- See, for example, T W Wälde and B Sabahi, ‘Compensation, Damages and Valuation in International Investment Law,’ Transnat'l Disp Mgmt (forthcoming); Irmgard Marboe, ‘Compensation and Damages in International Law—The Limits of “Fair Market Value’” (2006) 7 J World Inv & Trade 723); John YGotanda, ‘Recovering Lost Profits in International Disputes’ (2004) 36 Geo J Int'l L 61; W Michael Reisman and Robert D Sloane, ‘Indirect Expropriation and Its Valuation in the BIT Generation,’ in (2004) 74 Brit YB Int'l Law 115; Louis T Wells, ‘Double Dipping in Arbitration Awards? An Economist Questions Damages Awarded to Karaha Bodas Company in Indonesia’ (2003) 19 Arb Int'l 471; Markham Ball, ‘Assessing Damages in Claims by Investors Against States’ (2001) 16 ICSID Rev—FILJ 408. The preceding list is of course incomplete; however space constraints prohibit a complete listing of the recent, insightful scholarship.
- Some scholars assert that the terms ‘compensation’ and ‘damages’ are associated with the legality of the actions giving rise to the dispute and should thus differ in usage. See, for example, Marboe, above, at 725–26 (asserting that ‘in certain cases the use of one term [compensation or damages] might be more appropriate than the other’ based on the legality of the actions underlying the dispute). This article does not consider the legality of the actions underlying the dispute. See below text accompanying note 2. The two terms are thus synonymous for the purposes of this article and are used interchangeably.
- The mathematical models for determining the present value equivalent to projected future revenues derive from economic and financial considerations, not from the legal principles determining a claimant's right to compensation for loss of those revenues. Aswath Damodaran, Investment Valuation, Tools and Techniques for Determining the Value of Any Asset (2nd edition, 2002), pp 11–14 (providing the mathematical formula for the discounted cash flow method of valuation which does not depend on the legality of a respondent's act); Frederick S Mishkin, The Economics of Money, Banking, and Financial Markets (4th edition, 1995), pp 71–72 (same); Richard A Brealey and Stewart L Myers, Capital Investment and Valuation (2003).
- However, the applicable law governing compensation may in certain circumstances require adjustment of the calculation based on the nature of the wrong. For example, a tribunal recently held that an illegal expropriation of an asset that increases in value after the expropriation should result in compensation as of the date of the award, rather than at the time of the expropriation. ADC Affiliate Ltd et al v Hungary, ICSID Case No ARB/03/16, at paras 479–81,496–99, and 517–21 (Award of 2 October 2006), available atwww.worldbank.org/icsid/cases/pdf/ARB0316_ADCvHungary_AwardOctober2_2006.pdf (last visited 6 June 2007).
- The tribunal's conclusion is a recognition that, from a legal perspective, the measure of damages may vary depending on the nature of the wrong, giving rise to the right to recovery and the remedy for that wrong. Compensation for a loss, for example, requires making the claimant ‘whole’ for its loss (whatever that may mean), while disgorgement focuses on depriving the wrongdoer of the benefit of its wrong. Similarly, scholars and tribunals have suggested that awards premised on illegal acts should be greater than an award for a legal act with comparable economic effect. Marboe, note 1 above, at 725–26 (supporting this view and distinguishing between compensation as a result of a legal act and damages arising ‘as the consequence of a breach of an obligation, be it international or contractual’); see also Case Concerning the Factory at Chorzow (Germany v Poland), 1928 PCIJ (ser A) No 17, at 40 (Sept 13) (stating that a failure to distinguish legal from illegal acts ‘would… be unjust… since it would be tantamount to rendering lawful liquidation and unlawful dispossession indistinguishable in so far as their financial results are concerned.’). This rationale points to a measure of damages intended either to punish the wrongdoer or to deter other wrongs, as might be employed to differentiate damages awarded in cases of illegal, as distinct from lawful, expropriation. See, for example, Separate Opinion of Judge Brower, Sedco, Inc v Nat'l Iranian Oil Co, Interlocutory Award, No ITL 59–129–3 (27 Mar 1986), reprinted in 10 Iran-US CTR 189, note 35 (1986) (stating ‘the injured party would receive nothing additional for the enhanced wrong done it and the offending State would experience no disincentive to repetition of unlawful conduct’); see also Gotanda, note 1 above, at 62–66 (detailing the underlying theories for recovery of a breach of contract in a variety of jurisdictions). While such considerations could have significant impact on the damages awarded, they do not affect the method of determining the present value equivalent of a given stream of future revenues, other variables being held constant.
- Wells, note 1 above, at 473 (‘In most involuntary or efficient takings of investments, the goal of compensation ought to be to leave the investor in the same position it would have been in had the property not been taken.’); Himpurna California Energy Ltd v PT (Persero) Perusahaan Listruik Negara (Award of 4 May 1999), (2000) XXV YB Comm Arb 13, at para 275 (citation omitted); Paul D Friedland and Eleanor Wong, ‘Measuring Damages for the Deprivation of Income-Producing Assets: ICSID Case Studies’ (1991) 6ICSID Rev-FILJ 400, 404 (asserting that ‘it is generally accepted that the relevant value is the value of the asset to the investor who has been deprived of it….’, and ‘the measure of the value of an asset to the investor should be the price that a willing buyer would have paid to a willing seller….’); William C Lieblich, ‘Determining the Economic Value of Expropriated Income-Producing Property in International Arbitrations’ (1991) 8 J Int'l Arb 37,40 (citing Lena Goldfields, Ltd v USSR, excerpted in (1950) 36 Cornell LQ31, and stating that compensation should equal ‘the present value, if paid in cash now, of future profits which the company would have made and which the Government now can make—on the assumption of good commercial management and the best technical skill and up-to-date development.’); Sapphire Int'l Petroleums Ltd v Nat'l Iranian Oil Co, 35 Int'l L Rep 136, 185–86 (1967) (stating that ‘according to the generally held view, the object of damages is to place the party to whom they are awarded in the same pecuniary position that they would have been if the contract had been performed in the manner provided for by the parties at the time of its conclusion.’).
- Chorzow Factory, 1928 PCIJ (ser A) No 17, at 40. The Permanent Court of International Justice was the precursor of today's International Court of Justice.
- See, for example, Friedland and Wong, note 3 above, at 404 (asserting that ‘it is generally accepted that the relevant value is the value of the asset to the investor who has been deprived of it….’, and ‘the measure of the value of an asset to the investor should be the price that a willing buyer would have paid to a willing seller….’) (emphasis added); Todd Weiler and Luis Miguel Diaz, ‘Causation and Damages in NAFTA Investor-State Arbitration’, in NAFTA Investment Law and Arbitration: Past Issues, Current Practice, Future Prospects (Weiler edition, 2004), pp 188–94; Wells, note 1 above, at 473; ‘Draft Articles on Responsibility of States for Internationally Wrongful Acts,’ Article 36 and comment,’ reprinted in James Crawford, The International Law Commission's Articles on State Responsibility: Introduction, Text and Commentaries, p 225 (hereinafter ILC Commentary) (stating that the ‘reference point for valuation purposes is the loss suffered by the claimant whose property rights have been infringed.’) (emphasis added); Sapphire Int'l Petroleums Ltd v Nat'l Iranian Oil Co, 35 ILRat 185–86 (stating that ‘according to the generally held view, the object of damages is to place the party to whom they are awarded in the same pecuniary position that they would have been if the contract had been performed in the manner provided for by the parties at the time of its conclusion.’); UNIDROIT Principles of International Commercial Contracts (2004) Article 7.4.2, available atwww.unidroit.org/english/principles/contracts/main.htm (last visited 6 June 2007); United Nations Convention on the Law Applicable to Contracts for the International Sale of Goods, 11 Apr 1980, S Treaty Doc 98–9 (1983), (1980) 19 ILM 668; Dir of Buildings and Lands v Shun Fung Ironworks Ltd [1995] 2 AC 111, 125; Harvey McGregor, McGregor on Damages (17th edition, 2004), 1–021 (stating that the ‘object of damages is to give the claimant compensation for the damage, loss or injury he has suffered) (citations omitted); The Principles of European Contract Law Art 9.502, available at www.jus.uio.no/lm/eu.contract.principles.l998/doc.html (last visited 6 June 2007); Dobbs Law of Remedies (2nd edition), p 281 (stating that, in US law, the ‘plaintiff should be fully indemnified for his loss, but that he should not receive any windfall.’) (emphasis added).
- Cases have also indicated that, where a domestic compensation standard is applicable and would grant less compensation than international law, the latter should apply. Ball, note 1 above, at 412 (citing Compania Del Desarrollo De Santa Elena, SA v Costa Rica, ICSID Case No ARB/96/1, reprinted in (2000) 15 ICSID Rev-FILJ 167, at para 64). Whether the international law compensation standard could act to limit a more generous national law compensation standard remains an open question. Ibid at 413.
- Chorzów Factory, 1928 PCIJ (ser A), No 17, at 48. Restitution is often impracticable or insufficient to satisfy the Chorzów Factory standard. ILC Commentary 213–17 (discussing Article 35 of the Draft Articles and noting that restitution may not be available or sufficient); Walde and Sabahi, note 1 above.
- See note 5 above.
- Indifference is a part of the concept of utility in economics. It is the way individuals and asset managers reveal their preferences. Robert S Pindyck and Daniel L Rubinfeld, Microeconomics (2nd edition), pp 73–89.
- Lieblich, note 3 above, at 64.
- For example, Jan Paulsson, ‘The Expectation Model,’ in Evaluation of Damages in International Arbitration (Yves Derains and Richard H Kreindler editors, 2006), p 58 (stating that Chorzów Factory does not specify if the damages model is ‘one of rescission or expectation’); Walde and Sabahi, note 1 above (noting Chorzów Factory’s failure to specify a means of calculating what it deems appropriate compensation).
- For example, Damodaran, note 2 above, at 730 (‘The value of any cash-flow-producing asset is the present value of the expected cash flows on it.’); Ball, note 1 above, at 419–20 (noting testimony by Professor Stewart Myers in Phillips Petroleum Co v Iran that confirmed that the ‘market value of an asset equals its expected future cash flows discounted to present value at the opportunity cost of capital’ and noting that the discounted cash flow analysis has ‘been accepted and applied in the awards of numerous international arbitral tribunals, as well as in cases in national courts.’); Lieblich, note 3 above, at 60–61 (1991) (stating that ‘the value of an income-producing capital asset or enterprise to its present owner or to a potential private purchaser is a function of the cash that the asset or enterprise is expected to generate in the future’).
- The terms ‘cash flow’ and ‘net revenues’ refer to the after-tax difference between dollars received and dollars paid out. These terms should, thus, be considered outside any accounting or financial reporting concept, such as ‘profits’, which may incorporate differences in accounting practices between jurisdictions, parties, projects or individual assets. For example, Brealey and Myers, note 2 above, at 104.
- Lieblich, note 3 above, at 64 (discussing Amoco Int'l Fin Corp v Iran and stating that’ [t]he very purpose of such an award is to enable the claimant to replace his expropriated property which [sic] one that is capable of producing the same cash flows, no more and no less.’).
- The question of what does or does not qualify as a going concern in the context of hydrocarbon-producing properties is a complex inquiry and is not within the scope of this article, which will assume the evaluation of a property sufficiently developed to permit the projection of future production and associated costs and revenues with reasonable certainty. For discussion of the jurisprudence of what constitutes a going concern and the manner in which that determination affects the choice of valuation methodology, see generally Marboe, note 1 above, at 735; Faith Lita Khosrowshahi v Iran, Award No 558–178–2 (30June 1994), reprinted in 30 Iran-US CTR 76, at para 44 (1994); Resubmitted Case: Amco Asia Corp v Indonesia, ICSID Case No ARB/81/1, Award of 31 May 1990, 1 ICSID Rep 569, at paras 167–200; Gotanda, note 1 above, at 93–95; Friedland and Wong, note 3 above, at 405; Walde and Sabahi, note 1 above; Ball, note 1 above, at 422–23; World Bank, Guidelines on the Treatment of Foreign Direct Investment § A.IV.6, reprinted in Ibrahim F I Shihara, Legal Treatment of Foreign Investment: The World Bank Guidelines (1993), p 162; Wena Hotels, Ltd v Egypt, ICSID Case No ARB/98/4, Award of 8 Dec 2000, (2002) 41 ILM 896, at paras 122–25; Metalclad Corp v United Mexican States, ICSID Case No ARB(AF)/97/l, Award of 30 Aug 2000, 16 ICSID Rev-FILJ 168 (2001), at paras 119–20. Whether a hydrocarbon- producing property constitutes a going concern should also be informed by the industry's relatively inelastic demand, which assures the presence of a market for any produced reserves, and the expertise with which the oil and gas industry performs its profit and reserve estimates.
- See Ball, note 1 above, at 422–23 (stating that one problem in performing a discounted cash flow analysis is one of sufficient evidence as to net cash flows, and noting that the World Bank Guidelines require that an asset be a ‘going concern with a proven record of profitability’ in order to perform a discounted cash flow analysis) (citing World Bank, § A.IV.6, note 13 above, at 162); Lieblich, note 3 above, at 77–78 (explaining that one of the benefits of the discounted cash flow method is ‘its explicit recognition and treatment of risk and uncertainty as part of the valuation process’ and that ‘financial data concerning’ similar enterprises may provide a metric of the ‘uncertainty with respect to a specific enterprise's cash flows.’).
- See Marboe, note 1 above, at 735–36 (stating that the DCF method is the most common method for determining fair market value); Wälde and Sabahi, note 1 above (stating that the DCF method is ‘currently dominant’); Friedland and Wong, note 3 above, at 427.
- Ball, note 1 above, at 424 (stating that’ [a]rbitrators, even if they lean toward accepting a DCF analysis, are cautious. They tend to look for help from other sources’ and noting that NAFTA Art 1110 permits arbitrators to look at ‘other criteria, as appropriate, to determine fair market value.’) (citation omitted); see also Phillips Petroleum Co Iran v Iran, Award No 425–39–2 (29 June 1989), reprinted in 21 Iran-US CTR 79, at para 111–165 (analysing the discounted cash flow analysis performed by the claimant and performing an alternative ‘underlying asset valuation approach’).
- late Thomas Stauffer also made the provocative assertion that, given certain conditions, the inflation-updated book value, market price and net present value of the DCF method should all be similar in value. See generally Thomas Stauffer, ‘Valuation of Assets in International Takings’ (1996) 17 Energy LJ 459. However, as other scholars have noted, this assertion was based on assumptions including the absence of inflation between the time of the investment and the award; adjusting for real depreciation; the presence of normal profits; and research and development being treated as an investment rather than a cost. See Wells, note 1 above, at note 14; Marboe, note 1 above, at 737, note 83. The practical effect of Stauffer's point may also be undercut because ‘book value’, as used in the petroleum industry, is an accounting and reporting concept that is dependent upon the accounting rules and generally accepted practice of the reporting entity's jurisdiction. See Marboe, note 1 above, at 737 and note 83. Given these reservations, this assertion has not gained wide support in valuation theory or been widely accepted by international tribunals. See ibid (stating that it ‘remains to be seen if [the asserted equivalence of book value] will find wider support in valuation theory and in the practice of international tribunals’).
- See, for example, William C Lieblich, note 3 above, at 72–73, 77–78; see also Himpurna California Energy Ltd v PT (Persero) Perusahaan Listruik Negara, Award of 4 May 1999, (2000) XXV YB Comm Arb 13, at paras 348–78; Resubmitted Case: Amco Asia Corp, 1 ICSID Rep 569, at paras 188–200.
- Wälde and Sabahi, note 1 above; Lieblich, note 11 above, at 70–72.
- The mathematical equation for calculating the net present value of a stream of future income (NPV) is well known:
- Determining the NPV of a stream of income from a property, thus, requires the determination of the net revenues (C) for each time period (t) of the property's productive life and the discount rate (r).
- The discount rate is represented here as a constant. It can also be a variable that fluctuates depending on the time period that is being discounted. Brealey and Myers, note 2 above, at 187. In other words, the discount rate need not be held constant across time periods because the risks it assesses may fluctuate between time periods. Ibid. The authors are unaware of any award that differentiates between discount rates applied to different time periods of a property's productive life. Rather, awards consider the discount rate as being constant for the entirety of the property's productive life. The discount rate is, therefore, represented here as a constant.
- Damodaran, note 2 above, at 12 (explaining the basics of the NPV calculation and the discount rate's function).
- See, for example, Brealey and Myers, note 2 above, at 16–21, 31–35; Himpurna California Energy Ltd, XXV YB Comm Arb 13, at para 353 (explaining this in terms of the familiar concept of compounding).
- These are shared components of both a property's reserve estimate and a cash flow projection for the property.
- Often with further subdivisions. See Society of Petroleum Engineers, ‘Petroleum Resources Management System,’ available at www.spe.org/spe-site/spe/spe/industry/reserves/Petroleum_Resources_Management_System_2007.pdf (last visited 6 June 2007).
- See ibid.
- See Phillips, 21 Iran-US CTR 79, at para 152; Himpurna California Energy Ltd, XXVYB Comm Arb 11, at para 357 (citing Phillips.)
- See, for example, Brealey and Myers, note 2 above, at 185 (‘Each project should be evaluated at its own opportunity cost of capital’); ibid at 393 (explaining that the WACC is the correct discount rate for projects that are ‘carbon copies of the existing firm’ and have ‘the same business risk….’). It should be noted, however, that industry practice varies greatly. A yearly survey conducted by the Society of Petroleum Evaluation Engineers reveals that, although 90 per cent of the respondents (primarily producers, consultants and bankers) use the DCF methodology, the companies involved in the petroleum industry differ considerably in how they calculate an applicable discount rate. See Society of Petroleum Evaluation Engineers, Twenty-Fifth Annual Society of Petroleum Evaluation Engineers Survey of Economic Parameters Used in Property Evaluation, 14 (June 2006). Some respondents use a discount rate that is only equal to their cost of capital while others calculate discount rates that aggregate their cost of capital with other additional risk premiums. See ibid at 16–23.
- See notes 35, 38 and 39 below.
- See, for example, Lieblich, note 3 above, at 71–73, 77–78; see also Himpurna California Energy Ltd, XXV YB Comm Arb 11, at paras 348–78; Resubmitted Case: Amco Asia Corp, 1 ICSID Rep 569, at paras 188–200.
- Wälde and Sabahi, note 1 above; Lieblich, note 3 above, at 70–72.
- This is the result of a discounted cash flow analysis. See, for example, Friedland and Wong, note 3 above, at 407 (noting that'[t] he sum of the present values of the net cash flows for each of the future years is the value of the asset or enterprise as determined by the DCF method.’). Note that inflation must be accounted for consistently; in other words cash flows expressed in nominal terms should be paired with a discount rate that incorporates inflation.
- Brealey and Myers, note 2 above, at 186; Ibbotson Associates, Inc, Stocks, Bonds, Bilk, and Inflation 2006 Yearbook: Valuation Edition (2006), p 35. Note that the relevant WACC is that of the property itself, not that of the claimant. Brealey and Myers, note 2 above, at 186; Ibbotson Associates, Inc, above, at 35.
- Damodaran, note 2 above, at 69 (‘The risk and return model that… is still the standard in most real-world analyses is the capital asset pricing model.’); see also Brealey and Myers, note 2 above, at 171 (stating that the capital asset pricing model is the ‘most convenient tool’ but not necessarily the ‘ultimate truth’); Ibbotson Associates, Inc, note 29 above, at 57–62 (stating that the CAPM is ‘among the most widely used techniques to estimate the cost of equity’).
- The mathematical representation of the CAPM is straightforward in application despite its unintuitive form:
- See, for example, Brealey and Myers, note 2 above, at 167–69 (providing the same formula with a slightly different nomenclature); Damodaran, note 2 above, at 71 (providing the mathematical formula for the capital asset pricing model again with a slightly different nomenclature).
- Mishkin, note 2 above, at 103.
- A key tenet of Modern Portfolio Theory is that a portfolio of assets will benefit from diversification as long as the returns of assets in the portfolio are imperfectly correlated (in other words, to the extent they do not lock-step each other). As a corollary, the benefits of diversification are limited by the extent to which individual asset returns are correlated. Investors can optimise their portfolios to maximise the expected returns for a given level of risk, or minimise the risk for a given level of expected returns. Similarly, diversification lowers the required rate of return for a given level of risk. However, not all risks are diversifiable; therefore, required returns on an asset in an optimally diversified portfolio will fall somewhere between the required return on a riskless asset and required rate of return of the asset on a standalone basis. The overall market itself can be thought of as an optimally-constructed portfolio. The result is that the market prices assets as if they were held in such a portfolio.
- Brealey and Myers, note 2 above, at 186 (referred to as unique risk); Ibbotson Associates, Inc, note 31 above, at 57.
- Brealey and Myers, note 2 above, at 186 (referred to as market risk); Ibbotson Associates, Inc, note 31 above, at 57; Mishkin, note 2 above, at 101.
- There are four basic assumptions underlying the CAPM: no transaction costs; all assets are traded; all investors have the same information; and investments are infinitely divisible (in other words you can buy any fraction of a unit of any asset). Damodaran, note 2 above at 69.
- ‘By making these presumptions, [the CAPM] allows investors to keep diversifying without additional cost. At the limit, [the investors'] portfolios will not only include every traded asset in the market but will have identical weights on risky assets (based on their market value). The fact that this portfolio includes all traded assets is the reason it is called the market portfolio, which should not be a surprising result given the benefits of diversification and the absence of transaction costs in the [CAPM]…. In the CAPM world, where all investors hold the market portfolio, the risk to an investor of an individual asset will be the risk that this asset adds to the market portfolio. Intuitively, if an asset moves independently of the market portfolio, it will not add much risk to the market portfolio. In other words, most of the risk in this asset is firm-specific and can be diversified away. In contrast, if an asset tends to move up when the market portfolio moves up and down when it moves down, it will add risk to the market portfolio. This asset has more [non-diversifiable] risk and less [diversifiable] risk. Statistically, this added risk is measured by the covariance of the asset with the market portfolio.’
- Ibid at 69–70.
- This conclusion is an extension of the presumptions in the preceding footnote. If it is presumed that all investors hold the market portfolio and that every investor has the same information, the market equilibrium required rate of return will not reward the assumption of diversifiable risk.
- Brealey and Myers, note 2 above, at 216.
- Ibbotson Associates, Inc, note 31 above, at 15, 33 (providing, respectively, insight into the determination of the applicable tax rate and the calculation of a project's cost of debt) (citations omitted).
- Ibid at 175 (providing this example but using a factory in Mexico and a US investor as the example).
- Ibid at 174 (explaining that risk would ‘differ significantly’ if projects were located in different countries).
- Ibid at 175 (‘In calculating historical international risk premia, it is essential to keep in perspective the investor's location, because [it] is a crucial element in cost of capital analysis.’) This is because an international investor's risk premium is affected by ‘exchange rate gains or losses’. Ibid. The locale of the investor is thus important when currency risk is present but may not be important where currency risk is eliminated by the factual circumstances of the case, for example in a contract that stipulates payment in the investor's domestic currency. See ibid (providing an example of the different applicable risk premia for a Canadian investor investing in the United States). Currency risk is, of course, only one element of risk in international investments, and does not account for other components of political risk. See discussion of Himpurna, below.
- See ibid at 174–75; Brealey and Myers, note 2 above, at 198–201.
- Ibbotson notes: ‘[o] ne problem with market-based models is that they can only be applied to market-based economies. In a worldwide context there are few countries that have the data necessary to provide a CAPM cost of equity.’ Ibbotson Associates, Inc, note 31 above, at 180. Foreign markets commonly have less data over shorter time periods, are less diversified, and are more concentrated. See id at 175–76; see also Brealey and Myers, note 2 above, at 200–01 (stating that the lack of diversification leads to a lack of integration in the world market and necessitates adjustment to the basic CAPM).
- See note 46 above.
- Ibbotson Associates, Inc, note 31 above, at 175–76.
- See ibid at 177 (stating that ‘[t] he measurement of cost of equity estimates for international markets is a developing area of academia’).
- Ibbotson summarises five such models in one of its recent texts: the International CAPM, Globally Nested CAPM, Country Risk Rating Model, Country-Spread Model, and Relative Standard Deviation Model. Ibid at 177–84. While describing each of these models is beyond the scope of this article, it is interesting to note that Ibbotson suggests that the Country Risk Rating Model ‘offers a number of advantages that the other international models are unable to overcome’. Ibid at 183–84; but see Brealey and Myers, note 2 above, at 199–201 (proposing yet another method). The Country Risk Rating Model integrates biannual country credit risk ratings from The Institutional Investor to predict required rates of return. Ibbotson Associates, Inc, note 31 above, at 180–81. Ibbotson also notes however that ‘all the models have some flaws’ but ‘for most countries there is at least one model that produces a reasonable cost of equity estimate’. Ibid at 184.
- Brealey and Myers, note 2 above, at 198–201 (stating that the ‘opportunity cost of capital for foreign projects should depend on market risk’ and providing some discussion with a suggested method for calculating the applicable discount rate); see also notes 43–44 above.
- A few such publications include Brealey and Myers, note 2 above; Jean-Paul Chavas, Risk Analysis in Theory and Practice (2004); Johnathan Mun, Applied Risk Analysis: Moving Beyond Uncertainty in Business (2004).
- Brealey and Myers, note 2 above, at 232. Brealey and Myers emphasise the use of Monte Carlo simulations to estimate cash flow and caution against using the method to estimate net present value directly. See id at 238–39.
- The Asian Development Bank's Handbook for Integrating Risk Analysis in the Economic Analysis of Projects, on the other hand, departs from this usage by suggesting the use of Monte Carlo simulation to estimate net present value directly:
- ‘The process which is followed (and which is usually referred to as “Monte Carlo” or simulation analysis) is that values for individual variables are generated randomly according to their respective probability distributions, combined with other randomly generated values for the other variables, and these figures are used to calculate an estimate of the project NPV. This process is repeated a large number of times (a number which is specified by the analyst—in effect, equivalent to implementing the project again and again in different circumstances—and is usually at least 1000 times, and typically more than this) and an average (or “expected”) NPV is produced together with an associated probability distribution.’
- Asian Development Bank, Handbook for Integrating Risk Analysis in the Economic Analysis of Projects, Chapter 2 at 18, available atwww.adb.org/Documents/Handbooks/Integrating_Risk_Analysis/default.asp (last visited 6 June 2007).
- Brealey and Myers, note 2 above, at 232–35. Brealey and Myers provide an example of this process. Consider a business selling scooters that wants to project its future cash flows. The market size for scooters is a relevant variable. The owner anticipates that the market size will be one million scooters. However, the market size could be as low as 850,000 or as high as 1.15 million. The forecast error will therefore have an expected value of 0 (the owner does not expect that the forecast of one million scooters is wrong) with a range of plus or minus 15 per cent. Ibid at 234. Depending on the particular project and variable, the likelihood of error in a particular variable can be distributed in any manner necessary to properly replicate its perceived probability distribution. Ibid at note 10.
- Ibid at 235 (‘After many iterations, you begin to get accurate estimates of the probability distributions of the project cash flows….’)
- See ibid at 202–03 (stating that Monte Carlo simulations produce probability distributions for cash flows).
- See ibid at 235 (stating that an unbiased cash flow forecast is derived from the probability- weighted cash flows by aggregating the products of each potential outcome multiplied by the probability of its occurrence); Ibbotson Associates, Inc, note 31 above, at 16 (same).
- See Asian Development Bank, note 53 above, at Chapter 2, at 19–21.
- Ibid at Chapter 2, at 20–21 (stating that error forecasts for variables ‘still require judgment on the part of the analyst about what ranges are acceptable for values to fall within.’).
- Brealey and Myers, note 2 above, at 235.
- Ibid at 202.
- Cf J B Gustavson, ‘Valuation of Non-U.S. Oil and Gas Properties, ‘J Petroleum Tech, Feb 2000, at 56 (noting that other researchers have found that there is a ′6 to 8% excess of the average market discount rate over the average cost of capital’ and that the excess is ‘sometimes considered… [as] offsetting the “risk” of the oil business.’) (citation omitted). It is not clear whether the article is suggesting that the market is including some form of specific risk into the discount rate or if it is merely suggesting that the average cost of capital does not properly assess the amount of systematic risk that the market attributes to the oil business, which is unsurprising given that the systematic risk facing a foreign oil field will generally be greater than that faced by the company as a whole.
- Such a challenge may be no more likely to succeed than any other. See Bridas SAPIC v Gov't of Turkmenistan, 345 F 3d 347 (5th Cir 2003) (refusing to vacate award of damages based on discounting projected revenues from Central Asian gas properties at ten per cent based on contractual interest rate for carried interest with an estimated upward impact of $200 million on the award, noting discount rate is a matter of fact for determination by the arbitrators). (Messrs Knull and Tyler were counsel to the Turkmenian party.)
- Starrett Housing Corp et al v Iran, Award No ITL-314-24-1 (14 Aug 1987), reprinted in 16 Iran-US CTR 112 (1988).
- Ibid paras 342, 337 (reducing gross profit from 377 million Rials by 350 million Rials, to 27 million). Although the tribunal used the term ‘gross profit,’ the context makes clear that the numbers cited are based on analysis of revenues net of costs and do not purport to relate to the accounting concept of profits.
- Ibid para 277.
- The award in Starrelt Housing was signed by only two of the three arbitrators, the Iranian nominee having refused to join. In a concurring opinion, the nominee of the US party, Howard Holtzmann, indicated that he signed only in order to ensure that an award was issued, despite his disagreement with certain of the key determinations. Because Judge Holtzmann's disagreement largely flowed from conclusions he would have drawn from respondents’ failure to produce relevant evidence rather than on the methodology under discussion here, we will not address it further.
- Ibid para 32.
- Ibid para 196.
- Ibid.
- Ibid paras 196–97.
- Ibid para 336.
- Ibid para 274.
- Ibid para 338.
- Award No 425–39–2 (29 June 1989), reprinted in 21 Iran-US CTR 79 (1989).
- Ibid paras 112–13.
- Ibid paras 113–14.
- Ibid paras 3, 29.
- Ibid paras 100–01.
- Ibid para 106.
- Ibid paras 117–24.
- Ibid paras 125–31.
- Ibid paras 132–34.
- Ibid paras 135–53.
- Ibid para 118.
- Ibid para 129.
- Ibid para 131.
- Ibid para 125.
- Because it was deciding on the fair market value of the interest at the time of taking, the tribunal based its conclusion on the price expectations prevailing at that time, noting that ‘[h]istory, to date, has shown that the price expectations generally held in 1979 were grossly inflated, but that does not make it wrong or unfair to use those expected price levels in the determination of the value of the property in 1979. A state that takes property assumes the risk of its subsequent decline in value, just as it assumes the benefits if the value appreciates’. Ibid para 126.
- Ibid para 134.
- Ibid para 114.
- Ibid para 135.
- Ibid (citations omitted).
- Ibid paras 136–38.
- Ibid para 136.
- Ibid para 138.
- Ibid paras 141–53. As to the risk of oil price fluctuations, the tribunal concluded that ‘that the possibility of prices lower than the bottom range could then have been seen as no more likely than the offsetting possibility of prices higher than the top of the range, and that therefore, based only on the information available at that time, no further reduction of the price would have been warranted by virtue of such a risk’. Ibid para 150.
- Ibid para 148. On the other hand the tribunal concluded that non-policy risks such as the risks of delays or interruptions of production as a result of force majeure, such as war, further civil unrest or strikes by the labour force would not have had a significant impact on total production, while longer term interruptions, specifically the Iran-Iraq war that began in 1980, was not apparent at the time of the taking. Ibid para 149.
- Ibid para 153.
- Ibid para 155.
- Ibid.
- Ibid.
- Ibid, para 158. While it did not disclose the calculation underlying its quantum, the tribunal addressed with considerable specificity its calculation that updated book value tended to confirm its overall valuation. Ibid paras 159–65.
- Award of 4 May 1999, reprinted in (2000) XXV YB Coram Arbl3.
- Ibid para 1.
- Ibid para 332.
- Ibid para 347 (stating that the claimant had incurred costs of US$273,757,306, which was calculated using a multiplier to bring the previously paid costs to present value).
- Ibid para 365.
- Ibid para 318.
- Ibid para 313.
- Ibid para 347. In addition to the equitable considerations previously mentioned, the tribunal noted that claimant remained free to invest these amounts in other projects.
- Ibid para 353.
- Ibid para 355.
- Ibid paras 364–70. Lesser factors included ‘disruption, for technical or other reasons, of the rate of installation of Units; volcanic or hydrothermal eruptions; technical disputes as to the application of the price formula (for example, reference to a Unit Rate Capacity test in the absence of an operational Mechanical Gas Extractor could exaggerate the URC and thus the price); and costs could be increased by, inter alia: unanticipated expenditures on account of such problems as scaling due to the chemical composition of brine affecting the state of pipes, wells and turbine blades; or the need to drill more so- called make-up wells than anticipated in order to maintain the steamfield pressure; insufficient clarity in the claimant's computations as to the breakdown of costs in rupiah as opposed to US dollars.’ Ibid para 362.
- Ibid paras 363–71.
- Ibid para 371.
- Ibid paras 373–74.
- ICSID Case No Arb/03/16, Award of 2 October 2006, available at www.worldbank.org/icsid/cases/pdf/ARB0316_ADCvHungary_AwardOctober2_2006.pdf (last visited 6June 2007).
- Ibid para 521.
- Ibid paras 519, 521.
- Ibid paras 11, 109
- Ibid para 476.
- Ibid para 499; see also note 4 above (noting that the tribunal allowed the claimants to recover the market value of the investments as of the date of the award because the investments had increased in value since the time of the expropriation).
- Ibid para 514.
- Ibid paras 508–09.
- Ibid para 511. The award does not specify exactly how the beta applied was derived from the betas of various airports or how the betas of the various airports used to derive the applied beta were calculated.
- Ibid (noting that ‘the [r]espondent's contention that the country risk “may be understated’” was short of any substantiation). The award did not explain how this country risk adjustment was calculated, but its inclusion is theoretically congruent with the adjustments mentioned in notes 42–52 and the accompanying text.
- Ibid para 512.
- Ibid.
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Original Articles
Accounting for Uncertainty in Discounted Cash Flow Valuation of Upstream Oil and Gas Investments
William H Knull III William H Knull III, Mayer Brown Rowe & Maw LLP. William Knull is co-chair of the International Arbitration Group of Mayer Brown Rowe & Maw LLP ([email protected]). Scott T Jones, Senior Managing Director, Lexecon, an FTI Company ([email protected]). Scott Jones is also head of the energy practice for FTI Consulting Inc. Timothy Tyler ([email protected]) is counsel and Richard Deutsch ([email protected]) is an associate in the International Arbitration Group of Mayer Brown Rowe & Maw LLP.
, Scott T Jones William H Knull III, Mayer Brown Rowe & Maw LLP. William Knull is co-chair of the International Arbitration Group of Mayer Brown Rowe & Maw LLP ([email protected]). Scott T Jones, Senior Managing Director, Lexecon, an FTI Company ([email protected]). Scott Jones is also head of the energy practice for FTI Consulting Inc. Timothy Tyler ([email protected]) is counsel and Richard Deutsch ([email protected]) is an associate in the International Arbitration Group of Mayer Brown Rowe & Maw LLP.
, Timothy J Tyler William H Knull III, Mayer Brown Rowe & Maw LLP. William Knull is co-chair of the International Arbitration Group of Mayer Brown Rowe & Maw LLP ([email protected]). Scott T Jones, Senior Managing Director, Lexecon, an FTI Company ([email protected]). Scott Jones is also head of the energy practice for FTI Consulting Inc. Timothy Tyler ([email protected]) is counsel and Richard Deutsch ([email protected]) is an associate in the International Arbitration Group of Mayer Brown Rowe & Maw LLP.
& Richard D Deutsch William H Knull III, Mayer Brown Rowe & Maw LLP. William Knull is co-chair of the International Arbitration Group of Mayer Brown Rowe & Maw LLP ([email protected]). Scott T Jones, Senior Managing Director, Lexecon, an FTI Company ([email protected]). Scott Jones is also head of the energy practice for FTI Consulting Inc. Timothy Tyler ([email protected]) is counsel and Richard Deutsch ([email protected]) is an associate in the International Arbitration Group of Mayer Brown Rowe & Maw LLP.
Pages 268-302
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Published online: 09 Jun 2015
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