Freezing government policy: Stabilization clauses in investment contracts


To a significant extent the site of debate about the terms of globalization and its relationship to the regulatory state has shifted from the World Trade Organization to the world of investment treaties and arbitration. Investment treaties typically confer on a foreign investor a right to sue a host state that has allegedly failed to comply with a number of substantive obligations, typical among them the requirement to compensate for expropriation, fair and equitable treatment, and national treatment.

Critics of investment law have argued that investment treaties are unduly biased towards the interests of investors, and that, particularly through interpretation by pro-investor arbitrators, the expropriation and fair and equitable treatment provisions of these treaties have resulted in the requirement to compensate investors even for publically-interested regulatory change, including environmental and social regulations. Those who defend the arrangements in question argue that, in fact, in most instances where investors have received compensation, governments have acted out of regulatory opportunism, luring the investor into the country with promises of a stable and favorable regulatory framework, only to alter that framework to the investor’s disadvantage, or threaten to do so in order force renegotiation of the terms and conditions of the investment, after the investment is established.

As an alternative, or in addition, to an investment treaty, investors and host states can bargain contractually over the allocation of regulatory risk. In particular, they can include stabilization clauses in host government contracts, which commit governments to not alter regulatory frameworks in a way that undermines the economic viability of the investment. Moreover, they can make such contracts enforceable through international arbitration, thus avoiding dependence on the domestic court system in the host country.

Despite the enormous amount of controversy over BITs and their effects on regulatory autonomy, there has been very little attention to stabilization clauses. Yet such clauses are used extensively, particularly in the case of investments in extractive industries, infrastructure and the energy sector.   

Stabilization clauses and regulatory chill

The most sustained examination of stabilization clauses is in a 2008 study spearheaded by John Ruggie and the International Financial Corporation (IFC) of the World Bank.[1]  The Ruggie/IFC report mostly understands the problem of stabilization as a tradeoff between the need of developing countries for capital, which leads to a willingness to make such commitments to investors, and the policy autonomy that such governments would prefer in order to implement the social and environmental and other regulatory measures that respond to the needs of their citizens over time. The study surmises that, with strengthened negotiating skill and capacity, a better informed citizenry and pressure on multinational corporations to behave with social and environmental responsibility, developing country governments will be able to achieve “fairer” or more balanced stabilization clauses, which protect essential policy space, while addressing the key concerns of investors with respect to stability. The Ruggie/IFC report points to the much more balanced and nuanced nature of stabilization clauses in investment contracts to which OECD member countries are parties, suggesting that governments with sophisticated negotiating capacity are able to come to terms with investors while avoiding blanket “freezing” or “full equilibrium” clauses, which constrain policy space over a broad, or unlimited, range of regulatory fields. However, the variance between OECD countries and developing countries, particularly in sub-Saharan Africa, could be explained by the greater political and regulatory uncertainty in these countries; investors feel they are much less able to predict what kind of future regulatory and political changes may occur that may affect the value of the initial bargain with the state.

Generally speaking, it is not efficient to compensate private actors for regulatory change, a point extensively argued in Louis Kaplow’s classic article “Legal Analysis of Economic Transitions.”[2] In this study, Kaplow examines most of the rationales for compensation that relate to market and government failure and concludes that there is little likelihood, on balance, that government will do better than the market in efficiently allocating the risk of regulatory change.

If we begin from the default position that compensation for regulatory change is not efficient, then our preliminary conceptualization of a stabilization clause will be that it confers a benefit or rent on the firm. Either this rent reflects capture or it has a legitimate public policy rationale in that it affects the behavior of the firm in a manner that accomplishes a legitimate goal of the government. This goal is generally understood, for example in pro-stabilization documents of the World Bank, as the attraction of foreign capital that has a positive role in the country’s development strategy. That begs the question of why stabilization is desirable over larger subsidies to the investor, for example. A tentative answer is that investors show an inclination for such clauses.

Shareholders do not typically directly bargain with states when investment contracts are negotiated. Instead, managers and lawyers bargain with bureaucrats or the legal counsel they hire, who represent the political principals. The standard advice is that a stabilization clause should be demanded as a condition of an investment contract. The IFC/Ruggie study, which interviewed a wide range of managers and lawyers involved in investment contract negotiations, confirmed that demanding such clauses is assumed to be in the interests of shareholders.  Evaluation of regulatory risk in the host country by managers and lawyers is often difficult and expensive. Writing into contracts more refined allocations of regulatory risk (environment, labor laws, health, zoning, taxation etc.) between the investor and the host state, as is suggested by the IFC/Ruggie study, may simply be regarded by the managers and lawyers as too costly. This is especially the case in a state where there are multiple levels of regulatory authority that can affect the operations and revenues of the investment.

“Obsolescing bargain” theory holds that, over time, the bargaining power of the government increases relative to that of the investor. This is because of the hostage effect: having substantial sunk costs, the investor cannot easily walk away from the project if the state seeks to renegotiate the contract to its advantage, for example demanding a higher share of the returns from the project. In the case of a private contractual party, this kind of threat is mitigated by the fact that if the investor refuses to renegotiate it can always seek to enforce the terms of the contract in the courts, or in international arbitration. However, the state has an option not available to a private party, namely that it can unilaterally extract a greater share of returns through regulatory action.  The most obvious case, often discussed in the literature, and observed in practice, is changing the fiscal regime so as to impose a higher tax on the returns of the investor.

The IFC/Ruggie report makes the point that this kind of concern with regulatory opportunism, as opposed to mere regulatory uncertainty, could be addressed by very limited stabilization clauses, of the kind that trigger regulatory compensation only for discriminatory or arbitrary regulatory actions; these would appear to overlap substantially with obligations in BITs, with respect to national treatment and fair and equitable treatment, both of which embody non-discrimination norms. While it may seem implausible that a state would change generally applicable regulation in order to single out a particular investment and extract rents from it, the situation becomes complicated when there is only one investor in the sector, or all investors are foreign investors with comparable contracts. It may be further exacerbated where there is weakly developed rule of law and administrative procedure, such that targeted discriminatory action can be hard to distinguish from generally applicable legislative or regulatory action

If, in the absence of a stabilization clause, the government can adjust the bargain export or force renegotiation ex post, then it has a means to address information asymmetries. In general, anything that constrains the possibility of correcting for information asymmetries through renegotiation exacerbates transaction costs. The firm has less incentive to withhold relevant information at the time of the bargain, or misrepresent its capacities, knowing that, if it does so, the government has the unilateral option to react by changing the regulatory framework or forcing renegotiation through threatening to do so. In this sense, the transaction costs of contracting could be considered to be higher in the presence of a stabilization clause.

Stabilization clauses also create moral hazard on the part of the firm. Knowing it is insulated against regulatory changes the firm may decide not to take precautions against the occurrence of events that, because of their social costs, may predictably trigger regulatory responses that are costly to the firm (for example, certain environmental harms).

However, the political benefits that flow from investment contracts often accrue up front; there is the immediate promise of jobs and local economic development, while it may well be a subsequent government that pays the political price in terms of loss of policy space. In contrast, front loading of compensation to the firm, a rational response to regulatory opportunism enabled by the “obsolescing bargain”, entails immediate political costs, to the extent that the regime is left with fewer resources with which to win political support.


Policy implications and agenda for future research

A recent manifesto by a group of progressive academics was highly critical of the manner in which investment treaties interfere with regulatory autonomy, while stating a preference for investment contracts over treaty obligations on the apparent assumption that states can insure that commitments with respect to regulatory stability are more narrowly tailored and more clearly defined in contracts.[3] However, just the reverse may be true. Obligations such as the requirement of compensation for expropriation and of fair and equitable treatment have, admittedly, been read by some tribunals as providing some sort of guarantee against regulatory changes that are harmful to the investor. Nevertheless, these readings are the exception rather than the rule. The norms on expropriation and fair and equitable treatment do address concerns about regulatory opportunism that are often cited as rationales for stabilization clauses, but because of the considerable uncertainty as to whether a tribunal will order compensation for regulatory change in the absence either of a formal taking or evidence of arbitrary and/or discriminatory behavior of the regulator, investment treaties do not facilitate regulatory capture by the firm in the way that stabilization clauses do (of course depending on how they are drafted).          

The negotiation of stabilization clauses in secret contributes substantially to the danger of regulatory capture, as it provides interests opposed to, or which can check capture, with no opportunity to expose or protest the capture ex ante, while the effect of stabilization prevents them from working to reverse capture ex post. Thus, transparency in the negotiation of such clauses, as recommended by the IFC/Ruggie study, is highly desirable. So are requirements that the clauses be approved by parliaments and/or independent regulatory agencies. Strengthening governance mechanisms in developing countries and initiatives for grassroots education and empowerment are also highly desirable as means of countering capture. Further analysis needs to be done of the different challenges posed by regulatory uncertainty on the one hand and regulatory opportunism on the other. Both may be significant issues for investors. But they may require different kinds of contractual or other devices to manage.

Author: Robert Howse is the Lloyd C. Nelson Professor of International Law at the New York University School of Law.  This article draws on a larger work in progress on stabilization clauses and public policy.

[1] Ruggie, J., (May 2008). Stabilization Clauses and Human Rights. International Finance Corporation.

[2] Kaplow, L., (January 1986). An Economic Analysis of Legal Transitions. Harvard Law Review, 99 (3).

[3] Public Statement on the International Investment Law Regime,