however, high oil prices have led to an increase in nationalization of major Russian oil projects. (51) A prominent example of this trend is the case of the Yukos Oil Company, which was partially auctioned-off following a suspicious application of tax law against its president, Mikhail Khodorkovsky, and one of his partners, Platon Lebdev. (52) Following Khodorkovsky's 2003 arrest for fraud and tax evasion, the Russian government took control of Yukos's assets and auctioned them to a shell company, which subsequently merged with Rosneft, one of Russia's state-owned energy corporations. (53)

        Plaintiffs have had difficulty finding a jurisdictional hook for Russia under Article 10 of its 1999 law on Foreign Investment, a problem complicated by Russia's decision not to ratify The ICSID Convention. (54) In this instance, the ECT to which Russia is a signatory may be applicable because it grants foreign investors the right to initiate arbitration without privity. (55)

        Another technique Russia used to gain greater national control of its energy production market was the revocation of PSA licenses under the auspices of environmental regulation. (56) The joint venture between British Petroleum (BP) and Russian TNK, (TNK-BP), has recently come under attack following repeated feuds with Gazprom over pipeline access and oil field development strategy. (57) In 2006, TNK-BP was the focus of criminal investigations on charges alleging "systemic...

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