Under a cloud

On 3 October 2016, international headlines were filled with the news that Colombian voters had rejected a peace deal with Marxist guerrilla group the Revolutionary Armed Forces of Colombia (FARC) in a shock referendum result. Yet while undoubtedly the result is a blow for investors, for coal mining companies, the referendum result hardly tops the list of concerns. Instead, three pivotal legal decisions have taken place in 2016 that will directly impact coal miners. The rise of environmentalism Coal, like oil, has long been a pillar of the Colombian economy. From 2005, as the security threat from the FARC reduced and as prices for thermal coal rose, investment into Colombia rapidly increased. Changes to the legal and regulatory environment were designed to streamline the licensing process for miners, while tax breaks helped incentivise. From 2006 &ndash; 2010, nearly 9000 mining licences were granted.When prices for commodities, including coal, began to fall in 2012, mining investors across South America began to witness a political shift in perspective around environmentalism. Miners of all sizes were starting to be held to account for pollution, environmental damage and industrial accidents. Recognising the economic cost of environmental damage and its impact on social cohesion, governments in Peru, Brazil, Chile and Colombia all took action against miners through a tightening of the regulatory environment, the imposition of penalties and fines and, in some cases, through the scrapping of controversial foreign investment projects where there had been local opposition. This government commitment to environmentalism continued and gathered pace despite the ongoing fall in commodity prices and despite the risk that environmental reforms and tougher regulatory requirements might impact investor sentiment. All signs pointed to this new-found focus on protecting the environment and the sustainability of operations as a permanent shift in thinking and therefore unlikely to be reversed. In Colombia, a moratorium of licence issuance in 2012 stalled around US$7.3 billion of investment. By 2015, coal miners had been required to make significant investments in order to adjust their day-to-day operational practices, in order to abide by stricter environmental regulations. Those that fell short incurred hefty fines. Then in November 2015, the Samarco tailings dam failure occurred in Brazil. An iron ore tailings dam in Mariana state failed, causing 60 million m3 of iron waste to flood two villages and pollute the nearby Doce River. The mudflow reached the Atlantic Ocean just 17 days later. The incident was labelled by the Brazilian government as the worst environmental disaster in the country&rsquo;s history and immediately saw the spotlight turned onto mining companies and the environmental impact of their operations. An uncertain legal and regulatory landscape Governments across South America are keenly watching the legal case around the Samarco disaster and the Brazilian government&rsquo;s response. Already, insurers in Brazil are now refusing to offer insurance coverage for failure of tailings dams. For South America, the outcome of this case will be a pivotal milestone for the mining sector; precedent will be established around miners&rsquo; liability for environmental damage, questions will be raised around the adequacy of government monitoring of mining operations, and new benchmarks for fines and penalties will be established. In addition to fines of around &pound;92 million imposed on Samarco, there is now separate legal action for &pound;40 billion of damages and 21 executives connected with the case are being personally charged. The outcome will undoubtedly usher in a range of legal and regulatory reforms for the Brazilian mining sector, which will likely be replicated more broadly across the region, including in Colombia. For Colombia, this translates into a continuation of heightened legal and regulatory risks for miners. The push to implement stricter controls around licensing, operational processes, transport of commodities, reclamation of land and structuring a framework for penalties for non-compliance has continued apace. While the Samarco legal case continues, already in 2016, three pivotal decisions have been made by the Colombian Constitutional Court that will have an immediate impact on miners. The first decision of note took place in February 2016. In Colombia, nearly 70% of the population&rsquo;s water supply comes from high altitude moorlands, called &lsquo;paramos.&rsquo; These moorlands are particularly crucial for water supplies for the country&rsquo;s capital city, Bogota. In 2011, new mining operations were banned in the paramos. However, those mining companies with licences dating to before 9 February 2010 were permitted to continue operating until the expiration of those licences under a loophole in the National Development Plan 2014 &ndash; 2018. The decision of the Constitutional Court in February now overturns that decision and, as a result, all mining activity is now banned. Around 347 licences have now been revoked by the ruling. The second decision has far reaching implications for the Colombian mining industry. In late May 2016, the Constitutional Court struck down a provision within the 2001 Mining Code that handed decision-making for permitting exclusively to the federal government and barred local governments (departamentos) from contesting the issuance of licences or creating exclusion zones. This decision was highly controversial, as local authorities were unable to manage the concerns of their constituents and lost political influence to protect their jurisdictions. While in 2014 and 2015 attempts were made to require the federal government to co-operate with local authorities, these rulings still had the balance of power tilted towards the national government. The decision in May effectively means that mayors and their local governments can overrule decisions in Bogota around licensing and which areas can be excluded from the permitting process. The third decision of note occurred in June 2016, with the Constitutional Court revoking a government decree from 2012 that legalised mining operations in the eastern plains, Pacific rainforests and the Amazon. Strongly backed by indigenous groups, the court ruled that, in issuing the decree, the government had ignored the rights of these local communities. Again, this ruling raises the risk of licence cancellation or renegotiation for those miners operating in these regions. Taken together, these decisions indicate firstly, that the legal system in Colombia is tightening and to some extent, mining companies have lost much of their lobbying strength. Secondly, that the political influence of local communities has increased. Just as the direction of the FARC peace agreement has been changed by the public, the three decisions outlined above were made as a result of the people taking legal action to overturn long-standing government policy. Undoubtedly, the fact that over the last few years the system of mining royalty distribution has changed will also have become a determining factor in inspiring mining communities to take action; since 2015, mining regions only receive 20% of royalties directly, but bear the full environmental cost of hosting mining operations. The province of La Guajira, the home of the Cerrej&oacute;n project, has seen its retained mining income fall from 70% to 25%. Finding the opportunities The timing of these decisions is interesting when the outlook for the Colombian coal mining industry is considered. It is estimated that production of coal in Colombia will increase from around 87.2 million t to over 105 million t within the next four years and, theoretically, 2017 should present an opportunity to investors. The price of coal is slowly beginning to rise (at the time of writing, prices for Colombian coal are US$60.95/t, which is roughly on par with prices from late 2014) and demand for Colombian coal is increasing. In 2015, coal exports to Turkey, Colombia&rsquo;s number one export destination for coal, increased 24%. While Colombian coal is of a similar grade to Australia&rsquo;s high-quality coal, in the past, freight rates and voyage times of two months used to work against Colombian shipments. Now, with the expansion of the Panama Canal almost complete, and as freight rates have reduced, buyers in South Korea and Japan have returned to importing significant amounts of Colombian coal. This should represent an opportunity for those miners that are considering Colombia, or for those that want to expand operations. Yet the changing legal and regulatory environment is a barrier. Even in Colombia&rsquo;s two main coal producing departmentos, C&eacute;sar and La Guajira, opposition to large-scale mining is strong and as such, the renewal or issuance of licences will likely be a long and drawn out process. These rulings are indicative of a period of instability that will influence the Colombian investment environment over the next few years. In addition to further court rulings, the fallout from the FARC referendum also has some significance for miners. While many will point to continued security uncertainty, in reality, serious clashes between the government and the FARC are unlikely to resume. Instead, the outcome of the referendum (which failed on a margin of 50.2% against, and 49.8% for) has far-reaching political and economic implications. The result signalled that the government of Juan Manuel Santos has seen its popularity and influence decrease; currently Santos&rsquo; approval rating is hovering around the 38% mark. However, perhaps most crucially, the result of the referendum could delay the passage of the tax reform bill. The reform bill was set to increase tax rates to bolster revenue by almost 1% of GDP &ndash; crucial for offsetting the lost revenue from the energy sector on account of sustained low oil prices. The bill has been seen as pivotal for Colombia to maintain its BBB investment grade rating and a sizeable portion of the proceeds were set to be put aside for anti-poverty programmes. While Santos has a coalition that usually holds congressional majority, there is a block of opposition lawmakers willing to fight the bill and water down its terms. Without passage of the bill, Colombia risks its sovereign credit rating, a further widening of the fiscal deficit and the implementation of broader public spending cuts. The delay to the bill simply represents another layer of uncertainty in an investment environment where already there is overwhelming evidence that the tide is turning against coal miners. Furthermore, there is a presidential election on the horizon in 2018, which will spell further uncertainty. Managing political risk Rapid and inconsistent policymaking and a changing legal and regulatory environment poses considerable risks to coal investors. Shifting rules can mean unanticipated costs that can place immense pressure on operating margins, or costs that immediately hit the balance sheet. However, it is crucial to note that investors can shape the risk environment in which they operate. Non-compliance with environmental laws or a dismissal of corporate social responsibility will inevitably attract the attention of industry regulators and the government. This is particularly the case where a relatively small number of companies dominate the market; in Colombia&rsquo;s case: Cerrej&oacute;n, Prodeco, Drummond and Murray Energy. The best way of managing heightened political risks, such as a rapidly shifting legal and regulatory environment or local community protests, is to find ways to differentiate from the pack. The old rules around corporate social responsibility (CSR) and social licence to operate still apply: transparency, accountability, clarity about the benefits and remedies available to the community and adequate due diligence. Miners in Colombia must now take their CSR commitment to the next level: this is about demonstrating best practice in all facets of the mining operation if expectations of regulators and local authorities are to be managed appropriately. By going further in all aspects of CSR, a mining company will be better placed than its peers should a host government target the industry on account of its conduct &ndash; including workforce reductions. While political risks cannot be entirely neutralised, mining companies that work harder on CSR will reap reputational rewards that may, in the future, pay dividends when confronted with political risks. Finally, for those risks that cannot be entirely mitigated, Political Risk Insurance (PRI) offers an effective safety net against licence cancellation, selective discrimination (such as tax hikes), currency inconvertibility and transfer risks, expropriation, forced abandonment and loss of equity or default of debt as a result of strikes, protest risk, war risks and terrorism, to name just several of the coverable perils. About the author Amy Gibbs is Head of Global Mining at JLT Group. Note This article first appeared in World Coal November. 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Under a cloud

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