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Countries expected to face large claims from fossil fuel investors in pursuit of decarbonization

31 May 2022 Max Tingyao Lin

While there are growing calls from the scientific community that fossil fuel investment should be halted to avoid a climate catastrophe, lawyers and researchers warn governments could face large legal claims for cutting ties with high-carbon energy sources.

In a recent study published by Science, a team of researchers at Boston University, Colorado State University, and Queen's University in Canada estimated countries might be liable for up to $340 billion in compensation for terminating proposed oil and natural gas projects that have yet to begin production.

The analysis focused on potential claims from investors via the investor-state dispute settlement (ISDS) procedure, a type of international arbitration mechanism that allows an investor to take legal action against a foreign government for alleged violation of trade and investment agreements.

"Countries could be liable under investment treaties for billions of dollars in damages if they phase out fossil fuels in line with climate science," lead author Kyla Tienhaara, an assistant professor at Queen's, said in a statement.

The researchers assumed the net present value, which weighs future cash flows against the initial investment, as the maximum claim amount, and took into consideration into 1,828 investment treaties liable to ISDS claims.

Based on their findings, 97 national governments could face legal claims totaling about $234 billion for cancelling upstream projects that have yet to reach a final investment decision but received at least an exploration permit. Of that figure, $114 billion is linked to crude production, $90 billion to gas, $21 billion to condensate, and $8 billion to natural gas liquids.

If states are to terminate all projects that are under development but have yet to start production, investors could claim another $106 billion in compensation, including $52 billion related to gas projects and $42 billion to crude.

"Foreign investors may have a legal claim for compensation if countries cancel treaty-protected fossil fuel projects," the researchers wrote. "If the lawsuit is successful, countries face substantial financial losses and may pull out of climate commitments to avoid additional ISDS claims from other investors."

Recent reports suggest France and New Zealand have taken a less aggressive stance in countering climate change due to potential ISDS claims, prompting worries among climate scientists.

Earlier this year, the Intergovernmental Panel on Climate Change publicly acknowledged that countries might refrain from phasing out fossil fuels due to a "regulatory chill" arising from international investment agreements.

More climate-related claims

The Science study cited earlier findings by the International Institute for Sustainable Development (IISD) thinktank, which suggested oil and gas firms enjoyed decent success in treaty-related arbitration.

In a research report published in January, IISD identified 231 ISDS cases linked to fossil fuel investments, or nearly 20% of the total. About 92% of the fossil fuel cases are related to oil and gas projects.

Of the 169 concluded fossil fuel cases, 32% were decided in favor of investors while 31% were settled. The average amount awarded in fossil fuel cases was more than $600 million.

There have been a limited number of fossil fuel cases directly related to climate policies. Among them, the most high-profile are TC Energy's $15 billion claim against the US government's cancellation of the Keystone XL pipeline project, based on the North American Free Trade Agreement, and RWE's and Uniper's claims via the Energy Charter Treaty against the Netherlands for coal phaseout.

Still, some believe that governments will face more claims from fossil fuel investors in the coming years as they start to fulfill their decarbonization commitments under the UN Framework Convention on Climate Change.

"It is very likely that climate-related investor state disputes will increase … New and newly negotiated treaties are not updated at the pace of commercial change and scientific understanding," said Pamela McDonald, partner at law firm Pinsent Masons, adding that changes in domestic environmental regulations could affect foreign investors and lead to more ISDS cases.

Anja Ipp, co-founder of thinktank Climate Change Council, also suggested there will be more claims from fossil fuel investors as countries pass new laws and regulations to phase out fossil fuels. "It will be extremely interesting to see how the arbitral tribunals analyze and decide these cases," she told Net-Zero Business Daily by S&P Global Commodity Insights.

A dilemma for governments

Countries generally sign investment treaties to promote international trade and foreign investment, but critics suggest national governments could face additional legal risks as a result.

Earlier this year, the Organisation for Economic Co-operation and Development launched a public consultation on how to align investment treaties with climate goals.

Some in the legal and investment communities suggest that governments can seek to modify existing treaties with additional clauses to meet the Paris Agreement's goals, and formulate new treaties that focus on climate action.

"Governments must find a balance between protecting investors from abuse of regulatory powers, while at the same time securing the possibility to genuinely legislate in the area of environmental protection," McDonald told Net-Zero Business Daily.

To discourage further claims and pursue more climate action, Ipp said governments should first try to win some outstanding climate-related ISDS cases on existing treaty terms.

"The best way for states to mitigate their legal risks may be to fight these cases. Rather than giving in to investor threats, states should consider defending their right to regulate in the public interest," Ipp said.

Lea Di Salvatore, a law researcher at the University of Nottingham who wrote the IISD report, said countries can also terminate or withdraw from any investment agreements that could obstruct their decarbonization efforts.

Boston University's Rachel Thrasher, a researcher who also participated in the Science study, advocated an even more outright "abolitionist approach," and said: "Investment treaties number in the thousands and act as political risk insurance for foreign investors from government measures, even if those measures are in the public interest. The benefits to governments are few, as these treaties do not live up to their purported benefit of facilitating investment and may act as a 'chill' on needed climate action."

A new Energy Charter Treaty?

The Science and IISD studies both highlighted the Energy Charter Treaty as potentially the greatest contributor to climate-related claims, with 17% of all fossil fuel arbitration cases based on the treaty.

Launched in 1994, the Energy Charter Treaty allows investors to seek compensation from state governments for policy measures that could lower expected profits. It was signed by more than 50 countries, of which EU states account for nearly half.

The EU has been seeking to revise the treaty in recent years in a bid to phase out the protection for fossil fuel investors within 20 years. But signatories need to unanimously agree to any change, and some—like Japan—have vocally opposed the EU proposal.

If no conclusion is reached on the proposed reform in June, EU states could begin to withdraw from the treaty. In mid-May, Member of European Parliament Pascal Canfin tweeted: "The negotiation around the reviews of the Energy Charter Treaty have so far proven not to deliver meaningful changes up to the climate crisis … We call for a coordinated exit of all EU countries from it."

As the treaty has a clause letting investors sue a state for 20 years after the state's withdrawal, some analysts suggest EU states should team up and agree among themselves that they will not allow EU-based investors to sue them in the sunset period. In a parallel development, the Court of Justice of the EU has already ruled against intra-EU arbitrations based on the Energy Charter Treaty.

But the EU's withdrawal may not necessarily aid a low-carbon transition. In February 2021, S&P Global Market Intelligence reported renewables developers lodged twice as many claims under the treaty as fossil fuel backers and secured double the amount of damages.

McDonald stressed that the investment treaties are not inherently incompatible with deep decarbonization. "Attracting foreign investors will be a key component of countries' decarbonization plans … states need to modernize treaties at the point of negotiation or re-negotiation to expressly deal with environmental considerations," she said.

While agreeing that cross-border investment in renewable energy will be required to meet climate goals in the coming years, Ipp said there is no evidence suggesting investment treaties are necessary for those investments to happen.

"The problem with investment treaties generally is that they are difficult to revise once signed. In my opinion, there are probably better ways to offer investors protections and incentives," Ipp added.

Paul de Clerck, economic justice coordinator at Friends of the Earth Europe, suggested renewables investors can turn to local courts for protection. As a mechanism, the Energy Charter Treaty is too "flawed" because it covers fossil fuel projects and doesn't protect domestic renewables investors, he added.

Posted 31 May 2022 by Max Tingyao Lin, Principal Journalist, Climate and Sustainability



This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.

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