A guide to ISDS in the China-Australia Free Trade Agreement: A hollow promise or an answer to ISDS’ critics?

The China-Australia Free Trade Agreement (ChAFTA) is here. The landmark agreement was signed between the governments of Australia and China on 17 June 2015, although it will only take force once it hurdles the necessary ratification processes in both countries.

The agreement will significantly liberalise market access and deepen economic ties between both nations (not to mention the significant exports of beef products the Australian Government and meat producers hope it will encourage). With greater trade and investment, there will inevitably be more disputes. The focus of this article is the Investor State Dispute Settlement (ISDS) mechanisms, which form a relatively small part of the agreement, but have courted significant media attention and controversy.

This article examines in detail the drafting and scope of the ISDS clauses in ChAFTA and outlines the authors’ views of the potential impact of this regime for the Australian and Chinese governments and their investors.

ISDS – what is it?

By including ISDS provisions in free trade agreements and investment treaties, the governments who are party to these agreements grant investors the right to bring claims against them directly for breaches of the investment protection promises made in those treaties. ISDS gives investors the ability to have their claim determined in a forum where they are judged by rules of international law, and not merely by the domestic legal system. This is important because the government may have enacted domestic legislation permitting the action which is contrary to the investment protections in the treaty or free trade agreement. An example of this would be a domestic law cancelling an investor’s license to mine without compensation, which is made lawful by enacting local legislation permitting that action. 

Absent ISDS provisions, there is little prospect that a state will be held accountable for breaching its investment protection promises. Accordingly, absent investor-state dispute settlement, the investment chapters of free trade agreements and investment treaties are not worth the paper they are written on. 

ISDS – a crisis of confidence

ISDS clauses are routinely included in bilateral investment treaties and are commonplace in free trade agreements (such as ChAFTA and the Trans-Pacific Partnership (TPP) currently being negotiated between Pacific-rim countries[1]). However, there is a public crisis of confidence in ISDS.

Public backlash against ISDS has focused on the fact that some ISDS clauses permit investors to bring claims against governments for domestic regulation enacted in the public interest. Additional concerns include the lack of transparency of the dispute process, and concerns that ISDS is conducted in a forum beyond the reach of national judicial systems.

ISDS has been described by prominent US law makers as being a threat to the United States because it will “undermine U.S. sovereignty” and result in “rigged, pseudo-courts”. Similar invective has been invoked by anti-ISDS campaigners in relation to many free trade agreements currently under negotiation by European Union, African and Asian nations.

In Australia, the relationship with ISDS has been similarly fraught. The Australian Government formally discontinued the inclusion of ISDS procedures in trade agreements in 2011 in reaction to concerns over the investor-state arbitration commenced by Philip Morris over Australia’s cigarette plain-packaging reforms. Australia’s current position is that it will consider ISDS on a “case-by-case basis”[2], evidenced by the recent examples of the Japan-Australia free trade agreement not including ISDS, while the Korea-Australia free trade agreement and ChAFTA do.

ISDS may impact the manner in which a government regulates, as it may well encourage governments to regulate consistently with its investment protection obligations in its treaties and free trade agreements. On first glance, this seems sensible and unproblematic. However, where issues of public health and the environment are involved, this can be intensely controversial, as it may result in governments not taking action it otherwise would for a public good, or it may result in the government being required to compensate investors if it does take such action.

In recognition of this, there is a concerted movement toward limiting and modernising the drafting of ISDS clauses in investment treaties to address these concerns.

ISDS in ChAFTA – narrow investor protection

ChAFTA contains a thoroughly considered ISDS regime which reflects both China and Australia’s desire to limit investor protections. The ISDS clauses in ChAFTA are drafted extremely narrowly. The usual substantive protections contained in most investment treaties[3] are completely absent from ChAFTA.

This is no accident. The drafting of ChAFTA occurred over a period during which ISDS was under significant criticism and this section of the agreement was subject to particular scrutiny and specific ministerial approval. As will be seen from our analysis, the governments of both countries have been at pains to limit, rather than expand, the substantive protections available to investors in ChAFTA. 

Limited substantive rights

There is only one substantive right for investors of either country to bring any claim under ChAFTA: where the host government of the investment has failed to treat the investor’s investment in the same way as local investors’ investments (the so called “National Treatment” standard under Article 9.3).

National Treatment clauses are designed to guarantee foreign investors no less favourable treatment than domestic investors. So, if an Australian investor comes into China (or vice versa) and wants to operate a business, that business must be treated no less favorably than local businesses. The classic example of a breach of this clause would be either State levying a tax which applies to foreign investors or investments but not to their domestic equivalents.

Strikingly, Australian investors in China have more limited protection than Chinese investors in Australia. For Chinese investors in Australia, the obligation applies to all stages of investment, including the pre-establishment stage where an investor is seeking to make an investment.[4] However for Australian investors in China, the obligation only applies to the post-establishment stage.[5] The intention behind the difference in obligation is to allow the Chinese government to continue regulate sectors where establishment of foreign investment is either restricted or prohibited, without facing a potential ISDS claims.

The imbalance of this protection reflects the negotiating power of the parties, but also the differences in market liberalisation in both countries. Nevertheless, China has agreed that the scope of this protection for Australian investors in China will be discussed in the ongoing refinements to the treaty which we discuss further below.

Protections for legitimate discrimination

Although ChAFTA only offers this very limited form of investment protection, the two nations have been careful to ensure they retain carve-outs for regulating on public interest grounds in a manner that may nevertheless result in discrimination against the foreign investment.

Both states are entitled to enact measures which result in discrimination against foreign investors if to do so is: (i) necessary to protect human, animal or plant life or health; (ii) necessary to ensure compliance with laws and regulations that are consistent with ChAFTA; (iii) for the protection of national treasures; or (iv) relating to the conservation of exhaustible natural resources (including environmental measures). The safeguard for investors in this respect is that the government must not regulate in an arbitrary or discriminatory manner, or in a manner that is, in truth, restriction on international trade and investment disguised as regulation.

As a result, the ISDS provisions in ChAFTA do not prevent either Australia or China from changing their policies or legitimately regulating in the public interest. The flipside of this is that the protections provided to investors are leaner, and it is crucial that investors understand the relevant regulatory environment in both countries before they commit to making an investment.

Most-Favoured Nation

Another key aspect of the treaty is Article 9.4, the Most Favoured Nation (MFN) clause. The MFN clause ensures that both countries will continue to receive treatment no less favorable than any other nation, including nations that either country in future enters into new trade agreements with.

It should be noted that these are substantive obligations that Australia and China have between themselves and are not, as has sometimes been suggested, a separate basis for investors to bring an ISDS claim.

Transparency

Finally, in line with a trend towards transparency in investor-state arbitrations, the ISDS provisions in ChAFTA incorporate a high degree of transparency to the arbitration process. The request for consultations, notice of arbitration, and orders and awards of the arbitral tribunal must all be disclosed to the public.[6] The provisions stop short of full transparency, however, in that hearings will only be open to the public with the consent of the state against whom the dispute is being brought. Submissions by interested third parties, so-called amicus curiae submissions, may also be made where the tribunal considers that they will assist in the determination of issues.

ChAFTA and the Australia-China BIT – a work in progress

A final, unique, and crucial element of the ISDS clauses in ChAFTA is the “Future Work Program”.

The program, which is set out in Article 9.9, creates a status quo review by Australia and China of the investment legal framework within three years after the date of entry into force of ChAFTA. For that purpose, a future committee will be set up to negotiate various elements of the treaty, which include but are not limited to the addition of further substantive investment protections, including the protection against expropriation without compensation, which at present is a glaring omission.

The existing Australia-China BIT contains some of these additional investor protections and the status of the Australia-China BIT and its relationship with ChAFTA will be also be reviewed as part of the Future Work Program. The net effect of this is that the Future Work Program will clarify, both through the treaty itself and through its planned interaction with the existing Australia-China BIT, what the framework for ISDS between the two nations should be. It will therefore be essential that such a review be conducted as soon as possible after the entry into force of ChAFTA and that such a review be conducted with sufficient transparency.

ISDS in ChAFTA – what are the real benefits for both countries and their investors?

The lion’s share of capital flows between Australia and China, and which will be impacted by the ChAFTA, are in trade rather than investment. The ISDS provisions will not help either Chinese or Australian companies trading in the other’s territories. This is not unusual, such protections are never to be found in treaties, but must be bargained for between parties through commercial contracting processes.

The relevance of the ISDS provisions however is that they provide a measure of political risk protection to Chinese investors in Australia and Australian investors in China. If their investments are not treated in the same way as local investors’ investments, then the infringing government may be required to compensate the investor, if their actions cannot be justified on the public interest grounds provided for in the ISDS carve-outs. Crucially, ISDS protections and the investment liberalisation they protect play a function in encouraging good governance and generating state behaviour conducive with foreign investment.

Finally, the Future Work Program and the clarifications we expect it will bring to the scope of ISDS protections for investors and the interactions between ChAFTA and the China-Australia BIT should be welcomed by investors.

Practically speaking, whilst ISDS disputes are a burgeoning area of jurisprudence, China and Australia’s involvement in this area is limited. To date no successful claims have been made against either Australia or China under any of their various investment treaties.[7]

Conclusion

In every case, the goal of states in negotiating free trade agreements and investment treaties is to balance the interests of providing sufficient protection to investors such that the main purpose of the treaty is upheld – the encouragement of reciprocal trade and investment into each country’s territory by investors of the other state, while limiting its potential exposure to future claims and upholding its sovereign right to regulate in public interest.

The Australian and Chinese governments have carefully crafted the scope of the substantive protections offered in the investment chapter of ChAFTA to limit their potential exposure to investor claims. At the same time, they have given teeth to those investor protections offered through providing for ISDS. Investors can take a real degree of security from these protections, as they provide an avenue of redress in the event of discriminatory treatment for Australian investors in China and Chinese investors in Australia. Equally, critics of ISDS will find the regime in this treaty progressive, providing for greater transparency and increased legitimacy in the dispute resolution process.

The ISDS clauses in ChAFTA are expected to serve as a model for states wanting to offer narrower investor protections.