Does the Green Economy Need Investor–State Dispute Settlement?
Environmentalists have traditionally been among the staunchest critics of investor–state dispute settlement (ISDS). For those familiar with the litany of ISDS cases that have involved challenges to environmental regulations—ranging from bans on pesticides to efforts to save endangered species—the opposition to ISDS on the part of environmental non-governmental organizations and scholars is not difficult to understand. However, in recent years a different kind of “environmental” ISDS case has emerged, as renewable energy companies have become major players in investment arbitration.
In tandem with the rise in renewable energy disputes, an increasing amount of commentary suggests that environmentalists should embrace ISDS because it “should help mobilise the huge investments required to transform the energy sector to cleaner forms of generation and to meet the needs of those many countries that suffer from energy poverty.” It has been argued that the “environment needs more investment protection—not less.”
These assertions are based on three key assumptions: (i) political risk is a major impediment to investment in renewable energy; (ii) ISDS is an effective counter-measure to deal with political risk; (iii) agreeing to ISDS will help states to attract foreign direct investment (FDI) in renewable energy.
1. Is political risk a major impediment to investment in renewables?
The assumption that political risk is a major impediment to investment in renewable energy appears reasonable at the outset. Financial risk tops the list of concerns by executives in the renewable energy sector, but political or regulatory risk—the risk of a change in public policy on renewables—is not far behind.
One of the key reasons cited for this is the current dependence of renewable energy investors on incentive schemes like feed-in-tariffs (FITs), which guarantee renewable energy producers a set price for their energy over a fixed period of time. FITs are meant to reduce financial risk, and do provide increased security, but are not immune from political risk. In fact, Talus argues that relying on subsidies makes renewable energy investors particularly vulnerable to policy change. Changes in government or unexpected cost escalations can undermine support for schemes. Furthermore, as Stokes points out, unlike other government subsidies (for example, fossil fuel subsidies), FITs are highly visible and therefore more easily targeted when a country’s fiscal situation deteriorates. This is what happened in several European countries following the Global Financial Crisis. The investment climate for renewables has also been unstable in other countries, such as Australia.
However, political risk of this particular variety is becoming much less of an impediment to renewable energy for the simple reason that politics is being overtaken by economics. Mendonca et al. noted in 2010 that the costs of renewable energy would eventually fall below the price of conventionally produced electricity and that once this “tipping point” had been reached “FITs [would] have done their job, and [would] only be needed on a limited basis, if at all.” By 2015, the tipping point had been reached by several renewable technologies. A number of recent reports indicate that onshore wind can now provide electricity competitively compared to fossil fuel–fired power generation without financial support in some parts of the world. And solar photovoltaic, generally considered the most expensive form of renewable energy, is quickly catching up with wind. This data suggests that, although incentive schemes like FITs have played an important role, they are increasingly unnecessary to create a business case for investment in renewables. When government support is no longer needed in the sector, the case for ISDS as a protection against changes in subsidies will evaporate.
One could, of course, argue that renewable energy companies face other types of political risk aside from changes to subsidy schemes. For example, local opposition to development (often characterized as “Not In My Back Yard” behaviour) is a significant obstacle for wind energy investors in some jurisdictions. Whether ISDS presents an effective way of dealing with the risk of local opposition will be addressed in the next section.
2. Is ISDS an effective counter-measure against political risk?
The assumption that ISDS is an effective counter-measure to deal with political risk is grounded in the notion that ISDS acts both as a deterrent to states and as an insurance policy for investors. If a state changes the “rules of the game” after an investment has been made, the investor can seek monetary compensation in ISDS. The very threat of such action may in some cases be sufficient to deter a state from making changes in the first place. Deterrence is arguably more important from a green economy perspective, as the insurance function can be achieved through other means (for example, political risk insurance). Additionally, the insurance function only benefits the green economy if money awarded in ISDS is re-invested into other renewable energy projects, something that is not guaranteed to occur. Finally, while deterrence benefits all renewable investors, ISDS only plays an insurance role for a select group of investors, specifically large foreign investors that have the resources to launch a case and have standing under a treaty (or the ability to restructure their investment to gain such standing). Domestic courts, on the other hand, are generally accessible to all. As Aisbett et al. have shown, providing compensation to only one set of investors results in an “implicit subsidy” and can generate “excessive entry.”
Let us take the example of Spain. In 2008, the Spanish government began to make a series of changes to the country’s FIT that were detrimental to investors. The changes were, in part, a response to the Global Financial Crisis. However, another critical factor was the dramatic fall in hardware costs for solar modules (about a 60 per cent drop between 2008 and 2011). This drop in costs led to a surge of investment that stretched the capacity of FITs and other support schemes in several countries. This factor could have been accommodated if the Spanish FIT had been well designed, but it was both over-generous and inflexible. As a result, the system “overcompensated solar photovoltaic and failed to reduce compensation in response to the technology’s rapidly declining costs.”
When Spain moved to scale back the FIT, foreign investors turned to arbitration under the Energy Charter Treaty (ECT). By November 2015, there were 27 known ISDS cases pending against Spain under the ECT involving “legal reforms affecting the renewable energy sector.” Small-scale domestic investors and private citizens affected by the changes in Spain’s FIT do not have standing in international arbitration. The only domestic firms able to pursue arbitration are large multinationals such as Abengoa and Isolux, which are using their foreign affiliates to gain standing. Importantly, some of the companies involved in the ISDS cases only started investing in Spain after 2009 and continued increasing their portfolios throughout 2010 and 2011, when the country was in crisis and some changes to the FIT had already been made; some of them have continued to invest even after bringing an ISDS case. This suggests that some in the select group of investors that can access ISDS view it not only as an insurance policy, but also as an additional source of profit.
Whether the experience of Spain will deter other countries from changing their renewable energy incentive schemes is an open question. At least one author has mooted the idea that ISDS might have an environmentally beneficial “chilling effect” (as opposed to the chilling of environmental regulations usually at the focus of discussions on regulatory chill). Proponents of ISDS generally suggest that there is no evidence that ISDS produces chilling effects (of any persuasion) and that it is “impossible” to obtain such evidence. Other scholars (including the author) believe that it is a phenomenon worth continued study but one that is beyond the scope of this article.
However, it is questionable whether chilling changes to renewable energy schemes would, in every case, be positive from a green economy perspective. If a scheme was well designed and was going to be amended or removed for ideological reasons (for example, if a “climate sceptic” government came into power as happened in Australia in 2013), chilling would certainly be beneficial. But if instead the changes to a scheme were simply aimed at correcting flaws and reducing excessive profits, it is hard to justify chilling from a green economy perspective (which is concerned with the success of the sector as a whole, not the bottom line of individual companies).
Chilling effects could also, in theory, reduce the likelihood of governments changing investment conditions to appease local opponents of renewable energy. However, in practice this seems unlikely. Governments are more likely to respond to local opposition at the planning stage, rather than after an investment has been made, and most investment treaties do not cover the pre-establishment phase. However, even if this phase is covered, there are substantial obstacles faced by investors that want to bring a claim. This is evident in the NAFTA Chapter 11 case brought by American company Windstream against Canada in 2012. The company is challenging the imposition of a provincial moratorium on offshore wind projects, which it argues was put in place to placate local opponents to wind energy in an election year. Although the case has yet to be decided, it demonstrates that arbitration is not a clear-cut strategy for dealing with the problem of local opposition. Substantiating allegations of political or electoral expediency can be very difficult, even if access to government documents is available through freedom of information legislation.
In any event, from a green economy perspective there are much more desirable ways to deal with local opposition to wind projects than legal action. Research suggests that financial benefit arrangements, including community profit-sharing, or direct involvement of communities in wind farm projects are likely to quell or at least limit opposition in many cases.
3. Does ISDS reduce political risk and promote investment in renewables?
The final assumption of ISDS proponents is based on a logical combination of the first two assumptions: if political risk is a major barrier to investment and if agreeing to ISDS under a treaty reduces this risk, then it should follow that investment flows will increase to those states that sign investment treaties with ISDS. However, there is no strong evidence that this plays out in practice. Numerous econometric studies examine whether there is a causal link between the existence of an investment treaty and increased flows of FDI. The results have been mixed. Many early studies that demonstrated a positive effect have been criticized on methodological grounds. Some recent studies have addressed some, but not all, of the methodological issues and have found that treaties have little to no impact.
Most quantitative studies are based on highly aggregate investment data, which makes it difficult to assess their relevance to specific sectors, such as renewable energy. While more research in this area is warranted, existing evidence does not indicate that renewable energy is a “special case.” For example, a 2014 ClimateScope report that mapped the “frontiers” of clean energy investment found Brazil (a country that has never ratified a bilateral investment treaty) to be the second most attractive developing country for renewable energy investment (out of 55 countries studied).
There is currently no evidence that ISDS can make a positive contribution to the green economy. The key lesson that should be learned from the experience of Spain is that FITs need to be designed very carefully to allow for flexibility when market conditions change. Well-designed FITs are in the best interest of both governments and the industry, because the alternative is a boom and bust scenario in which everyone loses (except the arbitration industry). Similarly, an assessment of Windstream does not lead one to conclude that ISDS is a critical tool for combatting local opposition to wind farms. It is also worth noting that both Canada and Spain have strong domestic court systems that are well equipped to deal with investor claims at much lower expense to the public purse.
Most of those who advocate that ISDS can play an important role in the green economy are relying on an assumption that investment treaties will promote FDI in green sectors like renewable energy. Unfortunately, these advocates do not provide any empirical evidence to support this assumption. It has also been proposed that ISDS could produce beneficial chilling effects. However, even if it could be definitively shown that ISDS had chilled the amendment or removal of renewable energy incentive schemes, this would only be positive if such schemes were well designed in the first place and were amended or removed for ideological reasons: there is no environmental justification for providing “green” corporations with excessive profits. But even in these limited circumstances, any case for ISDS is rapidly diminishing as renewable energy subsidies become increasingly unnecessary. Those that propose that the environment needs “more investment protection” are recommending a very long-term solution (of questionable efficacy) to what is essentially a short-term problem.
Kyla Tienhaara is a Research Fellow at the Regulatory Institutions Network, Australian National University. This article is based on a chapter in: Kate Miles (Ed.), Research Handbook on Environment and Investment Law, Edward Elgar (forthcoming).
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