On the Spotlight: Investor-State Dispute Settlement Mechanisms and Climate Transition

By Alejandra Guraieb

The latest IPCC Report highlights a crucial obstacle to global climate transition: investor-state dispute settlement. “Despite improvements in the international governance of energy,” the report notes that “a great deal of this is still concerned with promoting further development of fossil fuels. One aspect of this is the development of international legal norms. Many bilateral and multilateral agreements, including the 1994 Energy Charter Treaty, include provisions for using a system of investor-state dispute settlement (ISDS) designed to protect the interests of investors in energy projects from national policies that could lead their assets to be stranded.”[1] 

In this brief, I explain the importance of the issue, identify major challenges and recent developments, and discuss ways to move towards investor-state dispute settlement mechanisms more suited to the urgent needs of global climate transition.

Alternative dispute resolution and the energy transition

Alternative dispute resolution (ADR) refers to processes that help disagreeing parties reach an agreement without litigation. Some commonly used methods are mediation, conciliation and arbitration, that seek to enable parties to find solutions outside of traditional court proceedings, in a confidential, rapid and flexible way.[2] The use of an ADR method is voluntary and has to be previously agreed to by the parties involved.

In the energy sector, ADR such as arbitration is frequently used to solve investor-State disputes (ISDS). Foreign investors are often reluctant to end up in a domestic Court in the event of a dispute. It is not unreasonable for them to believe that domestic Courts might be biased in favor of the host State, especially in countries with high impunity, weak separation of powers and State-owned energy companies. While the use of ADR has promoted inflow of foreign investment in energy, its use in investor-State energy related disputes represents a major obstacle to climate transition.

Imagine that in 2014 a foreign private investor signed an agreement with a government to build a coal-fired power plant in the country. As with all agreements, both parties -the State and the investor- need to comply with their contractual obligations in good faith (the principle of pacta sunt servanda). However, in a couple of years the country ratifies the Paris Climate Agreement. The government is now in a challenging position on enforcing net-zero policies. Early termination of the coal-fired power plant contract would trigger disputes with the investors and likely lead to arbitration. The resulting arbitration award could be costly for the country, involving huge compensation to the power plant investors.

This example illustrates the challenges that countries face in ensuring protection to investors in the energy sector while at the same time having to take strong policies to reduce and ultimately eliminate all forms of fossil fuel. It is therefore critical to find ways to mitigate such challenges.

The Energy Charter Treaty

The most frequently invoked investment agreement is the Energy Charter Treaty (ECT).[3] Signed in December 1994, it entered into legal force in April 1998. Currently it has 53 parties, including the EU. One of the goals of the ECT is “to promote and protect foreign investment in member countries” against political risks, such as discrimination, expropriation, and breach of investment contracts.[4] The ECT covers all types of energy materials and products, and the provisions on investment protection apply to fossil fuels, as well as all renewable energy sources.[5] The ECT sets forth options for the settlement of disputes arising from investments and issues covered by the treaty, such options comprise courts or administrative tribunals of the host State, a previously agreed dispute settlement procedure, or international arbitration or conciliation.[6]

There are currently at least two pending cases of arbitration under the ECT due to fossil fuels phase out measures implemented by a host State.[7] They are the energy companies RWE and Uniper against the Netherlands, both due to coal phase-out measures. Per media outlets, RWE is asking for 1.4 billion Euros as compensation, and Uniper 1 billion euros.[8] It is reasonable to conclude that such type of cases will become frequent under the ECT, as well as under other multilateral and bilateral investment treaties, as countries get serious with their climate goals. The two cases against the Netherlands could well be serving as a warning to other governments of the risks of enacting ambitious climate policies to reshape the energy sector.

The ECT, hence, represents a major obstacle to ambitious climate action by countries. However, it is also relevant to acknowledge that per the ECT Secretariat most of the treaty’s dispute settlement cases have actually concerned renewable energy sources.[9] This is not to say that the ECT is a “green” treaty, but it has to be recognized that the ECT has played a role in providing legal certainty to renewable energy investments too.

Modernization of the ECT

Why don’t the parties to the ECT withdraw from it, or push for an amendment to make the agreement more conducive to climate goals? The tasks are not that simple. Even if a party withdraws, the ECT contains a “sunset clause” by which the provisions of the ECT continue to apply to investments made in a country for a period of 20 years from the withdrawal date.[10] An amendment to the ECT to make it “sustainable”, requires consensus of parties, which is challenging to achieve.[11]

Since 2019 the ECT is under a modernization process, especially pushed for by the EU.[12] “Pro-environment EU parliamentarians have stated that the ECT would protect €2.15 trillion in investments in fossil fuels by 2050 if those fossil fuels are not phased out of the ECT’s scope of protection.”[13]  The EU is aiming at a revision that would “reform the ECT’s investor–state dispute resolution mechanisms and explicitly allow countries to take regulatory actions affecting existing investments [the right to regulate], for reasons such as environmental protection or climate action. The overarching objective is to ensure that the ECT is modernised in a way that would avoid the EU and its Member States deciding to withdraw from the ECT on either a coordinated or a unilateral basis.”[14] The Twelfth Negotiation Round on the Modernization of the ECT took place from 19-22 April, 2022. Progress is slow.

ECT and the European Court of Justice

In parallel to the modernization process of the ECT, a highly relevant development has occurred at the European Court of Justice (ECJ). On September 2, 2021, the ECJ issued the judgement of the case Republic of Moldova v. Komstroy LLC[15] where the Court finds that “Art. 26(2)(c) ECT [international arbitration or conciliation] must be interpreted as not being applicable to disputes between a Member State and an investor of another Member State concerning an investment made by the latter in the first Member State”.[16] The reasoning is that it “is necessary to constrain disputes under the ECT to the EU judicial system as the bulwark for the autonomy of EU law”.[17] Even though the referred decision does not allude expressly to climate or environment, it is reasonable to conclude that the Court was at least conscious of the current ECT architecture being an obstacle to the EU member States “right to regulate” for the energy transition and the achievement of the European Green Deal.

In practical terms, the EU is still a party to the ECT, and arbitration cases are expected to continue. However, the ECJ decision will have an impact as “parties seeking relief under the ECT will inevitably face difficulties in disputes connected to the EU. It seems quite likely that Member States will invoke the underlying reasoning of the ECJ to seek annulment of any award rendered by ad hoc tribunals seated in the EU…”. ^[18] The ECJ decision, thus, represents notable progress on the climate front. On the other hand, the decision of the ECJ might serve as an example for countries outside the EU to apply similar “protectionist” criteria to the enforcement of arbitration awards within their jurisdictions (in matters well beyond climate).

A comprehensive approach

Investor-state dispute settlement mechanisms urgently need to be made compatible with the goals of global climate transition. Per the IPCC, without a strengthening of policies beyond those that are implemented by the end of 2020, the world is headed towards an alarming median global warming of 3.2 °C by 2100.^[19]

The current time is a unique opportunity for investor-state arbitration to be climate-enlightened. To achieve this, we need a comprehensive approach, one that reconciles international investment law with international environmental law. Investor-state dispute settlement must adapt and take serious consideration of international environmental law. In the case of the ECT, even if its general environmental provisions are weak, the treaty provides for arbitration tribunals to “decide investor claims in accordance with applicable rules and principles of international law.”[20] Last year, the right to a clean, healthy and sustainable environment was finally recognized by the UN Human Rights Council,[21] which makes a stronger case for the due consideration of international environmental law by arbitrators and arbitration tribunals.

Dispute settlement organizations[22] and arbitrators have a golden opportunity to prove that arbitration can be climate-enlightened and that arbitrators do consider all applicable rules and principles of international law (especially international environmental law). Moreover, dispute settlement organizations and arbitrators have a new watchdog: environmental organizations. Environmental groups are already referring to arbitration mechanisms as “secretive tribunals”[23]; so, it is crucial that dispute settlement organizations improve their transparency. Another practical step that dispute settlement organizations could take is to mandate international climate law courses to arbitrators. Having climate-literate arbitrators would strengthen the credibility of the arbitration process in our current times.

The modernization process of the ECT should continue, but at an accelerated pace and with greater attention to becoming transparent. While the ECT is outdated, it can be adapted to current needs. An express inclusion of the right to regulate on environmental and climate matters is essential, not only on the ECT but in other investment treaties. Since consensus is required to amend the ECT, it is time to start pushing for it.

In the meantime, solutions to deactivate the sunset clause need to be urgently explored as science has made it clear that fossil fuels must stay underground now. The application of the doctrine of Rebus Sic Stantibus could potentially provide States with a way out of the sunset clause. The concept of rebus sic stantibus stipulates that “where there has been a fundamental change of circumstances, a party may withdraw from or terminate the treaty in question.”[24] In the case of the ECT, parties could potentially argue that withdrawal should be effective immediately as both the current state of the climate crisis and the new obligations under international climate law represent a fundamental change of circumstances (compared to 1994 when the ECT was signed).

Given the urgency to undertake global climate action, multiple pathways towards solutions need to be pursued, and the time is now.

*Alejandra Guraieb is Research Assistant at the European Chair for Sustainable Development and Climate Transition at Sciences Po, Paris. She holds a Bachelor of Laws from Universidad Iberoamericana, Mexico City, where she graduated Summa Cum Laude. In Mexico, she worked as an Environmental and Energy Associate at a renowned Firm where she advised energy companies throughout the development of their renewable energy projects in the country. She is a graduate of PSIA’s Master’s in Environmental Policy.

Views expressed in this publication reflect the opinion of the individual author and not those of Sciences Po.

* Important update since the publication of this brief. The Energy Charter Conference at its Ad Hoc Meeting held on 24 June 2022 approved a Public Communication explaining the main changes contained in the agreement in principle on the modernisation of the ECT. The draft text will be adopted by the Energy Charter Conference on 22 November 2022. Thereafter, the modernised ECT will enter into force 90 days after the ratification by three-fourths of the Contracting Parties. Communication available here: https://www.energycharter.org/fileadmin/DocumentsMedia/CCDECS/2022/CCDEC202210.pdf

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[1] IPCC. 2022. Climate Change 2022 Mitigation of Climate Change. Chapter 14, p. 81. https://report.ipcc.ch/ar6wg3/pdf/IPCC_AR6_WGIII_FinalDraft_FullReport.pdf

[2] https://www.law.cornell.edu/wex/alternative_dispute_resolution

[3] https://www.lexology.com/library/detail.aspx?g=9722773c-c1b1-4acd-bc09-d0437f49f49e

[4] https://www.energycharter.org/what-we-do/investment/overview/

[5] https://www.energycharter.org/process/frequently-asked-questions/

[6] Article 26 of the ECT https://www.energycharter.org/fileadmin/DocumentsMedia/Legal/ECTC-en.pdf  

[7] List of ECT dispute settlement cases, accessed April 25, 2022, see cases 139 and 141 https://www.energychartertreaty.org/fileadmin/DocumentsMedia/Statistics/Chart_ECT_cases_-_1_December_2021.pdf  Note that per the following source RWE and Uniper have also started court proceedings, and the Netherlands has “initiated two anti-arbitration injunctions (one against RWE and one against Uniper) before the German courts to block the ICSID arbitrations to proceed”: http://arbitrationblog.kluwerarbitration.com/2021/08/24/the-netherlands-coal-phase-out-and-the-resulting-rwe-and-uniper-icsid-arbitrations/

[8] https://www.dw.com/en/energy-charter-treaty-ect-coal-fossil-fuels-climate-environment-uniper-rwe/a-57221166

[9]https://www.energycharter.org/fileadmin/DocumentsMedia/News/Statistics_Cases_under_the_Energy_Charter_Treaty_as_of_1_June_2020.pdf   and https://www.energychartertreaty.org/fileadmin/DocumentsMedia/Statistics/Chart_ECT_cases_-_1_December_2021.pdf  E.g. the cases against Spain for changes to the renewable energy framework.

[10] See article 47 of the ECT https://www.energycharter.org/fileadmin/DocumentsMedia/Legal/ECTC-en.pdf This is the case of Italy, who withdrew in 2016.  “Under the ECT’s sunset clause, investors continue to be able to bring ECT-based claims in relation to investments made in Italy prior to that date up till 2036.” https://www.cms-lawnow.com/ealerts/2020/12/is-the-sun-setting-on-the-energy-charter-treaty-an-update-on-the-modernisation-process  https://www.energycharter.org/who-we-are/members-observers/countries/italy/

[11] See article 36 of the ECT https://www.energycharter.org/fileadmin/DocumentsMedia/Legal/ECTC-en.pdf 

[12] https://www.energycharter.org/who-we-are/subsidiary-bodies/modernisation-group/

[13] https://www.cms-lawnow.com/ealerts/2020/12/is-the-sun-setting-on-the-energy-charter-treaty-an-update-on-the-modernisation-process

[14] https://www.europarl.europa.eu/RegData/etudes/ATAG/2022/729379/EPRS_ATA(2022)729379_EN.pdf

[15] For a background of the case, access: http://blogs2.law.columbia.edu/aria/lights-out-for-the-energy-charter-treaty-the-ecjs-next-blow-to-intra-eu-treaty-arbitration/ Full decision available here: https://curia.europa.eu/juris/document/document.jsf?text=&docid=245528&pageIndex=0&doclang=en&mode=lst&dir=&occ=first&part=1&cid=635097

[16] http://blogs2.law.columbia.edu/aria/lights-out-for-the-energy-charter-treaty-the-ecjs-next-blow-to-intra-eu-treaty-arbitration/

[17] Following the reasoning of the landmark Achmea decision of 2018. http://blogs2.law.columbia.edu/aria/lights-out-for-the-energy-charter-treaty-the-ecjs-next-blow-to-intra-eu-treaty-arbitration/

[18] http://blogs2.law.columbia.edu/aria/lights-out-for-the-energy-charter-treaty-the-ecjs-next-blow-to-intra-eu-treaty-arbitration/#_ftnref3

[19] IPCC. 2022. Climate Change 2022 Mitigation of Climate Change. Summary for Policymakers. Available : https://report.ipcc.ch/ar6wg3/pdf/IPCC_AR6_WGIII_SummaryForPolicymakers.pdf

[20] Article 26 (c) of the ECT

[21] https://news.un.org/en/story/2021/10/1102582

[22] Of the dispute settlement cases under the ECT, “Of all cases, 77 have been brought before The International Centre for Settlement of Investment Disputes (ICSID), 24 before the Stockholm Chamber of Commerce (SCC), 10 before ad hoc arbitration tribunals under the Arbitration Rules of the United Nations Commission on International Trade Law (UNCITRAL) tribunals and 10 before the Permanent Court of Arbitration (PCA) (applying UNCITRAL rules).” https://www.energycharter.org/media/news/article/the-energy-charter-treaty-ect-remains-the-most-frequently-invoked-iia/

[23] https://www.theguardian.com/environment/2021/nov/03/secretive-court-system-poses-threat-to-climate-deal-says-whistleblower

[24] https://www.britannica.com/topic/international-law/International-law-and-municipal-law#ref794926