Traditional damage theory looks at (ex-ante) sunk costs as an explanation for how vulnerable to expropriation an industry may be: the larger the sunk costs (i.e., highly specific assets such as gas and electricity networks) the higher the risk of (ex-post) opportunistic behavior by the government. That is, once a company has made an irreversible investment, the government will have every incentive to appropriate the profits generated by the sunk asset by decreasing its revenue flow. This is normally why, before sinking the investment, investors will require ex-ante guarantees that their investment will not be expropriated ex-post through a reduction of the revenue flows to the asset.1
Sunk costs alone, however, cannot explain how a firm can prevent expropriation or minimize losses once expropriation is underway. The ratio of sunk to avoidable costs can. If a firm has a high sunk-to-avoidable cost ratio, it will be highly vulnerable to expropriation, as the government will be able to reduce the revenue flow to the company by a large amount (thus expropriating the sunk assets) before the firm decides to stop operations. Alternatively, a firm with a low sunk-to-avoidable cost ratio can signal to the government that it will not tolerate any revenue reductions, for it will stop operations as soon as revenues are lowered. The ratio of sunk to avoidable costs can therefore: 1) act as a deterrent for governments that may want to indirectly expropriate a company by reducing revenues, or 2) help a company mitigate damages by shutting down once expropriation is underway.
Importantly, this ratio varies considerably across energy-producing technologies. For instance, unconventional oil and gas have a low sunk-to-avoidable cost ratio, while wind and solar renewables have a high one. This has significant implications when it comes to the guarantees investors should require from governments to be willing to sink capital, and it is exactly what we observed in high-risk developing countries like Argentina during the 2016 – 2017 auctions of renewable projects. To be willing to participate in these auctions, investors demanded a series of additional guarantees from the government— guarantees not demanded by investors in the auctions of thermal power projects during the same period or by investors in unconventional oil and gas production, for instance, the Vaca Muerta fields in Southern Argentina.2
The following breaks down expropriation risk and damage mitigation by different energy sources
1. Expropriation Risk and Damage Mitigation
Conventional and unconventional oil and gas production3
Conventional oil and gas develop in pools housed by rock formations that typically have high porosity and permeability. These formations are normally found below impermeable rock beds that, once tapped, allow the underground oil and gas to freely flow to the surface by their own natural pressure and with minimal (either mechanical or chemical) stimulation. As such, most of the investment necessary to extract the hydrocarbons (i.e., land, exploration permits, geological surveys, drilling rigs, and equipment) is made at the beginning of the project’s lifecycle. Once this investment is sunk, the borehole drilled, and the reservoir tapped, oil and gas will flow to the surface by their own natural pressure, henceforth requiring only operation and maintenance (O&M) expenditures to keep the process running. Upfront facilities, land plus drilling costs can reach up to 70 or 80% of total costs, while O&M expenses represent 20 to 30%.4
As the long history of oil and gas nationalizations in developing countries demonstrates, any expropriatory government will find it very tempting to take over a project like this, that is, one with a large upfront sunk investment, with no alternative use once committed, and O&M expenditures that can be avoided without preventing underground resources from freely flowing to the surface.5
Contrary to conventional oil and gas production, unconventional oil and gas cannot flow naturally to the surface because they are trapped within rocks that have to be fractured using high-pressure water, chemicals, and sand to release the hydrocarbons. This rock fracturing or fracking, however, is a continuous process: if fracking stops, hydrocarbons will remain trapped inside the rock formation. In this sense, fracking resembles a manufacturing process that needs a constant flow of investment to keep the assembly line producing output.6
In unconventional oil and gas, the initial sunk investment in land acquisition, geological surveys, and drilling equipment is around 30% to 40% of total costs,7 while well completion and O&M expenditures comprise the remaining 60% to 70% that is usually outsourced to oil and gas service companies. In this case, an expropriatory government trying to take over the investment will think it twice: only 30% of total costs can be expropriated (i.e., land and sunk drilling equipment) but the remaining 70% (i.e. O&M avoidable costs) has to be incurred on an ongoing basis otherwise oil and gas production stops.
Conventional thermal and hydropower generation
In conventional thermal power generation, 50%-60% of total costs are avoidable, representing fuel costs (i.e., natural gas, liquid fuels, or coal) and O&M expenditures, including labor and materials. The remaining 40-50% represents the initial sunk investment in the power plant itself plus the land plot it sits on. In hydropower generation, however, fixed investment (and sunk) costs amount to 70% to 80% of total costs and include the land, dam, dam wall, and power-generating facilities. Avoidable costs represent 20% to 30% and account for only O&M expenditures.
Wind and solar power generation
As noted above, wind and solar renewable power generation have a very high sunk-to-avoidable cost ratio meaning that there is no cost that can be avoided to mitigate damages if the government starts reducing revenues. As long as the sun is shining and the wind is blowing, electricity will be generated and injected into the transmission grid anyway, no matter what the company or the government does.
Figure 1. Revenues vs. sunk plus avoidable costs for different technologies
Figure 1 illustrates how expropriation risk increases as the sunk-to-avoidable cost ratio increases for different technologies. The technology least vulnerable to expropriation is unconventional oil and gas production: as soon as the government starts reducing revenues seeking to expropriate sunk investment, it may quickly hit avoidable costs, causing the oil or gas rig to shut down and halt production with minimum benefit for the government. On the other end of the spectrum though, we see renewables with very low (even zero) avoidable costs, providing the government ample room for revenue reduction and asset confiscation without fear of output reduction. This is precisely why—and especially in high-risk countries such as Argentina—investors require additional guarantees to be willing to sink investment in the renewable sector.
2. Guarantees To Reduce Expropriation Risk in Renewables: The RENOVAR program in Argentina
During 2015-2019, Argentina embarked on a very ambitious program to attract private investment into the power generation sector, seeking more than 4GW of new capacity in thermal plants and 6GW in the renewable power sector. This capacity was finally allocated through several rounds of bidding processes conducted by Argentina’s system operator, Compañía Administradora del Mercado Mayorista Eléctrico Sociedad Anónima (CAMMESA), in 2016 and 2017. The thermal capacity was allocated through two rounds of bidding processes where potential investors had to make bids on firm capacity to be installed (MW), capacity remuneration ($/MW month), and (non-fuel) variable costs ($/MWh), with CAMMESA itself being the sole off-taker of the power purchase agreements (PPAs) and offering only standard contract guarantees.8
To participate in the bidding process for renewables projects though, investors demanded special guarantees that were provided by the RenovAR program.9 This program created a dedicated public trust fund (FODER) that would provide guarantees for investors to enhance the bankability of the Power Purchase Agreements (PPAs) and to protect the projects against the risks of (1) Non-payment and/or delayed payment by CAMMESA for the generated and delivered electricity; (2) Early termination of the contracts through a compensation implemented via a put option that would allow investors to sell the project’s assets at their net (non-depreciated) original value to the FODER fund under certain circumstances; and finally, (3) In case of non-payment of the put option, there would be (optional) guarantees payable by the World Bank up to 500,000 $/MW for a maximum of $500 million.
As of December 2023, 152 renewable energy projects are already in operation, and 38 are under construction, totaling US$8.3 billion in direct investment and 6.6 GW of new-built capacity—amounting to 15% of the 43.5MW of total installed capacity in Argentina’s power sector.10
3. Conclusion
This paper has argued that rather than sunk costs alone, it is the ratio of sunk to avoidable ones that can: 1) act as a deterrent for expropriation, or 2) help a company mitigate damages by shutting down once expropriation is underway. It has also shown that this ratio varies considerably across energy-producing technologies.
Unconventional shale and tight oil and gas production have a low sunk-to-avoidable cost ratio, showing a strong “natural” protection against indirect expropriation. Unconventional oil and gas producers will signal to the government that any attempt to lower their revenues will be met by the credible threat of freezing operations with an immediate halt in oil and gas production. This is probably why we observe booming unconventional oil and gas production in Argentina, even with 2.000 bp of country risk premium (i.e. 20% on top of 10-year - U.S. Treasury bills’ yield to maturity).
Wind and solar renewable power generation however has a very high sunk-to-avoidable cost ratio, rendering them highly vulnerable to (ex-post) opportunistic behavior by the government. This is why we observe investors demanding additional guarantees from the government in Argentina during the 2016–2017 auctions of renewable projects.
Consequently, and particularly in high-risk countries, additional guarantees against expropriation for investors should be granted only in those sectors with high sunk-to-avoidable ratios, including renewables, hydropower, and conventional oil and gas but not to those with a low ratio like unconventional oil and gas production.
1. See Chambouleyron, A. (2014) Mitigating Expropriation Risk through Vertical Separation of Public Utilities: The Case of Argentina, Utilities Policy, 30 (2014) 41 42, http://www.sciencedirect.com/science/article/pii/S0957178714000460
2. Between January 2016 and December 2023, Argentina’s country risk premium (CRP) as measured by Standard and Poor’s EMBI, increased from 450 bp (or 4.5%) to 2.000 bp or 20% (a 310% increase) while unconventional gas production increased from 8.5 billion cubic meters per year to 28 billion cubic meters in 2023, a 230% increase. During the same period though, conventional gas production fell from 36.6 billion cubic meters per year to 20 billion cubic meters per year, a 45% reduction. See https://www.argentina.gob.ar/economia/energia/planeamiento-energetico/panel-de-indicadores/superset-prod-gas-conv-y-no-conv
3. See Monaldi (2021) for the political economy of expropriation risk in the conventional and unconventional oil and gas sector in Argentina at https://www.sciencedirect.com/science/article/abs/pii/S0301420721002804
4. See EIA (2016) “Trends in U.S Oil and Natural Gas Upstream Costs” at https://www.eia.gov/analysis/studies/drilling/pdf/upstream.pdf p. 7.
5. For a review of oil and gas nationalizations in Latin American countries, See Monaldi (2021) https://www.sciencedirect.com/science/article/abs/pii/S0301420721002804
6. See Newell, Prest and Vissing (2016) “Trophy Hunting vs. Manufacturing Energy: The Price-Responsiveness of Shale Gas” a Resources for the Future publication, https://www.rff.org/publications/working-papers/trophy-hunting-vs-manufacturing-energy-the-price-responsiveness-of-shale-gas/
7. For more details see EIA (2016) “Trends in U.S Oil and Natural Gas Upstream Costs” at https://www.eia.gov/analysis/studies/drilling/pdf/upstream.pdf
8. See SEE Resolutions 21/2016 and https://servicios.infoleg.gob.ar/infolegInternet/anexos/255000-259999/259703/norma.htm and Res 287/2017 https://servicios.infoleg.gob.ar/infolegInternet/anexos/270000-274999/274571/norma.htm
9.See RELP (2023) https://www.energygreenmap.org/renovar/renovar-case-study-2023.pdf pp. 11-16
10. See RELP (2023) https://www.energygreenmap.org/renovar/renovar-case-study-2023.pdf
© Copyright 2024. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.
