To date, investors (claimants or investors) have launched at least 36 claimsi under bilateral and multilateral investment treaties against the Kingdom of Spain (Spain or respondent) following changes to its renewable energy incentive scheme. Tribunals have found against Spain in 13 out of 14 cases for which awards are publicly available, for a combined value of €999 millionii. This article considers the methods used in the calculation of damages in the 13 published awards made against Spain and the reasons for their choice.
Background
In its efforts to meet national and EU renewable energy targets, from 2004 Spain sought to attract investment in renewable energy with new legislation and an incentive scheme. Between 2010 and 2014, Spain subsequently repealed or amended the legislation on which those investments were predicated. The key legislation changes, which are set out in more detail below, have in the view of investors, negatively affected the return on the investment projects and their fair market value.
Investors argue that without the regulatory framework, which committed to a stable remuneration regime, they would never had invested. Spain, on the other hand, alleges that investors could not legitimately expect that the rules applicable to their investments would remain unchanged for the entire duration and should have been aware that the regulatory regime could be modified.
Initial Regulatory Framework
To promote investment in renewable energy, Spain developed a ‘Special Regime’ in 1997iii. The Special Regime was modified in 2004iv to improve the stability of the tariffs, and was subsequently modified again in 2007v. The latter modification specified the remuneration payable under the Special Regime as either a regulated tariff (feed-in-tariff or FIT) for the total net energy produced for the lifetime of the plants, or a premium.
Regulations adopted after 2010 (the ‘Disputed Measures’)
Beginning in 2010, Spain enacted a series of changes to the Special Regime, which included: limiting the FIT to the first 25 years of the plant’s operation rather than the lifetime of the facilityvi; capping the number of yearly production hours that would be entitled to receive the FITvii; and introducing a 7% tax on electrical energy producedviii.
From 2013, further reforms were made which eliminated the special premiums provided for in 2007ix, formally eliminated the existing Special Regime and provided for tariff revision every six yearsx, and established formulas for calculating the special payment under the new regime, limiting this special payment to certain operating hoursxi.
Energy Charter Treaty
The legal basis of the claims centre around the fair and equitable treatment (FET) standard, including the legitimate expectations of investors, under the Energy Charter Treaty (ECT), of which Spain was a signatory.
Article 10(1) ECT'sxii first sentence reads:
“Each Contracting Party shall, in accordance with the provisions of this Treaty, encourage and create stable, equitable, favourable and transparent conditions for Investors of other Contracting Parties to make Investments in its Area.”
In their claims, the investors, contend that Spain breached its duty of FET in at least three distinct ways:
1 By violating the legitimate expectation of fixed tariffs and premiums for the entire lifespan of the renewable energy facilities
2 By failing to provide a minimum standard of treatment
3 By failing to treat claimants’ investments transparently and consistently and acting in good faith
Calculation of damages
The purpose of calculating damages in these cases has been to put the investors into the position that they would have been were it not for the respondent’s actions.
The standard of damages is calculated as the difference between the value of the investment, had the initial legislation (RD 661/2007) been maintained (the hypothetical or but-for scenario), and the value of the investment under the ‘disputed measures’ (the actual scenario).
Although there are different approaches to calculate damages, the two main ones that have been adopted by the respective tribunals in the Spanish renewable energy cases are:
- Income based method – discounted cashflows (DCF)
- Asset based method – cost of assets plus a reasonable rate of return
DCF
Discounted cashflows is a valuation method used to estimate the value of an investment today (present value) based on projections of how much money it will generate in the future (future cashflows), adjusted for the time value of money and expected rate of return.
The time value of money assumes that a euro today is worth more than a euro tomorrow because it can be invested and earn a return. DCF analysis estimates the present value of expected future cashflows using a ‘discount rate’, which is often considered as a proxy for the required rate of return that investors can expect to earn relative to the risk of the investment.
Cost of assets plus a reasonable rate of return
One alternative method to the income-based DCF is an asset-based approach. Damages may be calculated as the costs already incurred, ie, the costs to build and maintain the assets, plus a reasonable rate of return (usually based on the minimum rate of return the assets must earn to satisfy stakeholders).
Review of the Spanish awards
To date, there have been 13 published awards made in favour of Claimants. In each case the approach taken by the claimant(s) and respondent to the quantification of damages differed fundamentally, with the claimants preferring DCF and the respondent preferring an asset-based method.
In the 13 awards, the respondent’s main assertion against the use of DCF was that the future cash flows, sometimes up to 40 years in the future, were highly speculative and therefore inappropriate due to:
- the investments were capital intensive with no relevant intangible assets
- there was a high dependency on volatile cashflows
- the long forecast period increased uncertainty
- there was an insufficient history of operations
- the economic conditions were constantly fluctuating.
The tribunal favoured the use of DCF over the cost of assets methodology in 11 of the 13 awards. While the facts and merits of each case were different, the following were the primary reasons for the use of DCF by the tribunals (majority view) based on the evidence put before them.
i) The DCF method is well established and widely accepted by arbitral tribunals in the renewable energy sector. The DCF method is universally used to value income producing assets and has been confirmed by numerous tribunals to be the standard approach for calculating the fair market value of an investment for purposes of compensation of breaches of law. Tribunals acknowledge that projecting future cashflows depend on the quality of the inputs and a careful analysis of the underlying assumptions, in order to minimise speculative elements. Additionally, DCF valuation risk is minimised by assigning distant cashflows a higher discount (and therefore a lower value) to reflect the way that uncertainty compounds over time.
ii) Plants had sufficient operational history and were operating as a going concern.
iii) Revenues and costs of plants were predictable due to operating in a regulated industry.
iv) Power stations have a relatively simple business model with readily available data. The inputs into the DCF model are primarily based on objective or actual data, such as production, electricity prices, inflation, maintenance costs, lifetime of the plants, regulatory risk and discount rate used. There is, therefore, a somewhat mathematical precision to the output, if properly exercised with a degree of skill and judgement.
These reasons for the use of DCF, i) to iv) (where provided by the tribunal in the award), have been linked to each award in the table below under ‘Tribunal method to calculate damages and reasoning’:
