How much is your investment worth? Using DCF in valuing mining investments in BIT arbitration
Investors in mining often structure their investments to deliberately benefit from the protections of bilateral investment treaties (BIT). A key question in any proceedings brought by an investor under such protections (particularly in cases of expropriation / nationalisation) is the value of the investment in the eyes of the arbitral tribunal. Equally for an arbitrator, one of the more difficult questions in any BIT arbitration is identifying the value of what the investor has lost.
Unlike most methods of quantifying an investor’s loss, the discounted cash flow (DCF) valuation method gives the investor full value for the investment’s future profits. The World Bank defines DCF as the net cash receipts of the enterprise in each year of its economic life, after discounting by a factor reflecting the time value of money, expected inflation, and the risk associated with such cash flows. This is what most investors expect to receive when making their investment, and would similarly hope to receive in a BIT award.
DCF is nevertheless controversial. A recent survey by PwC of international arbitral awards (the majority of which were BIT awards) found that DCF was rejected in 22 out of 59 cases where it was proposed as the primary damages quantification method. Principally, this was because the investment did not have a track record of producing revenue, so the tribunal considered a result based on projected future revenues would be too uncertain or speculative. A recent example is Tenaris S.A. and Talta. v Venezuela where, in an award delivered in January 2016, the Tribunal refused to accept DCF because the operating period was too short, even though the project had operated for 42 months.
This is a particular concern for mining investments. Mining projects characteristically feature large upfront investment and a long lead time before production. Until the mine shows consistent production, there may be a significant period where the investor may not be able to recover the future expected profits of the enterprise. If tribunals are unwilling to consider future cash flows because they are too uncertain, mining investors will be systematically short-changed because of the nature of the industry.
However, encouragingly, tribunals have shown a willingness to be more accepting of DCF in a mining context, on the basis of evidenced reserves where appropriate. In Occidental Petroleum v Ecuador, for example, the tribunal applied DCF to value the investment simply on the basis of the reserves and production profile. In Crystallex International Corporation v Venezuela the Tribunal was satisfied that the claimant had proved future profitability of the mine even though it had never operated, because of the mine’s proven reserves. This line of thinking was acknowledged in Khan Resources Inc v Mongolia, where the claimants submitted that in the case of a mine with proven reserves and a market price, DCF can be used even where the mine has not come into full production. The Tribunal agreed that in such cases DCF may be considered appropriate, although did not consider it suitable for that particular case.
Clearly, an investor in the mining industry who suffers loss due to breaches of a BIT wants full value for its loss. DCF, compared to other methods of valuation, is often the best method for doing so. Tribunals have shown a willingness to be robust in addressing the problems characteristic to mining - high upfront costs and long lead times before sustained production. But it is critical that counsel in a BIT arbitration properly appreciates the nature of the industry and the value of proven reserves to properly present the investor’s case, and ensure a fair recovery of loss.