Risks and the Search for Security in Business


CP&S/Corporate Planning Department, NNPC

Any company hoping to generate a flow of revenue from projects in emerging markets must first make non-recoverable, up-front investments. For instance, in order to ship crude oil from Venezuelan fields, ExxonMobil must first invest in drilling and extraction equipment. While projects of this nature offer considerable opportunities, it is significant to consider risks to revenue flow, which could include currency crises, wars and political upheaval.

This article focuses on a less obvious problem associated with upfront investments, whereby the investment itself may leave the company vulnerable to renegotiation. This is particularly salient for companies in emerging markets who may be unable to write binding, long-term contracts that lock in the future revenue streams needed to pay for sunk costs.

A common risk for companies operating in emerging markets is that contracts will be renegotiated to their disadvantage once the initial investment has been made. Professors Ray Fisman and Eric Werker of Harvard Business School explore ways to prevent these “hold-ups” and explain how uncertainty can be a powerful source of opportunity.

“Hold-up” on the Bangkok Expressway: In 1988, a construction consortium led by the Japanese company Kumagai Gumi signed a 30-year contract to build and operate a new toll road in Bangkok, Thailand. The contract originally allowed the consortium to cover its costs by charging a Bt30 toll. In 1993, with 20 km of the road completed, the Thai government changed its mind and reduced the toll to Bt20 because it feared the higher toll might prove damaging to its re-election prospects. Could Kumagai Gumi have seen this coming? And was there anything the company could have done to prevent it?

The situation that Kumagai faced is a classic illustration of the hold-up problem, which is particularly common in the poor contracting environments of many emerging markets. The government knew that Kumagai faced a different cost-benefit trade-off after investments were made and took advantage accordingly. For its part, the company remained willing to operate the toll road, however regretted the investment.

What could have prevented the government from acting opportunistically? If both parties could have agreed to the terms of operating revenues prior to investment, then Kumagai could have built its road without fearing a change of price. This is exactly what did happen, at least initially. Before construction began, the Thai government signed a contract specifying a Bt30 toll and only later did it choose not to honor these terms.
Hold-up, Russian Style: Imagine that instead of renegotiating the terms of the toll, the Thai government had simply seized the road, leaving Kumagai with nothing to show for its investment. While this extreme form of “renegotiation” is rare these days, more subtle methods are often used by corporate insiders to expropriate value from foreigners in countries with weak property rights.

Consider the infamous case of Russia’s Gazprom, the former Soviet state-run energy company. Following the privatization of Russia’s energy industry in the 1990s, the German gas company, Ruhrgas, took the obvious risky decision to become the main foreign investor in Gazprom. In 1998, Gazprom sold hundreds of millions of cubic meters of gas at below-market prices to Itera, a Florida-based company with alleged connections to Gazprom management. In a separate transaction, gas fields were also handed over to an Itera-controlled entity. In both cases, billions of dollars in value were transferred from Gazprom investors (including Ruhrgas) to Itera’s owners.

The two characteristics underlying the hold-up problems described above are: (1) the mismatch in the timing between investment and the subsequent revenue stream and (2) the inability to ensure future cash flows from contracts written at the time of investment. Anything that managers and investors can do to change either of these factors will help to mitigate the hold-up problem.

Self-enforcing contracts: The simplest way to make the counterparty stick to the agreement is to ensure that it is in its long-term interests to do so. That is, the agreement must be what economists call a “self-enforcing” contract.

Reputation and time horizon. The Thai government’s decision to renegotiate the contract was not without costs. There were plans for further infrastructure projects in Bangkok but, having reneged on its agreement with Kumagai, the government’s reputation, and hence its ability to attract investors for future projects, was damaged by its behavior (although not sufficiently to discourage reneging for short-term political gain).
Investors may be able to use a government’s concern with public opinion to protect against hold-up. For example, Kumagai might have taken greater care to get popular support through, for example, better public relations on the road’s benefits or by locking in employment opportunities for key political constituencies. Alternatively, companies can act as good corporate citizens, building schools or health clinics, for example, to win local support.

Reputation and shame. Anything that investors can do to publicize their plight will increase incentives for good behavior by counterparties, such as governments. This was the approach taken by Bill Browder of Hermitage Capital, a major foreign investor in Gazprom. In the wake of the Itera affair, he launched a massive campaign in an attempt to encourage the Russian government, which was trying to attract foreign investment at the time, to intervene with Gazprom management.

Cost and revenue sharing. What generated the mismatched incentives of the Kumagai consortium and the Thai government? Kumagai bore the full investment cost up-front, and only reaped the benefits later. Asking the Thai government to bear some of this sunk cost in exchange for lower toll rate would be one way to better align incentives.

Choice of technology: Companies constantly choose among different technologies to ensure maximum efficiency. However, in the face of contractual problems, some efficiency might be sacrificed for the sake of reducing the risk of hold-up.

Hold-up and sunk investments. A crucial element of the hold-up problem is that the investment, once made, cannot easily be redeployed or resold. This is certainly the case for large, immovable objects such as a toll road or power plant. Or maybe not – floating electricity barges in Nigeria are one real-life solution to the hold-up problem. Similarly, investments that rapidly depreciate or require specific operating skills are hard to hold-up.

Matching of costs and revenues. Labor and capital may be used in different combinations to generate the same output. For example, since capital expenses are usually front-loaded and labor expenses are incurred over time, a company could build a cheaper plant with lower rates of automation, but with higher labor requirements. Moreover, big labor employers tend to be in a good negotiating position vis-á-vis the government because they are popular with the local population.

Ownership versus control. In the case of Gazprom, Hermitage Capital had trouble reining in the expropriation of management because it held only a small stake in the company. By comparison, the German gas company, Ruhrgas, managed to acquire a sufficiently large stake to give it the right to appoint a director at Gazprom, hence was able to influence board decisions directly.

Uncertainty creates opportunity: If uncertainty over contract enforcement creates difficulties for managers, the flip-side is that this uncertainty must create opportunities for those best positioned to cope with it. Investors facing political uncertainty should expect to be able to invest at bargain rates, and earn higher returns commensurate with the perceived risk of hold-up.

Thus, savvy investors who take concrete steps to minimize hold-up problems can reduce uncertainty to levels that should deliver higher profits – exactly the strategy of Hermitage Capital when it shamed management into expropriating less from shareholders.

For the past 20 years, the trend in emerging markets has been for governments to sell assets to private owners. While it is tempting to project current trends forward, the fundamentals of the hold-up problem have not changed.

Once governments have no assets left to privatize, they have every incentive to start another wave of expropriation. Thus, it becomes all the more imperative to manage political uncertainty, even in the absence of observable breaches of contracts.

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