Investment treaties and the energy transition: challenges and opportunities

There is growing recognition that Australia, like other countries around the world, must encourage foreign investment to achieve its clean energy transition goals. Investment treaty protections have long been seen as an important tool for attracting foreign investment. However, amidst concerns about governments’ ability to execute on their energy transition goals, this traditional view is increasingly being challenged.

Recent developments are prompting a close examination of the role investment treaties play in promoting renewable energy investments and the relevance of investor-state dispute settlement as a risk mitigation tool for foreign investors in renewable energy projects. As traditional energy sources continue to get replaced by renewable ones, one thing is clear – change is on the horizon.

According to Austrade, ‘[f]oreign direct investment is supporting Australia to lower carbon emissions and move towards sustainable energy sources’.[1] This is consistent with the Paris Agreement, in which Contracting States (including Australia) recognise that finance flows are required to lower greenhouse gas emissions and support climate-resilient development. Globally, the International Energy Agency estimates that in order to reach net zero emissions by 2050, annual clean energy investment worldwide will need to more than triple by 2030 from the current US$1.4 trillion to around US$4 trillion annually.[2] 

On the other side of the ledger, we are already seeing new and increasing export markets for Australian energy products – hydro, wind, solar and hydrogen – and for key components of low-emissions technologies, capitalising on Australia’s abundant rare earth and critical mineral deposits. As BHP’s Chief Executive recently commented, “the chase [for mining investment is] now on and… many other nations are competing for capital”. That competition was ramped up in August 2022 by the passage of the Inflation Reduction Act in the United States, which pledges A$520 billion in the pursuit of energy transition.

Recognising the “big risk with the inflation Reduction Act… that you would see capital leave Australia to go to the United States”, Prime Minister Anthony Albanese recently struck a compact pursuant to which the United States would recognise Australia as a domestic source for critical minerals and clean energy, allowing qualifying Australian companies to access (via facilitative legislation) subsidies and other benefits under the Inflation Reduction Act.

The compact’s emphasis on critical minerals, storage and hydrogen technologies plays to Australia’s unique opportunity as the nation with some of the world’s largest reserves of the critical materials that will be crucial to the global energy transition. The compact has been backed by the Australian Government’s recent A$2 billion commitment to the new Hydrogen Headstart program to ensure that Australian remains in the race to become a global clean energy superpower.

For several decades, robust investment treaty protections were seen as an important tool for attracting foreign investment, and for protecting domestic investors abroad. This is due to investment protections afforded under investment treaties, which effectively restrict the ability of governments to act in certain ways that may impact the economic interests of foreign investors who seek to invest, or who have invested, in those countries.

However, this traditional view is increasingly being challenged due to the chilling effect investment treaty protections can create on government regulation. More recently, this has manifested in a concern about governments’ ability to execute on their energy transition goals. The challenge is demonstrated by a series of recent cases where states were faced with investment treaty claims bought by traditional and renewable energy investors following changes in the states’ energy policy.

Investment treaty claims can be brought pursuant to a legal mechanism included in some investment treaties which empowers foreign investors that have suffered certain adverse effects by reason of regulatory measures introduced by the host state of their investment to seek compensation by bringing a claim directly against the host state and having that claim determined by an independent panel of arbitrators. If the measure in issue breaches investment treaty protections, the investor may recover damages for both current and future economic loss (in other words, the measure of damages is not constrained by the usual contractual measure that we are accustomed to in common law jurisdictions).

The challenges emanating from the current international investment treaty regime in the context of the energy transition are multi-faceted in that the regime allows claims to be pursued in response to both fossil fuel phase-outs and policies promoting investment in renewable energy. For example:

• German energy companies Uniper and RWE, owners of coal-fired power plants in the Netherlands, have brought investment treaty claims against the Netherlands in connection with the Dutch government’s commitment to reduce the capacity of its remaining coal-fired power stations by 75% and implementing a package of measures to reduce Dutch emissions.[3] 
  
  
• The UK-headquartered oil and gas company Rockhopper Exploration was successful in its investment treaty claim against Italy in which it challenged Italy’s rejection of Rockhopper’s application for an offshore exploitation concession based on a new law that introduced a complete ban on offshore drilling in Italy. An arbitral tribunal held in August 2022 that the rejection of the application was an immediate and complete deprivation of Rockhopper’s investment in Italy and constituted an expropriation under the applicable treaty (the Energy Charter Treaty).

On the other hand, there have been myriad instances of investors challenging decisions by states to scale back subsidies and other financial incentives originally introduced to attract investment in renewable energy projects. Spain alone has been the respondent in dozens of investment treaty claims after it had retracted some features of its solar energy incentives regime, with many investors arguing that this contravened their treaty-protected ‘legitimate expectations’ that the favourable regulatory framework would remain in place.

Developments such as these necessitate a close examination of the role investment treaties play in promoting renewable energy investments, and the relevance of investor-state dispute settlement as a risk mitigation tool for foreign investors in renewable energy projects. Several empirical studies have recently been completed or are currently underway looking at these issues. There are also ongoing discussions regarding reforms of the international investment treaty regime, so as to enable it to expedite the energy transition by protecting both foreign investment and climate change regulation.

Several options have been proposed by way of reform. On one extreme, some have called for an abolition of the investment treaty system – although a growing consensus seems to be that the regime (in some form) must be preserved in order to incentivise the investment required to achieve the clean energy transition. If the investment treaty regime is to be preserved, the existing investment treaties may be amended (and new treaties negotiated) to exclude, or enable Contracting Parties to exclude, protections for fossil fuels in their territories. Alternatively, provisions may be negotiated that protect Contracting Parties’ ability to introduce more ambitious regulations to mitigate climate change, to the extent these are adopted in good faith and are capable of resulting in emissions reduction. Other proposals include amendments to substantive treaty protections by, for example, clarifying that investors will not be protected when foreseeable climate policies are adopted by host states to comply with their Paris Agreement targets, or when host states discriminate between projects based on their climate impact.

Apart from substantive reforms, some states may opt for limiting access to investor-state dispute settlement. Perhaps in response to experience from overseas, Australia’s Federal Government seems to be steering away from dispute settlement provisions in its investment treaties that allow direct claims by investors – in November 2022, shortly after a new Federal Government came to power, Australia’s Trade Minister announced that the Government would “not include investor-state dispute settlement in any new trade agreements”.

The reality is, however, that while there are a number of alternatives being advanced (including, for example, the establishment of a multilateral investment court), in the absence of an investment treaty including an investor-state dispute settlement mechanism, investors may be left with only domestic (which are limited) or state-to-state dispute resolution options (which are heavily dependent on the political will of the investor’s home state). That is typically an unattractive and unrealistic option for most private entities – and one that does not seem to take advantage of the investment promotion potential of investment treaties which is particularly important in the context of the energy transition challenge.

How the anticipated reforms unfold will be important to cross-border investors in new energy projects. Investment treaties that contain investor-state dispute settlement mechanisms can and do play a part in the management of risk for foreign investors. Renewable energy investors will be well advised to explore how best to structure their investments to avail themselves of the most robust investment treaty protections. At the same time, investors with existing investments should consider how amendment or termination of investment treaties which might have underpinned their investment decisions will affect their future ability to enforce treaty protections.

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While the ultimate characteristics of a reformed investment treaty regime remain uncertain, it is clear that changes are on the horizon and that they will impact the manner in which the interests of foreign investors are protected as traditional energy sources get replaced by renewable ones.

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_{[1] Austrade, ‘Foreign investment helping Australia transition to a green future’, 18 August 2021.}

_{[2] International Energy Agency, ‘Net Zero by 2050: A Roadmap for the Global Energy Sector’, May 2021.}

_{[3] Uniper has since withdrawn the ECT claim to secure a bailout agreed with the German government in the midst of financial difficulties following the drop in supplies of Russian gas. The RWE claim is currently pending, despite a judgment handed down by a German court in September 2022 declaring the ECT claim to be inadmissible under EU law on the basis that the ECT does not extend to intra-EU investor-state disputes.}