Change in Law Protection under the Model Project

Change in Law Protection under the Model Project Development Agreement in Nepal[1]

1. Project Development Agreement (the “PDA”)[2] is considered as one of the most important project documents for any privately financed infrastructure projects. Privately financed infrastructure projects are generally developed on a build-own-operate-transfer (BOOT) modality and generally involve a concession period of 25 years to 35 years. Given the long term nature of such projects, the PDA is generally entered into between the Government or its relevant authority (the “Contracting Authority”) and private sector developer (the “Concessionaire” or the “Company”) as a very useful tool of allocating responsibilities, risks and rewards between the parties.

2. The PDA is essentially founded on certain economic and financial assumptions and calculations existing at the time of entering into the PDA. Any expected return of the Concessionaire from the project is based on such assumptions and any material change in such assumptions arising out of the factors beyond the reasonable control of the Concessionaire will adversely impact the financial model developed at the time of entering into the PDA.

3. For example, while developing a financial model for the project, the Concessionaire takes existing rate of income tax (say 20%) as the basis for income tax liability of the project. However, if the rate of income tax is changed from existing 20% to 30% by the relevant laws after signing of the PDA, this will adversely affect the cash flow of the project thereby limiting its ability to for repayment of the interest and principal amount to the project lenders. This will also reduce the returns originally envisaged to the project sponsors. Given the long term nature of the infrastructure projects, the effective change in law provision is essential to provide confidence to both the lenders and the sponsors investing in the infrastructure projects. In order to address, allocate and mitigate such risks, the PDA generally incorporates the change in law provision and the Contracting Authority undertakes to provide certain reliefs/protections to the Company with defined triggering events which normally includes increase in the project cost or reduction of the revenue as a result of change in law.

4. The purposes of this Article are to –(1) give brief outline of change in law in the context of any PDA that is entered for an infrastructure projects, (2) assess the relevant provisions of the draft of the Model Project Development Agreement disseminated by Ministry of Energy, Government of Nepal for Hydropower Projects with installed capacity of less than 500 MW[3], and (3) identify the reforms that are critical to make the change in law provision enshrined consistent with internally accepted principles and best practices . As the template project development agreement developed for the hydropower project with installed capacity of 500 MW or more is not publicly available, we have made assessment of change in law provision based on the Model PDA.

5. Any change in law provision under the PDA is essentially a risk allocation and management tool. Generally allocation of risk of change in law depends upon the type of the change in law. The use of change in law provisions made in the project development agreements may be generally classified into -(1) general change in law, (2) specific change in law, and (3) discriminatory change in law.

6. Any changes in the general laws which apply to all sectors of business without specific reference to the project can be understood as the general change in law. Any change in minimum wages of workers can be an example of general change in law. Generally, any change in general laws is considered to be risk of the Concessionaire. However, given the nature of the project and concession period, the Contracting authority also shares the risks of general change in law.

7. As a matter of general rule, any change in law which is specific to project is considered to be the specific change in law, for instance, changes in the rate of royalty applicable to the hydropower projects.

8. Any change which is discriminately adopted and applied to the project, then such change in law is considered to be discretionary change in law, for example, if any environmental regulations are brought into force specifically making these regulations applicable to the project only and no such regulations are applied to other hydropower projects. Generally, risk of specific change in law and discriminatory change in law are borne by the Contracting Authority.

9. Like any other individual or project companies, the Concessionaire is required to comply with all the existing laws of the country and cost of compliance with such laws need to be borne by such Concessionaire. While developing the financial model with expected internal rate of return, the Concessionaire takes care of and includes all cost that will be incurred in the course of complying with the existing laws. However, the Concessionaire cannot anticipate the cost of complying with the existing laws and probable changes that any change in law existing laws might bring in terms of cost, revenue and construction and operation schedule of the project for the entire concession period.

10. Given this practical difficulty and to avoid any material risks that a project may be subjected to due to adverse change in law future, the PDA usually contains a change in law protection. The change in law provision provides a mechanism pursuant to which the contracting parties agree to share risks as per the provisions defined in the PDA.

11. Any change in law is generally considered to be within the control of the Contracting Authority or wider Government and over which the Concessionaire has no control or influence. Hence, the Concessionaire typically seeks that the risk of the change in law to be borne by the Contracting Authority and especially given the fact that the project will be handed over to the Contracting Authority after the end of the concession period. However, the Contracting Authority also seeks to minimize its liability arising out of the change in law as ultimately the Contracting Authority will be funding through the taxpayer’s money. In view of this, any change in law provision to be provided under the PDA is essentially an outcome of the negotiation between the parties.

12. The level of risks that the Contracting authorities should take against the change in law is also based on the type of the Contracting Authority. For example, if the project development agreement is entered between a local body and the Concessionaire, then the local bodies may not be able to take entire risks of change in law as any change in law is not within the effective control such local bodies. However, if the Contracting Authority is the Government itself, then risk of change in law is fully taken by the Contracting Authority as it is generally considered that the Government has ability to control or mitigate the effects of change in law that might occur on the project.

13. The Ministry of Energy has disseminated the proposed draft of the Model Project Development Agreement for Hydropower Projects with installed capacity of less than 500 MW (the “Model PDA”). The Model PDA replaces draft PDA which was published by Ministry of Energy and made available at the website of DOED which was dated April 10, 2010.

14. After enactment of the Investment Board Act 2011 (2068) (the “Investment Board Act”) in 2011, investment in any hydropower project with installed capacity of 500 MW or more will be approved by the Investment Board constituted under the Investment Board Act. The Investment Board has also drafted the model project development agreement for the projects with installed capacity of 500 MW or more. The model PDA to be used for such projects has not been made publically available.

15. Any protection of change in law is of two types- (1) statutory protection, and (b) contractual protection in the form of the project development agreement.

16. The Electricity Act 2049 (1992) (the “Electricity Act”) and Electricity Rules 2050 (1993) (the “Electricity Rules”) do not provide any specific legal basis for the project development agreement and change in law provision. Section 9 of the Electricity Act provides that the Government of Nepal may enter into an agreement with the licensed person for the purpose of purchase of the electricity, providing guarantee for the investment being made and other financial and technical matters related to the project.

17. The issue as to whether project development agreements in the nature of the Model PDA, scope of which is wider than purchase of electricity and guarantees, are covered has not been clarified by any Government authorities or courts of Nepal yet. The wordings used in Section 9 are not sufficient to cover the change in law provision. Even in the absence of specific provision under the Electricity Act, the Model PDA would be covered under the general principles of contract under the Contract Act 2056 (1998) and is therefore, binding to the Parties. However, issues as to whether the Government of Nepal can take such binding obligations having impact on state treasury without a clear legal basis might be subject to challenge.

18. Act concerning Private Financing in Construction and Operation of Infrastructure Facilities 2063 (2006) (the “Concession Act 2006”) and Rules concerning Private Financing in Construction and Operation of Infrastructure Facilities Act, 2063 (2006) (the “Concession Rules”) have provided a clear basis for the PDA. However, the Concession Act and Concession Rules also have not covered all aspects of change in law provision. Section 34 of the said Concession Act provides that the rate of income tax prevailing at the time of entering into the agreement shall remain valid for the entire duration of the agreement. The said Section 34 has guaranteed protection against adverse change in rate of income tax only and has not covered any adverse change in other areas of laws including other areas of tax laws. The protection granted under Section 34 of the Concession Act is very limited in its scope and application.

19. The Investment Board Act and Investment Board Rules 2069 (2012) (the “Investment Board Rules”) have also provided clear legal basis for the PDA to be entered between Investment Board and the Concessionaire in relation to implementation of any infrastructure project including a hydropower project with installed capacity of 500 MW or more. Regarding change in law protection, Section 11(2) of the Investment Board Act provides that-(a) no legal, administrative or policy provisions shall be made adversely impacting the terms and conditions of the project license during the validity period of the license, and (b) even if such provisions are made, such provisions will not be applicable to the project.

20. The change in law protection guaranteed under the said Section 11(2) of the Investment Board Act extends to only the terms and conditions of the project license and does not cover any adverse change in law in any areas of the laws that are applicable to the projects. In view of this, change in law protection guaranteed under the Investment Board Act is not sufficiently broad. Other issues that are related to Section 11(2) are-(a) what if the generation license itself contains the protection of change in law so that the protection is extended and made available in all qualifying situation of changes in law, and (b) as to whether including such change in law protection is the generation license will be consistent with Section 11(2). This provision has also given room for interpretation as to whether any change in law protection provided to the companies beyond the scope of Section 11(2) will be consistent with the said provision. Though the legislative intent appears to afford the change in law protection available to the companies, wordings used in the said Section 11(2) are potential to give different legal interpretations.

21. Section 11A of the Income Tax Act 2002 (2058) (the “Income Tax Act”) also guarantees protection against change in income tax law. Pursuant to Section 11A, if any agreement has been entered into between the Government of Nepal (GON) and any person for development and operation of infrastructure facilities, any tax facilities available at the time of making such agreement shall remain valid for the entire period of the agreement. Section 43 of the draft Electricity Act has also provided similar kind of protection.

22. Though the statutory backing of the change in law provision under both the Concession Act and Investment Board Act are not strong, as these laws have provided clear legal basis for the PDA, any change in law provision consistent with the provisions of these laws are enforceable.

23. Supreme Court of Nepal has also passed various judgments recognizing the protection of change in law under the Industrial Enterprises Act. For example, in one case[4], Supreme Court ruled, “the State is stopped from refusing to provide facilities and concession committed by the State in the relevant Industrial Enterprise Act after the investor has established the industries after considering the benefits provided at the time of the establishment of the industries. The investor makes investment decision on the basis of attractiveness of benefits and security of his/her investment. The legal provisions in the countries like Japan, India, China and United States of America which are known for being attractive for foreign investment have given special attention to this. This is the reason that even if any changes in law are made in these areas, such changes are made with retrospective effect. The benefits provided by the law existing at the time of establishment of an industry cannot be adversely affected by the law introduced at a later date. This is the international norm which has been accepted as minimum principle of trade jurisprudence. The state is bound by estoppel after accepting of the same. “

24. The legal recourse available to the Concessionaire will be different depending upon the statutory protection of change in law or contractual protection of change in law. If change in law protection guaranteed under the relevant laws is not honored by the Contracting Authority or some other authority, then the Concessionaire can seek the remedy as provided under the relevant laws or if no such remedy is available, then can seek remedy through the writ petitions. If the change in law is guaranteed under the project development agreement without any specific statutory legal backing, then the Concessionaire will need to follow recourse provided under the project development agreement through the contractual route. However, if the contractual remedy is not effective or sufficient or if the project development agreement itself permits the Concessionaire to seek remedy available under the applicable laws, then the Concessionaire should be also entitled to seek any remedy beyond the provisions of the project development agreement.

25. Section 1.1 of the Model PDA has defined the term “Change in Law” and Section 17 has dealt with the criteria for protection of change in law and relief/remedy provisions.

26. The definition of the “Change in Law” has covered-(a) change in any Laws of Nepal, (b) change in interpretation or modification of any Laws of Nepal by the Government agency or by a competent court of Nepal, (c) imposition of any material condition in connection with the issuance, renewal or modification of any Government Approval by the Government Agency, (d) change or modification of the Generation License by any Government Agency, (e) imposition of any other obligations imposing a cost on the Company. The definition of the “Change in Law” is comprehensive enough as it has covered change not only in the Laws of Nepal and judicial interpretations but also in the terms and conditions of the Generation License and Government Approvals.

27. In view of the definition of the “Change in Law” under Section 1.1 of the Model PDA, protection against change in law is available only if-(a) effect of such change in law is either a material increase in cost, material reduction in revenue or material delay in schedule for the completion or operation of the project, (b) pursuant to Section 17.1.7, any increase of cost or reduction of revenue is considered “material” if the total material increase or costs incurred or material reduction in revenue as a result of Change in Law have reached a certain aggregate amount (the “Threshold”) to be specified based on value of the project on a case to case basis, and (c) such change in law has started from the agreement date, meaning after signing the PDA.

28. Definition of the Change in Law has excluded certain changes in different areas of laws. Further, Section 17 has also excluded certain change in law.

29. In view of definition of Change in Law under Section 1.1 and Section 17, following are excluded from the protection against change in law:

30. The exclusions above have made protection of change in law to the Concessionaire insufficient. As a matter of general principle, any change in law irrespective of the area of changes which brings material impact on cost, revenue or completion or operation schedule of the project are included within the protection under the project development agreement entered with Government. Since, any change in income tax and royalty which are direct burden to the company and which the company typically wants to be static during the entire concession period are excluded, protection against change in law will not be of much worth to the company. These are direct elements that are carefully considered at the time of developing the financial model for the project by the company and which forms a basis for the overall calculation of the cost and revenue of the project. If these elements are made variable, there will be no certainty that financial model will work and will yield the expected revenue and return to the company, its lenders and sponsors. This will operate as a detriment to the project as the sponsors may fear that GON may try to recover the amount that it has provided to the Company on account of the other Change in Law event by imposing additional Income Tax or Royalty.

31. As Section 11A of the Income Tax Act has also guaranteed protection against any change in income tax and as the Concession Act and Draft Electricity Act have also provided similar protections, there is no reason as to why such protections are not to be covered within the Model PDA. Having such protection under the Model PDA will add comfort to the companies and will also provide contractual remedies if such provisions are amended/repealed to the detriment of the company.

32. In terms of protection period as well, protection of change in law is also limited to 20 years starting from the Commercial Operation Date, which is the date of signing of the PDA. This provision may have founded on the assumption that by that time, the company should have paid all loan and interest to the project lenders and company will have sufficient cash flow to cope with any financial implications that may be brought about by the change in law. But, such logic does not appear to be practical as the company and/or sponsors develop the financial model on the assumption that it will work during the entire concession period and calculate the financial return accordingly. There is nopractical reason as to why the change in law protection is not to be made available during the entire concession period.

33. In view of discussion in the preceding paragraph, a company is entitled to protection against change in law only if-(a) such change in law protection is covered under the Model PDA, and (b) such change in law are not expressly excluded under the Model PDA.

34. If there is any dispute between the Company and the Government of Nepal regarding entitlement or extent of the protection, then such dispute becomes subject to dispute settlement process as provided in the Model PDA.

35. The recourse and remedy available to the company in the event of adverse change in law is limited under the Model PDA. The Company will not be able to claim any monetary compensation against the GON directly. Pursuant to the Model PDA, the Concessionaire will need to try to recover the cost and loss of revenue as a result of adverse change in law through the following means:

1. Firstly, through proceeds the Company is entitled under the Export Power Purchase Agreement. Generally, the off-takers under the power purchase agreement do not take such risk and the power purchase agreements do not provide mechanisms to increase the power purchase rate to cover the cost or loss of revenue suffered by the Concessionaire in its home country. It is not clear as to how this issue would be addressed for domestic projects.

2. Secondly though insurance proceeds. The draft PDA provides that the Company is required to obtain the insurances for the Project as outlined in Schedule 6 which is not available for review. It is also not clear as to the extent of mandatory insurance the Company is required to obtain at its cost. Further, this requirement poses two problems: (1) firstly, insurance against risk of change in law may not be available as generally they are considered to be the “political force majeure”, and (2) secondly even if they are available, this will increase the premium.

3. thirdly, to the extent cost or loss of revenue is not covered as per above, the obligation of GON to fund cost or loss of revenue is limited to one or combination of the following which is to be determined at the sole discretion of the GON:

4. Finally and only as a last recourse, in the event the Company is not able to fully recover the losses from all those means described above, then Company will need to submit a formal claim to the GON. The amount of monetary compensation is then determined by the Compensation Committee of Independent Experts.

36. Another remedy that is available to the Company is extension of the timeline for performance of the Company’s obligations. Pursuant to Section 17.1.3, the Company is allowed extension of timeline for the relevant performance of its obligations so long such performance has been delayed due to the effect of change in law.

37. The relief provisions of the Model PDA do not appear to define them as the rights of the Company. The type of the remedy to be granted is subject to discretion of the GON and it might take a considerably longer time for the project company to obtain remedy in hand.

38. Pursuant to Section 17.2, any change in law which is in favor of the Company and which increases the revenue of the Company, the Company is required to share such portion of revenue as determined by the Compensation Committee with the GON.

39. The Model PDA provides following 2 forums for determination of the effect of change in law and dispute settlement: (1) Compensation Committee of Independent Expert, and (2) arbitration.

40. If the GON accepts the effect of change in law, then time to be extended and amount to be compensated as a result of change in tax will be determined by the Compensation Committee of the Independent Experts. Pursuant to Section 16.5.4 of the Model PDA, the GON is required to constitute a Compensation Committee of Independent Experts. As the independent experts are solely appointed by the GON, this provision might not be acceptable to the Company. If the determination made by the Compensation Committee is not acceptable any party, then such party can refer the dispute to arbitration.

41. Pursuant to the Model PDA, any dispute regarding the effect of change in law is submitted to arbitration under following 2 circumstances:

42. The Model PDA grants the rights to GON to terminate the PDA as a whole if-(a) level of costs fixed by arbitration tribunal is more than the specified ceiling, or (b) revised timetable fixed by arbitral tribunal provides for a movement to the timetable set out in the PDA of more than certain limit. It appears that such ceiling and limit will be specified in the PDA on a project to project basis. Section 18.4 has provided transfer options and project buy-out provisions. Schedule 4 of the Model PDA is to contain such provisions. However, as information in Schedule 4 are not available, it is not certain at this stage how the compensation components will be defined and included should the GON decides to terminate the PDA on the ground of change in law.

43. Section 18.1 of the Model PDA has provided that any default by the Company is a result substantially from a Change in Law, then such default is not considered to the Company Event of Default. Pursuant to Section 18.2.3 of the Model PDA, the Company can terminate the Model PDA if the GON fails to remedy a Change in Law within 60 days after written notice to the GON from the Company. However, such termination right is not wide enough as the Company will be able to exercise termination right only if the effect of the Change in Law is such that the Change in Law-(a) makes any material obligation of the Company under this Agreement unenforceable, invalid or void, or (b) makes it unlawful for the obligation of the Company or the Contractors to make or receive any payment, to perform any material obligation or enjoy or enforce any material right under any Government Approval or the PDA. As the termination right of the Company is made subject to limitations, termination right of the Company on the ground of failure of the GON to remedy the Change in Law is not effective.

44. The Electricity Act and Electricity Rules should provide a clear legal basis for the PDA and underlying change in law provision. The provisions of the Concession Act and Investment Board Act should be amended to empower the GON to enter into PDA with the detail Change in Law provision.

45. Both the sponsors and lenders are typically want to have strong protection of change in law given the fact that-(a) any change in law is generally within the control of the Contracting Authority or wider government, and (b) privately financed infrastructure projects are of long term nature ranging from 25 years to 35 years and it would be practically next to impossible to ascertain the effect of any change in law on financial position of the Company. The existing provisions of the Model PDA related to Change in Law do not provide adequate protection to the Company and it is potential to operate as a strong disincentive for the Company to enter into the PDA.

46. In order to make the Change in Law provision more reasonable, following reforms are recommended:

[1]           This Article was published in Nepal Bar Council Journal 2011/12.

[2]           Project Development Agreements are also referred to as “Project Agreement”, “Implementation Agreement” or “Concession Agreement”.

[3]           This Article is based on the provisions of the Proposed Draft of the Model Project Development Agreement (for hydropower projects with installed capacity of less than 500 MW) as available in official website of Ministry of Energy as on July 01, 2013. We understand that the Proposed Draft is being revised by Ministry of Energy.

[4]          Eastern Sugar Mills Limited Vs. Government of Nepal and others, Nepal Law Reporter 2068, Baisakh, p. 123 (Decision No. 8542)