Over a year ago, the International Energy Agency (IEA) called for an immediate end to fossil fuel expansion if the world is to decarbonise by 2050 and limit warming to 1.5°C. Along with many other organisations, including the Intergovernmental Panel on Climate Change, the IEA has set out comprehensive pathways to meet those goals. However, countries that impose laws to curb fossil fuel production are liable to be sued for compensation by affected investors via a system called investor-state dispute settlement (ISDS).

ISDS, which is embedded in a network of 2,600 investment treaties, empowers investors to transcend domestic courts and sue their host nations for policy changes that threaten their investments via special international tribunals, supposedly a fairer setting than the domestic courts.

Oil refinery and pipelines. (Photo by Imaginima via Getty Images)

The Energy Charter Treaty (ECT) is the largest agreement of its kind. Among its 54 signatories are the UK and EU, with major players such as the US and Saudi Arabia on board as observers. The incentive for countries signing ISDS treaties has typically been to attract foreign direct investment (FDI). Most of these treaties were signed in the 1990s after the Cold War to capitalise on improved international relations and the fresh allure of free trade (and to protect new western investments in the east).

“[The 1990s] was a big signing period for a lot of investment treaties and free trade agreements like the North America Free Trade Agreement between Canada, Mexico and the US, or the Energy Charter Treaty,” says Rachel Thrasher, a researcher with the Boston University Global Development Policy Center’s Global Economic Governance Initiative. “Around that time, the World Trade Organization was constructed as an expansion of the much older General Agreement on Tariffs and Trade signed in the post-war era. The other side [of the ISDS appeal] was the energy side. The goal was to ensure energy security. [Countries] needed to make sure they didn’t lose access to [crucial] energy sources to keep things going.”

A 2006 G8 meeting concluded that “clear, stable and predictable national regulatory frameworks significantly contribute to global energy security, and multilateral arrangements can further enhance these frameworks”. Accordingly, the G8 supported “the principles of the Energy Charter and the efforts of participating countries to improve international energy cooperation”.

An industrialisation boom contributed to the treaties’ popularity, but a growing body of research suggests that international treaties have neither positively influenced inward FDI flows nor financial gain for host countries. In fact, for lower to middle-income countries, ISDS can put an entire economy at risk.

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Unjust transition

ISDS treaties appeal to investors because they offer protection against potentially fickle governments. "The promise of international investment treaties was to bring new investment into countries that needed it and protect the foreign investments of higher-income countries in lower or middle-income countries whose institutions weren’t historically trustworthy,” explains Thrasher.

“But investment treaties don't do what they promise to do. The promises that go along with that investment – new industries, jobs, development, a restructuring of local economies – have not happened. We have seen an increasing inequality gap regardless of whatever flowed in from [treaty-led] investments,” she adds.

Instead, investment treaties can prove a danger for a nation's entire economy if a government is sued for a large sum of money it cannot pay.

Legal claims by oil and gas investors against states imposing laws to limit fossil fuel activities could reach a total cost of $340bn for governments – more than the $321bn spent globally on public climate finance in 2020 – found new research published in Science in May 2022. This named the ECT as the agreement protecting the most oil and gas production worldwide and noted that its termination could reduce the global cost of oil and gas project cancellations by more than $5–20bn.

The researchers criticised ISDS tribunals’ tendency to award compensation to investors based on the would-be revenue of the entire life cycle of their projects while using discounted cash flows to calculate that revenue. This results in fossil fuel investors being awarded vastly inflated financial awards of up to billions of dollars, the researchers said. As well as potentially crippling an economy, such settlements divert critical public finance from climate mitigation and adaptation to polluters' pockets, they added.

A regulatory “chill”

There have been at least 231 ISDS cases – 20% of all cases – related to fossil fuel investments so far and investors were successful 72% of the time where the final award was disclosed, according to the work in Science. The threat alone of massive settlement costs has been sufficient to put countries off implementing immediate climate policy.

Yamina Saheb, senior climate and energy policy analyst at Paris-based think tank OpenExp and a former head of the Energy Efficiency Unit at the Energy Charter Secretariat, has suggested Denmark set a 2050 end date for oil and gas extraction rather than an earlier one to deliberately avoid disputes with existing exploration licence holders.

New Zealand banned all new offshore oil exploration in 2018 but did not cancel existing contracts. The climate minister acknowledged that a more aggressive plan “would have run afoul of investor-state settlements”.

France also succumbed to the threat of litigation in September 2017 when it revised a draft law banning fossil fuel extraction by 2040 to allow the renewal of existing oil exploration permits after the Canadian oil company Vermilion Energy threatened to sue.

When governments ignore the threat of litigation, ISDS has proven to be a barrier. The Netherlands, for example, is being sued by energy companies RWE and Uniper under the ECT over its plans to take coal power plants offline.

Energy Charter Treaty "modernisation"

The ECT has been under growing pressure to address the risk it poses to the energy transition. The treaty underwent five years of negotiations to achieve its "modernisation" – essentially creating space for countries to decarbonise without penalty. On 24 June 2022, discussions culminated in the introduction of a "flexibility mechanism", which lets nations opt out of fossil fuel investment protection. Following this, the EU and UK announced they will exclude new fossil fuel investments from protection after August 2023 and will continue to protect existing investments for another ten years “with limited exceptions”.

While it is unclear what those limited exceptions are, the reform has come under heavy fire for being anything but modern. The Energy Charter Secretariat was unavailable for comment when contacted by Energy Monitor. Think tank E3G voiced its concern that investors will retain privileges and access to loopholes to sue EU governments for their climate policies.

“This compromise fails to align the ECT with the Paris Agreement and the European Green Deal,” Ignacio Arróniz Velasco, E3G’s trade and climate researcher, told Energy Monitor. “Fossil fuel companies will continue to hold climate policies hostage well beyond this crucial decade for the energy transition, despite it being a key security priority given Russia’s aggression.

“The agreement is at odds with the EU’s ambition to align global rules with the climate transition and does not meet the benchmarks set by Germany, France, Spain, the Netherlands and others. These countries should now join efforts to lead a coordinated withdrawal [from the ECT] before November [2022], providing investors with certainty about the EU’s commitment to the energy transition.”

In addition to its flexibility mechanism, the ECT reform is controversial for “a reckless expansion of the treaty to hydrogen, biomass and other energy materials, exposing us to even greater risks of uncapped compensation claims in future”, says Cornelia Maarfield, a trade and investment policy expert at Climate Action Network Europe.

ECT signatories wishing to rid themselves of fossil fuel investor protection can leave the treaty entirely, as Italy did in 2015. However, leaving the treaty triggers its sunset clause, which obliges governments to continue to protect fossil fuel investments for another 20 years.

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Thrasher denies the choice is binary for nations such as Spain, which want to rid themselves of the ECT. “That ten-year period is better than the 20-year period, [but] lawyers and legal scholars are trying to think through ways countries could literally withdraw their consent to be arbitrated and just be done [with the ECT], regardless of the sunset clause.” She suggests countries would need to go through litigation to withdraw their consent, but through state-to-state dispute settlements rather than investor-state disputes. “I feel better about state-to-state disputes than investor state disputes," she says. "It is more of a level playing field.”

“[The ECT reform] is a possible ploy to keep [members] in,” Thrasher adds. “It has a lot of climate-friendly language and if I didn’t feel so sceptical about investment treaties and their roles up to this point, I might feel differently. [At the end of the day] it is still an investment treaty. A lot of the changes are simply taking case law from the last 30 years and uploading it to the new text.”

ECT signatories must now decide whether they opt in to the new flexibility mechanism or leave the treaty entirely. The coming months will shed light on the treaty's ability to survive – and support – the energy transition.

Editor's note: Rachel Trasher's first quote was corrected on 14 July to reflect that the World Trade Organization was constructed as an expansion of the much older General Agreement on Tariffs and Trade, not that the two were created at the same time.