Foreign investment and political risk: Measuring and mitigating exposure at the outset

Introduction

The energy transition and developing renewables industry present a wealth of opportunity for foreign investors but significant risks can arise as a result of the involvement, direct or indirect, with host states. This article canvasses the potential political risks faced by investors choosing to invest in foreign states and identifies mechanisms that can help mitigate those risks.

Identifying and measuring exposure to political risk

A foreign investor’s risk mitigation strategy should begin long before breaking ground on a new project. This is particularly important in the energy sector, where significant capital must often be expended upfront, exposing investors to the risk of never being able to generate profit from the project or seeing their ability to do so curtailed by the host state. (For an analysis of risks specifically related to expropriation, see ‘Expropriation: a strategic review’, IAR Issue 18, p. 7.)

Investors should consider the following when evaluating political risks in the energy sector: (i) the host state’s track record, including hostility toward foreign direct investment (FDI) or foreign investors; and (ii) the host state’s political and regulatory stability, both in the short and long term, including its position on the corruption index, electoral history, the strength of its public institutions and its history of changes to environmental and energy-related policies.

First, the host state’s historical behaviour toward FDI, foreign investors and the resolution of FDI-related disputes can provide important information. Is the host state a member of key international investment conventions, namely the New York Convention and the Convention of the International Center for the Settlement of Investment Disputes (ICSID)? If so, has the host state expressed unfavourable opinions of either convention or taken unfavourable actions in their regard. Publicly-available arbitration awards and related documents involving the potential host state, including court judgments relating to award enforcement, will also reveal the nature of its disputes with foreign investors and its voluntary compliance with adverse awards. Local counsel in the host state can provide valuable insight into the independence of the host state courts and their approach to matters involving the state. This is important not only at the award enforcement stage, but during the life of the investment, such as if interim relief is needed from local courts pending the constitution of an arbitral tribunal.

Second, a state’s history of political (in)stability and/or the state of its public institutions can provide additional relevant information. An ever-changing government, corrupt institutions or an executive body engaging in a tug-of-war with the judiciary can lead to uncertainty and inconsistency. For instance, foreign investors with investments in the Mexican hydrocarbons industry are currently faced with a legislative limbo, as provisions of a controversial 2021 law on hydrocarbons have been suspended by the Mexican courts.

Political and regulatory instability often go hand in hand: foreign investors should expect frequent regulatory changes in a politically unstable host state. However, regulatory instability can occur in any state. As the pandemic has shown, emergency regulations may be enacted as a result of unforeseen circumstances. Such measures may or may not be enacted on a non-discriminatory basis. Many states have seen a rise in populism causing changes at the executive and legislative levels. In some cases, this includes resource nationalism and pressure to protect the local environment and communities. Governments may also be pressured to meet emissions targets set in the Paris Agreement or mitigate the looming possibility of a global recession.

Structuring the investment to mitigate political risks

Foreign investors should carefully structure their investment and any related agreements to maximize protections. Investments can be protected via treaty, investment agreement, and/or project agreement. In each of these cases, foreign investors should ensure they have access to a mechanism for investor-state dispute settlement: dispute resolution, usually international arbitration, in a neutral forum before an independent and impartial panel of adjudicators (ISDS). Without ISDS, foreign investors may have no effective investment protection in the face of adverse treatment by the host state.

Various forms of investment protection (including bilateral and multilateral treaties) may be available to investors depending on the structure and whereabouts of their investment. Many will provide recourse to ISDS and access to international standards of protection for foreign investors. However, not all treaties are created equal; some treaties have variable standards of protection depending on definitions of key standards of protection and some have bespoke carve-outs, such as in respect of the nature of the investment (e.g. natural resources) or types of government treatment (e.g. taxation). Additionally, recourse to a treaty and its protections may not be available for the duration of an investment, such as where a foreign investor is a national of a state having adopted a policy of withdrawal from investment treaties, ISDS in particular or specific sectoral treaties, such as the Energy Charter Treaty (ECT).

Where treaty protections are less favourable or unavailable, such as due to the foreign investor’s home state nationality, investors should consider structuring the investment in such a way as to take the benefit of treaty protections through a third state. This must be done at the outset of an investment and is usually done in tandem with tax planning for the investment. Investment structuring is also prudent to avoid difficulties at the enforcement stage if, as is often the case, ISDS would have been available when the investment was structured. For example, EU national courts have been directed to refuse to enforce any arbitral awards arising from intra-EU disputes under the ETC (Moldova v. Komstroy, Case C 741/19).

The host State may also provide for or require an investment agreement to be entered into between the foreign investor and the host state government. Investment agreements often offer a degree of protection for the foreign investor, including recourse to ISDS, stability clauses, and sovereign immunity waivers. Foreign investors may be limited in what they can negotiate to include in such agreements in the absence of political support. Where available, stability clauses can greatly assist in reducing risks relating to political and regulatory instability for the duration of the investment. They may fix or freeze important applicable legislation or regulations, provide for a right to renegotiate the investment agreement, and/or provide for an economic rebalancing of the investment where the foreign investor must incur costs to comply with any new laws. Sovereign immunity waivers are also critical. Where possible, investors should seek to secure both a jurisdictional and an enforcement waiver. Although jurisdictional waivers are extremely important, they can prove to be futile if the investor has no ability to enforce a successful claim by moving against state assets to recover any damages owed

Finally, project agreements involving a state entity may also include protections for the foreign investor (although these are often not binding on the host state). Unlike investment agreements, these agreements are less often governed by local laws and may allow for the negotiation of stronger and/or more project-specific protections.

Conclusion

The energy transition will involve political risk for foreign investors, including those caused by pressures upon host states. In order to mitigate these risks, foreign investors should carefully evaluate the host state’s political and regulatory stability, as well as its history with FDI in general and the energy sector in particular. This will allow investors to consider whether their investment can be structured in a way to avoid or reduce these risks, as well as ensure that any agreements with the host state or related entities include appropriate protections.