How to deal with political risk in the US gas sector
The country’s gas boom has lured foreign investors into the sector, but risks remain, writes David Evans, a partner at law firm Clifford Chance
The rise of US shale oil and gas has been a boon for foreign investors. Major Asian and European companies have signed long-term contracts to buy liquefied natural gas (LNG) from planned US liquefaction facilities, while others have invested (or plan to invest) in shale properties themselves. Some investors are honing in on the low-cost industrial market which shale gas is creating in the US, for example in petrochemicals, steel plants and pipelines.
In legal terms, the US is a safe place for foreigners to invest. The US constitution prohibits confiscation of private property by the government without “just compensation”. Foreign investors are given equal protection under the law. The legal system makes decisions of administrative agencies subject to judicial review, enabling courts to remand, modify or set aside administrative actions that violate due process or are arbitrary, capricious or unlawful. The US judiciary is strong and independent, created as equal to the executive and legislative branches of government, and it has the final say on issues of constitutionality.
Nonetheless, political risks exist. The most obvious is the Committee on Foreign Investment in the United States (CFIUS), which can require any foreign entity trying to buy a US business to divest its ownership position on the grounds of national security (or take action to mitigate the national security implications of its acquisition). The latest in the parade of transactions wrecked by the opaque CFIUS process came when Chinese-owned Ralls Corporation was forced to unwind its acquisition of wind-farm assets near a US naval base in Oregon. CFIUS has previously reviewed foreign acquisitions of US businesses in the energy sector, and potential acquirers of US “critical infrastructure” associated with LNG – such as pipelines or liquefaction facilities – could face scrutiny in the future.
Another risk comes with permits. As elsewhere, US projects and businesses need certain permits. A project, such as an LNG project, also needs to obtain, renew and retain a necessary permit on a timely basis. The risk comes when it can’t do this for reasons unrelated to the project’s merits. Particularly concerning for the LNG projects now being developed or proposed is the US Department of Energy’s (DOE) assertion that it has the right to revoke its Section 3 export approval to protect US interests – even if the licence holder is in full compliance with its licence. Don’t forget changes in the laws governing these investments, either. Any change in law that makes a project or investment less economically attractive or viable as a technical matter is not a commercial or technical risk; it’s a political risk. There are protections built into the US system against this kind of risk, and there is more transparency and predictability in the system, too. But the risks are still there. On top of generic concerns about regulatory, environmental and tax changes, shale-gas investors also need to beware the proposals to amend the Natural Gas Act to make it more difficult to export shale gas as LNG. Legislation, recently introduced, requiring all US shale gas remain in the country (similar to the existing rules governing domestically produced crude oil) are another potential risk.
Policy can also change – and dramatically affect the efficacy of a project or investment. For example, the DOE could elect to move slowly in approving LNG exports. Or the Federal Energy Regulatory Commission could adopt more rigorous safety and environmental analyses of LNG facilities. The Environmental Protection Agency or states might demand stricter regulation of hydraulic fracturing, and so on. As a matter of judicial restraint, US courts defer to administrative agencies when they legislate within their area of expertise. Agency-led policy changes could bring major consequences for foreign investors.
So what can investors do? To the best of our knowledge, classical political risk insurance is not available for investments in the US. There are, though, several ways to mitigate the risks. Comprehensive due diligence is an effective tool for investors, given the relative transparency of government programmes and access to information. For example, parties may voluntarily submit their proposed acquisition to CFIUS for prior approval, creating (if approved) a safe harbour against divestiture being required after closing. Partnering in a transaction with a strong local company that knows the US legal and political system can be just as valuable in the US as elsewhere. Foreign investors should take the information gathered from their due diligence and then negotiate transaction documents that allocate US political risks to the party best able to bear it: the US counterparty. This risk allocation can be accomplished through clauses dealing with milestones, conditions precedent, indemnities, unwind provisions or puts, and many others. In the end, if the foreign investor is not satisfied with the results of its due diligence or risk allocation, it should think about dropping the deal.
Foreign investors should always involve their host government in some capacity. If a political risk ever develops into political action, it is better for governments to be talking with each other, rather than an individual investor trying to take on the US government. Involving the government can take several forms, from lending by export credit agencies, to government back-stops of a portion of the risk, to soft power meetings by host government officials with appropriate US agencies to show support and concern.
Investors should be ready to use the US legal system, too, if it thinks it is the victim of discriminatory treatment, unfair processes, deleterious delays, confiscation of its economic rights, or any other wrong. Given the scope of its powers, it’s easier to list the few areas the US judicial system would not address, rather than the ones it would. These include “political questions”, national security and foreign-policy matters. It is, of course, precisely in the areas where the courts defer to the executive and legislative branches that political risks arise for foreign investors. Beyond the US courts, foreign investors should investigate other forums available to protect US investments, including bilateral investment treaties and enforcement of free-trade agreements.
Finally, plan for the worst. So, for example, if you think it possible that environmental regulation will increase the cost of fossil fuels through a carbon tax, you should model what the impact of such a tax would be on the planned investment. If the project or investment would no longer make sense, devise an exit strategy that reduces the impact of the change in law or policy. Such a strategy would also make sense if the change were one that could not be modelled as a cost, for example a revocation by the DOE of a Section 3 permit. In short, there is little point debating whether political risk exists in the US. It does. The better approach is to recognise the threats and mitigate them. That kind of approach by foreign investors would put a finer screen on their US investments decisions and strengthen the quality of their US transactions – even if no US political risks ever materialise.