An Expert Brief on Economic Security, Investment and Jurisdictional Risk

| Norman Roule

A rarely discussed but high impact trend that seems to have been amplified by the COVID-19 virus is affecting investment in countries that have traditionally attracted investors interested in minerals and rare earth materials.  

A process that is open to corrupt parliaments, dictators and authoritarian governments has long been around, but today, is trending worse for companies that make multi-billion-dollar investments in long-term enterprises, according to Cipher Brief Expert Norm Roule.  And the ramifications are huge.  

The question now is what to do about bad governance without bullying resources from developing countries, and how to ensure that the environmental impact of these investments is recognized and addressed.  

The Cipher Brief spoke with Roule to better understand the overall impact of this issue.

Cipher Brief Expert Norm Roule served for 34-years in the Central Intelligence Agency, managing numerous programs relating to Iran and the Middle East.   He served as the National Intelligence Manager for Iran (NIM-I) at the Office of the Director of National Intelligence.  He regularly consults on energy-related issues in the region.

The Cipher Brief:  What is jurisdictional risk, and how is it impacting investment?

Roule:  Imagine investing in a multi-billion-dollar mining project in another country over a decade. Your investment is based on an agreement with the host country in which your share of the revenue from the project is guaranteed for a specified period of time. If successful, the project will be one of the largest sources of income for the host country.  Now, imagine that when the project is completed, the host government changes its laws and announces that you must pay a larger share of the profits.  In addition, you can only renew the license that allows you to operate if you accept a smaller share of the revenue, pay substantial new taxes, license fees, etc.  Alternatively, you can abandon the project and lose your investment.  Most companies end up complying with the new demands, albeit after lengthy negotiations and litigation.

In the last decade, it has become increasingly routine for governments to assert greater control over strategic extractive resources and associated revenue streams to augment national budgets or to sustain their hold on power.

Jurisdictional encroachment and resource nationalism should be considered inevitable elements of any extractive operation in those countries that lack a transparent judicial system, strong anti-corruption laws, a stable legislative system, and a diverse economic base.  Such conditions are often common in countries dominated by authoritarian, corrupt, or populist leadership.  The failure of the international community to respond to these actions has created a sense of normalization to expropriations. This trend doesn’t mean that foreign operations won’t be profitable, but rather that investors must recognize that profits will likely erode during the lifetime of the project.

The Cipher Brief:  What are the benefits to states that engage in this practice?

Roule:  Outright or gradual expropriation provides a steady stream of revenue that can be used to achieve political goals, mobilize popular support, build patronage networks, and retain the loyalty of influential business leaders.  At the same time, the risks are surprisingly few, especially if the expropriation process is well managed.  There is little reason to believe countries will face more than bilateral political difficulties and here countries – and often the companies – are reluctant to risk a breach in relations that might end up with complete expropriation.

The Cipher Brief:  Are there characteristics where such events are most common?

Roule:  I can think of five that tend to appear most often:

  • A resource from which the host country derives or could derive a significant portion of its annual revenues.
  • Host countries that are dominated by authoritarian or populist leadership that exploit compliant legislatures and social media to facilitate new revenue demands or outright expropriation.
  • An absence of established host country legal traditions, regulatory ambiguity, and national requirements for transparency in commercial operations.
  • Multinational companies with no host country constituency.
  • Countries where a perception exists that short or mid-term economic benefits outweigh the need to offer foreign investors legal assurances or financial predictability.

The Cipher Brief:  Are US investors the only groups targeted by such actions? Can you cite a few examples and how they’ve played out?

Roule:  Not at all. In recent years, companies based in the United States, Canada, Europe, and China have all been the target of jurisdictional encroachment.

Let me run through a handful of examples over the last decade:

  • Since 2011, Indonesia has required that foreign companies sell increasingly significant amounts of their local operations to local investors, banned raw ore exports to compel the development of indigenous mineral processing, and increased royalties, taxes, and fees.
  • In 2011, the populist Bolivian government ordered a review of the country’s mining code to increase revenue from that sector. In April 2012, its government seized a massive zinc and tin mine from the Swiss conglomerate, which has operated the project since 2005. The Swiss firm claimed that the seizure took place after it had agreed to increase government ownership of the firm to as much as 79 percent.  During this same time, Bolivia took control of electric-grid operations owned by a Spanish company in which the Spanish government held a 20 percent interest.
  • In 2013, the Dominican Republic informed mine operators that it sought a “more favorable” revision of the 2009 contract on a gold, and silver mine two weeks after the $3.7 billion project reached commercial production. Shortly after, the government halted mine shipments due to alleged faulty customs paperwork.  Work resumed once the mine operator agreed that the latter’s share of gross profits would grow from 37 to 51 percent, and the company would increase local tax payments.
  • In 2017, Tanzanian President John Magufuli announced an “economic war” against mine operators, claiming that the latter had failed to pay royalties and taxes amounting to $190 billion with interest and penalties. Magufuli’s government also instituted legislation that required renegotiation of contracts and an end to international arbitration in disagreements. Mine operations halted and resumed only in 2019, after the company reportedly provided Tanzania with $300 million, shared ownership of its three local mines, and half of the mines’ royalties and cash distributions.
  • In January 2018, the Democratic Republic of Congo authorized an immediate 50 percent tax on super profits. It also allowed the government to raise metal royalties from 2 percent to 10 percent if the government determined that the mineral is a “strategic substance.”
  • Kyrgyzstan represents a great example of this challenge. In 2009, Kyrgyz officials compelled a Canadian company to divest one-third of its equity in one of the world’s largest gold deposits. Two years later, Kyrgyz officials demanded an increase in mine revenues, resulting in a special dividend to the government of $33 million. In September 2017, the government increased its annual environmental fees ten-fold. It successfully demanded a $6 million annual payment to the Kumtor Rehabilitation Fund, an additional $50 million to the Nature Development Fund, and $10 million to the Cancer Research Development Fund. Around 2019, the Canadian operator also agreed to make multi-million-dollar contributions to various Kyrgyz social and development funds.
  • For several years, Papua New Guinea and a Canadian mining company were locked in a dispute over a 30-year-old operation that mine operators called “nationalization without due process.” The issue ended with an agreement that the government would receive a significant share in the operation while foreign companies operated the mine.
  • Over the past few years, Bostwana, Mali, Mongolia, and Zambia have also pushed for a larger share of local mining revenue. Several incidents of this nature were underway this year. Just last month, China canceled its purchase of a gold mine in Ghana, claiming that its current Australian owner failed to inform it of Accra’s decision to terminate the lease on the mine.

The Cipher Brief:  Is it possible to predict when these actions will take place?

Roule:  Up front, companies already understand that they work in a world where such demands are likely inevitable. Growing international competition over rare earth metals, gold and other scarce minerals will exacerbate this trend.  However, it will come as little surprise that the threat of resource nationalism tends to spike once revenue potential is assured. Steps for partial or complete nationalization begin with a narrative that wealthy multinational firms have unfairly gained an unreasonable share of revenues from national strategic resources. Such themes may appear during elections, periods of rising populism, or environmental or social protests by distressed nationals from resource-rich regions. Host governments easily weaponize the message on social media and in party campaign narratives alleging environmental concerns or the theft of national resources by multinational firms.

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At the same time, high commodity prices aren’t always a driving factor. During periods of high prices, host governments are likely to demand a more significant bite of a larger pie. However, interventions do not end when resource prices fall. Instead, financially pressed leaders will inevitably seek to sustain revenue flows at the expense of foreign investors.  Last, extractive resources are also inherently non-renewable, and, over time, extraction becomes more costly. These considerations together inevitably encourage local leaders to demand contract concessions, especially when project production reaches, or is about to reach, its maximum potential.

The Cipher Brief:  How do companies respond?

Roule:  External investors possess few useful tools to thwart resource nationalism. Unlike traditional industries, strategic resource opportunities are few. They cannot be recreated in other jurisdictions, limiting the threat that investors will withdraw to seek geography with a more compliant government. Extractive industries also inherently involve capital-intensive projects that must be forfeited should a foreign owner break with the host country. Increasingly, it seems that the best companies can do is to engage in negotiations or litigation, hoping that the host country will reduce demands to sustain operations or avoid reputational damage in other sectors.

The question, therefore, becomes, how do companies get ahead of this risk? 

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