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Investment Treaty Arbitration and Climate Change

This section was last reviewed in June 2024.
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Introduction
Climate change has created a dynamic environment that necessitates a careful interpretation of treaty standards in line with international climate commitments. Investment treaty arbitration plays an increasingly important role in disputes over policies aimed at mitigating climate change. As governments implement climate change mitigation measures, such as the phasing-out of fossil fuels, investors in affected industries may claim that such measures violate treaty protections. With new generation investment treaties demonstrating clearer commitment to environmental issues, the balance between investor rights and environmental protection becomes a salient issue.
Investment treaty arbitration provides the framework for adjudicating these issues. States actively negotiate bilateral investment treaties (BIT), multilateral investment treaties, trade and investment partnerships (TIPs), and free trade agreements to promote foreign direct investment. In these treaties, States may undertake to (i) provide fair and equitable treatment of investments, (ii) guarantee against the expropriation of investments, and (iii) not act in an arbitrary or discriminatory manner towards foreign investors.
- Climate change mitigation measures have provoked claims from investors, particularly in the fossil fuel industry, who allege that such measures violate the fair and equitable treatment (FET) clause and protection against expropriation.
- The Energy Charter Treaty (ECT), a significant multilateral energy agreement, has been used by fossil fuel companies to challenge phase-out policies, despite its potential to support renewable energy investments. This has led to numerous legal disputes and criticisms.
- Investment tribunals face challenges in adjudicating climate-related disputes, especially on issues regarding the FET clause and legitimate expectations of investors. Cases have demonstrated diverging approaches on States’ liability, which calls for clarification and refinements through progressive case law developments.
- New generation investment treaties are incorporating explicit environmental provisions to align with climate commitments, which includes prohibitions on lowering environmental standards and requirements for environmental impact assessments.
- There is a growing emphasis on holding investors accountable for environmental damage through State-asserted counterclaims. New generation investment treaties are addressing these obligations, potentially increasing successful environmental counterclaims despite existing jurisdictional challenges.
How Climate Change is Impacting Investment Treaty Arbitration
Climate-Related Treaty Disputes
Measures taken to mitigate climate change may continue to incite claims from investors in industries that are affected by phase-out policies, in particular the fossil fuel industry.[1] Such disputes usually concern (i) the alteration of domestic legislation to prevent further environmental damage, (ii) the introduction of environmental impact assessments (EIAs), and (iii) a sudden transition to renewable technology causing the amending or curbing of pre-existing fossil fuel subsidies. When discussing investment treaty disputes in the context of climate change, it is useful to first distinguish between “first generation” and “new generation” investment treaties. “First generation” investment treaties are commonly characterised by having broad and open-textured standards, which includes the obligation to afford “fair and equitable treatment” (FET) to investments and the protection against expropriation.[2] By contrast, “new generation” investment treaties demonstrate clear commitment to sustainable energy transition by containing express provisions that recognise the right to regulate for climate change and implement climate action treaties.[3]
The issue is that many of the disputed investment treaties are “first generation” treaties before environmental issues entered international investment law considerations.[4] The implementation of phase-out policies may, therefore, breach the FET clause and protection against expropriation that are contained in such treaties. One contentious example is the Energy Charter Treaty (ECT), which has formed the basis for several claims brought forward by fossil fuel companies through the Investor-State Dispute Settlement (ISDS) mechanism. The ECT is the multilateral agreement for energy cooperation and security under international law.[5] With the view to maintaining the competitiveness and openness of energy markets, the ECT covers four areas, namely (1) the protection of foreign investments based on the investor protection provisions, (2) non-discrimination in the trading of energy materials, (3) dispute resolution, and (4) energy efficiency. There are currently over 40 signatory States to the ECT, which makes it the world’s largest existing agreement that provides investment protection and access to the ISDS mechanism.
It should be noted that the ECT is energy agnostic. The ECT is a neutral instrument that protects electrical energy investments irrespective of the technology used to produce the energy.[6] Article 19 of the ECT obligates the signatory States to strive to minimise the harmful environmental impacts that arise from their energy operation in an economically efficient manner. On one hand, some critics consider that the ECT has the potential to protect new investments which are critical to energy transition.[7] The special protection afforded by the ECT could strengthen investors’ confidence to channel funding into renewables energy projects, considering that high-risk, emerging technologies and the need to reallocate private capital may materially affect investment decisions. On the other hand, investors have taken advantage of the ECT to challenge phase-out policies. Research shows that the fossil fuel industry is the most litigious industry in the ISDS system,[8] and the average award is estimated to amount to $600 billion. Some prominent examples of treaty disputes include the claims brought by Uniper[9] and RWE[10] against the Netherlands, in which the German energy companies challenged that the Dutch Prohibition of Coal in Electricity Production Act violates investors’ rights under the ECT. Another instance was Kruck v Spain,[11] in which the investors alleged that Spain had induced foreign investment in renewable energy sources and made regulatory changes that fundamentally altered the framework. The investors claimed that the changes to Spain’s incentives regime had violated their legitimate expectations under the Article 10(1) of the ECT and sought compensation.
How investment tribunals adjudicate these treaty disputes is coming under increasingly intense scrutiny, and the issues could be mainly distilled into three topics.[12] First, the extent to which investors may legitimately invoke the FET clause to challenge phase-out policies, or other similar climate change mitigation measures. There is no single standard to determining a breach of the FET clause.[13] For a given conduct to constitute a breach, it may have to fall within the list of conduct specified in the relevant treaty language (arbitrary treatment, discrimination, loss of stability or full protection and security), or be subject to the investor legitimate expectation test. Critics have observed a trend that refuses treating the FET clause as comprising a strict obligation of regulatory stability, and a growing focus on the protection of legitimate expectations.[14] This inevitably entails more debates surrounding the circumstances in which an expectation arises, more specifically the reasonableness of the expectation that a regulatory regime would not change, in light of the state of knowledge of climate change and the development of net zero obligations.[15] The series of claims brought against Spain for changing its renewable energy framework demonstrate the lack of consensus on the appropriate approach. While some tribunals found that Spain’s general legislation created legitimate expectations that the relevant tariffs or premiums would remain the same,[16] other tribunals found that it created limited,[17] if not, no expectations.[18]
Nevertheless, as tribunals seek to refine the legitimate expectation test, it is possible to derive some common threads from recent case law developments.[19] Where the State has made specific commitments to the particular investor in the context of a particular industry, the tribunal is more likely to find legitimate expectations.[20] The more drastic the alteration of the State’s regulatory framework, the more likely the tribunal would find legitimate expectations.[21] The tribunal may consider the proportionality of the alteration to the State’s objectives, while accounting for the surrounding economic and social context.[22] Simultaneously, the tribunal may attach weight to whether the investor has exercised due diligence in line with the industry practices and expectations.[23]
Second, whether a State that adapts its policies to mitigate climate change is necessarily liable for acting contrary to the investors’ legitimate expectations. Cases have suggested that failure to satisfy the legitimate expectation test may not automatically entail a breach of the FET clause. For example, in Saluka v Czech Republic,[24] the tribunal dealt with the questions of (1) whether legitimate expectations had arisen and (2) whether the frustration of such expectations was justified separately. The view that there are competing opinions as to whether the frustration of investors’ legitimate expectations necessarily amounts to a treaty breach was similarly shared by Professor Zachary Douglas KC in his dissenting opinion of Kruck v Spain.[25]
Third, the extent to which a State may rely on the police powers doctrine in instances where the investors allege expropriation. Cases of expropriation may involve either direct or indirect State conduct. The police powers doctrine provides that a State possesses an inherent right to regulate in protection of the public interest. Applying the doctrine to the context of climate change, a State does not act wrongfully when it implements climate mitigation measures, provided it enacts bona fide, non-discriminatory, and proportionate regulations in accordance with due process. Nevertheless, the application of the police powers doctrine in practice has not been straightforward. In Rockhopper v Italy,[26] the tribunal ruled in the investor’s favour after the Italian authorities denied a production permit for an offshore oilfield. While the tribunal stressed that the decision is not intended to restrain Italy’s sovereign power to regulate, and that the decision merely enforces Italy’s obligations under the ECT, the decision leaves open unresolved issues regarding how expropriation claims would be handled against the backdrop of climate change mitigation.
Climate-Related Treaty Provisions
Incorporating environmental considerations in the drafting of investment treaties is likely to be an increasingly common practice. Generally, climate-related treaty provisions may take the form of prohibiting the lowering of environmental standards to attract investments, excluding certain investments from the scope of treaties for environmental reasons, and mandating investors to carry out a full environmental impact assessment on any investment.[27]
As discussed above, the ECT has been used by fossil fuel investors to challenge phase-out policies, which makes a case for arguing that the ECT is no longer fit for purpose. Another criticism to the ECT is that it contributes to the “regulatory chill” upon a State’s right to regulate in relation to its domestic and international environmental commitments. The risks of costly arbitration and lengthy proceedings have undermined efforts by States to achieve net zero within the committed timeframe.[28] There have been attempts in the past to modernise the ECT to allow greater deference to the States’ right to regulate for environmental protection, especially where a “legitimate public policy objective [such as] the protection of the environment, including climate change mitigation and adaptation, protection of public health, safety or public morals” are concerned.[29] Among the proposed methods of reform was to align the ECT with the Paris Agreement through a flexibility mechanism that allows signatory States to exclude protection for fossil fuels in their territories. Following failed reform attempts and the continued misalignment between the ECT and net zero, the EU, Euratom, Germany, France, Spain, Portugal, the Netherlands, Luxembourg, Denmark, Poland, Slovenia, Ireland, and the United Kingdom have announced their departure from the ECT.[30]
However, there remains a strong appetite to introduce reforms and address the legacy arbitration claims under the ECT. In June 2024, 26 EU Member States clarified the common understanding that the ECT and its ISDS mechanism does not apply within the EU.[31] The agreement is to prevent fossil fuel investors from taking advantage of the survival clause to hinder climate change mitigation, a clause that confers the legal privilege to sue States for a period of 20 years even after their withdrawal from the ECT. Earlier in March 2024, the Organisation for Economic Co-operation and Development (OECD) proposed a carveout of climate change measures in ISDS as a central reform to align investment treaties with the Paris Agreement.[32] One of the suggested treaty provisions is that “no claim may be brought under Article X in respect of a climate change measure”. The idea is to exclude climate change measures that are defined as “related to reducing or stabilising greenhouse gas emissions” from the scope of ISDS. It was also proposed that the carveout would be accompanied by a two-tiered mechanism that allows States facing an ISDS claim to request a joint decision by environmental authorities, and that the carveout could either be retroactively fitted in existing investment treaties or inserted through renegotiations. If implemented effectively, the proposed carveout may protect climate mitigation measures from the threat of ISDS claims.[33]
Enforcement of Investor Obligations
Investors’ ability to pursue claims through the ISDS mechanism demonstrates its asymmetrical nature, such that it only confers protection to investors. Critics have noted that the salience of climate change mitigation may drive States to rebalance their relationships with investors by pursuing counterclaims for environmental damage.[34] Pursuant to Article 46 of the International Centre for Settlement of Investment Disputes (ICSID) Convention, the ICSID Arbitration Rules, and the UNCITRAL Arbitration Rules, respondents may be able to pursue counterclaims, provided that there is jurisdiction to consider such claims. Recent arbitration cases, notably in the mining industry, show the States asserting counterclaims in relation to the environment against investors. In Burlington v Ecuador[35] and Perenco v Ecuador,[36] the tribunal found that Ecuador was entitled to compensation for the costs of addressing environmental damage. Nevertheless, instances where State-asserted counterclaims were successful remain rare due to jurisdictional challenges, and it should be noted that jurisdictional issues were not brought to light in those two cases.[37] In Paushok v Mongolia, the State’s attempt to bring a counterclaim for an alleged breach of the investors’ “environmental obligations towards Mongolia” was dismissed because the tribunal held that the counterclaims did not demonstrate a sufficiently close connection with the investor’s claim. In Saluka v Czech Republic,[38] the tribunal found that the Czech Republic’s counterclaim did not satisfy the requirement for a “close connexion” with the primary claim, and therefore there was no jurisdiction.
However, there are prospects for State-asserted counterclaims to increase under the new generation bilateral investment treaties. States are actively engaged in negotiations and drafting treaties that address counterclaims, while simultaneously acknowledging the States’ right to regulate in the public interest. For instance, Article 18 of the Morocco-Nigeria BIT requires investors to maintain a post-establishment environmental management system and obliges them to not operate investments in a manner that disregards the environmental and social obligations of the State. It remains to be seen whether such provisions would help State-asserted counterclaims meet the jurisdictional test, and whether more environmental counterclaims would lead to successful recovery of damages.[39]
How can Investment Treaties help Drive Net Zero Transition?
Incorporating Carveout Provisions for States to meet their Climate Commitments
As discussed above, there are continuing efforts to align investment treaties with net zero by inserting carveout provisions. Carveouts render climate change mitigation measures immune to challenges through the ISDS mechanism. One key advantage of carveouts is that they are considered at the outset of any dispute, which pre-emptively avoids the need to evaluate the merits of the claims brought by investors, thus contributing to the expeditious resolution of disputes.[40] It is proposed that States may take a targeted approach to carveouts by adopting a purpose-based framework and complementing it with specific sectoral-based applications.[41] In this way, there would be systematic phasing-out of investments in emission-intensive industries.
Strengthening Incentives for Green Investments
Considering that phasing-out and scaling-up are both facets to the net zero transition, investment treaties are likely to be increasingly important in mobilising sustainable investment activities. States could facilitate liberalisation and market access to sustainable investments through removing restrictions in investment treaties (for example, the limitation on foreign shareholding in green technologies firms), though some contend that investment treaties may not have a significant impact in this respect.[42] Other avenues include providing investors with incentives in exchange for investors’ compliance with the performance requirements.[43] Such incentives could take the forms of tax incentives, financial incentives (direct grants and cost-sharing schemes, lending instruments and guarantees, land and infrastructure incentives, research and development incentives), regulatory incentives (exemption from certain laws, special privileges, stabilisation clause), and technical and business support incentives (readily accessible information).[44] More significantly, investment treaties could further create platforms for international cooperation on collective action problems that concern sustainable investment incentivisation.
[1] Lukas Schaugg, Suzy H. Nikièma, and Nathalie Bernasconi-Osterwalder, ‘Investor–State Dispute Settlement and Fossil Fuels: What role for a carveout?’ (International Institute for Sustainable Development, 8 March 2024). link.
[2] Alison Macdonald KC, Peter Webster, and Mubarak Waseem, ‘Climate Change, International Investment Law, and Arbitration’ (Essex Court Chambers, 7 March 2023). link.
[3] ‘Trends in the Investment Treaty Regime and a Reform Toolbox for the Energy Transition’ (UN Trade and Development, August 2023) 11
[4] Jorge E. Viñuales, ‘Foreign Investment and the Environment in International Law: An Ambiguous Relationship’, (2009) 80(1) British Yearbook of International Law, 244
[5] ‘The Energy Charter Treaty’ (International Energy Charter, 18 February 2019). link.
[6] ‘Is the ECT an Obstacle to Energy Transition?’ (Arbitration Journal, 10 September 2021). link.
[7] Guillermo García-Perrote and Ella Wisniewski, ‘Inside Arbitration: The ECT Exodus – Politics and Unintended Consequences’ (Herbert Smith Freehills, 15 March 2023. link.
[8] Lea Di Salvatore, ‘Investor-State Disputes in the Fossil Fuel Industry’ (International Institute for Sustainable Development, December 2021) 8
[9] ICSID Case No. ARB/21/22
[10] ICSID Case No. ARB/21/4
[11] ICSID Case No. ARB/15/23
[12] Alison Macdonald KC (n 2)
[13] ‘Fair and Equitable Treatment’ (UNCTAD Series on Issues in International Investment Agreements II, 2012) 8
[14] Alison Macdonald KC (n 2)
[15] ibid
[16] Cube Infrastructure Fund SICAV and others v Kingdom of Spain, ICSID Case No. ARB/15/20; 9REN Holding S.a.r.l v Kingdom of Spain, ICSID Case No. ARB/15/15
[17] Infracapital Fl S.a.r.l and Infracapital Solar B.V. v Spain, ICSID ARB/16/18; RREEF Infrastructure (G.P.) Limited and RREEF Pan-European Infrastructure Two Lux sarl v Spain, ICSID Case No. ARB/13/30
[18] Charanne Construction v Spain, SCC Case No. 062/2012; NextEra Energy Spain Holdings B.V. and NextEra Energy Global Holdings B.V. v Spain, ICSID Case No. ARB/14/11
[19] Elodie Dulac and Jia Lin Hoe, ‘Substantive Protections: Fairness’ (Global Arbitration Review, 21 December 2023). link.
[20] Total S.A. v Argentine Republic, ICSID Case No. ARB/04/01
[21] Toto v Lebanon, ICSID Case No. ARB/07/12
[22] Blusun S.A., Jean-Pierre Lecorcier and Michael Stein v Italian Republic, ICSID Case No. ARB/14/3
[23] Perenco Ecuador Ltd. v Republic of Ecuador and Empresa Estatal Petróleos del Ecuador (Petroecuador), ICSID Case No. ARB/08/6
[24] PCA Case No. 01/04
[25] Professor Zachary Douglas KC, ‘Partial Dissenting Opinion of Zachary Douglas’ (14 September 2022). link. para. [49]
[26] ICSID Case No. ARB/17/14
[27] Charles E. Harris, Rachel O’Grady, Kwadwo Sarkodie, and Oliver Williams, ‘Climate Change and Investment Treaty Arbitration’ (Mayer Brown, 6 January 2022). link.
[28] Elizabeth Meager, ‘COP26 Targets Pushed Back under Threat of being Sued’ (Capital Monitor, 14 January 2022). link.
[29] ‘Finalisation of the Negotiations on the Modernisation of the Energy Charter Treaty’ (Brussels, Energy Charter Secretariat, 24 June 2022)
[30] ‘UK departs Energy Charter Treaty’ (Department for Energy Security and Net Zero, 22 February 2024). link.
[31] ‘New Agreement Marks First Step in Addressing Energy Charter Treaty Legacy’ (International Institute for Sustainable Development, 27 June 2024). link.
[32] Joshua Paine and Elizabeth Sheargold, ‘Carving-out climate action from investor–State dispute settlement (ISDS): Suggested treaty language and commentary’ (OECD 9th Annual Conference on Investment Treaties, 11 March 2024)
[33] Schaugg (n 1)
[34] Ted Gleason, ‘Examining host-State counterclaims for environmental damage in investor-State dispute settlement from human rights and transnational public policy perspectives’ (2021) International Environmental Agreements 427, 440
[35] ICSID Case No. ARB/08/5
[36] ICSID Case No. ARB/08/6
[37] Gleason (n 34)
[38] (n 24)
[39] Yasmine Lahlou and Rainbow Willard, ‘The Rise of Environmental Counterclaims in Mining Arbitration’ (Global Arbitration Review, 9 June 2021). link.
[40] ‘Overcoming International Investment Agreements as a Barrier to Climate Action: A Toolkit to Safeguard Fossil Fuel Measures from Investment Treaty Claims’ (Center for International Environmental Law) 12
[41] Ibid.
[42] Josef Ostřanský and Jonathan Bonnitcha, ‘Rethinking Investment Treaties’ (International Institute for Sustainable Development, May 2024). link.
[43] Nathalie Bernasconi-Osterwalder, Aaron Cosbey, Lise Johnson, and Damon Vis-Dunbar, ‘Investment Treaties & Why they Matter to Sustainable Development’ (International Institute for Sustainable Development, 2012). link.
[44] ‘Investment Incentives: A survey of policies and approaches for sustainable development’ (Columbia Center on Sustainable Investment, October 2022). link.