Introduction

Damages, valuation, and whether there should be limits on monetary compensation are core questions for investment treaty reform. One key concern about ISDS is that the high damages awarded to claimant corporations may lead to regulatory chill, preventing states from undertaking necessary measures to protect human rights and the environment. Another key concern is that crippling damages may imperil social programs, thereby enforcing austerity and obliging the state to renegotiate contracts to the detriment of public interests. Hence, damages valuation is a key tool for harmonizing investment treaties with human rights and environmental protection. This has been recently emphasized by the Inter-American Court of Human Rights in its Advisory Opinion on Human Rights and the Climate Emergency (para 164).

Concerns of excessive damages in ISDS are well-founded. In one example, the case of Tethyan v Pakistan involves a mineral exploration project in the province of Balochistan. In its decision, the arbitral tribunal awarded almost 6 billion USD for a mining project that had not yet been constructed, i.e., the investment had not yet been made by the investor. In its reasoning, the arbitral tribunal assumed, amongst others, that a mine that did not exist would be in successful operation for 56 years (para 1521). How is this possible? Why is an early-stage investment—an exploration project—compensated as if it were a different thing, i.e., a mine?

At the core of damages inflation lies the use of a valuation method called “discounted cash flow” (DCF, or discounting). This valuation method focuses on the likely income that can be generated in the future by an investment. This method provides an estimate of future cash flows by applying a discount factor that considers the time value of money and risk. For example, if one needs to ascertain the value of an operating factory or an operating mine, one can use past performance to project cash flows into the future and discount them (bring them) to the present. While DCF had traditionally been used for investments that were going concerns, DCF is increasingly being used by arbitral tribunals to value investments that are not going concerns. The use of this technique in these types of early-stage investments has led to inflated claims and exorbitant awards imposing crippling damages.

This article argues that discounting, as it is used in investment treaty arbitration, fails to account for the radical uncertainty inherent in early-stage projects such as mineral exploration. The result? Compensation for assets that don’t yet exist, and awards that defy the principle of full reparation and depart from fair market value (FMV).

Mining Exploration: A lottery-like activity

Mining critical minerals for the energy transition is a long-term project. The content of the investment, the assets that form such investment, and the legal relationship between the state and the investor that enables mining (the mining concession) change over time. As such, mining is a sequential investment. The first stage of a mining project that requires authorization by the state is exploration. At the exploration stage, a mining company is seeking to find out whether there are economically mineable deposits underground. To progress through the mining cycle, the investor must comply with several obligations, secure land rights, obtain licences, and obtain approval of the environmental impact assessment.

Industry experts estimate that only a tiny fraction of exploration projects ever become operational mines. For every 10,000 mineral occurrences identified, only one might reach production. Hence, mining exploration is not only risky but also affected by what economists call Knightian uncertainty: a situation that is so unique that probabilities cannot be reliably calculated. To manage this uncertainty, the mining industry has developed a corporate structure that separates exploration from exploitation. Small, venture-backed firms known as junior mining companies specialize in uncertain exploration. If they succeed, they sell the information they have accumulated to larger firms that handle construction and extraction. Most juniors fail, and that’s part of the model. Juniors may fail to find mineable deposits either because these are not found or because even if they are found, their exploitation cannot be brought forward due to “modifying factors,” which include human rights and environmental considerations. In other words, under domestic law, exploitation cannot take place at any cost.

Exploration is inherently uncertain, a lottery-like activity. It is a process to turn Knightian uncertainty into knowable probability about what may lie underground and how to extract it. However, at the exploration stage—even if it is quite advanced—there is no mine. Hence, the existence of an operating mine remains affected by Knightian uncertainty. The next section assesses how to compensate an investor whose rights are breached during the exploration stage.

The Problem With Discounting

Several investment treaties refer to FMV as the standard of valuation for lawful expropriation. In case of unlawful expropriation or other breaches of investment agreements, treaties tend to remain silent. In these cases, the principle of full reparation, established in the Chorzów case and in the Articles on State Responsibility, has been applied in practice. In both cases, investment tribunals aim to ascertain the FMV of the investment and, to do so, they routinely apply DCF. The theory behind the use of DCF in investment arbitration goes as follows: following the decision in Phillips Petroleum v Iran (para 112), arbitral tribunals consider that because corporations use DCF in their daily operations (para 348), DCF can be used to indicate the FMV of an investment. However, to ascertain value, one must focus on the purpose of such valuation technique. Discounting enables corporations to make choices in an uncertain world. But does it reflect FMV? Is it compatible with the principle of full reparation? The answer is no in both cases.

The purpose of valuation in the context of an investor’s daily operations is different from the purpose of valuation in an arbitration process. What is relevant for the financial analyst or investor is not calculating a single value (price equilibrium, in neoclassical terms), but rather projecting many alternatives and having the freedom to choose among their own estimations. Hence, discounting is a technique to deal with uncertain contexts and decide on a course of action. Even though investors take into account DCF calculations, they do not base their decisions solely on this, and, accordingly, the price they pay does not only reflect the DCF calculation used for the decision. When investors invest, they may do so in light of DCF, but also in consideration of heuristics, biases, beliefs, narratives, and institutions. Accordingly, the market, i.e., the market price, reflects heuristics and biases. In addition, discounting introduces investors’ concerns through the discounting rate, which is typically the cost of capital. An investor making a choice would be careful to calculate an adequate discounting rate, so when they choose between different courses of action, they have an appropriate benchmark to make this choice. Investors are conservative when they apply DCF in such scenarios. This is not the case in a one-shot arbitration. Unlike in their daily operations, the investor has no incentives to provide a high discount rate that would diminish the value of the investment. Moreover, in daily operations, corporate structures provide accountability mechanisms to tame excessively adventurous or optimistic estimates. Such accountability is not present in ISDS. Hence, DCF does not strictly align with market value, especially at the early stage of mining investments, which are affected by radical uncertainty.

Secondly, the use of discounting departs from the principle of full reparation. The principle of full reparation aims to restore the investor to the situation that would have existed if the unlawful act had not occurred. Discounting, as it has been explained above, is a technique to make choices. To do so, discounting treats uncertainty as risk. Discounting deals with uncertainty by introducing probabilities based on historic measurements. In projects with a history of profitability, risk (probability) can be calculated. However, in early-stage projects that are not a going concern, the sheer existence of the investment is affected by Knightian uncertainty, and as explained above, what characterizes Knightian uncertainty is that probabilities cannot be calculated. Rewarding an investor who has not yet invested with the profits of such future investment would leave the investor better off: it would turn the uncertain, certain. It would not return the investor to the situation that existed if the unlawful act had not occurred. Hence, the distinction between risk and radical uncertainty matters, and they cannot be conflated.

This argument is observable in investment treaty cases: when arbitral tribunals pay due regard to uncertainty, they apply more sensible valuation methods. This is the case, for example, of Bear Creek v Peru, where the tribunal rejected DCF and awarded compensation based on sunk costs, recognizing that the project faced fundamental uncertainties due to the lack of environmental and social licences and strong community opposition. In cases of advanced exploration projects, arbitral tribunals took as a reference for compensation the amount of observable arm’s length transactions. To the contrary, when uncertainty is dismissed and misconstrued as a mere risk, arbitral tribunals have applied DCF to value early-stage investments, leading to crippling damages. We already mentioned the ICSID tribunal that awarded nearly USD 6 billion to Tethyan Copper Company for Pakistan’s denial of a mining licence in the Reko Diq region. The project was still in the exploration phase. It had not secured environmental approvals, land access, or construction permits, yet the tribunal treated the project as if it were a fully operational mine, projecting 56 years of profits using DCF. It assumed that all regulatory hurdles would be cleared, that mineral prices would remain stable, and that infrastructure—including a 700 km pipeline—would be built in a conflict-prone region. The result was an award that dwarfed the actual investment. Years later, construction has yet to begin, and one of the project’s partners, Antofagasta, exited the venture for a fraction of the award amount. As of today, the project is owned by Barrick (50%) and Pakistani stakeholders (50%), but Barrick is still seeking funding to begin mine construction.

Policy Recommendations

Moving forward, states must acknowledge that the way DCF is used in investment treaty arbitration does not reflect FMV, and its use does not follow the compensation rules established under international law or investment agreements. To allow for flexibility to deal with uncertainty when calculating damages, future investment treaties should be reformed. The following criteria may guide such reform:

1. If early-stage investments are to be valued through FMV, the baseline to calculate such value must be provided by sunk costs and observable arm’s length transactions involving the investment.
2. Secondly, investment treaties must preclude the possibility of using DCF for early-stage investments, as discounting cannot address Knightian uncertainty and therefore leads to overcompensation.
3. Thirdly, investment treaties must proscribe crippling damages.

Reform of investment treaty clauses regarding compensation will not be enough. In the case of Tethyan, the relevant investment treaty provided that in case of expropriation, compensation should be awarded with reference to the FMV of the investment. However, the treaty acknowledged that FMV is not always readily ascertainable. In such cases, the treaty provided that “the compensation shall be determined in accordance with generally recognised principles of valuation and equitable principles taking into account the capital invested, depreciation, capital already repatriated, replacement value, and other relevant factors.” Despite the clear drafting of the treaty, which enabled a tribunal to reach an equitable solution considering the absence of an observable market value, the arbitral tribunal, inspired by blind-sided neoclassical assumptions on economic value, took the path of overcompensation. Hence, rethinking arbitral appointment and the composition of arbitral tribunals is also necessary.

Conclusion

As the world transitions to cleaner energy, mining will play a central role. But that doesn’t mean that every exploration project that goes sideways deserves billion-dollar compensation. Valuation in ISDS must accurately reflect the real risks and uncertainties associated with mining, rather than rewarding speculation. By taking uncertainty seriously, tribunals can uphold international law, protect public budgets, and ensure that investment arbitration serves, not undermines, the public interest. Policy-makers and negotiators must pay special attention to the clauses in the treaty referring to compensation. Both in cases of lawful expropriation and unlawful expropriation or other breaches of investment agreements, investment treaties should exclude the use of DCF for calculating the value of early-stage investments, such as a mining exploration project.

Author

Clara López is a Lecturer in law at King’s College London, Deputy Director of the Centre for Climate Law & Governance.