Manuel A Abdala and Pablo D Lopez Zadicoff, Compass Lexecon
This is an extract from the first edition of GAR’s The Guide to Mining Arbitrations. The whole publication is available here.
Introduction: Why so many mining disputes?
Because of their intrinsic economic features, mining assets are highly susceptible to disputes and economic experts play an important role in determining the size of damages in such disputes. First, mining projects are exposed to highly volatile mineral prices, which translates into market risks that not only impact immediate profitability but could also alter the economic viability of resources yet to be extracted. Price risks also create friction in projects with minerals sold under long-term contracts, which, in the presence of price volatility, may require adjustments, renegotiations or reviews of price clauses. Second, because investors do not typically own the mineral resources that they mine (owning only the right to explore and extract them), and because their investments become sunk, mining projects are vulnerable to regulatory risk and government opportunism. The economic literature recognises that the resource owners (generally governments) may be tempted to act opportunistically in the presence of profitable sunk investments, though this is not to say that opportunistic behaviour is the source of all conflicts in the mining industry. Mining projects are also exposed to regulatory risks arising from evolving environmental requirements, as well as general changes in legislation affecting the way mines operate. Both opportunistic and non-opportunistic actions by governments may lead to conflicts and disputes in mining investments. Economic experts play a critical role in at least two dimensions. First, they can contribute with their expertise as economists on the standards of regulatory treatment on mining concessions, as well as on the economic and commercial interpretation of complex concession contracts. Second, to estimate damages, they often have the assess the fair market value of the mining concession rights in both counterfactual and actual scenarios.
Key challenges in the valuation of mining assets
Developing mining fields is a lengthy process that requires significant upfront investments before the project is ready to commence commercial production and earn revenue. Thus, investing in mining means that the potential returns of the undertakings will take a long time to materialise. If geologically successful, investments are expected to be recovered throughout the life of the project, until the exhaustion of the mineral reserves or until the expiry of a licence or permit to operate.
High-profit margins are another characteristic of successful mining projects. Successful mining projects are particularly profitable for two reasons. First, once operational, gross margins must be sufficiently high to cover for both operating expenses and recovery of (large) past investments. Second, the high profitability observed ex post in successful projects must be commensurate with the level of risk inherent in the identification and extraction of mineral resources (which does not always result in resource findings).
The value of a mining asset, as does the value of any asset, depends on its capability to generate cash flows to the investors into the future. Consequently, the standard valuation methodologies used in arbitration are the discounted cash flows (DCF) method, the relative multiples valuations based on transactions and traded comparable companies, and any inferences based on stock market performance of the asset or that of comparable traded companies. The general application of these methodologies has been developed in multiple papers, both in the financial and economic literature, and in other arbitration-related literature. Consequently, in this chapter we do not address the basic implementation of these valuation methodologies, and instead focus on key challenges specific to the valuation of mining assets, namely:
- How should mining assets be priced at different stages of their life cycle?
- How appropriate are forward-looking valuation methods to value pre-operational mining assets?
- What is the size of extractable minerals during the life of the mine and how do they relate to the mineral resources and reserves estimates?
- How should the volatility of mineral prices be controlled?
- How should any protection clauses found in the contractual terms, and proper regulatory and country risk exposure be adjusted for?
- How should the environmental responsibilities embedded in a mining project be accounted for?
Pricing mining assets at different stages of life cycle
A successful mining asset tends to exhibit meaningful discrete adjustments in value throughout its life cycle. This is because a mining project must overcome multiple hurdles and a relatively long path to reach production.
Mining projects must obtain land mining rights, scope the land for evidence of resources, measure them, and undertake a feasibility analysis to evaluate whether the measured resources can be economically extracted (i.e., extracted at a profit) based on market and technological constraints.
The final pre-operational stages involve structuring and securing of the financing and the necessary construction, environmental and operational permits as well as, ultimately, overcoming construction risks. Once in operation, the value of the mine depends on the amount of reserves estimated for recovery, the market price of the mineral commodity and the regulatory compact involving the terms of operation. If the time frame for the mine is sufficiently long (e.g., 20 years or more) and reserves estimates are confirmed to be accurate, the yearly production rate should be relatively stable during the first years of its operations. Once the reserves begin to dwindle, assuming no more reserves can be added (through additional areas that are sometimes explored once a main discovery is exploited), the production rate may gradually decline, and so will the value of the mine as reserves are exhausted.
The existence of these changes in value throughout the life cycle of a successful mining project needs to be accounted for within the selected valuation technique. It is important to recognise the project’s current stage in its life cycle, and in so doing identify the list of applicable risk factors. For example, the risk embedded in a project that has completed only the preliminary economic assessment (PEA) is far greater than the risk affecting a similar project that has the DFS and is permitted and ready to begin construction. Within the DCF methodology, the risk or reliability of the resources estimates can be accounted for in the discount rate – that is, everything else being equal, the cash flow profile forecasted at the PEA stage would call for a higher discount rate compared to a similar cash flow profile forecasted at the DFS stage.
Given the challenges in estimating discount rates at different project stages, which is particularly true for the pre-DFS stages where market information is more limited, it is common in the mining industry to control for the riskiness of the project stage at the overall value level. That is, the present value of the cash flows could be calculated using a similar discount rate (which could be a rate consistent with the riskiness of an operating mining asset), while the resulting value would be ‘de-risked’ based on the probability of the project successfully completing the pending stages of development. For example, the completed PEA asset could be valued at a significant discount to the present value of the project had it already been operating, whereas the completed DFS project, depending on the complexity of the construction, could be valued at very close to the full operational value.
The same careful treatment of project stages needs to be carried out when performing valuations based on market multiples or stock market analysis. It is important for market information to be extracted from comparable companies that are at a similar ‘risk stage’ as the asset under consideration. If the number of comparable companies is too limited, however, it is crucial to adjust the available market information for the discrete value adjustments that occur throughout the life cycle of a successful mining project.
This can be accomplished by, for example, analysing the impact that environmental permits or completion of a DFS has on the value of traded mining companies (i.e., on junior mining companies in which the target asset represents a meaningful share of its mining sites) and then adjusting the price of comparable companies, which are at a different stage as compared to the target company.
Forward-looking valuation methods are appropriate to value pre-operational assets
While the DCF method and other forward-looking valuation methods are widely used, the 1992 World Bank’s guidelines on investment arbitrations recommends the use of the DCF method only for companies with a track record of performance.
Such a recommendation, however, has little economic merit, and less so on the valuation of mining assets given that projects with extractable resources are commonly traded or transacted in the marketplace at significant value, based on price per resource or price per reserve basis, even when commercial operations have not yet started and hence no track record of operating performance exists. Thus, tribunals should not be reluctant to adopt the DCF method or other forward looking valuation approaches, especially when the mining asset in question has reached the development stage of its life cycle.
Furthermore, imposing limitations on the use of the DCF method on mining assets is counterintuitive from an economic perspective, since once the exploration stage is surpassed and the reserves are quantified, there should be little doubt that the reserves can be monetised into future cash flows. In sum, economic valuation should always be forward-looking when dealing with ventures that were successful at the mineral discovery stage.
In the previous subsection we highlighted the importance of adjusting the value of the mining asset for the level of risk inherent in each stage of its life cycle by using either the discount rate or the de-risking factor. The need for risk adjustment, however, does not remove the rationale for adopting forward-looking valuation methods as highlighted by both the Canadian and the Australian mining professional organisations. Furthermore, both the Canadian and the Australian mining organisations recommend the use of forward-looking valuation techniques for any mining project that has surpassed the PEA stage.
For the pre-PEA stage project, given the difficulties that exist in accurately assessing geological risks, historical cost-based valuation approaches can sometimes be accepted as a reference to value. Yet even at a pre-PEA stage the valuation expert should analyse the forward-looking prospects of the project. Otherwise, relying exclusively on a backward-looking approach (e.g., based on historical costs) may result in value estimates that overstate or understate the real potential of the project.
For example, in the Crystallex v. Venezuela award, the tribunal considered that only forward-looking methodologies aimed at calculating lost profits would be appropriate to determine fair market value for a gold mining project at Las Cristinas, which had surpassed the PEA stage and had the final permit before operation status arbitrarily denied. The tribunal understood that it had been sufficiently established that the Las Cristinas gold project would have gone on to become profitable in the absence of the disputed measures, despite the fact that commercial operations had not yet started.
The accuracy of mineral resources and reserves estimates
Assets in the mining industry derive value from their potential to extract and monetise underlying minerals at some future date. Underlying minerals are categorised into mineral resources and mineral reserves.
Valuation experts will typically rely on technical assessments from reserve experts or specialised outfits that certify the size of extractable reserves at any given point in time. Given that output prices are volatile, it is important that the reserve certification be as contemporaneous as possible to the date of valuation, to avoid the size of economically extractable reserves to be over- or underestimated.
Furthermore, changes in taxation regimes can affect the economic viability of reserves and downgrade those to resources. This is particularly important when a mining operation continues while an alleged breach is ongoing, as actual investment and volumes extracted might not be representative of a ‘but-for’ environment in which higher volumes would be economically feasible.
Controlling for the volatility of mineral prices
Minerals are commodities sold in international markets, with highly volatile prices, and are thus prone to disputes. When market prices of minerals change dramatically, parties involved in long-term contractual arrangements might have strong incentives to renegotiate terms, and when renegotiation is not viable or feasible, disputes arise. In addition, governments might be more likely to renegotiate permits, concession contracts or royalties and investment requirements entered by prior administrations under different prevailing prices, and private parties might renege on their obligations if they have been deemed too onerous (when prices fall after the contract has been agreed upon). Equally, disputes between shareholders will become more likely when the volatility of prices alters the initial allocation of risks between partners in ways that were unforeseen or unexpected. Finally, from a regulatory standpoint, short-term price volatility may lead to disputes if it triggers price clause reviews or regulatory reviews related to long-term profit-sharing or profit-cap agreements. In all these cases disputes arise because, despite balanced ex ante risk-reward allocation, ex post, one party might obtain a disproportionate share of revenues. To control for the volatility of mineral prices, valuation experts can rely on contractual arrangements or on specialised outfits that model supply and demand, to obtain forecasts on mineral prices. Futures contracts, when existing and sufficiently liquid, provide the forecaster with market evidence of contractual agreements between buyers and sellers, which might serve as a benchmark for the future price level. Long-term price forecasts, on the other hand, can be assessed using supply and demand models, or resorting to existing price forecasts from specialised outfits. By using all information available, possibly discarding projections that are considered extreme or outliers, valuation experts can make informed decisions about expected future prices for traded minerals.
Contractual terms and adjustments for proper regulatory and country risk exposure
Contractual, regulatory and country-specific risks play an equally important role in the valuation of damages in mining disputes. Contractual terms and regulatory conditions can significantly impact the risk inherent in the valuation of any asset, and therefore adjustments are required to account for the risk exposure of the specific asset being valued. Obtaining all the necessary permits for operation, including the environmental permits, for example, may impact the value of a pre-operational asset if there is lack of definition related to the timing and the scope of completion for permit requirements.
Contract length, for one, can have a direct impact on the estimate of reserves, as it can limit the amount of resources that can be productively extracted during a limited period. Shorter production contract terms may imply lower reserves, given the time constraint inherent in the contract itself. For the same reason, contract renewal provisions play an important role in the valuation of mining assets, particularly in the calculation of their terminal value.
Similarly, the location of an asset matters, as the level of associated risks depends, among other factors, on the predictability of the local economy, infrastructure, labour force and the strength of institutions. The term ‘exposure to country risk’ is therefore used to capture incremental risks such as:
- The additional volatility of domestic demand, which may be more prone to recessions and booms in less developed economies. In the case of the mining industry, the products are usually sold (or capable of being sold) in international markets, and therefore, ignoring any specific sale arrangements, mining assets are mostly immune to demand fluctuations in the country where they are located.
- The infrastructure of a developing economy, which may expose the asset to supply risks, since services, logistics and suppliers may be unreliable.
- Governmental actions and macroeconomic policies (e.g., changes in taxation, royalties and other forms of ‘government take’), which may disrupt the stability of the business environment, and thus increase the overall risks of doing business.
A distinction must be made between general country risk and the specific exposure that any given asset might have to this type of risk. General country risk measures the incremental risk that an average investor faces from investing in a given country. The specific exposure to country risk, by contrast, is the incremental risk that an investor in the target asset faces. That is, the analysis of specific exposure of country risk is based on the specificities, protections and safeguards that the asset might have, which may differ from those of the average investor holding assets in any other industry.
Because mining assets involve sunk investments and are particularly prone to government opportunism, they are typically contracted out with regulatory arrangements that shield them, at least in part, from the full extent of the general country risk. Most notably, significant portions of revenue from these assets are isolated from country-specific demand risk, given that their products (i.e., commodities) are traded worldwide as opposed to being sold in the domestic market. In addition, many concession contracts, licences or operating permits include explicit or implicit protections, some in a partial manner and others in full. The most common types of protection mechanisms include:
- stabilisation clauses, which compensate the investors from changing regulatory regimes (tax increases or other regulatory actions that tend to increase the ‘government take’ to the detriment of the investor’s stake);
- economic equilibrium clauses, another form of the stabilisation clause, which allows for regulatory changes so long as the original contract equilibrium is maintained;
- force majeure clauses, which protect parties from events or circumstances beyond the control of either party;
- liability provisions;
- assignment clauses;
- termination clauses; and
- intellectual property clauses.
As a result, it is important that valuation experts consider the specific exposure of the project to country risk, and do not simply apply a standardised measure of country risk to the asset, without any adjustment. In the Gold Reserve v. Venezuela award, for example, the tribunal rejected the discount rate proposed by one of the parties’ experts, noting that it ‘was based on both full and “generic” country risk for an investment in Venezuela’, and therefore failed to adjust for the risk exposure that was specific to the assets in question.
Investors in mining assets also face environmental risks throughout the life cycle of the asset, which the damages valuation expert should consider. Among others, these risks range from vegetation clearance during initial surveys and groundwork, to atmospheric emissions and waste disposal, with its impact on local populations, during resource extraction and operation phases. It would be common to find that companies allocate a portion of their expenditures (or set aside cost provisions) to allow for environmental compliance.
To mitigate such environmental risks and comply with environmental responsibilities, investors and operators of mining assets may have to implement controls such as habitat protection plans or waste management schemes. Environmental legislation could also evolve in the future, leading to stricter future regulation or actions by the government.
Valuation experts must be conscious of accounting for these costs and risks based on the investment horizon, likelihood of the risks materialising and their impact on the value of the asset. In the short term, to the extent that environmental commitments are relatively predictable and non-recurring, the costs of compliance can be accounted for on a cash flow basis. If the risks are recurring with the potential to affect the value of the asset throughout its life cycle, however, they can be accounted for in the discount rate.
The role of the economic expert
Economic experts play critical roles in multiple dimensions of mining disputes. The most obvious is the calculation of value, for which the economic expert needs to derive mineral prices, cost estimates and the cost of capital applicable to the industry. For this purpose, the economic expert often needs to rely on the estimates of the geological expert on the size and quality of reserves and resources, although not exclusively, given that owing to their strategic value, reserves of mining assets are usually published or analysed by governmental entities in charge of regulation or financial planning.
Furthermore, the computation of damages usually involves the computation of the difference in value under two different scenarios: the but-for the alleged measures value, and the value of the asset affected by these measures. Many times, the value of the latter is nil, given that it is common for cases to be based on expropriation or alleged unlawful termination of mining permits. In cases dealing with changes in regulatory regimes, permits or taxation, however, the economic expert is required to perform full valuations under both scenarios.
The expert should always be able to properly isolate the impact of the measures from other macroeconomic and technological events affecting the mining operations, so that the calculation of damages is limited to the impact of the alleged measures. The discounted cash flow methodology is especially apt for modelling and controlling for such circumstances. By making all forecasting assumptions explicit, it is possible to isolate the impact of the measures and provide an accurate calculation of damages under this approach. Transactions can also provide meaningful market evidence if there is market evidence of transactions that take place under both scenarios, although the availability of this type of information is usually limited.
Economic experts can also assist on the liability discussion by contributing their expertise as economists on the standards of regulatory treatment on mining concessions. As discussed previously, the mining industry is subject to substantial price volatility, and to technological and environmental changes, among others. Regulatory frameworks may evolve through time in response to these variables and economic experts can inform the legal analysis regarding the consistency of the changes with the original agreement of the parties as of the time of the investment as well as on helping judge the regulatory changes with regard to regulatory experience facing similar adjustment situations in other jurisdictions.
In cases of creeping measures, where there is a sequence of alleged improper measures affecting the mining asset, economic experts can help isolate the impact of each measure, which is instrumental for the proper assessment of damages (where tribunals can rule independently on each of the measures), and also inform the legal decision about the proper date of valuation.
Similarly, mining operations are usually regulated by specific complex concession contracts. The economic and commercial interpretation of these contracts provides useful information as to the expectations that economic agents might have had for the mining asset, which in turn may translate into how to assess certain parameters that would influence the market value of the assets in a counterfactual scenario. Additionally, mining contracts sometimes include specific provisions or clauses that determine compensation for certain pre-established events, or may have limitations of liability that may require both legal and economic interpretation.
In sum, economic experts can have a role that is broader than the calculation of damages in mining disputes, by providing economic and financial analysis on the concession contract and its regulatory framework, as well as opining on regulatory conduct, all of which can inform the legal analysis regarding liability, date of valuation and the proper allocation of damages to multiple measures.
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