Inside Arbitration: The ECT exodus – Politics and unintended consequences

With a host of states to leave the Energy Charter Treaty amid climate concerns, we explore what the flashpoint means for multilateralism and the energy transition

Once a mainstay of international energy markets, the Energy Charter Treaty (ECT) has become mired in controversy, with Poland, Spain, the Netherlands, France, Belgium, Slovenia, Germany and Luxembourg having all recently announced their intention to withdraw from the agreement. At the centre of the controversy are arguments that the multilateral framework initially dominated by fossil fuels is restricting states' ability to robustly tackle climate change.

This article provides a refresher on the ECT, an outline of the debate surrounding the treaty, our take on the rationale of the exiting states and final thoughts on what this means for the energy transition.

What is the ECT?

The ECT is a multilateral investment treaty which came into force in 1998 with the aim of promoting international co-operation in the energy sector. The treaty, which was partly drawn up to help integrate the energy markets of the Soviet Union and Eastern Europe into the wider energy sector at the end of the Cold War, provides an investment protection regime for foreign investments similar to those in older generation bilateral investment treaties. The foreign investor may commence arbitration directly against the host state in respect of an alleged breach of the investment protection obligations set out in the treaty.

To fall within the scope of the ECT’s regime, the foreign investment must be associated with an “economic activity in the energy sector”. That term is broadly defined and includes the “construction and operation of power generation facilities, including those powered by wind and other renewable energy sources”, while also encompassing investments in battery power and storage and energy efficiency.

Competing viewpoints

On one hand, commentators have pointed to the ECT's potential to protect new investments that are critical to the energy transition. By offering foreign investors a means of viable redress, the ECT protections may provide the confidence needed to support funding for new clean energy projects. This is particularly true where emerging technologies are involved, or the prospective investment is in a jurisdiction where sovereign risk poses a real concern. In the context of an energy transition heavily reliant on new or reallocated private capital, the availability of such protections may be a key factor in private investment decisions.

A review of recent investor claims shows the ECT has a track record of providing renewable energy investors with recourse where regulatory or political measures have adversely impacted their interests. The increase in cases brought by investors in the renewable energy sector has been remarkable. Available data suggests of all claims initiated under the ECT since its inception in 1994, approximately 60% are claims made by investors in the renewable energy sector (up to 1 June 2022). Of all claims commenced since 2012, claims relating to reforms affecting the renewable energy sector make up just under 70%.

However, critics have voiced concerns about its investment protections being ‘energy-agnostic’ as investors in fossil fuels may invoke them in response to measures to mitigate the effects of climate change, including the phasing out of the fossil fuel industry. These concerns are often articulated by reference to ECT cases such as Rockhopper v Italy, which involved a claim in relation to the reintroduction of a general ban on oil and gas exploration and production activity within the 12-mile limit of the Italian coastline. The tribunal found Italy had unlawfully expropriated Rockhopper’s investment.

The outcome in Rockhopper v Italy turned on the fact that a 1994 Italian decree required production concessions to be granted within 15 days of environmental approval being awarded. Because of this decree, Rockhopper was entitled to be granted the relevant concessions as of August 2015, after Italy’s Ministry of the Environment approved the project. This was the factual context for the subsequent conduct that was found to be expropriatory, when Rockhopper’s application was rejected on the basis of the general ban reintroduced in late 2015.

It is worth noting the tribunal stressed that the arbitration was not concerned with whether Rockhopper’s project should have proceeded to a production stage (ultimately, it did not). Likewise, the tribunal made clear that the decision to ban offshore production was Italy’s sovereign choice to make, and the tribunal “should not be taken in any way to either criticize or deprecate that decision from either a political or environmental standpoint”. The sole question before the tribunal was whether Italy’s sovereign promise under the ECT had been broken by a subsequent sovereign act, to enliven Rockhopper’s entitlement to compensation under international law. The tribunal emphasised that Rockhopper did not seek compensation on the basis that Italy’s sovereign choice to regulate offshore production in its territorial waters was somehow wrong. Instead, it was because the specific prior interaction between Italy and Rockhopper gave rise to certain rights which were then negated without an offer of compensation.

The Rockhopper case provides a useful illustration of the fact-sensitive nature of ECT decisions. Such decisions do not – as a rule – rise and fall on the basis of value judgements about whether a state’s exercise of sovereign power is morally just. As Swedish arbitration veteran Jan Paulsson puts it, investment protections under international law defy “resolution by abstraction”. Rather, tribunals will determine claims with careful regard to the relevant economic, political and environmental factors at play, but with a focus on the specific interactions between the claimant investor and the respondent state in the case at hand. Accordingly, although the ECT does extend protections to foreign investors in a wide range of energy-related fields, these are not applied on a one-size-fits-all basis. They are elastic concepts which, as the recent wave of renewable cases demonstrates, are flexible enough to accommodate changing circumstances, including – insofar as the ECT is concerned – the commercial and technical complexities of a transitioning energy market. The recent report released by specialist think tank Climate Change Counsel, which reviewed dozens of awards rendered in respect of claims brought under the ECT, provides an insight into this body of jurisprudence, including in relation to cases concerning fossil fuel investments.

Rationale for withdrawal and unintended consequences

In the last year states such as Netherlands, Spain, France and Germany have announced plans to withdraw from the ECT, citing the incompatibility between the ECT and goals of the Paris Agreement climate accord. However, such comments can be contrasted with the fact that most claims in the past decade relate to state conduct that adversely impacted the renewable energy sector, not to mention recent efforts to modernise the ECT. In announcing that an agreement on modernised treaty text had been reached, the European Commission in 2022 proclaimed: “We have thereby aligned the ECT with the Paris Agreement and our environmental objectives”.

The modernised ECT would include a "flexibility mechanism" allowing contracting parties to phase out protection for fossil fuel investments. The EU and the UK have already taken up this option, such that any new fossil fuel investments in their territories will lose protection under the ECT as of 15 August 2023. In addition, the modernised ECT would enable the EU to exclude protection for all existing investments in fossil fuels in the EU as of 10 years from the implementation of the modernised ECT. The effect of the amendments was recently summarised by the prominent investment law arbitrator Nikos Lavranos as follows: “…the revised ECT text contains the strongest language of any trade or investment agreement as regards the right to regulate and has strong language on the need to meet the Paris Agreement targets. This is coupled with the flexibility to go further than other ECT members, a gradual carve-out of fossil fuels from the treaty’s coverage and protection, and the banning of intra-EU ISDS claims.”

Although the withdrawing parties will be released from obligations under the ECT in relation to investments one year from formal notification, under the sunset provision of the current ECT, investments prior to that point may be covered by the protection regime for 20 years. In effect, this may mean the withdrawal will eliminate protection for all existing energy investments (including fossil fuel investments) at least 10 years later than the phase-out period for existing fossil fuel investments contemplated in the draft modernised ECT. Hence, it has been observed that "withdrawing from the ECT might have the paradoxical effect of prolonging protection under the old ECT regime”.¹ It is difficult to reconcile this potential outcome with the rationale provided by the withdrawing states.

While the contracting parties were scheduled to finalise the draft modernised ECT on 22 November 2022, the vote has been postponed to a meeting in April 2023 instead. The prospects of these discussions are uncertain, particularly since the EU Parliament passed a resolution calling for the withdrawal from the treaty and the nullification of the sunset-clause between willing parties. It is unclear whether this strategy can succeed as, despite the European withdrawals, the ECT has still attracted states, particularly from Africa, willing to accede to the treaty.

Implications

Some commentators have argued that, given the significant take-up of treaty protections by renewable energy investors in recent years, the withdrawal announcements will send a negative message to investors, and create legal uncertainty that may delay the energy transition. Ultimately, any adverse impact on investor certainty or decision-making in the renewable energy industry will be difficult to measure, particularly in view of the extensive framework of bilateral and multilateral investment treaties, including free trade agreements and regional partnerships.

It could also be argued the departure of European states from the ECT reflects a wider movement away from multilateralism in certain areas. Where states have experienced firsthand the significant costs associated with findings of liability against them under international treaties, they may be less inclined to continue to participate in efforts to reform those treaties in favour of a complete departure from the treaty-based system. This is particularly true where reform efforts are focused on procedural or cosmetic features of the system, rather than addressing the criticisms of its purpose. As academic, author and arbitrator Andrea Bjorklund has observed, the concern about international investment law infringing on national has sovereignty goes to the heart of the treaty-based system and is unlikely to be addressed by procedural reform within the existing model.

However, entry into international investment treaties like the ECT, and participation in reform of those treaties, are also calculated exercises of state sovereignty. As such, for states contemplating withdrawal this is not a choice between preserving or relinquishing sovereign power. Rather, it is a matter of how best to exercise it. Ultimately, this demands an assessment of whether the benefits of participation are outweighed by the benefits of withdrawal. Besides political statements underscoring commitments to the energy transition, it is not clear that departing states have coherent strategies in how their investment treaty frameworks will support the clean energy they claim to be prioritising.

For now, what is apparent is that this European exodus will undercut the planned conclusion of the ECT modernisation process. As noted above, the withdrawing parties may remain bound by the provisions of the old ECT due to the operation of the sunset clause, which is difficult to reconcile with their stated rationale for withdrawal. Putting to one side the direct implications for the departing states, if their exit undermines the modernisation process, it will be a lost opportunity to harness the considerable benefits of ECT membership and modernise its provisions to reflect the energy needs and priorities of the present day and beyond.

1. “Withdrawing from the Energy Charter Treaty: The End is (not) Near”, Kluwer Arbitration blog (4 November 2022) https://arbitrationblog.kluwerarbitration.com/2022/11/04/withdrawing-fro...