When investing overseas individuals and companies benefit from protections accorded under more than 2,500 International Investment Agreements (IIAs) and Free Trade Agreements (FTAs) presently in force globally. Typically, these treaties guarantee that the investor’s rights and the value of the investment will not be adversely affected by wrongful conduct by the Host State – that is, the government of the state where the investment is located.

In a recent Insight, we discussed how investment treaty protections and ISDS can be leveraged to minimise foreign investment risk. In particular, they may allow investors to seek compensation in response to unlawful government action, by commencing international arbitration proceedings – commonly referred to as investor-state dispute settlement (ISDS) – against the Host State.

Increasingly, however, investment treaties and the protections they afford are being examined through the lens of the broader imperatives of environment and climate protection. In this Insight, we consider how investment treaties interact with the environment, how that interaction is shaping investment treaty practice, and what this means for foreign investors going forward.

Investment treaties were developed to promote cross-border direct investment flows by protecting foreign investors and their investments from the most egregious forms of mistreatment by the state in which they invest.

However, the role of investment treaties is now being re-examined in light of a proliferation of ISDS cases in which investors have sought compensation for legitimate government regulation, including measures introduced to protect public health, prevent environmental harm and mitigate against climate change.

As a consequence, states and arbitral tribunals are being called to re-evaluate the interaction between the right of states to regulate in the public interest and investors’ treaty protections, as well the ability of investment treaties to channel investments that contribute to sustainable development and the net zero transition.

The relationship between investment treaties, the environment and climate change has been and continues to be tested and defined in a growing number of ISDS cases and the new generation of investment and trade agreements.

With a gradual phase-out of emissions-intensive energy sources, court decisions forcing governments to adopt regulatory changes and massive private investment in ‘green’ projects, this trend is set to continue.

Interaction between investment protections and the environment

Investment treaty protections and the environment overlap in a number of ways, and there has been a series of cases brought by investors over the implementation or enforcement of Host States’ environment protection legislation and climate-related regulatory changes.

To give a sense of the vast variety of these cases, we examine some typical examples of ISDS claims that have involved environmental and climate considerations.

The most common are claims that arise from a negative assessment of a project’s environmental impacts which results in either a rejection of a project or the imposition of (overly) burdensome conditions.

Investment treaties may protect investors from discriminatory, unfair, non-transparent and procedurally flawed environmental impact assessment processes which unduly prejudice the economic viability of an investment.

Investment treaties are also increasingly being invoked by investors complaining of losses that result from changes to environment protection regulations and the evolution of Host States’ energy transition policies – in both traditional and renewable energy sectors.

Notably, there have been myriad instances of investors challenging a decisions by the Host State to scale back subsidies and other financial incentives originally introduced to attract investment in renewable energy projects. Spain alone has been the responded in over 50 investment treaty claims after it had retracted some features of its solar energy incentives regime which, many investors have argued, contravened their treaty-protected ‘legitimate expectations’ that the favourable regulatory framework would remain in place.

On the flip side, introduction of stricter regulation of the traditional energy sectors by states to mitigate against the effects of climate change has also started to generate investment treaty claims. For example, ISDS proceedings have been commenced against Canada over a moratorium on fracking that led the Quebec government to revoke certain permits for oil and gas exploration and over Alberta’s Climate Leadership Plan which accelerated the phase out of coal power to 2030.

More recently, in 2021, two investment treaty claim were brought against the Netherlands by German investors under the Energy Charter Treaty due to the government’s plan to phase out coal by 2030 in order to comply with judgments of the Dutch courts in Urgenda Foundation v the Netherlands requiring it to significantly limit GHG emissions.

Claims typically arise from regulatory action taken by the Host State but a treaty claim could also be grounded in the Host State’s failure to implement its environmental protection legislation. This was the basis upon which a Canadian investor commenced investment arbitration against Barbados, claiming (although unsuccessfully in that case) that a failure by Barbados to take environmental protection measures violated the applicable investment treaty and destroyed the value of his investment in an eco-tourism site.

While many environment-related measures have given rise to investor claims, Host States can also invoke, and have sought to enforce, environmental laws against investors in investment arbitration.

For example, respondent states have challenged tribunals’ jurisdiction or admissibility of treaty claims on the basis that the investment in question was made in breach of the Host State’s environment protection legislation.

The challenge arises from the ‘legality requirement’ which expressly or implicitly requires investors to comply with Host State domestic laws if they are to benefit from investment protections or be entitled to seek recourse through ISDS. The argument was successful, for example, in Cortec Mining v Kenya, where Kenya argued that the investors’ Special Mining License was void ab initio because it was granted without a mine feasibility report and an environmental impact assessment study having been completed, the latter being conditions precedent to the issuance of a special mining license in accordance with Kenyan law.

The tribunal found that environmental considerations were of ‘fundamental importance’ and the claimants’ failure to abide by the relevant regulations, especially in an environmentally vulnerable area like the project site, justified declining jurisdiction.

Further, Host States have pursued counterclaims against the investor for environmental damage caused by the investment. While a tribunal appointed to hear an investment treaty claim will not necessarily have jurisdiction to determine environmental counterclaims, there are examples where counterclaims have been determined on their merits and have resulted in a damages award against the investors.

Environmental failings of the investor have also been invoked by Host States to dispute the investor’s entitlement to the damages sought. An argument that is becoming more common in Host States’ submissions – in particular in disputes involving mining projects – is that by failing to engage in public consultations with local population and to maintain a ‘social license to operate’, the investor contributed to or is responsible for its losses.

The argument is one of contributory fault which, if accepted by a tribunal, may mean that the investor either does not have a claim or is only entitled to a portion of the damages claimed.

Evolution of treaty practice and ISDS

As the overlap between investment protections and the environment continues to evolve and expand, countries are turning their minds to how investment treaties can be re-balanced to avoid fettering their ability to implement progressive environment and climate protection measures, and to promote investments that support climate change mitigation and adaptation efforts.

Various global reform initiatives are presently underway that seek to achieve this.

The United Nations Conference on Trade and Development (UNCTAD) has issued comprehensive guidance to states negotiating new investment treaties. The ‘UNCTAD Reform Package’ provides drafting guidelines for treaty provisions aimed at safeguarding Host States’ policy space.

According to a recent UNCTAD Report, all investment treaties concluded in 2020 contain reform-oriented provisions which rebalance the scope of investor protections. Examples of reform provisions include limiting forms of compensable indirect expropriation and Host States’ fair and equitable treatment obligations, excluding certain types of assets from the definition of protected investments, a commitment by states parties not to relax their environmental standards to attract investment, and limiting access to ISDS.

An innovative example of the recently concluded treaties is the Morocco-Nigeria Bilateral Investment Treaty (BIT). It grants protections only to those investments which contribute to ‘sustainable’ development, recognises the Host States’ right to exercise discretion with respect to regulatory matters regarding the environment; and introduces a series of obligations upon investors, including (among others) to comply with the most rigorous of the state parties’ environmental assessment screening requirements, apply the precautionary principle; and maintain an environmental management system in the course of operations.

The introduction of investors’ responsibilities is a particularly novel feature of investment treaties which have traditionally been seen as one-sided, creating rights for the investors on the one hand, and obligations for the contracting state parties on the other hand.

Another reform initiative is the proposed revision of the Energy Charter Treaty (ECT) – an international agreement that establishes a multilateral framework for cross-border cooperation in the energy industry – to modernise and bring the agreement in line with the net zero transition. Negotiations for reform of the treaty began in 2018 and are ongoing.

The ECT affords protection to a large number of investments in coal projects, the industry with the largest impact on climate change, and the treaty has been used by investors to challenge government action aimed at phasing out the use of coal. Recent proposals contemplate excluding future investments in fossil fuels from the scope of protection afforded by the ECT.

Finally, there have been a number of reform initiatives focused on the ISDS.

For example, there has been a push for increased transparency in ISDS. In 2014 the UNCITRAL adopted Rules on Transparency in Treaty-based Investor-State Arbitration, which require, amongst other things, the publication of certain documents including the parties’ pleadings and for hearings to be public to the extent possible;

Also, recently concluded treaties between the European Union (EU) and states like Canada, Singapore and Vietnam provide for an Investment Court System (ICS) to replace ad hoc party-appointed investment tribunals with a permanent tribunal coupled with an appeal mechanism, in an effort to promote greater transparency and consistency in the ISDS jurisprudence.

For example, the Canada-EU CETA provides that a joint committee of the States must appoint arbitrators, similar to the way judges are appointed in a court system. The decisions of the tribunal are subject to appeal before an appellate body.

There is also a provision requiring parties to pursue with other trading partners, the establishment of a multilateral investment tribunal and appellate mechanism; the EU’s longer term goal is to establish a single, permanent institution to hear investment disputes. Negotiations for setting up this multilateral investment court are currently underway.

Another area of concern is the involvement of third parties. While amicus curiae submissions may be permitted from third parties, there are concerns over the lack of protection of third party rights and that the process does not adequately allow for meaningful third party participation.

There can be a number of third parties affected by investments particularly in the energy and natural resources field. For example, projects can adversely affect the land of local and indigenous communities. Commentary in this space, and submissions to the UNCITRAL Working Group III, suggests comparable arrangements to the court system for third party participation or other reforms such as requiring investors to exhaust domestic remedies before pursuing ISDS, dismissing claims where third parties could be affected, or reframing claims to minimise the impacts on third parties.

Why is this relevant to individuals and corporations with cross-border assets?

We are seeing an increased commitment of states to take action to meet the Paris Agreement targets and, where regulation is lacking, climate change litigation is increasingly being used as a tool to force states to implement stricter environmental measures.

In the landmark 2015 decision in Urgenda Foundation v Netherlands, the Supreme Court of Netherlands found that the Dutch State had a duty of care, arising out of the European Charter of Human Rights, to achieve a reduction in greenhouse gas emissions. Following this case, there have been numerous court actions commenced against governments, both overseas and in Australia, alleging a failure to adequately combat climate change.

Currently ongoing are proceedings commenced in the Australian Federal Court by Torres Strait Island leaders, on behalf of Torres Strait Islander communities, against the Australian Government seeking orders requiring the government to reduce greenhouse gas emissions in order to prevent ocean levels rising and in turn flooding and destroying irreplaceable cultural heritage and sacred sites.

This follows the 2021 decision of the Australian Federal Court in Sharma v Minister for the Environment [2021] FCA 560. In that case, the Court found that the Minister for the Environment had a duty to take reasonable care to avoid causing personal injury to children in Australia in deciding whether to approve an extension to a coal project in New South Wales. The ‘personal injury’ referred to was injury due to climatic hazards.

Similar activity is taking place elsewhere. There has been a series of rulings against the French State for its failure to combat climate change, including the Grand Smythe case, in which the French State was ordered to take additional measures by March 31, 2022 to achieve a reduction in greenhouse gas emissions by 40% by 2030, in line with its obligations under the Paris Agreement.

Along with the precedents that these cases have set, the growing body of scientific evidence of climate change now accepted by Courts around the world will make it easier for claims related to environmental issues to be pursued. In turn, this will force governments to implement regulations aimed at achieving the net zero transition.

The anticipated regulatory changes are expected to prompt individuals and corporations with cross-border assets to seek relief through ISDS. However, investment treaty practice is evolving and will continue to change the recourse available to foreign investors.

States are pivoting away from viewing investment treaties merely as investment facilitation instruments. We are now seeing investment treaties being approached as tools that promote sustainable development by demanding compliance – expressly or implicitly – with ESG requirements. In this way, like in other areas, ESG concerns are coming to the fore.

Foreign investors should be mindful of the continuous developments in this field to maintain access to the most favourable treaty protections when investing or operating overseas.