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EXPROPRIATION BY 2 COUNTRIES IS ALLEGED

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Political risk insurers could face potentially huge claims following government actions in Pakistan and Indonesia that insurers and brokers say are tantamount to expropriation.

Foreign investors in power utility projects in the two countries have seen their power purchase agreements suspended or threatened with cancellation, which could result in billions of dollars in losses.

In Pakistan, the government is waging an acrimonious battle with foreign investors, known as independent power producers. The government has threatened to cancel 21 power producers' electricity contracts unless they reduce their rates, which Pakistani officials charge were inflated due to corruption in the previous government of Benazir Bhutto. The power producers deny the allegations.

The power projects range in value from tens of millions of dollars to more than $1 billion and represent a total foreign investment of more than $4.2 billion by companies from the United States, Europe, the Middle East and Japan, according to the U.S. Department of Energy.

The situation is complicated by economic and political instability in Pakistan and Indonesia.

The government of Pakistani Prime Minister Nawaz Sharif defaulted on foreign debt payments earlier this year after the U.S. imposed sanctions after Pakistan's nuclear testing in May.

In addition, the power producers' primary customer, the state-owned Water & Power Development Authority, is debt-ridden. The Pakistani army seized WAPDA Oct. 18 to force the utility to make its payments.

"Pakistan is opening up a Pandora's box. It's going to have the effect of sending a chill around the foreign investment community," said Dan Riordan, head of political risk at Zurich-American Insurance Co. in Washington.

The Asian financial crisis and regional currency devaluations further cloud the political risk outlook. The government of Indonesia has unilaterally suspended a number of power purchase agreements with foreign investors because the state-owned electricity utility, Perusahaan Listrik Negara, was unable to pay for power it contracted to buy.

"A lot of issues have been thrown up by the economic circumstances. We are looking at power projects with a little more skepticism," said Adrian Lewers, political risk underwriter at Lloyd's of London managing agency Brockbank Group P.L.C.

"I think that where the cancellation of a PPA brings about the permanent shutdown of a power plant, it is insurable as a catastrophe," said Angus McCallum, managing director of London-based Sedgwick Group P.L.C.'s Financial and Political Risk division.

Political risk insurance covers any cancellation, revocation or abrogation of the power purchase agreement that causes a cessation, he explained.

Mr. McCallum said two basic issues arise in the Pakistani and Indonesian actions: The first is a devaluation of the local currency, which in the case of Pakistan was aggravated by the nuclear tests. The second was that the government deemed as too high the unit prices of electricity sold by the independent power producers. Pakistan has ordered the power producers to cut their rates on average between 30% and 40% or see their contracts terminated.

In Indonesia, attempts to increase electricity and fuel costs this spring led to rioting that overthrew President Suharto. In addition, the devaluation of the rupiah by more than 40% has meant that GDP is expected to shrink by 15% this year. A number of projects were canceled because the state power utility was unable to pay on the power purchase agreements it had signed.

These actions, while not an outright expropriation, have the effect of an expropriation, though over a longer period of time, insurers and brokers say.

"Governments have become extremely sophisticated in how they do this. It's no longer the case of sending tanks to surround the factory and throwing you out," said Mark Vandewater, international development vp at the Overseas Private Investment Corp. in Washington. OPIC offers long-term political risk and credit guarantees to U.S. businesses investing abroad.

"You can restrict the profitability of an enterprise in many ways through taxes, surcharges, tariffs and levies," noted Mr. McCallum.

But, in the case of utilities, not all political risk insurance specialists agree.

"There is a difference between the actions of a government within its governing capacity and a government acting in its commercial capacity," said Geoffrey Lynch, head of political risk at Lloyd's of London managing agency Hiscox P.L.C.

The Pakistan government first confronted the private power sector in May when Power Minister Nadir Perwaiz said the government had proof, from government court actions against Benazir Bhutto and her husband, that a number of projects had obtained contracts through bribes and kickbacks to the Bhutto government. Then the Lahore High Court ordered the largest project, The Hub Power Project, to cut its tariffs by 57%. Hubco appealed the ruling and denied the corruption allegations.

Hubco is a consortium headed by U.K.-based National Power P.L.C. with Xenel Industries of Saudi Arabia and Mitsui Corp. of Japan. The project is a 1,294-megawatt, gas-fired, four-unit power plant costing $1.77 billion.

Pakistani officials began an investigation into charges of corruption and overpricing; froze Hubco's bank accounts because of non-payment of taxes, which the company said it did not owe; and for a time barred some Hubco officials from leaving the country. The investigation ended, though Hubco has not reached an agreement with the government.

Sources at the World Bank in Washington who spoke on condition of anonymity said the matter is headed for arbitration. The World Bank is both a creditor and guarantor of the Hubco project and is eager to reach a settlement.

The settlement would be necessary to any international agreement to renegotiate Pakistani foreign debt, the World Bank sources said.

A Hubco spokesman in Karachi said: "Matters are still at a standoff. WAPDA is still buying electricity. One or two units out of four operate each day. The allegations are going on as usual."

According to Hubco, part of the project's financing was guaranteed under political risk insurance underwritten by the World Bank and the Japan Export Import Bank. A further proportion of the debt was guaranteed by export credit agencies such as Coface of France, SACE of Italy and Japan's Ministry of International Trade and Industry.

The Hubco project was the first project undertaken by the World Bank in a program to restructure the Pakistani energy sector that began in 1985. However, World Bank sources said the restructuring of the electricity sector is incomplete, accounting for the problems WAPDA faced.

Hiscox's Mr. Lynch confirmed this view following his conversations with the independent power producers. "WAPDA had a master plan drawn up with the World bank on a logical basis, but then the government allowed anyone to bid for power stations, and they were located in the wrong place," he said.

"The fundamental problem with creating independent power producers in developing countries is that initially it is based on political expediency. These things sometime bear no relation to economic reality," said Christopher Weston-Simons, director of the global property and casualty department, with responsibility for the IPP Focus Group, at London-based Willis Corroon Group P.L.C. He added that the independent power producers negotiate contracts in good faith, with prices decided at the time to respond to debt service and profit.

Future demand for electricity in Pakistan also has been overestimated, putting many of the projects at risk, he said. "From what I have seen, developing countries have negotiated for more power than they need, and so the PPA (power purchase agreement) cannot be sustained by the local economy. But no country is going to talk down its economic prospects," noted Mr. Weston-Simons.

Pakistan has a temporary power overcapacity, and WAPDA has difficulty paying its bills, the World Bank sources said.

Atlanta-based power utility Southern Co. canceled plans to build a 1,320-megawatt coal-fired power plant in Pakistan because "it appears that Pakistan did not need the electricity," a company spokesman said. The company had negotiated a PPA with the Bhutto government, though the company had "never put a value on the project," he said.

According to insurance industry sources in Pakistan and to reports in the international media, the Southern Co. project is the only contract to have been canceled outright and is the subject of a political risk insurance claim. The utility spokesman denied the reports.

Another U.S. power utility, Arlington, Va.-based AES Corp., has received notices from the Pakistani government that it will terminate AES' power purchase agreement for two projects with a total value of $700 million.

An AES spokesman said the company does not have political risk coverage for its Pakistan projects and that the dispute is now in arbitration. In a statement, AES denied government allegations of corruption.

Although the Pakistan government is attempting to renegotiate contracts with power producers, any reduction could result in a breach of contract claim, World Bank sources said. "If a local court orders a tariff to be reduced, that is a breach of contract. If WAPDA pays less (to the IPPs), then the government has to make up the difference," the sources said.

Contracts in Pakistan are guaranteed by the government. "So you go back to looking at sovereign guarantees. But then what do you do if the government goes broke?" the sources asked.

Political risk insurance underwriters and brokers disagree on whether such a breach of contract should be classified as a commercial risk or political risk.

"You have to look at the individual elements. You could offer cover for non-honoring of sovereign guarantees. If you are looking at whether WAPDA as a buyer can pay, then that is a commercial risk. You wouldn't put that under politics. The issue of renegotiation can take place in a commercial context. At what stage do you deem a project to be expropriated? These are all issues which are new to investors and insurers," said Brockbank's Mr. Lewers.

The issue of inability to pay for power also arose in Indonesia. In January, the government suspended three projects operated by Omaha, Neb.-based CalEnergy Co. Inc. because the state electric utility, PLN, was unable to pay.

In a statement earlier this year, CalEnergy said it had a total investment in Indonesia of $275 million and that after deductibles it expected about $210 million would be recoverable under political risk insurance from OPIC. But Craig Hammet, CalEnergy senior vp and chief financial officer, said the company now wants to pursue compensation for loss of profits, which under its 30-year power purchase agreement could have totaled billions of dollars.

But, Hiscox's Mr. Lynch and others say that "future income streams are difficult if not impossible to insure. If you spent $30 million, you can get your money back."

An asset expropriation has a calculable impact on a company's balance sheet. Once the claim is paid for the asset, though, it is difficult to see why an insurer should compensate a company for more than one year's cash flow as the earlier investment may be reinvested elsewhere, Mr. Lynch said.

OPIC's Mr. Vandewater said that CalEnergy has not yet submitted a claim and that the insurer has a limit of $200 million per project in Indonesia. OPIC does not cover failure to honor sovereign guarantees, he said.

Indonesia "basically reneged on a deal," Mr. Hammet said. All of the contracts specified payments by PLN to CalEnergy in U.S. dollars and were guaranteed by the Indonesian government. But Mr. Hammet rejected the idea that Indonesia is unable to honor its sovereign guarantees. "It's hard for me to imagine that a country as rich as Indonesia is broke," he said.

Political risk insurance specialists meanwhile are looking for new ways of covering the risks of utilities in developing countries. "Over the last two years we have been looking at the risk classification and evaluation associated with limited and non-recourse project finance," said Willis Corroon's Mr. Weston-Simons. The problem is to avoid piling on insurance premium costs that cannot be sustained by the project. "So we have to find a way of transferring the risk in a good manner to reduce the cost of borrowing. The market for this will not be the conventional one -- probably (it will be) in the alternative market," he added.

But Mr. Lewers said that alternative risk financing products for political risks "can never take off all the risk."

Zurich-American's Mr. Riordan believes that in the future the political risks associated with water utility projects will be even more difficult to evaluate.