The arbitration game

The Economist | 9 October 2014

The arbitration game

Governments are souring on treaties to protect foreign investors

IF YOU wanted to convince the public that international trade agreements are a way to let multinational companies get rich at the expense of ordinary people, this is what you would do: give foreign firms a special right to apply to a secretive tribunal of highly paid corporate lawyers for compensation whenever a government passes a law to, say, discourage smoking, protect the environment or prevent a nuclear catastrophe. Yet that is precisely what thousands of trade and investment treaties over the past half century have done, through a process known as “investor-state dispute settlement”, or ISDS.

ISDS first appeared in a bilateral trade agreement between Germany and Pakistan in 1959. The intention was to encourage foreign investment by protecting investors from discrimination or expropriation. But the implementation of this laudable idea has been disastrous. It has become so controversial that it threatens to scupper trade deals the European Union is negotiating with both America and Canada.

Multinationals have exploited woolly definitions of expropriation to claim compensation for changes in government policy that happen to have harmed their business. Following the Fukushima disaster in Japan in 2011, for instance, the German government decided to shut down its nuclear power industry. Soon after, Vattenfall, a Swedish utility that operates two nuclear plants in Germany, demanded compensation of €3.7 billion ($4.7 billion), under the ISDS clause of a treaty on energy investments.

This claim is still in arbitration. And it is just one of a growing number of such cases (see chart). In 2012 a record 59 were started; last year 56 were. The highest award so far is some $2.3 billion to Occidental, an oil company, against the government of Ecuador, over its (apparently lawful) termination of an oil-concession contract.

There are several reasons for the sharp rise in contentious arbitrations, says Lori Wallach of Public Citizen, a watchdog group. Companies have learnt how to exploit ISDS clauses, even going as far as buying firms in jurisdictions where they apply simply to gain access to them. Arbitrators are paid $600-700 an hour, giving them little incentive to dismiss cases out of hand; the secretive nature of the arbitration process and the lack of any requirement to consider precedent allows plenty of scope for creative adjudications.

At the same time, academics have begun to question whether ISDS delivers the benefits it is supposed to, in the form of increased foreign investment. Foreign investors can protect themselves against egregious governmental abuse by purchasing political-risk insurance, points out Terra Lawson-Remer, an economist at the Brookings Institution. Brazil continues to receive lots of foreign investment, despite its long-standing refusal to sign any treaty with an ISDS mechanism.

Other countries are beginning to follow Brazil’s lead: South Africa says it will withdraw from treaties with ISDS clauses and India is considering doing the same. Indonesia plans to let such treaties lapse when they come up for renewal. Australia briefly forswore ISDS in the wake of a complaint by Philip Morris about its requirements for health warnings on cigarette packets. But its new government says it will consider allowing such mechanisms in future treaties.

Disgruntled investors in these places will have to take their chances in local courts. But there are other, less radical routes to reform. Recent treaties have used far more precise definitions of expropriation. Other possible improvements include requiring firms to exhaust domestic legal remedies before an arbitration can begin and making arbitration more transparent, with greater reliance on precedent.

So far, the country showing least interest in moving away from the current practice is America. Jeffrey Schott of the Peterson Institute, a think-tank, reckons that America’s insistence on an arbitration clause in its deal with the EU does not stem from any concern about the strength of property rights in Europe. Rather, it is a marker for future negotiations for a bilateral trade deal with China. “America wants to set a precedent for China by creating a world-class template for trade agreements,” he says. Even so, given Barack Obama’s reputation for bashing business, his administration’s steadfast support for a special privilege that many multinationals have abused is odd.

source: Economist