FAQs: What is Investor-State Dispute Settlement and What Does it Mean for Climate Action?

Photo by Worksite Ltd. via Unsplash.

By Rachel Thrasher

A controversial legal process known as investor-state dispute settlement (ISDS) threatens to hamper the ability of governments to mobilize finance for ambitious climate action and a just transition. When assets are protected by international investment agreements (IIAs) with ISDS, private investors in the fossil fuel sector can bring legal claims against countries for climate measures that negatively impact the value of their investments.

A May 2022 journal article in Science by a team of researchers from the Boston University Global Development Policy Center, Colorado State University and Queen’s University in Canada estimates the costs of possible legal claims from oil and gas investors in response to government actions to limit fossil fuels could reach $340 billion. This is a substantial amount that would divert critical public finance from essential mitigation and adaptation efforts to the pockets of fossil fuel industry investors. We also noted that, while high-income countries have the most to lose with respect to the Energy Charter Treaty, Global South countries remain highly vulnerable to ISDS – especially climate vulnerable countries already facing debt distress.

A new journal article in Climate Policy by the same team of researchers calculates the risks of Global South countries, finding that at least two-thirds of the calculated financial risk through potential ISDS claims globally is borne by Global South countries. This amounts to a de facto transfer of wealth from the Global South to the Global North and undermines global climate finance commitments.

Our research finds that ISDS will not only have impacts on the supply-side of climate policymaking, but also on achieving a “just transition” – wherein “no people, workers, places, sectors, countries or regions are left behind in the move from a high carbon to a low carbon economy.” As a result, we recommend that countries immediately stop issuing new permits for new fossil fuel projects, terminate their investment treaties and, where the latter is impossible, develop rules to cap the amount of compensation available to investors.

Despite these findings, many proponents of the investment treaty system, and ISDS more specifically, have argued that international investment agreements (IIAs) are a much lesser threat than they seem as long as states are engaged in good faith public policy and not imposing disguised restrictions on foreign investment. Moreover, they argue that IIAs are essential to the renewable energy transition because of the large amount of private investment needed.

In response to these concerns, this FAQ blog seeks to provide clarity on the connections between investment treaties, ISDS settlement and climate policy.

1. Isn’t there a good reason for these treaties in the first place?

The original rationale for IIAs was rooted in a lack of trust that developing country institutions will provide fair legal protections to foreigners, and a promise of technology, jobs and development from advanced economies. The lack of trust in domestic institutions is a much smaller concern than it may have been in the mid-20th century, and developed countries have not delivered on their promises. Decades of empirical research have shown that standalone investment treaties have not made a big impact, if any, on the flows of foreign direct investment (FDI). The investment that has crossed borders has not consistently contributed to increased savings, jobs, infrastructure and innovation through backward and forward linkages in the economy.

Moreover, investment treaties and their ISDS enforcement are inherently asymmetrical. The origins of IIAs derive from developed and developing country pairs, such that one party is the main investment exporter and the other an importer – responsible for protecting foreign investments. IIAs offer protection to foreign investors without imposing obligations on them, so that there are almost never any legally binding rules governing good investment practices to preserve human rights or the environment. The primary concern addressed in the most common treaty language is that of state overreach or “political risk.” Finally, in addition to the implicit asymmetries, outcomes are similarly inequitable. Research shows that investors from high-income states are more likely to prevail in their claims.

2. Private investors in fossil fuels are like any other private investor – a property holder who has a right to protection under the law. Why should fossil fuel investors be treated differently?

Although there has been some historical disagreement, under customary international law, foreign investors are generally owed an international minimum standard of treatment – police protection and due process in their country of residence, protection from arbitrary or discriminatory regulation/taxation/other state acts and usually compensation for nationalization. Countries that recognize this international minimum standard, which is presently most countries, have often built this treatment standard into their law and foreign investors have access to domestic remedies they are owed in national courts.

What is decidedly not guaranteed under international law is for private individuals or corporations to have a forum “before which to submit claims” against a state outside of the courts of that state. ISDS is, at the least, a very extraordinary remedy for private actors in international law. Furthermore, it is an unnecessary remedy given the other domestic options already available to them (see Question 1).

There are also several, viable reasons to treat fossil fuel companies and investors differently than other types of investors. Fossil fuel companies, like tobacco companies and pharmaceutical companies developing opioids, have known for decades of the negative global impact of their products. Meanwhile, they have actively lobbied their governments to block any laws limiting their access to growth, expansion and profits, despite the risks to the environment. Companies engaged in large-scale public deceit and harm should be held to account. Removing access to special arbitration courts that are not available to domestic investors would be a mild discipline.

3. As noted in the Science article (supplementary materials), there aren’t that many ISDS cases based on climate policy. What evidence is there that the number of cases will increase?

There is significant data on the extensive use of ISDS by fossil fuel companies.

There is also a large increase in countries pursuing supply-side climate policies as a way to meeting commitments at UN Framework Convention on Climate Change and elsewhere. As countries take more ambitious action – which is likely as they face an increasingly warming earth and the corresponding impacts on public health, agriculture, productivity and more – fossil fuel firms will likely seek to recover their lost value through ISDS.

4. Investment treaties will protect renewable energy investors, too. Will canceling the treaties altogether discourage investment in essential resources for mitigating and combatting climate change?

FDI flows are not correlated with investment treaties, but rather with other country indicators like institutional stability, large consumer base and economic growth. As such, countries that seek investors in the renewable energy sector will do well to put in place targeted policies to attract investment in the sector while also promoting domestic welfare, instead of signing treaties that prioritize foreign investors over domestic ones.

Several European countries have been on the receiving end of these renewable energy ISDS cases targeting changes to their energy policies. Spain, the Czech Republic and Italy had to modify renewable energy incentives in responses to market instability and faced ISDS claims as a result. Moreover, the primary beneficiaries of these cases were not the renewable energy firms themselves, but the share-holding financial firms.

It is also important to remember that renewable energy investors have the same legal rights as any other investor (domestic or foreign) in just about any state. ISDS then implicitly provides special legal rights to foreign investors, putting domestic investment at a relative disadvantage.

5. National governments are at least as culpable for continuing investments in fossil fuels as private firms. Should they share the burden of the energy transition, too?

Governments are culpable for their inadequate response to the climate crisis – both historically and presently. In addition to refusing to provide licenses and permits for new fossil fuel projects, and eliminating ISDS that challenges climate policy, national governments should make ambitious commitments in climate negotiations and take aggressive action to meet those commitments. As noted in the Science article, the 2020 global climate finance was $321 billion, which is far from what is needed to meet the world’s 1.5C goal.

Given that ISDS poses additional financial and legal risks to countries, however, it is already hindering countries from taking the action they need to, especially among Global South countries. Our research also shows that ISDS risk has already eclipsed the ability of some countries to invest enough to meet their nationally determined contributions (NDCs). Moreover, since two-thirds of the financial risk through potential ISDS claims is borne by the Global South, essential public finance needed for mitigation and adaptation efforts, as well as programs to assist workers and communities currently dependent on fossil fuel production, could be diverted to private firms and shareholders. This is the opposite outcome that global climate finance commitments are supposed to achieve and would constitute a de facto transfer of wealth from the Global South to the Global North.

6. What concrete actions can governments take to mitigate the impact of ISDS on climate action?

ISDS is far from necessary to protect private property rights, neither IIAs nor ISDS contribute substantially to the flow of FDI into Global South countries, and ISDS puts additional financial strain on countries struggling to meet even the most basic climate goals. Countries should cease licensing for new fossil fuel exploration or production projects to limit future liability to ISDS claims. Second, countries should withdraw from their IIAs with ISDS collectively or individually as quickly as possible. While unilateral withdrawal can subject them to on-going liability under provisions that offer continued protection of investments in place at the time a treaty is terminated for up to 20 years (known as “sunset clauses”), mutual withdrawal can include a negotiated agreement to nullify such clauses in the interest of collective climate goals. Finally, our research recommends, with others, that countries develop binding rules limiting the amount of compensation available to investors – especially for claims covering assets stranded by supply-side climate policy.

The climate crisis is too great and too urgent to wait for thousands of treaties to be re-negotiated or reformed. Instead, countries must take rapid action to prevent ISDS risk from presenting an obstacle to essential public policies.

Read the Journal Article


Never miss an update: Subscribe to the Global Economic Governance Newsletter