Fair and equitable treatment in present and future investments: What to expect in times of climate change?

The issues

Action taken by states to address climate change may bring them into conflict with foreign investors who have invested in the host state. Many states have obligations to protect foreign investments under International Investment Agreements (IIAs). Numerous IIAs, which include bilateral investment treaties (BITs) or multilateral investment treaties, exist to promote and protect investments and ensure the flow of capital, technology and know-how between state parties. Whilst the contents of IIAs vary, most contain an obligation for host states to provide “fair and equitable treatment” (FET), which essentially guarantees a stable and predictable legal environment to foreign investors and their investments, failing which investors may commence arbitral proceedings against host states under the investor state dispute settlement (ISDS) clause contained in the IIAs.

In circumstances where states are required to comply with global climate change agreements, including by amending their domestic legislation, this article considers:

• The tension between states’ obligation to maintain and provide foreign investors with regulatory stability and predictability, and their obligation to regulate to combat climate change;
• Whether foreign investors can argue that changes in legislation breach the FET provision of an IIA;
• Even if such a breach is found to exist, whether there are any challenges a foreign investor may face when attempting to recover any resulting losses; and
• What foreign investors can expect in the future.

International efforts to address climate change

The global effort to arrest and reverse adverse climate change has accelerated since the early 1990s. A number of global agreements have been concluded, setting out objectives for states, including specific emissions targets, to address the issue.

The United Nations Framework Convention on Climate Change (1992) (UNFCCC), the first major global agreement in relation to climate change, set out principles and basic state commitments and objectives, and provided a framework for subsequent negotiation to address the issue. The Protocol to the UNFCCC, known as the Kyoto Protocol, was signed a few years later in 1997. It set binding obligations on developed nations, subject to penalties for non-compliance, including requiring them by 2012 to reduce their greenhouse gas (GHG) emissions by an average of 5 percent below recorded emissions levels as of 1990.

The Paris Agreement of December 12, 2015 superseded the Kyoto Protocol and built upon existing obligations to reduce climate change by capping global warming to a maximum of 1.5 to 2°C beyond pre-industrial levels. The Paris Agreement sets out commitments for almost all states obliging them to publish a climate change action plan (known as Nationally Determined Contributions) every five years. Unlike the Kyoto Protocol, noncompliance with the Paris Agreement does not give rise to penalties for the non-compliant party.

The conflict between a state’s right and/or duty to regulate to protect the environment and its obligation to provide foreign investors with a stable and predictable legal environment

There is inherent tension between a host state’s right to regulate to protect the environment, including in compliance with its international commitments, and an investor’s right to expect that state to comply with its obligations under an IIA to not harm its investment.

The right for states to prescribe and amend their domestic legislation to protect public interests, including the environment, is recognized under public international law. The right for states to regulate to protect the environment has also been acknowledged in some IIAs, such as the Energy Charter Treaty (ECT) (Articles 19 and 24(2)(i)).

Separately, the right for foreign investors to operate in a “transparent, stable and equitable legal framework” and the obligation for states to provide such environment is included in most IIAs. An “investment can only be economically viable and flourish in the long run if States create and maintain a climate favorable to the operation of enterprises and to the flow of investments” (Silver Ridge Power BV v Italian Republic, ICSID Case No. ARB/15/37, Award of February 26, 2021, para 399).

There is inherent tension between a host state’s right to regulate to protect the environment, and an investor’s right to expect that state to comply with its obligations under an IIA to not harm its investment.

The tension between states’ climate-focused regulations and investors’ right to FET is undeniable. For example:

• The adoption of legislation to phase out high-carbon industries, for instance through the cancellation of fossil fuel projects, has given rise to FET breach claims (see for example, RWE AG and RWE Eemshaven Holding II BV v Kingdom of the Netherlands, ICSID Case No. ARB/21/4, where investors commenced proceedings against The Netherlands on the basis that its 2019 Coal Act mandated the phase out of the production of energy from coal by 2030).
• The amendment or roll-back of climate-related measures, such as incentive schemes to promote investments in renewable energy, particularly because of policy changes in reaction to the 2008 financial crisis, has resulted in a multitude of treaty claims under the ECT filed against European countries.
• A host state may fail to implement climate change-related obligations under international agreements, adversely impacting foreign investors by failing to meet their legitimate expectations, and this may result in FET breach claims.

The tension between states’ climate-focused regulations and investors’ right to FET is undeniable.

How the tension between environmental regulation and protection of foreign investors is resolved in proceedings commenced by an investor against a host state for breach of the FET protection is determined on a case-by-case basis.

What to expect in times of climate change: Test for an FET breach

The test for an FET breach can be uncertain and appears to turn on the facts of each case, but arbitral tribunals, including in climate-related arbitrations, are likely to consider various key factors, including the following:

• Whether the regulatory change by a host state is unfair, unequitable or unreasonable.

In PSEG v Turkey, ICSID Case No. ARB/02/5, Award, June 4, 2004, para 240), the arbitral tribunal held that “[I]nconsistent State action, arbitrary modification of the regulatory framework or endless normative changes to the detriment of the investor’s business and the need to secure a predictable and stable and legal environment” may constitute unfair measures. Similarly, regulation, or its underlying aim, should be legitimate, rational and in the public interest, and not “entirely lacking in justification or wholly disproportionate” (Philip Morris v Uruguay, ICSID Case No. ARB/10/7, Award, July 8, 2016, para 419). “[U]npredictable radical transformations in the conditions of the investments” does not create a stable environment for the foreign investor (RREEF v Spain, ICSID Case No. ARB/13/30, Decision on Responsibility and Principles of Quantum, November 30, 2018, para 315). In all circumstances, an arbitral tribunal should give “great deference” to the “discretionary exercise of sovereign power, not made irrationally” (Philip Morris v Uruguay, para 399). In Eiser v Spain, where a wholly different regulatory approach was in place, the arbitral tribunal found that the “new system was profoundly unfair and inequitable as applied to [the investors’] existing investment, stripping [them] of virtually all of the value of their investment” (ICSID Case No. ARB/13/36, Award, May 4, 2017, para 365 (the award was subsequently annulled but resubmission proceedings are pending)). When investing in industries that may be severely affected by climate change regulations, such as the oil and gas or mining industries, the test to establish legitimate expectations will be more difficult to meet. Material and adverse changes to regulatory frameworks are to be expected unless the host state made specific assurances that there would not be any regulatory changes or if there is a stabilization clause

• Whether the investor held legitimate expectations at the time of its investment.

An investor must establish that representations or assurances that the legislation will remain the same were made by the host state personally to the investor. Representations or assurances are often specific or express, and made through contractual arrangements, public statements, government decisions, general conduct or promises. Specific commitments may take the form of a stabilization clause. Legitimate expectations can also arise from a legal framework put in place by the host state with the specific aim “to induce investments,” which “cannot be radically altered” (Antin v Spain, ICSID Case No. ARB/13/31, Award, June 15, 2018, para 532).

The host state’s representation or assurance must have formed the basis of the investor’s expectations, and must have been relied on by the investor at the time of investing in the host state, on the “date of actual investment or irrevocable commitment to invest” (Cavalum v. Spain, ICSID Case No. ARB/15/34, Decision on Jurisdiction, Liability and Directions on Quantum, August 31, 2020, para 451).

To be legitimate, the investor’s expectations at the time of investment must be reasonable, “not [] frivolous or unrealistic and must be grounded in reality” (Belenergia v Italy, ICSID Case No. ARB/15/40, Award, August 6, 2019, para 571). The political and socioeconomic context must be considered when investing (Duke v Ecuador, ICSID Case No. ARB/04/19, Award, August 18, 2008, para 340). Investors cannot reasonably expect circumstances not to change in the future (Saluka v Check Republic, PCA Case No. 2001-04, Partial Award, March 17, 2006, paras 304-305), particularly in times of crisis. Diligent investors are also expected to maintain their awareness throughout their investment, such as following parliamentary debates regarding changes to an environmental law (Plama v Bulgaria, ICSID Case No. ARB/03/24, Award, August 27, 2008, para 221).

• Whether the unfair, unequitable or unreasonable regulation violated the investor’s legitimate expectations.

“[O]nly measures taken in clear violation of the FET will be declared unlawful and entail the responsibility of the State” (RREEF v Spain, para 262). Bona fide changes by a host state to its regulatory regime, even when adversely impairing an investment, may not result in a finding by an arbitral tribunal of a violation of an FET provision.

An arbitral tribunal may consider whether the regulatory change had a disproportionate effect on the investment, creating an excessive burden on an investor’s rights (Muszynianka v Slovakia, PCA Case No. 2017-08, Award, October 7, 2020, paras 566, 574). The arbitral tribunal may also consider whether the regulatory change outweighs the public interest disproportionately, in the sense of “imposing burdens on foreign investment that [go] far beyond what [is] reasonably necessary to achieve good faith public interest goals” (Eskosol v Italy, ICSID Case No. ARB/15/50, September 4, 2020, para 410). In cases where particularly strong public interests such as the environment or public health are concerned, this factor will guide the assessment of what is “far beyond what was reasonably necessary”, or whether the state measure is “wholly disproportionate”(Philip Morris v Uruguay, para 419), or “obviously disproportionate to the need being addressed” (LG&E v Argentina, ICSID Case No. ARB/02/1, Decision on Liability, October 3, 2006, para 195).

Retroactive or retrospective regulatory changes are “more likely to violate legitimate expectations” as disproportionate

Another relevant consideration for the arbitral tribunal is whether the regulatory change was abrupt or if the investor had been given sufficient time to adjust to the new regulatory regime, through for instance, announcements or the implementation of transition periods. Retroactive or retrospective regulatory changes are “more likely to violate legitimate expectations” as disproportionate (Renergy v Spain, ICSID Case No. ARB/14/18, Award, May 6, 2022, para 681(iii)).

Where an FET claim is made in relation to a climate-focused regulatory change, an arbitral tribunal is likely to consider whether there is a provision protective of the environment in the applicable IIA, and whether that provision takes precedence over the FET clause. For example, the ECT, Article 24(2)(b) (i), provides that states may adopt or enforce any measure “necessary to protect human, animal or plant life or health” as an exception to the provisions contained in the ECT. However, Part III ECT, which includes the FET protection at Article 10(1), appears to be excluded from the exception (see however, in RWE Innogy v Spain, ICSID Case No. ARB/14/34, Decision on Jurisdiction, Liability and Certain Issues on Quantum, December 30, 2019, para 447: “Article 24(2) ECT militates against any expansive concept of [the] FET standard under Article 10(1)”; see further, at para 446: the arbitral tribunal noted that where protection of human life is regulated, this regulation would not be “regarded as unfair and inequitable unless it was arbitrary or discriminatory or in some other way contrary to customary international law.”)

Investors should expect increased importance being given to the protection of the environment (which may be extended to the protection of human life), over an investor’s right to a stable and predictable legal environment. This normative tension was recognized in 1997 by the International Court of Justice (ICJ), which noted the “need to reconcile economic development with protection of the environment” (Case Concerning the Gabcikovo Nagymaros Project (Advisory Opinion, Hungary/Slovakia), Judgment, ICJ, September 25, 1997, page 78). ISDS tribunals have held that “an investor cannot pretend to have legitimate expectations of stability of environmental regulations in a State […] where concern for the protection of the environment and of sustainable development are high” (El Paso Energy International Company v Argentina, ICSID Case No. ARB/03/15. Award, October 31, 2011, para 361).

Investors should expect increased importance being given to the protection of the environment over an investor’s right to a stable and predictable legal environment. 

In the event that a finding of an FET breach is made by an arbitral tribunal, this will not necessarily result in the award of full damages and compensation.

Damages and compensation in climate-related arbitrations

States found to be in breach of their FET obligation must make full reparation for any injury caused (Draft articles on Responsibility of States for Internationally Wrongful Acts (2001), Article 31; see also, the Factory at Chorzów case, Permanent Court of International Justice, September 13, 1928).

However, where radical policy changes relate to the implementation of climate-related obligations and objectives, the question of whether the host state should consistently bear the financial burden suffered by an investor may arise. States may argue that the costs for climate change mitigation and prevention should be borne by the polluter (the Polluter Pays Principle) (see Trail Smelter, Awards, April 16, 1938 and March 11, 1941). The Rio Declaration provides: “[n]ational authorities should endeavour to promote the internalization of environmental costs and the use of economic instruments, taking into account the approach that the polluter should, in principle, bear the cost of pollution, with due regard to the public interest and without distorting international trade and investment” (Principle 16, see also Article 19 ECT). An arbitral tribunal may consider this principle where a state’s regulatory change aims at reducing GHG emissions. It may be difficult, however, to assess the actual damage caused to the environment by an investor and determine whether such damage would prevent an investor from recovering its losses.

Where radical policy changes relate to the implementation of climate related obligations and objectives, the question of whether the host state should consistently bear the financial burden suffered by an investor may arise.

Investors may also bear part of their losses on account of contributory fault. In ISDS cases, arbitral tribunals have “reduced damages by a percentage reflecting the investor’s role in the events leading to a loss” (for example, Stati v Kazakhstan, SCC Arbitration Case No. V 116/2010, Award, December 19, 2013, para 1331).

Is there a future for the FET protection in disputes arising out of radical climate focused regulations?

There are calls from sections of the international community to amend existing IIAs to facilitate climate-focused state regulation and remove the risk of states’ exposure to FET claims. Various measures have been taken by states in the past in this regard, and similar measures may be expected to be taken in the future:

• Revising or removing FET clauses (see for example: India Singapore CECA);
• Including protections for environmental regulations or incentives for climate-friendly investments (for example: Article 24 ECT);
• Including narrower climate-specific exceptions for certain types of regulatory activities (for example, exceptions for ‘legitimate public policies’ in the Canada-Chile FTA (1996) (Article G-01, clause 3), or see the United States-Singapore FTA (2003), Article 15.10); and
• Including language in the preamble to show that the state parties intend to promote sustainable investment through the incorporation of the goals and objectives of the UNFCCC and the Paris Agreement (for example: the Netherlands model BIT (2019), Article 6(6)).

The tension between affording protection to investors whilst freely regulating over foreign investments to protect the environment and address global warming, is likely to remain for many years to come.

Some of the above measures, such as removing the FET protection for investors, may result in a reduction of the flow of foreign investments, which may not be a desirable outcome for states.

A recent decision by the European Court of Human Rights found that states have a positive obligation to adopt legislation in compliance with the objectives of the UNFCCC and the Paris Agreement (Verien Klima Serniorinnen v Switzerland, European Court of Human Rights, Application No. 53600/20, April 9, 2024, paras 544-548), paving the path for more similar decisions to come and potentially giving rise to a public international law principle of protection of the environment that will prevail over an investor’s FET protection.

The tension between affording protection to investors whilst freely regulating over foreign investments to protect the environment and address global warming, is likely to remain for many years to come. In the meantime, unless a simultaneous global effort is conducted to remove FET protection, foreign investors will mostly be able to make use of that protection (whether successfully or not).

Conclusion

Investors should expect an era of regulatory instability as states increase their efforts to address climate change and meet their international commitments. Regulatory change will continue to occur and should be foreseeable for a diligent and reasonable investor. Unless the investor obtains specific and clear assurances from a host state that the regulatory framework in place at the time of investment will remain the same, including by way of a contractual commitment in this regard, an investor may find it increasingly difficult to establish that legitimate climate-focused regulatory changes violate its legitimate expectations and give rise to an FET breach.

Unless the investor obtains specific and clear assurances from a host state that the regulatory framework in place at the time of investment will remain the same, an investor may find it increasingly difficult to establish an FET breach.

Striking the right balance between regulatory risks faced by investors and the litigation risk faced by host states will depend on each market. Larger markets can have a greater degree of regulatory risk and still attract foreign investors. In contrast, smaller, less economically attractive markets may need to strike a balance that reduces regulatory risk to attract foreign investment. Investors may also perceive a greater degree of risk when deciding whether to invest in climate-affected industries, and this may result in a reduction in foreign investment flows at an international level.