Navigating the minefield of non-technical risk
It is conceivable that every professional employed in the mining industry will at some time be involved in foreign direct investment (FDI). Mineral occurrences of interest may be in foreign jurisdictions, and therefore it is essential that decision-makers are fully aware of the legal and fiscal mechanisms of these jurisdictions and can objectively evaluate the risks that exist when investing their shareholder’s funds.
The decision-maker needs to be both bold and cautious, a combination of attributes that can only come with experience and knowledge.
One of the most characteristic features of trans-boundary resources investment is the dramatic risk/reward relationship associated with exploration and production. Therefore, it is essential that resource professionals understand the dynamics of these risks.
The focus of this article is on the means by which company management can identify, characterise, quantify and mitigate the risks associated with foreign direct investment.
Mineral resources in a globalised world
Exploration for minerals is a strategic requirement when planning the future of a mineral producing corporation. However, it is not just a strategic requirement, but also an economic strategic requirement.
The United States, Australia, Canada and South Africa have traditionally been the major mineral producing areas. However, as the mining industries in these four countries have matured, and new targets diminished in number, there has been growing interest in the relatively unexplored regions of the world.
Since the early 1990s, mineral exploration interests have been increasingly apparent in developing countries located in South America, Sahelian and Sub-Saharan Africa and Central and Eastern Asia. Investors are looking for growth, and these are perceived as the growth areas.
This article highlights some of the major factors that should be considered when contemplating foreign direct investment in resource and major infrastructure projects abroad, and in the developing world in particular.
Even though non-technical risks may be high or extreme, by using suitable risk mitigation mechanisms, there is no country that couldn’t be considered as a foreign direct investment target, providing there are no unilateral or multilateral sanctions in place, which would legally restrict investment in that state.
The author endeavours to make the investor aware of these risks and to enable the investor to manage and mitigate these risks. This is achieved by highlighting the importance of research, supervision, good corporate and state governance, and dispute resolution as mechanisms to avoid the countless pitfalls not normally encountered by the average Australian professional.
Investing and working in the developing world is a rewarding experience in many ways. Preparation, independence, persistence and honesty are the keys to success, as well as an understanding of geopolitics and the local social, cultural and business environment.
Foreign direct investment
The author’s primary interest is foreign direct investment, in particular, foreign direct investment by transnational corporations (TNCs) in the exploration and exploitation of the Earth’s natural resources.
Graham and Krugman (1991) define FDI as ‘ownership of assets by foreign residents for purposes of controlling the use of those assets’. This is a deceivingly simple definition of a highly complex professional pursuit practised and studied by individuals, entrepreneurs, treasurers and scholars for many years.
The UNCTAD World Investment Report (2014), estimated that global FDI would reach US$1.6 trillion in 2014 (actual was US$1.23 trillion – down 16 per cent), US$1.5T in 2015 and US$1.7T in 2016. Of this, Africa attracted US$54 billion and Australia US$52 billion. Developed Asia is the largest inward FDI recipient of US$465 billion in, and US$300 billion out.
In 2013, the then Foreign Minister Bob Carr stated that in Africa alone there are 200 Australian resource companies involved in 650 projects in 37 African countries. This is markedly reduced today, but nevertheless, Australian presence in the developing world is still significant, and will be more significant in the future.
An integral component of a transnational company’s (TNC) corporate strategy is investment strategy. Typical questions a TNC considers would be:
- Into which commodity do we invest?
- How much do we invest?
- Is there a market for the product?
- What is our competition?
- What alternatives do we have?
- Where do we invest?
- What are the risks?
The first five questions are common to most investment types. However, the last two are interrelated insofar as the investor may be pioneering new territory.
Investment demands a risk. To what extent this risk plays a part in the investor’s decision is determined by the return. Investing in the developed world has its own particular risks. However, investment in the natural resources sector is, by its very nature, a high-risk, high return activity. The investor in the natural resources sector contends with commodity price risk, geological risk, geotechnical risk, environmental risk and a host of other natural and technical risks.
When considering investing in the developing world, the investor also needs to take into account sovereign risk, legal risk, political risk, regulatory risk and any other risk groups associated with FDI infrastructure that may be a feature of a particular host state.
The TNC investment strategist must consider the long term, as an agreement may need to survive 50 years or more. Other considerations include the consequences of a change of government (democratically or otherwise), the security of tenure and, should things go wrong (such as government expropriation), the existence of an efficient and fair dispute resolution mechanism.
Other factors influencing foreign direct investment
The following can all have negative effects on investment and the prudent investor should have contingency plans for a wide variety of scenarios. It needn’t always be as bad as described below. Good governance is the key; or at least a genuine attempt to find the road to good governance – not just State Governance, but Corporate Governance too – is a start. The developing world has many success stories such as Ghana, Tanzania, Botswana Namibia and Chile; however, there are countries on the other end of the scale as well.
Expropriation is the taking of a foreigner’s property. According to the UN General Assembly Resolution 3281 (1974), expropriation is legal, and can be achieved through straight confiscation, or by ‘Creeping Expropriation’, ie through tax increases, licence cancellations, breaking government obligations or through any action or inaction by the government that renders the project uneconomic. A sovereign state has the sovereign right to expropriate, providing adequate compensation is paid; however, it is the quantum of compensation that is normally the issue in dispute.
War, terrorism and sabotage
War is not only an obvious risk, but also a sure sign of political instability, and a certain method of discouraging investment. For example, in Africa alone, armed hostilities have plagued the continent over the last two decades. In addition to wars, terrorism and sabotage can affect the personal safety of investors.
The major problem-diseases with huge economic cost are: HIV/AIDS, malaria, typhoid and now, ebola.
HIV/AIDS take an enormous toll on indigenous personnel, and according to Roberts (2007), malaria and typhoid account for 25 per cent absenteeism for all personnel including expatriates. HIV/AIDS kills about 2.5 million people a year and malaria another 2 million. Polio, a disease long eradicated in the developed world, is still evident in Sub-Saharan Africa. Philanthropic private companies and NGOs are working to eradicate these diseases; however, many obstacles to success are present.
Roads, rail and air transport in the developing world are notoriously inefficient. Sealed roads and bridges are non-existent in many countries, and in the wet-season, transport of equipment and movement of population is impossible by land. Air safety is a major concern, as is ticketing, timetabling and maintenance.
Reliable power and telecommunications networks are essential utilities. Landlines are often stolen for scrap and reliance has switched to expensive mobile networks run by private operators. Power transmission is unreliable, forcing resource investors to supply their own networks. This is often the deciding factor of whether a project succeeds or not.
Education and health
Education and medical facilities are extremely important to a foreign investor trying to attract senior personnel into the country. However, premium standard, general medical treatment is required for everyday needs such as accidents, childbirth, heart attacks and any other treatment that a developed country national takes for granted at home.
Education is a primary need of every nation to ensure development. Local personnel are easy to find, but not experienced, educated personnel. The investor must allocate funds for formal training programs. In a lot of countries, the government requires it. This is an expensive process and can take years to produce personnel of acceptable levels of competency and safety. Any state with a head start in an educated workforce will immediately attract investors.
Banking and trade
Banking and currency controls require good governance. Many nations have independent currencies floating on the world markets. Many are plagued with a worthless highly inflated currency, meaning that investors will only deal in hard currency.
The investor needs to be secure in the knowledge that there are no restrictions enabling repatriation of profits and dividends.
Crime – violent, non-violent or both – is a major problem. Police forces can be inefficient or corrupt, or the law can be unenforceable due to lack of infrastructure and rule of law. Security costs are high and inefficient.
Corruption is a fraudulent activity used to gain advantage in business negotiation, whether official, such as to government members or servants, or unofficial, such as to private individuals with corporate knowledge or power.
Corruption takes various forms and degrees of magnitude. However, the anatomy of the beast is fairly constant.
Experience in the developing world exposes one to endless varieties of petty corruption. Examples are customs and immigration officers, police barriers, junior bureaucracy and countless others.
The World Bank defines governance as ‘the manner in which power is exercised in the management of a country’s economic and social resources for development.’
Good governance is built around incorruptibility. This is true. Cronyism and nepotism increase the solid citizen’s disenchantment, and thus encourages a feeling of hopelessness. Eventually, it becomes an ‘if you can’t beat them, join them’ mentality which spreads throughout the public service.
International involvement in economic relations entails both increased risks and benefits. One important element of such additional risks is non-payment of debts: the debtor may feel themselves to be safely out of the creditor’s reach when they are across a border.
A dispute may be with a foreign state as in the case of mining and oil companies and foreign direct investors, or a foreign commercial entity. In international legal terms, a dispute with a foreign state is an International Investment Dispute; and a dispute with a foreign commercial entity is an International Commercial Dispute.
Should such a situation arise, whereby an Australian investor experiences such difficulties, what can be done?
A contract is only as strong as the law governing any dispute that may arise; therefore, when embarking on a foreign venture, the TNC will need to consider the mechanisms available, and choose the mechanism desirable to meet its needs. These needs are typically the expectation of a fair hearing, in a timely manner, enforceable and economically conducted. To be heard in our native tongue would also be desirable, but not always negotiable.
If no provision is made through the dispute resolution clause in the contract, then it is probable that litigation will ensue, and the dispute will be heard in the national courts of the host state. This may be acceptable in a state with a fully developed legal system. However, the contrary may be true in a developing state. A delocalised and independent forum of dispute resolution, for the parties irrespective of their nations of origin, should be the choice.
So, what is available? There is a hierarchy of dispute resolution mechanisms known as Alternative Dispute Resolutions (ADR). Potential disputes can be avoided, or if necessary, settled privately, honourably and economically through ADR.
ADR includes negotiation, mediation, expert determination, international commercial arbitration (ICA) and international investment arbitration (IIA).
Arbitration is an additional dispute resolution mechanism available to disputing parties on both a domestic and international level. It is in many respects similar to court proceedings. However, significant differences are that the parties to the dispute choose the arbitrators (in national courts the state appoints the judge), the venue, the applicable law, the language, and the procedural rules under which it will be conducted.
No party has to submit to the national court of the other party. This is an obvious advantage where there may be a perceived or real national prejudice.
Unless otherwise agreed by the parties, confidentiality is maintained throughout the proceedings. The arbitration and its outcomes are kept confidential, thereby increasing the chances for peaceful settlement.
Enforceability of an award of a domestic arbitration will be enforced in the normal way through the national courts; however, in an international arbitration, the award will be enforced by international treaty. The relevant international treaties are the New York Convention on Recognition and Enforcement of Arbitral Awards 1958 for International commercial disputes; and the Washington Convention for the international Settlement of Investment Disputes. These two conventions set the standard requirements for a successful international arbitration process.
Over 150 countries are party to the Conventions and the award can be enforced in any of states that are contracting parties to the conventions. In a normal litigation, a judgement can only be enforced within the one jurisdiction, which in some cases may be difficult to impossible. There are few private law conventions that have achieved such a wide international acceptance.
One must be aware that a sovereign state has a sovereign right to have a case heard against it in its own national courts and tribunals; therefore, before any investment, we need to persuade the sovereign state to surrender that sovereign right, either through international treaty or bespoke agreement.
When considering a venture in the developing world, the investor has pre-conceived ideas of what to expect. Optimism is the lure of the investor, particularly in the mineral industry. Investors must be satisfied that they have the capacity to deal with all the above factors, and be prepared to research the host state prior to actual investment.
Graham, E H and Krugman, P R (1989). Foreign Direct Investment in the United States. Washington, D.C.: Institute for International Economics. Xiii
The UNCTAD World Investment Report (2014), UN Symbol: UNCTAD/WIR/2014
Africa Down Under, speech, 29 August 2012, Australian Minister for Foreign Affairs, foreignminister.gov.au/speeches/2012/bc_sp_120829.html
United Nations General Assembly, Res/29/3281 (XXIX). Charter of Economic Rights and Duties of States, Chapter II, Article 2.2 (c), 12 December 1974.
Roberts C (2007). ‘Current and Priority Markets for Australia’s Mining Services Sector, and Addressing and Mitigating International Market Risk’, Western Australian Government Overseas Network, Perth.
World Bank. (1992). Governance and development. Washington, DC : The World Bank. P9. http://documents.worldbank.org/curated/en/1992/04/440582/governance-development
Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958) (the ‘New York Convention’).
Convention on the Settlement of Investment Disputes Between States and Nationals of Other States – International Centre for Settlement Of Investment Disputes, Washington 1965.
Feature image: CC jbdodane.