51280 Public Disclosure Authorized with confidence UNDERSTANDING POLITICAL RISK MANAGEMENT IN THE 21% CENTURY LT ee) enol Eat MICA Sa ee Une td nen eet eee PateThe Changing Face of Political Risk Patrick Garver Multinational corporations active in the global resources sector face a number of challenges when looking to expand their operations into new territories. Four key questions come to mind m1 How have political risks for global natural resources compa- nies changed over the last three to five years? m= How have recent changes in the global economy affected the political risks we face? m= How has Barrick’s appetite for political risk insurance (PRI) evolved? Apart from PRI, what tools are available to today’s investor to manage political risk? Patrick Garver is Executive Vice President and General Counsel of Barrick Gold Corporation. Barrick Gold Corporation, headquartered in Toronto, is the world’s largest gold mining company. Barrick currently operates 27 mines and 10 new projects in various stages of development on four con- tinents. The views expressed in this chapter are those of the author and do. not necessarily represent those of Barrick Gold Corporation. 8182 Patrick Garver Past ‘The Changing Face of Political Risk For large multinational resources companies, risks of a noncom- mercial nature have evolved substantially in the last five years. While the three main traditional political risks—expropriation, polit- ical violence, and currency inconvertibility—are still of concern, sig- nificant new risks have emerged alongside them. The principal emerging risks for a foreign investor in many parts of the developing world are those associated with the empowerment of local, regional, and nongovernmental interests—including local and regional governments, cultural or religious interests, and non- governmental organizations Some portion of this growing area of risk is due to the formal devolution of political power from national governments to local or regional subdivisions of government, as has been demonstrated, for example, in Indonesia and Peru, But most of this risk is more a func- tion of new technology and globalization than of changes in gov- ernment structure, namely, the more informal empowerment of certain interests that only recently have gained dramatically improved access to information, communications, and the media, including the global media. These interests now have a global voice, in real time, and are becoming increasingly sophisticated at assert- ing their considerable political will. As a consequence, local and regional interests and certain special interests now share power with national governments to a degree unheard of in recent history. In short, in most jurisdictions the support of a national government may be necessary to ensure political stability, but it is no longer sufficient. Today, local, regional, and special interests often assert themselves in connection with what is colloquially known as the “social license to operate.” The political risk associated with such interests first becomes apparent when, for example, the local community organ- izes a “referendum” regarding a project; a local magistrate suddenly revokes zoning approval; the local parish priest and 100 campesinos block the road to the operations; or a provincial official arbitrarily bans some commercial activity that is essential to the operations. ‘One then finds that the national government, which seemed to have ‘on some level committed to support the investment, is conspicu- ously absent or ineffective. Asecond significant genre of evolving threats facing international investors is that associated with transnational crime, corruption,‘Tus CHANGING FACE oF PouITcat Risk 83 and certain nontraditional competitors who do not operate by the Marquess of Queensberry rules. In some developing countries, crim- inals and criminal networks may constitute the most powerful inter ests confronting a government, national or local, often with resources, capabilities, and tenure that exceed those of the government itself. In that context, itis not surprising that illicit businesspeople can create an unlevel playing field to affect an investment in a natural resources project. It is not surprising that they can cause a govern- ment bureaucrat to revoke an operating license or cancel a conces- sion agreement and cause it to be issued to another “friendly” party. Itis not surprising that they can cause national or local governments to use their regulatory powers—tax, immigration, police, environ- mental, or the like—to undermine an investor's interest in a prop- erty or project or favor the interests of a local partner. In fact, in some jurisdictions it is increasingly difficult to differ- entiate between criminal elements and the political interests with which they appear to be aligned. The lines between “traditional” political violence or terrorism and such criminal activity and cor- ruption are also increasingly blurred. Whether speaking of old risks or new, today the specific nature of political risks faced by a global company can be quite different from region to region. For example, and speaking generally: Risks attendant to public corruption are typically much more prevalent in certain regions or countries that do not tradi- tionally score well for transparency or the rule of law, for example, countries in the Commonwealth of Independent States, Kazakhstan, or Indonesia. im Risks attendant to resource nationalism are most prevalent in Latin America and Africa, where populist politics often drive a country’s political agenda to seek a greater piece of the min- eral resources pie. Obviously, resource nationalism is alive and well in other countries (such as the Russian Federation) and regions, but it appears to be more contagious in certain parts of Latin America and Africa, In contrast to resource nationalism, risks attendant to crimi- nal behavior (for example, piracy, kidnapping, industrial sab- otage, theft of intellectual property) are far less sensitive to a country’s prevailing political leanings. Such risks are more pronounced in failed or failing states (for example, Sudan,84 Patrick Garver Past Somalia, the Democratic Republic of Congo) with either lim- ited institutional will or limited law enforcement capacity to protect investors or prosecute prominent criminal elements. m= In contrast, in the last several years political risks attendant to the empowerment of local or regional interests have increased vir- tually everywhere in the world where Barrick does business. ‘Today's Economy and Political Risk By its nature, political risk is a transitory phenomenon. At any given time, political risk is, after all, simply an expression of current social, political, and economic pressures. For the last several years political risks in the natural resources industries have been dominated by developments in the global economy. Until mid-2008, record-high global commodity prices and booming emerging markets put polit- ical pressure on governments all over the world—both in develop- ing and developed economies—to cancel or renegotiate contracts and concessions or impose new taxes and royalties to dramatically change the economics of natural resources development. While countries such as Reptblica Bolivariana de Venezuela and Russia may have led the charge to change the ground rules for existing investors in the resources sector, the common perception of “wind- fall profits” accruing to foreign investors was an irresistible target for politicians worldwide. Despite recent dramatic decreases in commodity prices, there has not yet been a corresponding reduction of the political pressure to extract more revenue from foreign investors. It appears that the politicians and their constituents in many developing countries are simply not as responsive to the recent changes in the investment cli- ‘mate as are the worldwide capital and debt markets. This disconnect between significantly lower commodity prices and continuing political pressure to tap investors for more revenue ‘occurs, in part, because the average person on the street in La Paz or Ulan Bator is likely to oversimplify foreign investment in natural resources projects, It is not uncommon for people to simply assume that resources development is inherently profitable. Consequently, political pressure mounts to increase the size of the government's share of the proceeds of the sale of production, largely without regard to considerations of profitability or other developmental ben- efits (such as employment, training, technology transfer, infrastruc- ture development, and so forth) that flow from the underlying investment. In any event, the pressure for more revenue from‘Tug CHANGING FACE oF PouITicat. Risk 85 foreign investors continues. And this pressure may be slow to abate in many countries because government officials see precious few other options to meet their revenue needs in a weakening global economy. In the last two or three years, high commodity prices empowered a new wave of emerging market competitors, such as parastatal resources companies, sovereign wealth funds, Russian oligarchs, and other private equity of indeterminate origin. These competitors were often flush with petrodollars or other proceeds of a booming global economy (and not always the mainstream economy). For a variety of reasons, these competitors significantly increased the political risk profile faced by more established global resources com- panies. The recent retreat in oil prices from US$130 per barrel to less than $50 per barrel, and the dramatic softening of the global econ- omy, will surely slow that trend. But whatever the short-term eco- nomic situation, nontraditional competitors in many industries such as natural resources, power, and infrastructure appear to be here to stay. Their potential impact on the evolving landscape for political risk and PRI should not be underestimated Case Study: Barrick’s Appetite for Political Risk Insurance Barrick is frequently asked about the company’s perspective regard- ing PRI. While the company believes that PRI has an important place in its risk management portfolio, the overall appetite for PRI has been tempered by a number of concerns. It should first be noted that Barrick recently put in place a new global PRI policy covering 11 mines and projects in six different countries—Argentina, Chile, Papua New Guinea, Peru, South Africa, and Tanzania. Rather than moving away from using PRI, the company believes that as it ventures further afield on the global stage PRI has the potential to play an even larger role, However, sev- eral issues must still be addressed. First, a perception has arisen that available PRI coverage is increasingly too narrow and has not evolved with the changing face of political risk. Despite some recent improvements in available cov- erage, PRI products and the language of existing PRI policies still remain largely focused on specific clements of the traditional risks mentioned earlier. Consequently, such products and policies do not mitigate several of the risks with which Barrick is most concerned. Second, there is also a perception among some insureds that the international financial institutions (IFIs) and export credit agencies86 Patrick Garver Past (ECAs) that issue PRI do not have the same “deterrence” value that they have had in the past, For many companies, deterrence was the principal attraction of such coverage. This view of the declining deterrence value of PRI is based on the judgment that many coun- tries no longer see themselves as beholden to the IFIs because they have far less, or in some cases no, outstanding exposure to such institutions. Some countries, particularly in Latin America, have even found it politically advantageous to publicly thumb their noses at institutions such as the World Bank Group. Last, some concern has also arisen that some of the IFls and ECAs have become less willing to intercede with host governments to pro- tect the interests of their clients in loss-avoidance discussions. If this estimation is correct, it may be a function of the insurers perception of its own declining influence in certain countries, perhaps reflect- ing conflicting political priorities of the insurer’s government spon- sor in its strategic relations with a host country. (Political imperatives such as access to oil or the war on terrorism can affect a govern- ment's priorities.) Or, it may reflect an insurer's reluctance to take any action that may seem to acknowledge that a particular potential loss is covered. Whatever the reason, if the insurer is not viewed as a proactive and enthusiastic advocate to avoid a potential loss, PRI becomes far less attractive to a company like Barrick. The recent collapse of the global credit markets may have some important implications for the demand for PRI. First, as commercial credit dries up more companies like Barrick might rely on the IFls and ECAs to participate in projects as lenders in place of commercial banks that either have no appetite or no capacity. Their participation as lenders has the potential to obviate the need to also include PRI as part of project financing. Second, the simultaneous collapse in credit markets and com modity prices also will have a significant effect on the absolute num- ber of new natural resources projects that are going to be undertaken. A recent Reuters article listed some 60 projects in the mining industry that had been canceled or shelved in the last three months alone of 2008. Itis likely that the actual number will even- tually be much higher than that. And this trend is not limited to the mining industry. It may provide a preview of what could be expected on the demand side for PRI. It will also be interesting to monitor how the current credit crisis affects both the health and the capacity of political risk insurers and reinsurers, and whether PRI can continue to be competitively priced in the private market given current credit spreads.‘Tug CHANGING FACE OF PouITicaL RISK 87 On a more positive note, however, circumstances have changed for many host countries. As countries now begin to look at their options for funding impending budget deficits, many may have no choice but to return to the IFls for assistance. That, in turn, may breathe some additional vigor into the concept of deterrence. Other Tools Available to Mitigate or Manage Political Risk A few tools other than PRI can be used to mitigate political risk. Most of these tools are employed in an investment well before the project gets to the point at which PRT comes into play. First and foremost, it is essential to assess the nature of the risk comprehensively before making an investment. A com- pany must do its homework on the country, the region, and prospective partners well before it becomes contractually committed. Ample resources are available to assess political risk—one just needs to use them. (In this regard, the task of comprehensively assessing the risk of a particular investment is not so much different than the same exercise by a political risk insurer.) Once the initial evaluation is complete, those risks, because they are not static, must be actively monitored, and mitigation strategies must be adjusted without hesitation. Akey mitigation strategy for those investing for the long term in the natural resources industry is for companies to seize the moment and make fair deals, structured to keep the interests of the foreign investor generally aligned with those of all of, the key stakeholders—including local and regional interests— over the life of an investment, To the extent possible, the deals should be structured to account for the cyclical nature of com modities prices While it has been considered by many to be beneficial to include local partners or investors that are thought to bring something to the table, it is equally important to ensure that they profit only if the investment prospers. Investments should be structured to take advantage of invest- ment treaties and access to international arbitration. If fiscal or tax stabilization arrangements are envisioned under local law, the time must be taken to complete such agreements before fully committing to a project. It is also important to keep in mind that with such agreements, as with PRI policies, the devil is in the details.88 Patrick Garver Past = Companies also need to ensure, more than ever before, that adequate capacity is committed to establishing and main- taining the company’s local “social license” to operate. From a risk avoidance standpoint, this point cannot be overem- phasized. Last, irrespective of predominant local business practices, com panies must be utterly and uncompromisingly transparent. Conclusion A discussion of political risk at any appointed time necessarily tends to focus on events and forces that by their nature are ephemeral. Undoubtedly, today’s political risk profile will change tomorrow with the global economy, global commodity prices, and global social and political winds. While the global commercial world may have gotten smaller and flatter, it has not gotten any less complicated. Consequently, assessing and managing this moving target have never been any more important to the success of our businesses than they are today.