The Investment Treaty Arbitration Review: Other Methods for Valuing Damages in Arbitration
When assessing the value of damages in arbitration, a number of different approaches are available. In many cases these approaches seek to determine the market value of the asset or assets that are at issue in a claim for damages.
Market value can be defined as 'the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm's-length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion'.2
A widely used approach to estimating market value is the income approach, using a discounted cash flow model to assess the value of possible future cash flows that might be generated through the use of the assets being valued. The income approach is covered elsewhere in this volume. In this chapter, we discuss two different valuation approaches: the market approach and the cost approach. Given the wide acceptance of the income approach, we start by setting out reasons for considering these different approaches in an arbitration setting, either as an alternative to the income approach or to complement its results. Second, we set out details of how the market approach and the cost approach can be applied. Finally, we discuss how the suitability of these valuation approaches might be assessed case by case.
II Why use other valuation methods?
i An alternative to the income approach
When a claimant is found to be entitled to damages, arbitral tribunals regularly calculate compensation on the basis of market value. In general terms, this is based on the idea that some or all damages are caused by the financial benefits that would have been expected (at a given valuation date) to be realised had there been no breach leading to damages. This can be assessed through estimating the amount that could have been achieved in an arm's-length transaction at the relevant date; that is, through calculation of the market value of the assets subject to dispute.
In many cases, the primary benefit that companies seek to realise from most projects is future positive cash flow (and hence profit). Because of this, damages can be calculated on the basis of the value of expected future cash flows as at the date of breach. This is the income approach. In this approach, expected profit from future income in a 'but-for' world in which the breach did not occur, are compared to the profits from income that actually occurred. This is often accomplished using a discounted cash flow (DCF) model, in which expected future net cash flows are calculated and discounted to a suitable valuation date. A more complex variation of this approach, which has become known as the 'modern DCF' approach, was adopted by the tribunal in Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan.3
We will not address the details of the income approach in this chapter. It is covered extensively in the literature on damages, and elsewhere in this volume. For present purposes, we note that the use of the income approach relies on certain assumptions. Primarily, it relies on the assumption that future cash flows can be estimated with reasonable certainty. Although there can be debate about what constitutes reasonable certainty, there are cases in which future cash flows cannot be estimated with any reasonable certainty, in which case the income approach may have limited, if any, applicability. For example, this is the case in very early-stage commodity exploration projects for which there is no reliable estimate of the quantity of resources that might be extracted in a hypothetical development project.4 In this case, an alternative method for valuing lost profits must be found.
ii A complement to the income approach
Even where the income approach is used, other valuation methods can be used to complement it. Having decided that an income approach is viable, tribunals often have to rely on extensive (and technical) expert evidence on how it should be applied in practice. The resulting analysis can be complex, with a whole host of underlying assumptions being discussed in expert evidence. In these circumstances, an alternative method giving a similar result can give the tribunal comfort that it has reached an answer supported by other market evidence.
It is also in line with valuation best practice to benchmark valuation results using multiple valuation approaches. This allows a valuation practitioner to highlight any anomalous results and to identify areas for further research and analysis.
iii The methods
We are examining two alternatives to the income approach to valuation. Both attempt to quantify the market value of an asset, that is, the monetary amount at which that asset would change hands in an arm's-length transaction, subject to the criteria set out in the definition above. However, they approach this quantification from different angles.
The market approach
An alternative to the income approach is given by the idea that the market itself is the final arbiter of market value. Although the market value of an asset will reflect the price that would be achieved in a transaction between a hypothetical willing buyer and a hypothetical willing seller, in the market we can see what prices were actually achieved in sales, either for the asset in question or for comparable assets. In this context it is important to notice the difference between value and price – the value of an asset may not be accurately reflected in a price paid for that asset. This might be the case if the relevant transaction was not arm's-length, was not made in full knowledge of all relevant information or was a forced sale. Any valuation based on actual prices will have to assess the extent to which this difference affects the derived value.
It may be possible to assess the value of an asset through analysis of prior transactions for the asset itself. Intuitively, this could be expected to provide the best evidence regarding the market value of an asset. However, it is subject to a number of constraints.
There may be few, if any, prior transactions. We would expect any analysis under the market approach to be stronger the more market transactions are available to take into account. If there are limited transactions involving the asset itself, then it may be necessary to consider additional evidence.
Prior transactions may not have taken place close in time to the valuation date being considered in the calculation of market value. If this is the case, then it will be necessary to consider any changes in the intervening time. These changes may be changes to the asset or changes in the overall market in which the prior transactions took place.
Finally, prior transactions must be assessed to ensure that they fulfil as closely as possible the requirements for consideration of market value – they must be arm's-length, between a willing buyer and a willing seller, take place after proper marketing and with all the relevant market knowledge.
A common approach when assessing the market value of an asset is to use the value of comparable assets as a benchmark. This can be achieved either by reference to the value implied by transactions for comparable assets or by reference to the value of comparable companies.
Analysis of comparables is relatively simple to implement but must be approached with care.
First, a suitable set of comparable assets or companies must be identified. This raises several initial questions:
- What does comparable mean? Assets that might appear similar can have significant underlying differences that can limit their usefulness in any analysis of value. These differences must be corrected for if possible, or taken into account in any subsequent discussion if not. In general, a number of factors should be examined to assess the comparability of assets, which should be analysed and corrected for if possible:
- Cash flows: Are the underlying cash flow structures similar? For example, the value of a development of an oil and gas production project is heavily dependent on the stage of development. The expected future cash flows of an early-stage exploration project are structured very differently from a project that is already producing significant quantities of product.
- Growth: Are the growth prospects for future cash flows similar? For example, if the revenue of a project is dependent on growth in the iron ore market, then future cash flows will be different from a project dependent on growth in the gold market.
- Risk: Are the risks to cash flows similar? For example, a company that mines and sells gold faces risks that are not faced by a company that just receives a royalty stream from a company to which it has leased a gold mining concession.
- What effect does time have on comparability? All things being equal, a comparable transaction will provide a better indication of market value if it takes place closer to the valuation date. If it is decided that a time difference is significant, then any implied value may have to be adjusted using a suitable index to take into account changes in the value of the asset over time.
- How many comparable assets or companies are needed for a robust analysis? In an ideal world, an analysis would use a large set of comparable asset values, ensuring that any outliers (comparables that result in abnormally high or low valuations) can either be excluded or have only a minimal effect on the final analysis. Unfortunately it is often difficult to find a large set of high-quality comparables. It may therefore be necessary sometimes to use a smaller set of comparables.
Second, having identified a set of comparable assets or transactions, the next step is to identify a suitable unit of comparison. This is generally achieved using a per unit valuation metric, where the unit will differ from industry to industry. For example, for transactions in the upstream oil exploration and production industry, the value implied by purchases of licence shares might be expected to follow the quantity of oil resources that have been discovered. A suitable valuation metric, therefore, could be dollar per barrel of oil resource (written $/bbl). For example, a purchase for US$100 million of a licence area with assessed resources of one billion barrels of oil would imply a valuation metric of 0.1$/bbl.
Third, the chosen valuation metric is calculated for each comparable that has been identified. This calculation will take into account any adjustments that need to be made to the valuation metric to account for any relevant differences between assets, and any time or geographical adjustments that may be necessary. Once the valuation metric has been calculated for each comparable, a suitable average value must be derived. This may be the mean or median average, depending on the specifics of the data set being considered.
Finally, the average valuation metric for the set of comparables is applied to the asset being valued. To continue the example given above, if in the upstream oil exploration and production industry a set of transactions for comparable licences gave an average value of 0.1$/bbl, and the licence being valued had resources of 200 million barrels at the valuation date, this would imply a value of US$20 million.
The cost approach
A further alternative to valuation is the cost approach. This is based on the idea that the buyer of an asset will not pay more than the cost of obtaining an equivalent asset. This approach can be applied in two principal ways.
The replacement cost method
The goal of this method is to arrive at the cost that would be incurred to own an asset that, at the valuation date, has the same use value to its owner as the asset being valued, rather than an asset that is identical in every respect.
The value of an asset is assessed as the cost of a similar asset that could act as a replacement for the asset being valued. This can be calculated by summing all the costs that would be incurred by a market participant creating or purchasing a similar asset in an arm's-length transaction. This analysis would generally take into account any deterioration that has affected physical assets, depreciation in value and other factors that might have altered the value of the asset being valued over time.
The replacement cost method may assume that a replacement is being costed using current (at the valuation date) costs, materials, techniques, etc.
The reproduction cost method
In some circumstances it may be more appropriate to calculate the cost of a replica of the asset being valued, rather than a replacement. This might be true when it is only an exact replica that can result in the same use value of an asset to its owner, or when it is cheaper to replicate an asset than to replace that asset with a current equivalent.
If this is the case, the value of an asset is assessed under this method as the cost of creating an exact replica of the asset being valued, again taking into account any deterioration, depreciation, etc. that may have occurred over time.
Under either method of applying the cost approach, it is important that all relevant costs are taken into account. Although the exact types of cost will differ from asset to asset, they may include direct costs, such as materials and labour, as well as indirect costs, such as delivery, taxes, financing and any third-party profit margins. The general principle is that any cost that would be incurred by a typical market participant in purchasing or creating the asset should be included in the valuation.
It may be that the best indicator of the costs that would be incurred to replace or replicate an asset are the actual costs that were incurred creating that asset itself. For example, consider an early-stage mineral exploration project. A licence is granted to an exploration company by a government, some minimal exploration is conducted and limited knowledge of mineral deposits is obtained. The value of the exploration licence following this initial exploration could be assessed as the sum of the costs of obtaining the licence (licence fees, etc.), the cost of the exploratory activity that was conducted, and the cost of any data interpretation and reporting that took place.
iv Which method is appropriate?
The suitable valuation method or methods to apply to calculate damages will vary from case to case. As discussed above, in many cases the market approach in particular may be useful as a benchmark against which to compare and complement the results of a more detailed DCF analysis. However, in some cases, the market or cost approaches may be a more suitable primary valuation approach.
In an arbitration setting, industry valuation codes can be particularly instructive. For example, in the mining industry, the Australasian Code for the Public Reporting of Technical Assessments and Valuations of Mineral Assets (the VALMIN Code) sets out fundamental principles that represent good professional practice in the valuation of mineral assets in the Australian mining industry.5 Similarly, the Canadian Code for the Valuation of Mineral Properties (the CIMVAL Code) provides guidelines to be followed in the valuation of mineral assets in the Canadian mining industry.6 In the oil and gas industry, the Petroleum Resource Management System (PRMS) sets out relevant valuation methods.7 At a more general level, guidance on valuation approaches and their uses is provided in the International Valuation Standards (IVS) issued by the International Valuation Standards Council.8
At an industry level, the VALMIN and CIMVAL Codes are designed to reflect both domestic and international best practice. They set out the circumstances in which it is appropriate to use specified valuation techniques. The market approach is deemed applicable at all stages of project development. This reflects the fact that transactions for mining assets take place at all stages of project development, meaning that it is likely that relevant market information can be found on which to base a valuation, taking into account comparability issues as discussed above. Under the IVS criteria, this is an appropriate application of the market approach, given that the asset being valued, or similar assets, are often subject to observable transactions.9
In contrast, the cost approach is deemed applicable only in the exploration phase and, in some cases, the pre-development phase (that is, when mineral resources have been identified but no decision to develop those resources has been made).10 Again, under the IVS criteria this is appropriate, as in these early phases an asset is not generating income, and with no reasonable certainty in terms of either timing or scale of future income, the value of such an asset is largely in the replacement or replication of that asset.11
In all cases, the valuation practitioner will be guided by a number of factors. These include the nature of the asset being valued, the amount and quality of data available to aid in this valuation and how similar assets are commonly valued in the market.
1 Christian Jeffery is a principal at Charles River Associates.
2 International Valuation Standards, effective 31 January 2020 (IVS 2020), 30.1.
3 Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan (ICSID Case No. ARB/12/1), paras. 1600–601.
4 See, e.g., Australasian Code for the Public Reporting of Technical Assessments and Valuations of Mineral Assets (VALMIN Code), 2015 Edition, Table 1, p. 29.
5 VALMIN Code, 2015 Edition, p. 3.
6 Canadian Code for the Valuation of Mineral Properties (CIMVAL Code), 2019 Edition, p. 1.
7 Petroleum Resource Management System, June 2018.
8 International Valuation Standards 2020 (IVS 2020).
9 IVS 2020, 20.2-3.
10 VALMIN Code, 2015 Edition, p. 29 and CIMVAL Code, 2019 Edition, p. 16.
11 IVS 2020, 60.2.