Enron dabhol case study analysis

Case Study: International Business Negotiations

1. Why do you think the results of the first negotiation were so skewed in favor of Enron?

2. In the second round, Enron appears to have traded off equity ownership for increased capacity. Its reduction in tariff of 1 cent per KwH appears to have been absorbed by the larger production quotas and the use of lower-priced naphtha fuel. Why was Enron willing to make this trade-off? Why did the state of Maharashtra get more for its willingness to allow Enron to restart the project?

3. What can be learned from the first two rounds of the Dabhol power project negotiations about engaging in big foreign direct investment projects that are highly visible on the world economic scene?

4. How did GE and Bechtel’s filing for arbitration move the dispute along?

5. What is the difference between GE’s deal versus Bechtel’s deal? Both had the same amount of equity in the DPP, so why was Bechtel able to get $15 million more?

6. What general principles can you come up with for foreign direct investors using interests, rights, and power to protect their investments in developing countries?

7. What general principles can you come up with for governments negotiating with foreign direct investors?

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IG APPENDIX 7.2.1 THE CHECKERED NEGOTIATION HISTORY OF THE DABHOL POWER

PROJECT (STUDENT VERSION)

Dylan Dias and Sashi Pemmansani (Used with permission of the authors)

This case reviews the on-again, off-again history of negotiations surrounding the development, opening, shutting down, and ultimate restarting of the Dabhol Power Plant (DPP) project in the state of Maharashtra, India. The case chronicles and studies relevant events from 1992 to summer 2005. The four main parties were the Maharashtra state government of India, which alternated under the direction of the Congress Party and the BJP/Shiv-Sena party coalition; the Enron Development Corporation (Enron), which became defunct in 2001; Enron successors GE and Bechtel; and the central government of India. A lesser role was played by Indian and foreign debt holders. Interestingly, although one would expect the World Bank to be a player in a large infrastructure project like this, it was not, because the bank refused to invest in the original project. The case illustrates the challenges and surprises when a foreign investor works with state and national governments whose motivations are very different from those of private enterprise and who are vulnerable to changing political opinion. CHRONOLOGY OF EVENTS

• Early 1992: The Indian government passes a series of

reform acts that allow for a broad restructuring of the Indian energy sector. The path is cleared for significant foreign investment in India’s energy infrastructure.

• May–June 1992: Enron and the Indian government begin discussions about Enron’s developing a power project in the state of Maharashtra.

• June 1992–May 1993: A first round of negotiations takes place between Enron and the state of Maharashtra.

• December 1993: A binding agreement about the DPP project is signed between Enron and the state of Maharashtra.

• March 1995: Maharashtra state elections are held. The Congress Party loses control of the state government to the BJP/Shiv-Sena, a coalition of two nationalist political parties that had run on a platform of “Throw Enron into the Arabian Sea.”

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• August 1995: Now controlled by the BJP/Shiv-Sena coalition, the Maharashtra state government cancels the Dabhol plant project.

• November–December 1995: A second round of negotiations begins as Enron and the state of Maharashtra reopen discussion of the future of the project.

• February 1996: A new agreement is reached. • 1999: The first phase of the project is completed.

Dabhol is generating power. • May 2001: The Maharashtra state government, the sole

buyer of power, deems DPP’s power too expensive. The Dabhol plant is shut down.

• May 2004: A third round of negotiations undertakes to reopen the Dabhol plant. On one side are GE and Bechtel (now the major U.S. interests in DPC). Other parties are the Maharashtra state government, the government of India, and Indian and foreign financial institutions.

• July 2005: GE and Bechtel settle with the Maharashtra state government, the government of India, and Indian financial institutions (which had already settled with the foreign financial institutions).

• May 2006: The power plant reopens.

Next, we analyze the three rounds of negotiation. THE ROUND ONE NEGOTIATIONS This section explores the initial (1992–1993) negotiations for the agreement between Enron and the state of Maharashtra. The Parties and Their Interests The Government of India. The government of India initiated economic liberalization in 1992. (Until that time India had a heavily regulated economy with much state ownership and little foreign investment. For example, Coca Cola had pulled out of India in response to the 1973 Foreign Exchange Regulation Act that required foreign investors to dilute their shareholdings to 40 percent.) The Indian government’s interests in a deal with Enron were varied. First, it was concerned about meeting the growing power needs of India, particularly in a rapidly industrializing state such as Maharashtra. But in addition, the Indian government wanted to use the Dabhol project to showcase the liberalization of the Indian economy to foreign investment. A successful project with Enron had the potential to ease the reluctance of foreign direct investment in India, which had risen from years of a closed economy and negative experiences such as the Coca-Cola withdrawal.

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The State of Maharashtra. The Maharashtra state government was particularly interested in gaining a reliable power source to facilitate growth and development. Bombay, now Mumbai, is the largest city in Maharashtra state. (See the map in Exhibit 7.2.1.) Other considerations should have been the price of power and the environmental impact of the power plant, although it is not clear these issues received major attention during the negotiation.

Exhibit 7.2.1. India and Maharashtra State

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Enron and Rebecca Mark. In 1994 Enron was a diversified provider of services in the natural gas industry. In its 1995 annual report Enron stated its vision “to become the world’s leading energy company—creating innovative and efficient energy solutions for growing economies and a better environment worldwide.” Under the direction of CEO Kenneth Lay, the company had grown rapidly both in size and reputation. In the years 1996 to 2001 it was named by Fortune as one of America’s most innovative companies. The Dabhol project had the potential to bring Enron international recognition as a pioneer in energy development projects in developing countries and to advance the career of thirty-eight-year-old Rebecca Mark, CEO of Enron International. Enron’s international projects carried a particular structure to maximize return on investment and minimize risk. These international projects were “project financed,” which means that they were guaranteed by long- term contracts for sales with pricing agreed upon in advance. In addition, Enron insisted on sovereign guarantees, meaning that if the buyer of power—in this case Maharashtra state—failed to pay, Enron theoretically could seize state assets. Enron’s projects were tied to the U.S. dollar; the host government or an outside agency was responsible for currency conversion. Political risk was mitigated by commercial political risk insurance providers.1 Interestingly, Rebecca Mark’s preferred strategy for Enron was a traditional and capital-intensive approach, which involved buying or building “big iron”: the generating facilities, pipeline networks, and distribution companies that form the backbone of the global energy system. In contrast, her competition for leadership of Enron, Jeffrey Skilling, advocated and carried out a different strategic approach: that Enron should own an asset only for as long as it took to learn the secrets of a given business and that it must be willing to sell the asset if a better opportunity for the money arose. (Mark lost the strategic struggle with Skilling and left Enron in 1998. She moved on to head up Enron’s foray into the water business, Azurix, but left that struggling company, too, in 2000.)2 The Negotiations Between June 10 and 20, 1992, a group of Enron officials met first with officials from the government of India and then with officials of the state of Maharashtra and signed a nonbinding memorandum of understanding to build the Dabhol Power Plant. Enron submitted a detailed application to the governments on August 29, 1992, envisioning a $3.1 billion project to generate 2,550 megawatts of electricity

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fueled by liquefied natural gas to go online in December 1995. On December 12, 1992, the Maharashtra government informed Enron that the project would have to be scaled down and split into two phases, with the first phase fueled by naphtha and the second by liquefied natural gas. Enron agreed. On February 3, 1993, the government of Maharashtra state notified Enron that its project had been approved and that the government would apply for financing. The World Bank rejected the financing request in April 1993, saying that the project was not economically viable. Nevertheless, the government of Maharashtra state gave final clearance. In early December 1993 it signed a twenty-year power- purchasing agreement with the company formed to operate the plant, the Dabhol Power Corporation (DPC). Elements of the First Agreement Among other things, the agreement covered return on equity, volume of power to be purchased, payment, dispute resolution, and “educational payments.” Return on equity was a major Enron concern. Enron’s initial proposal called for a 26.52 percent ROE. When this was rejected by Maharashtra’s finance secretary, Rebecca Mark suggested that the company’s standard ROE for other projects in the developing world was 30 percent. The finance secretary countered that the standard ROE of other power projects in India was 16 percent. Mark threatened to pack up and go home. The ultimate agreement was for an ROE of 25.22 percent.3 Regarding volume of power, the state government agreed to purchase all the power produced by Dabhol whether or not there was demand and whether or not there was cheaper available power. Regarding payment, the Maharashtra and Indian governments waived sovereign immunity in providing counter-guarantees in the event of failure to pay. This meant that in theory, Enron could seize state assets if the state government failed to pay for the power it had contracted for. Dispute resolution language shielded Enron from Indian jurisdiction: all disputes were to be settled under English laws through international arbitration. As part of the agreement Enron paid “educational gifts” totaling $20 million. Critics consider these payments to have been bribes to clear the project.4 The Aftermath of Round One

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In March 1995, Maharashtra state elections were held, and the BJP/Shiv-Sena coalition took over state government from the Congress Party. BJP and Shiv-Sena are nationalistic political parties and, as noted in the chronology, their political platform was one of resistance to the leading national party’s (the Congress Party’s) path of opening India to foreign investment. For example, soon after coming to power the new state government changed the official name of Bombay, its largest city, to its local equivalent, Mumbai. In August 1995, the BJP/Shiv-Sena government canceled the Dabhol project. Enron responded by filing for arbitration in London, claiming $300 million in damages. THE ROUND TWO NEGOTIATIONS Enron’s first problem was getting the Maharashtra state government back to the negotiating table. According to Sanjay Bhatnager, the managing director of the Dabhol Power Company, “We worked round the clock after the cancellation, both directly and through friends, to convince press, industry commentators, and every level of the new state government of the facts of the case.”5 After two months of public relations action, a meeting between Kenneth Lay, Rebecca Mark, and Chief Minister Joshi resulted in a promise to review the project and reopen negotiations. This time on the Maharashtra side of the negotiation was a committee of experts, not politicians, and their focus was on the economics of the deal, not the politics. Elements of the Second Agreement According to the Harvard case the agreement (January or February 1996) changed the following six points of the initial agreement:

• Capacity: Phase I capacity increase from 695 MW to 826 MW.

• Power Tariff: Phase I tariff reduction by one cent per kilowatt hour. This tariff to last until Phase II was operational instead of the twenty years in the original agreement.

• Capital Costs: Reduction from $2.85 billion to $2.5 billion with clearance for both phases. The initial agreement only provided clearance for Phase I.

• Ownership: Enron to transfer 15 percent of its ownership equity stake to MSEB (Maharashtra State Electricity Board).

• Fuel: In Phase I, the fuel for electrical power production to be naphtha, rather than a previously agreed upon distillate oil.

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Three points apparently did not change: the MSEB’s guarantee to buy 90 percent of the power produced by Dabhol; the state and central government’s counter- guarantees in case of payment failure; and the use of liquefied natural gas as fuel for the plant in Phase II. The Aftermath of Round Two In 1998 Enron’s financing plan for Phase II, totaling $1.87 billion and including over forty lenders, won international praise as one of the best international project-financing deals ever put together,6 but Ms. Mark left Enron. In 1999 the Phase I Dabhol Power Plant began producing power. However, the Maharashtra government quickly determined that Dabhol’s power was too expensive and refused to buy more. The plant was shut down in May 2001. In the fall of 2001 Enron went into bankruptcy and essentially ceased to exist as a corporate entity. In April 2004 GE and Bechtel, 10 percent equity owners from the beginning of the project, bought Enron’s 65.5 percent share from the bankruptcy court for about $20 million. THE ROUND THREE NEGOTIATIONS The Parties and Their Interests GE. One of the world’s largest and most respected companies, GE was increasing its investments in India. It expected revenue from India to increase from $.8 billion in 2004 to $3.0 billion in 2008.7 GE was looking for opportunities in India. Bechtel. One of the world’s premier engineering, construction, and project management companies, Bechtel was looking for a legal settlement in which their rights were upheld and they were compensated fairly for the shuttering of the Dabhol plant. Government of Maharashtra State. This state had become one of India’s most vibrant economic engines, with its capital, Mumbai, considered to be the financial capital of India. Rapid industrialization without matching infrastructure development had resulted in severe electricity shortages that threatened the state’s economy. Government of India. Well aware that China was hogging the limelight as a destination for foreign investment, the government was actively working to promote India as an equally attractive destination. The Dabhol fiasco was a major stumbling block to promoting the image of India as a reliable investment destination. The government also

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realized that it needed to have good relations with companies such as GE to gain access to technology and capital to realize infrastructure development. Indian Financial Institutions. The four primary Indian financial institutions reportedly had claims to as much as Rs 9,000 crores (one crore equals ten million) as principal and Rs 2,500 crores as interest. (In 2006 one Indian rupee was worth about $.02. Thus, one crore is about $200,000, so the principal claim was for about $1.8 billion.) These financial institutions wanted to see a return on their investment. Foreign Financial Institutions. The consortium of foreign institutions included the U.S.-government-backed Overseas Private Insurance Corporation (OPIC) and a set of overseas lenders including Citibank and Bank of America. OPIC’s claims were for Rs 965.9 crore, about $190 million. The other banks’ claims were Rs 1,012 crore, about $202 million. The Round Three Negotiations The following exhibits offer an analysis of the parties’ interests, rights, and power as well as their BATNAs and reservation prices.

Round 3 Dabhol Power Plant Negotiations: Parties’ Interests, Rights, and Power

Parties Power Interests Rights General Electric

Continue to block the

operation of the DPC

Recover fair value for its

dues and assets Retain

ability for future

business in India

Legal claimants (right to

sue GovtM/GovtI)

Bechtel Continue to block the

operation of the DPC

Recover fair value for its

dues and assets

Legal claimants (right to

sue GovtM/GovtI)

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Governments of India

(GovtM/GovtI)

Expropriation of assets Default on

debt/accounts payable

Continue to block

purchase of power from

DPC

Get power at a reasonable cost per unit

Save face Maintain

international reputation Maintain

Indo-United States

relations Ensure the

future of FDI Political survival

Legal rights

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Round 3 Dabhol Power Plant Negotiations: Parties’ BATNAs and Reservation Prices

Parties BATNAs Reservation Price General Electric

Arbitration Fair value minus cost of litigation minus percentage

of opportunity cost of blocked funds minus

percentage of present value of future business potential

gains due to settlement Bechtel Arbitration Fair value minus cost of

litigation minus percentage of opportunity cost of

blocked funds Governments

in Maharashtra and India

(GovtM/GovtI)

Power from other states or projects

Fair value plus cost of litigation plus percentage of

present value of loss of economic output plus

percentage of loss of FDI interest in India

The first challenge was getting the parties to the negotiating table. Several factors brought this about. In May 2004, GE and Bechtel filed for arbitration in London claiming Rs 26,000 crore, or about $6.2 billion, which helped bring the government of India to the negotiation table. Also, there were power outages in Mumbai and power cuts of up to eight hours per day in industrial cities such as Pune, Nasik, and Aurangabad. There also were riots in some cities protesting power cuts.8 In January 2005, the Indian lenders agreed in principle to buying the foreign lenders out of the foreign portion of the debt; that transaction was completed in July 2005. Also in July, GE and Bechtel settled with the two Indian governments and the Indian lenders. As part of that settlement GE and Bechtel withdrew their arbitration case. On the surface it appears that Bechtel got a better financial deal than GE. GE took $145 million to settle the claims relating to Dabhol.9 Bechtel was a bigger hurdle, and it finally settled for $160 million. [The case writers point out that the negotiations with Bechtel were more acrimonious than those with GE. At one point the Maharashtra government filed lawsuits against Bechtel alleging Bechtel responsibility for groundwater pollution around the Dabhol Plant.] In addition to the money, GE got a contract for consulting services to the new company

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running Dabhol and for supply of equipment to the company (GE makes turbines). In return GE agreed to reinvest the $145 million in future projects in India. Clearly GE had long-term interests in India. DISCUSSION QUESTIONS 1. Why do you think the results of the first negotiation

were so skewed in favor of Enron? 2. In the second round, Enron appears to have traded off

equity ownership for increased capacity. Its reduction in tariff of 1 cent per KwH appears to have been absorbed by the larger production quotas and the use of lower-priced naphtha fuel. Why was Enron willing to make this trade-off? Why did the state of Maharashtra get more for its willingness to allow Enron to restart the project?

3. What can be learned from the first two rounds of the

Dabhol power project negotiations about engaging in big foreign direct investment projects that are highly visible on the world economic scene?

4. How did GE and Bechtel’s filing for arbitration move the

dispute along? 5. What is the difference between GE’s deal versus

Bechtel’s deal? Both had the same amount of equity in the DPP, so why was Bechtel able to get $15 million more?

6. What general principles can you come up with for foreign

direct investors using interests, rights, and power to protect their investments in developing countries?

7. What general principles can you come up with for

governments negotiating with foreign direct investors? NOTES 1. Harvard Business School (HBS) Case 9-596-099: 3. 2. R. Smith and A. Lucchetti, “Rebecca Mark’s Exit Leaves

Azurix Treading Deep Water,” Wall Street Journal, August 28, 2000, p. A.1.

3. HBS Case 596-099. 4. T. Allison, “Enron’s Eight-Year Power Struggle in

India,” Asia Times Online. January 18, 2001, available at www.atimes.com/reports/CA13Ai01.html.

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5. HBS Case 9-596-101. 6. Allison, “Enron’s Eight-Year Power Struggle in India.” 7. In 2001 when the plant was shut down, GE and Bechtel

each held 10 percent of the equity. In 2004, a U.S. bankruptcy court awarded these companies 65.5 percent of Enron’s equity in the project. The two companies consequently held 85.5 percent share of the DPC.

8. “Is Dabhol to Blame for Maharashtra’s Woes?,” Rediff.com, May 19, 2005, available at http://inhome.rediff.com/money/2005/may/19dpc.htm.

9. GE to Invest DPC Proceeds in India, November 10, 2005, available at http://inhome.rediff.com/money/2005/nov/10dpc1.htm.