Energy Charter Treaty “modernized” to reflect low-carbon transition needs after two years of talks

A 28-year-old international treaty designed to protect foreign investors in energy projects is set to be revised to promote a low-carbon transition, according to its signatory countries, but environmentalists and legal experts are divided on whether the new version can help fight climate change.

The Energy Charter Treaty's 53 signatories, consisting of the EU and dozens of Asian states, reached a tentative agreement last week to allow an opt-out of protection over fossil fuel investments and to explicitly shield certain types of decarbonization technologies.

The "modernization" is being introduced to support "the respective rights and obligations" of the signatories, which separately committed to the Paris Agreement's climate goal in 2015 under the UN Framework Convention on Climate Change, the treaty's secretariat said in a statement 24 June.

"The contracting parties reaffirmed their commitment to clean energy transition, promotion of low-carbon technologies in energy trade and investment, and cooperation in implementing climate change-related policies," the statement said.

Launched in 1994, the treaty has faced growing criticism from green lobbyists because it grants energy investors—regardless of their green credentials—the right to seek compensation from state governments for policy measures that could lower expected profits.

There have been over 100 treaty proceedings in global arbitration tribunals like the World Bank's International Centre for Settlement of Investment Disputes since 2001, mostly brought by EU investors against EU states.

Among the most high-profile cases, German utilities Uniper and RWE have launched claims totaling €2.7 billion ($2.82 billion) against the Dutch government for its plan to close their coal-fired power plants by 2030.

The EU kickstarted the treaty's renegotiation in May 2020 and, despite early opposition from Japan, managed to achieve a compromise deal after 15 rounds of talks.

"The ECT will offer investment protection reflecting the reformed and modernized standards developed by the EU … preserving the right of governments to pursue their public policy objectives, including for climate change mitigation and adaptation," the European Commission (EC) said in a statement 24 June.

"This fully preserves the EU's ability to develop our climate policies," the EU's executive branch added. "We have thereby aligned the ECT with the Paris Agreement and our environmental objectives."

Fossil fuel phaseout

Central to the revision is a "flexibility mechanism," which allows signatories to exclude investment protection for fossil fuels in their territories based on their climate goals.

Those who opt for the exclusion can stop protecting existing fossil fuel investments 10 years after the revised treaty comes into force, with the same applying to new investments after 15 August 2023.

The UK, a treaty signatory, said the new terms will limit costly legal challenges from fossil fuel investors in the country and reduce the risks to British taxpayers.

"It will protect the UK government's sovereign right to change its own energy systems to reach emissions reductions targets in line with the Paris Agreement," the Department for Business, Energy and Industrial Strategy (BEIS) said in a statement 24 June.

When introducing decarbonization policies, countries could be liable for up to $340 billion in compensation for terminating proposed oil and natural gas projects that have yet to begin production, according to a recent study published by Science.

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.

Based on the estimates of an environmental thinktank, the International Institute for Sustainable Development (IISD), the ECT served as the legal ground for 17% of the 231 fossil fuel-linked ISDS cases filed as of January, outnumbering any other agreements.

Rachel Thrasher, a researcher with the Boston University Global Development Policy Center, said the opt-out clause could actually trigger a raft of claims from existing fossil fuel investors in the coming years.

"There will be 10 years before existing fossil fuel investments are no longer covered," Thrasher told Net-Zero Business Daily by S&P Global Commodity Insights. "As such investors are likely to be aware of the future limitations to their reliance on ISDS and may indeed attempt to bring cases before the time runs out."

Law firm Clyde & Co Partner Richard Power holds a different view, saying investors' appetite for arbitration could be curbed as tribunals are likely to take into consideration the Paris Agreement.

"Any compensation will be based upon the fair market value of the investment, and arguments can be made that such valuations should be reduced to reflect lifespans necessarily limited by binding emissions reductions plans," Power told Net-Zero Business Daily.

Just walk out?

In its current form, the ECT has a sunset clause that suggests any signatory needs to protect investors for another 20 years after withdrawing from the treaty.

EU member states France, Spain, and Luxembourg had threatened to exit the treaty if the renegotiation failed to yield satisfactory results. Italy left in 2016 after several proceedings.

The revision, with the 10-year sunset clause for existing investments, will result in a shorter timeframe for phasing out protections for fossil fuel investors than a withdrawal, would, the EC said.

But some environmentalists believe signatories should still opt for an immediate, "coordinated withdrawal" if serious about decarbonization.

Rather than ratifying the revised treaty, the EU and signatory countries can opt to neutralize the 20-year sunset clause by agreeing to not allow claims among themselves, said IISD International Law Analyst Lukas Schaugg.

"In the next few years, governments will have to take substantial action if they want to keep their climate commitments. These first few years are crucial and arguably more important to start putting phaseouts in place," Schaugg said.

"States opting for a coordinated exit with the neutralization of the sunset clause would be in control of the timing" and not wait for 10 years, he added. "The effect would be immediate."

But this approach might not be the best way forward as "removing legal rights and protections goes against the rule of law and natural justice," Power said.

"Some sort of grace period had to be given. While the 10-year period could perhaps have been shorter, it is the result of negotiation and compromise," he added.

Protection over decarbonization technologies

Since 2013, a boom in ECT-based disputes launched by both renewable and fossil fuel investors has led to states paying damages in the hundreds of millions of euros at a time.

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.

The revised treaty will come with new provisions that offer explicit protection for hydrogen, anhydrous ammonia, biomass, biogas, synthetic fuels, and carbon capture, utilization, and storage in the energy systems.

"For the first time, it will ensure legal protections for overseas investments into the UK in green technologies," BEIS said. "This will help give private investors in these types of technologies increased confidence as the technologies develop."

The terms will help promote decarbonization investments "to a certain degree" by offering foreign investors the right to compensation in such high-risk, capital-intensive projects, Power said.

"But ultimately, positive steps, such as subsidies, incentives, regulatory certainty and harmonization, and levelling the playing field with fossil fuels [via means like] the imposition of a realistic carbon price, will have a greater effect," he added.

Others pointed out that foreign investors tend to be lured by institutional stability, a large consumer base, and economic growth, rather than favorable terms in investment treaties. "The same applies to decarbonization technologies," Schaugg said.

No more intra-EU cases

The revised treaty will also ban ISDS claims among signatories that belong to the same "regional economic integration organization," effectively preventing intra-EU cases from arising in the future.

Last September, the Court of Justice of the EU ruled against intra-EU arbitrations based on the ECT.

"This shall finally bring an end to the intra-EU applications under the ECT that are contrary to EU law," the EC said.

But Power expressed concerns that the development will prove detrimental to investors in EU energy projects.

"Investors will lose the right to their claims being decided by an independent and impartial tribunal of their choosing, determined in a neutral venue, and will be faced with the prospect of having to claim compensation for breaches of their protections in the national courts of the defendant states," he said. "Investors might not be confident of obtaining a truly fair and balanced hearing of their claims for compensation in national courts."

Uncertainty ahead

On 22 November, signatories will hold a meeting to decide on whether to formally adopt the revised treaty. A unanimous decision will be required.

If adopted, the new ECT will enter into force 90 days after the ratification by three-fourths of the signatories and be reviewed every five years.

Despite the EC's approval, the EU will still need consent from member states and the European Parliament before ratifying the treaty.

Anna Cavazzini, a member of the European Parliament, said the revision is "too limited and slow" in phaseouts even though "it is good that there is a partial carve out of investments in fossil energies."

"The agreement is better than the status quo, but withdrawing together from this climate-damaging treaty would still be a cleaner solution," Cavazzini told Net-Zero Business Daily.

The ratification process could be drawn out and fail to recognize the urgency in addressing climate change, Schaugg suggested. "The new treaty might never enter into force, leaving the old treaty fully applicable. Or it might enter into force in several years, affording protection [for fossil fuel investments] for well over a decade."

Posted 30 June 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.