ABOUT TDM
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Compensation for non-compliance on PPAs and similar long-term contracts
Mr. Wells,
The issue you raise has been a standard question of how to calculate damages for a long period of time in common law jurisdictions and civil code jurisdictions alike. The awards in question neither engage in double counting nor are they "bad decisions", although I am sure counsel for Pertamina disagree with my view!
In effect, the Karaha Bodas award applied the actual contract terms in calculating damages for breach of contract . The Patuha/Himpurna awards, in contrast, were unusual because damages were effectively limited to the amounts Rob Howse has suggested in his email to you (on a very unique application of an international law theory known as "denial of justice"). The reason why damages included both the return of the equity investment and the foregone return on the equity investment in Karaha Bodas was a simple matter of contract law and damages for breach of contract. This contract was in fact a "sales" contract - the Energy Sales Agreement (ESA). As a matter of damage theory, as I am sure you know the courts have consistently held that a breaching party is required to put the non-breaching party into the position the non-breaching party would have enjoyed if the breach had not occurred.
Otherwise, the non-breaching party will not be fully compensated for the harm caused by the conduct of the breaching party. The terms of the Energy Sales Contracts in question explicitly obligated the power purchaser, in the event of its breach of contract, to pay to the project company an amount sufficient to enable the project company to (1) repay the debt incurred to finance the project together with accrued interest, (2) return the invested equity to the equity investors and (3) provide the equity investors with the discounted present value of their anticipated rate of return over the remaining life of the operating period if the power purchaser had not breached the contract.
Under the terms of the Energy Sales Agreement in Karaha Bodas (and, indeed, the ESA's in Patuha/Himpurna), the Indonesian power purchaser (PLN and/or Pertamina -- the contract arrangements involved both State enterprises) had contractually agreed to pay a monthly tariff for each month of the operating period (a long-term period beginning on the date the relevant project was completed). The amount of that tariff was negotiated, just like virtually all other private power projects with long-term power purchase agreements, so that it would over the term of the operating period cover (a) the fixed costs of building the facility (a "capacity charge" in an amount sufficient to provide for the return of the investors' equity, payment of scheduled debt service on the basis of amounts of construction debt and interest rates assumed at the time the contract was signed, and a return on the invested equity at an implied internal rate of return - usually from 15-25%, depending on the deal) and (b) variable operating costs (a "operating charge" in an amount intended to reimburse the project for the variable costs of actually operating the facility).
Under the terms of the ECA's, if the facility was properly constructed by the project company on time and in accordance with specifications set out in the ECA, then so long as the facility was "available" for generation of electricity, the power purchaser was unconditionally obligated to pay the monthly capacity charge (the only excuse from this obligation was if a contractually defined event of force majeure occurred, and even that excuse was very limited by the terms of the contract). In addition, if the power purchaser "dispatched" the facility by requesting electricity, then during the period the facility was in fact generating electricity the power purchaser would also be obligated to pay the monthly variable operating charges (again, subject only to the occurrence of force majeure as defined in the ECA). The reason for this structure was financeability - the lenders to the limited recourse project company would not have agreed to provide construction finance for the project unless the monthly tariff was "sized" to provide sufficient firm cash flow to amortize their loan and pay interest thereon over a reasonable amortization period commencing when construction was finished, and the equity investors would not have provided the equity capital unless they also saw a firm source of recovery of their capital and a return on that capital.
In essence, the basic characteristics of such a power purchase agreement are that the project company (and thus its investors and lenders) take the commercial risk of construction and operation. If it fulfills its obligations, then the power purchaser is obligated to provide a stream of cash sufficient to enable the project company to recover 100% of the funds provided by lenders and investors to build the project and the pre-agreed rates of return. This contract structure is obviously very different from the cash flow picture a normal operating company faces, where it does not have pre-agreed commitments to purchase its output.
In all of these cases, the arbitrators concluded that either the project was in fact completed in accordance with the ESA (either Patuha or Himpurna, I forget which) or would have been so completed but for the breach of contract by the Indonesian side (Karaha Bodas and the other of Patuha/Himpurna). Moreover, the arbitrators also concluded that the Indonesian side was not entitled to a force majeure defense (whether under the force majeure provisions of the relevant contract or applicable doctrines of excuse from performance for changes circumstances).
Therefore, the arbitrators applied the negotiated terms of the contracts in calculating damages (except that the arbitrators in Patuha/Himpurna reduced the otherwise applicable amount by applying a "denial of justice theory - the arbitrators in Karaha Bodas were asked to do the same but did not believe a "denial of justice" had occurred). The very large amounts of damages involved arise, of course, because of the large capital costs of constructing a power project and the long-term nature of the power purchaser's unconditional tariff obligation.
A couple of comments. First, you are certainly correct about the problem of calculating damages based on long-term projections. Use of historical data, while preferable, is not always feasible. Since none of the power projects involved in Patuha/Himpurna or Karaha Bodas had an operating history, the arbitrators were unable to use historical operating expenses and revenue payments from those projects to evaluate the earnings potential for those deals. They could, and did, however use historical data for the capital costs actually incurred in constructing the facilities rather than the unadjusted assumed capital costs originally built into the tariff computations under the ESA's.
Moreover, since none of the 26 private power projects in Indonesia had fully completed construction and begun normal operations before the Asian financial crisis brought them to a halt, there was no historical data from comparable investments to use as a benchmark. However, as mentioned last night the damages in the Indonesian arbitrations were based on breaches of the electricity sales contracts obligating PLN/Pertamina to make fixed monthly tariffs payments, not on projections of investment returns. In Patuha/Himpurna, the arbitrators said "[i]n the present case, the lost profit claim is the numerical representation of contract stipulations.
It is not the expectation of what will happen in real life." The arbitrators then in effect used the notion of "abuse of right" [I misstated the name of the relevant international law doctrine last night - it is not "denial of justice" - no excuse, but it was late at night for me!] and a 21% discount rate to reduce the award from the amounts produced by the contractual calculations
I have been looking at the caselaw and commentary recently in order to help myself understand competing damage calculations for some arbitrations I am hearing. The cases make clear that the usual damage limitations of foreseeability and not granting "speculative damages" come into play to limit the amount of damages payable on account of future profits based on projections. There are two methods often used to deal with the issue; (a) modifying individual revenue and cost numbers in a projection to adjust for the uncertainty of the future streams of cash flow and expenditures (a very difficult task, as you will imagine) and then present-valuing on the basis of a discount rate that reflects the cost of capital without a risk premium, or (b) not adjusting the actual amounts in the projections, but instead using a discount rate for present-valuing that embodies both the cost of risk-free capital and a risk premium for the uncertainty of that particular stream of future profits (the so-called Discounted Cash Flow (DCF) approach).
The DCF method is much more popular, because it condenses the risk adjustment into a single factor rather than adjusting each item within the projections for risk separately. Of course, there is no consensus as to how to select the correct risk premium for the discount rate, and proposals by disputants in actual cases differ wildly. There is some measure of agreement that the best means of determining the risk-free component is to use the then-current interest rate for US Treasuries with an average-life-to-maturity equal to the relevant projection period, but even that has been disputed in a matter I am hearing. As you know, a lower risk premium in a discount rate implies a lower risk of uncertainty that the net revenue stream contemplated by the projections will actually occur. The lower the discount rate the higher the net present value and thus the award, and vice versa.
One recent US case discussing when a risk premium is appropriate is Energy Capital Corp. v. United States, 302 F.3d 1314 (Fed Cir. 2002).
In Patuha/Himpurna, there proper discount rate was a matter of controversy. In those awards, the arbitrators limited (by using the doctrine of "abuse of right") the lost profits component of the damage claim solely to lost profits on account of the percentage of the fixed monthly capacity tariff attributable to capital actually invested, not capital the Claimants intended to invest under the terms of the ESA. Thus, the damage claim was based on 30% of the sum of the contractually-required monthly tariffs over the contract term, not 100%. Then, the arbitrators applied a discount rate to that sum.
The Claimants (the project company) argued for use of a discount rate of 8.5%, comprised of a 5.5% cost of risk-free capital for the average-life-to-maturity of the 30-year contractual operating period (remember, this was 1999 and rates were a little higher than today) and a 3% risk premium for the uncertainty associated with the project. The arbitrators described the 3% risk component as "absurd." The arbitrators contrasted this number with the 24% internal rate of return projected by the equity investors before construction of the project commenced, which of course was the return the investors were seeking in order to compensate themselves for the project's risks. The arbitrators also noted some of the many commercial, political and economic uncertainties involved in an Indonesian private power project. Since most of the construction risk had already passed in the Patuha project before the Indonesian side breached the contract, the arbitrators selected a 21% discount rate. Thus, the arbitrators did recognize that the higher rate of return required by investors for an Indonesian geothermal power project had to be offset by a discount rate that recognized the uncertainty of returns over the contract period for that project. Whether the risk adjustments actually made by the arbitrators were based on the correct evaluation of that uncertainty is, however, another matter!
The arbitrators offered a number of candid comments about the unscientific nature of their choice of a discount rate. Among the better comments was the following: "The arbitrators make no pretense that this is the result of precise weighings of the discrete considerations that have influenced the arbitrators; nor do they wish to create the illusion that they have engaged in econometric modelling, or even calibrated costs and revenues with a time line that establishes hypotheses for the commission of generating Units, contingencies of reserve evolution and the like. Both the rate and its application reflect a series of adjustments made by the arbitrators in their equitable assessment of the evidence, and, in the circumstances of this case, resolving all doubts in favour of PLN, the debtor." The arbitrators also commented that an objection could be made that the approach taken by the arbitrators "exposes the ostensible adoption of the DCF method as something of a fig leaf". [I don't have Himpurna in front of me, but there is a similar discussion in that award - I don't know offhand the discount rate used in Karaha Bodas, but it is public]. It is clear that the arbitrators were very uncomfortable with a damage amount based on a strict reading of the contract, and sought to reduce that amount substantially by employing assumptions favorable to the Indonesian side and by means of the "abuse of right" doctrine. The arbitrators in Karaha Bodas, by contrast, were nowhere near as inclined towards the Indonesian side in their damage calculations.
In one of the matters I am hearing, a US merchant power project, the Claimant is arguing for a 3.5% discount rate and the Respondent is arguing for a 22% discount rate. [The Respondents had required a minimum 16% internal rate of return for their investment in the power project, and the Claimants held an equity position subordinated to prior receipt of that 16% IRR by the Respondents]. In another matter, an international telecoms transaction, both parties are focusing on a range of 12-14% as the appropriate discount rate. In an US acquisition dispute, Claimants are arguing for a 14% discount rate. In none of these cases does a long-term contract exist - all of them involve projections of investment returns. As you can see, the range is quite broad.
I hope this is useful. I too would be interested in a finance-savvy discussion of this topic from someone with lots more knowledge than me, as well as criticisms and corrections with respect to my comments above.
regards, Mark Kantor
From: Twwalde
Subject: compensation for non-compliance on PPAs and similar long-term contracts
I have reviewed a little bit more closely the prior and interesting discussions. Without reviewing the awards in full detail, I would not be able to come to a conclusion, but I find merit in both Kantor's and Wells' comments.
First, Kantor is right that we have here an application of the normal law of damages: putting the aggrieved party in the position they would have been had the incriminated act not occured.
Second: There are problems everywhere in the law of damages when calculating damages arising out of a projection long-term into the future. If a car gets damaged, the repair plus loss of value is a quite easily identifiable damage. If a contract over 20 years is abrogated or not complied with, the required comparison between the "healthy-contractual" situation and the "unhealthy-non-contractual" situation is very difficult. It involves nothing more than a speculation 20 years into the future about two very uncertain events. You can not argue that one future sequence for comparison (the "healthy-contractual" sitaution) is quite certain because the contract in fact "fixes" or guarantees the 20-year future, because the surrounding economic context is unpredictable. One can not truly determine how the "healthy future" would look like before the end of 20 years.
So the problem with "lucrum cessans" is that it is highly speculative - involving a comparison of two speculative and uncertain sequences.
It is for these reasons that courts/tribunals have as a rule and for reasons of "decision/ judicial economy" preferred to rely rather on "historical" data - i.e. reasonably certain (within a range of accounting disputability) - than on NPV of future cash flows. An investment made (say at 1 BN Euro) may have more or less value in the future. That value may change as the economic circumstances change (interest rates, fuel prices, electricity prices, market moods etc). But it is a firm number which gives "comfort" to dispute deciding third parties.
The problem of "double counting" raised by Prof Wells of Harvard Business School does seem to me to be a legitimate one: Once the original investment is returned and if the tribunal then also awards an "average" profit/rate of return over the next 20 years, the compensated investor is in the indeed happy situation of having one billion US $ to re-invest and make the normal rate of return - plus he gets his rate of return on the now closed investment paid by the tribunal.
But even if one assumes that some double-counting may be legitimate (e.g. because the investors in these Indonesian PPAs made a particularly lucrative deal and assured themselves per contract a very good rate of return - as compared to for example an average rate of return for invested capital (or God forbid capital invested not in INdonesian' PPAs but in contracts with Enron) and if this particularly lucrative rate of return is compensated by the tribunal (itself a problematic acceptance of possibly unequal deals), then there is an issue of risk which may not have been properly presented to the tribunals and appreciated by them. The relation of risk/reward is in my experience rarely well understood by lawyers and takes considerable financial analysis training to generate sufficient familiarity. Let me illustrate this further:
If the Indonesian deals had a high contractual rate of return (much higher than capital normally deployed then or now) and if the tribunals now compensate for the loss of this lucrative opportunity to make a profit in Indonesia for the next 20 years, the tribunals have misunderstood the implication of the risk: The beyond-average rate of return in the Indonesian contracts is likelyt o be related to the higher risk taken (a risk that seems to have fully or partly materialised). But if they now award to the investors/contractors the much higher rate of return in a lump sum discounted to present value, they in effect exchange a high-risk, high-reward future cash flow with its current net present value, but without any longer a 20-year risk exposure. So this risk-focused analysis would seem to confirm Prof Well's suggestion there is double counting: The double counting is implicit in the payment of both an origianl investment amount plus an amoutn reflecting higher-than-normal future (20-years) profits - but without that the risk reflecting the 20-years higher return is present any longer.
I would welcome very much a more in-depth (and financial-analysis savvy) formal analysis of the two Indonesian arbitral awards cited. The issues have come up as well in the context of the US-Iran claims tribunal, but also the UNCC compensation awards, particularly in the oil industry.
T. Waelde
I would like to make just one more observation on the question of whether awarding lost profits in an expropriation case is "double counting." As one of the team involved in the enforcement of the Karaha Bodas award, I would concur completely that the Karaha situation was very distinct from the typical expropriation case we encounter in recent investor-state arbitration, because of the contractual provisions involved.
I think that in some expropriation circumstances, an explicit award of lost profits, calculated over the entire anticipated life of a project and without regard to the date the award is rendered, could be considered a double recovery. There is no double-dipping involved where lost profits are calculated only from the date the government institutes expropriatory measures until the date the award is rendered, however. Indeed, without such a head of damages, the claimant cannot be truly made whole, since his investment is tied up until he receives compensation, and cannot be used for other purposes. Indeed, unless tribunals routinely include expropriation-to-award lost profits, host governments will have perverse incentives to seize projects "on the cheap."
On this point I would direct those interested to a somewhat-dated, but thoughtfully-composed article by Prof. Derek Bowett, "Claims Between States and Private Entities: The Twilight Zone of International Law," 35 Cath. U. L. Rev. 929, 941 (1986):
"In the Aminoil case the tribunal emphasized the obligation of a dispossessed or expropriated corporation to reinvest the proceeds of any arbitral award. This would accord entirely with the common law duty of a plaintiff to mitigate his damages. Conceptually, therefore, when the private claimant receives, by way of an award, compensation representing the value of his assets, plus any loss of profits in the interim period between the act of nationalization, breach of contract or expropriation and the date of the award, at that date he receives back the value of his business. His "capital" is returned to him. He is presumed to invest that capital elsewhere so that it will earn him profits in some other business, in some other country. Why, therefore, should the private claimant expect the tribunal to award him loss of profits under the terminated contract for the same period during which the same capital is earning a second set of profits elsewhere? On the assumption that he has put his returned capital to good use, the claimant, in effect, is claimang a double recovery for loss of profits. Such a claim seems both illogical and unethical."
Noah D. Rubins, Esq.
Jones Day
51 Louisiana Ave., NW
Washington
