ISDS regime could choke climate action in emerging economies, experts say

Global Trade Review | 21 February 2024
By Jenny Messenger

ISDS regime could choke climate action in emerging economies, experts say

The investor-state dispute settlement (ISDS) system could be putting climate action at risk in emerging and developing economies as investors in fossil fuel projects angle for compensation, experts say.

Intended to avoid interstate disputes and give foreign investors protection in countries with more exposure to political risk, the ISDS arbitration system is embedded in international investment agreements and enables states to be sued if they take actions that affect investments.

But states adopting tougher environmental and climate measures such as refusing oil and gas exploration or mining permits – set to increase in the coming decades as the world transitions away from fossil fuels – has prompted a spike in climate-related ISDS cases.

According to the United Nations Conference on Trade and Development (UNCTAD), 12 ISDS cases linked to protecting the environment were started before 2000, 37 between 2000 and 2010, and 126 between 2011 and 2021.

Arbitration is often costly, and although most ISDS cases have so far been decided in favour of the state, investors have been awarded billions in compensation, leaving emerging economies particularly vulnerable to large payouts that could potentially cripple them financially.

UNCTAD data shows that out of all the concluded original arbitration proceedings, 37% have been decided in favour of the state, with 28% in favour of the investor.

A report published earlier this month by the Columbia Center on Sustainable Development and commissioned by Friends of the Earth claims Mozambique in particular is at risk of a further surge in ISDS cases due to its burgeoning liquefied natural gas (LNG) market.

The report argues that international investment agreements with companies such as TotalEnergies and ENI for LNG are exposing the country to an estimated US$29bn of financial risk – equal to “almost a decade of Mozambique’s government expenditures on poverty, health, and education”.

“Mozambique’s gamble on fossil fuel-based economic growth comes with significant economic risks and crowds out investments in the country’s enormous renewable energy potential,” the report says, with the country “already struggling to afford the costs of damage caused by flooding, droughts and cyclones linked to climate change”.

The report adds that because Mozambique is not likely to benefit financially from its LNG projects until the late 2030s, it may miss out on profits due to falling global demand for gas.

“Fossil fuel companies have been repeated players of the ISDS system. Big oil companies have specialised departments that deal with arbitration only, and they know the system through and through,” Josef Ostřanský, policy advisor at the International Institute for Sustainable Development (IISD), tells GTR.

“For fossil fuel assets that become stranded, they are likely to resort to investment treaties, to at the very least attempt to postpone the regulation pending disputes,” he says.

In July last year, David R. Boyd, United Nations special rapporteur on human rights and the environment, released a paper claiming that the ISDS system posed a “daunting obstacle” to climate action and risked encouraging so-called “regulatory chill”, with states backing away from ambitious policies.

And in a 2022 paper, researchers from Boston University and Queen’s University in Ontario found that efforts to limit the supply of fossil fuels could lead to US$340bn in legal claims from oil and gas investors.

Reform attempts

In response to criticisms of the ISDS regime, an UNCITRAL working group has been discussing a number of reforms to the ISDS system since it was set up in 2017.

So far it has agreed on a limited number of changes, but is likely to set up an advisory council for dispute resolution that aims to remove potential conflicts of interest among arbitration lawyers with links to investors.

Other areas for reform include the calculation of damages and compensation, rules for third-party funders, which provide financial support to investors, and termination of international investment agreements.

Ostřanský says the high value of damages and compensation is the most pressing problem.

“Sometimes the methods that are used to calculate compensations tend to be speculative, and they award exorbitant amounts of damages based on discounted cash flow methods that calculate the lost profits for, let’s say, 30 to 40 years into the future, for projects with little to no record of profitability and for which future profitability is far from certain,” Ostřanský says.

“This sometimes leads to awards to the tune of billions of US dollars.”

In 2019, Pakistan’s government was ordered to pay Tethyan Copper US$6bn in damages by the International Centre for Settlement of Investment Disputes after a provincial government refused to grant a lease for a copper and gold mine.

And although export credit agencies are not directly addressed in the working group’s efforts to reform the ISDS, Ostřanský says “discussions about reform of the international investment regime should take home state measures into account”.

“Home states’ agencies have an important role in supporting certain types of investment – they can support sustainable and climate-aligned investments and discourage unsustainable investments,” he says, adding that “international cooperation between states on support mechanisms that encourage sustainable investment can be improved”.