The tension between the right of a state to regulate in public interest and the rights of investors will be crucial for future investments in energy infrastructure. The global low-carbon energy transition leading to stricter environmental regulations and creating increasing uncertainty for investors, particularly for those investing in legacy infrastructure. This article describes how regulatory changes, geopolitical shifts and the evolution of energy markets are impacting the security of investments in legacy infrastructure and explains how investors can safeguard their interests.
Introduction
Climate change is one of the greatest challenges of our time. Obligations of states are rapidly changing as the climate crisis accelerates. By signing the 2015 Paris Agreement, 194 countries and the European Union (“EU”) legally commitment themselves to reduce global greenhouse gas emissions in order to limit global temperatures (United Nations, 2024). A major concern is the potential conflict between measures of states to fulfill their climate protection obligations and the investor protection standards enshrined in relevant investment treaties. There is a growing argument that the protection provided by current International Investment Agreements (“IIAs”) fundamentally clash with regulations designed to address climate change. This incompatibility stems from the fact that many first-generation IIAs (concluded in the 1980s and 1990s) still in effect feature broad investment protection standards, including fair and equitable treatment (“FET”) and protections against illegal expropriation, without making any explicit allowance for a state’s right to enact climate-related regulations (Aggarwal & Kabra, 2023). Consequently, a state’s efforts to tackle climate change may result in a wide range of investor claims. This significant tension between a state’s sovereign authority to implement necessary climate actions and its compliance with existing investment treaties presents a considerable challenge. In the end it is up to Arbitral tribunals to find a balance between the legitimate expectations of investors and public welfare (Gessel-Kalinowska vel Kalisz, Frontczak, & Paprota, 2023).
Current warming is already causing catastrophic damage to humans and ecosystems. The Intergovernmental Panel on Climate Change warns from even increasing negative impacts in the future. Experts of the United Nations (“UN”) and global leaders agree, that the current situation reflects a human rights crisis (de Anzizu & Reisch, 2023). In 2021 and 2022, the Human Rights Council and the General Assembly formally declared a universal human right to a clean, healthy, and sustainable environment at the UN level for the first time. More than 80 per cent of UN Member States acknowledged the right to a healthy environment through their constitutions, national laws, and regional treaties (United Nations Human Rights Office, 2024).
Fossil Fuels Phase Out and Geopolitical Shifts
The introduction of a system based on sustainable, low-carbon energy sources is crucial to achieving the targets set. In areas such as hydrogen and carbon capture storage technologies significant progress has already been made (Collins, 2024). Beyond technological and economic factors, and aside from climate and energy objectives, the geopolitical shifts, particularly the war between Russia and Ukraine, has given a strong incentive to the push towards hydrogen. In response, the European Commission recently introduced the REPowerEU plan, which revises and amplifies several goals initially established in the Fit for 55 package, including those related to hydrogen (Cellura & Ferraro, 2023).
Conversely, in 2022, at the start of the Russia-Ukraine war, the effort to reduce the dependency on Russian gas has led to a significant development away from the goal of increasing the use of renewable energy sources. At this time, Russian gas comprised 40 per cent of the total consumption within the EU. The most effective solution to get independent and combat potential energy insecurity in the future, at least in the short term, has been through floating storage regasification units (“FSRU”), which allow for an increase in liquified natural gas (“LNG”) import capacity (Soliman Hunter, 2023).
Until April 2022, Germany and Finland were the two EU Member States that were the most dependent on Russian pipeline gas and unprepared for alternatives. Finland’s rapid conversion to a FSRU at the Hamina port on the Baltic Sea has significantly strengthened its energy security by providing access to diverse LNG suppliers and introducing gas storage capacity for the first time. Also, Germany faced significant challenges to its energy security due to its lack of LNG import terminals. Like Finland, Germany also leased five FSRUs and therefore managed to switch to alternatives to Russian pipeline gas in a short period of time (Soliman Hunter, 2023). LNG is a cleaner alternative to traditional fossil fuels while also helping to address the challenges posed by unstable renewable energy sources and can therefore be seen as a bridge fuel (Usiagu, Adekoya, Okoli, Daudu, Ekemezie, & Ayorinde, 2024).
Regulatory uncertainty
To prevent the threat of climate change, there is a consensus that a long-term strategy that moves away from fossil fuels and towards renewable and sustainable energy sources is needed. transition entails the implementation of new governmental regulations. Implementing international climate commitments will inevitably require a variety of governmental regulations that may substantially alter the extent of previously authorized activities and property rights in industries associated with high greenhouse gas emissions. Some of these regulations could undermine the economic viability of proprietary interests and the established rights of private sector investors. Foreign investors in the fossil fuel sector are confronted with great regulatory uncertainty and may turn to investor-state dispute settlement (“ISDS”) mechanisms to claim compensation for their economic losses or to deter actions that result in the investment becoming unprofitable (Cleary Gottlieb, 2024).
Withdrawal from the Energy Charter Treaty
As the development and implementation of new regulations increase significantly, the bases for investors to challenge these state regulations and protect their investments against their decay have notably diminished.
The FET standard is the most significant basis for investor-state claims. Investors have frequently invoked this standard, and it has been applied by tribunals in nearly all investment cases (Levashova, 2019). The reason why investors repeatedly rely on this clause is due to its unqualified (Levashova, 2019), open-ended and broad formulation in most IIAs, particularly in first-generation IIAs, which often only state that investors “shall at all times be accorded fair and equitable treatment” (Aggarwal & Kabra, 2023). The FET standard has evolved over time and especially in the early 2000s there were many dissenting interpretations by different tribunals. Early decisions often favored investor rights and adopted a very broad interpretation of the FET standard to cover a wide range of state actions. Over time, tribunals have moved toward a more balanced approach, considering the interests of both the investor and the host state. The current understanding of the FET standard is generally defined by key principles such as due process, protection of legitimate expectations and the prohibition of arbitrary and discriminatory treatment (Levashova, 2019).
A comprehensive FET provision, which has been clarified and applied by various arbitral tribunals over time can also be found in Article 10 of the Energy Charter Treaty (“ECT”) (Schreuer, 2007). The ECT has triggered a growing debate and there were increasing calls to renew it or replace it with an international framework that is more in line with global climate goals while promoting investment in renewable energy projects. (Pearsall, Ingle, & Smadja, 2023). In 2022, several European countries, including Spain, the Netherlands, France, Poland and Germany, decided to withdraw from the ECT. In February 2023, the European Commission announced a coordinated withdrawal of the EU itself and all EU member states from the ECT. (Pearsall et al., 2023). Dissatisfaction was particularly felt in relation to the agreement’s investor protection mechanism, the ISDS procedure, as this allows foreign investors from the fossil fuel sector in particular to file compensation claims against governments if political changes have a negative impact on their investments. Many critical voices see this system as a significant obstacle to the clean energy transition, as it could deter states from implementing much-needed climate action for fear of costly litigation. This phenomenon is often referred to as “regulatory chill”. There is much evidence to suggest that the mere threat of ISDS proceedings could deter governments from adopting climate legislation and thus affect their ability to meet decarbonization targets (Pearsall et al., 2023).
President Macron sees France’s withdrawal as in line with its commitments under the Paris Agreement and emphasized that European countries must not neglect their responsibility to reduce carbon emissions, even in times of geopolitical crisis (Le Monde, 2022). Despite these concerns, France has not yet been the recipient of lawsuits directly related to its decarbonization policy. However, France was threatened with a dispute before the European Court of Justice by the Canadian company Vermillion. The dispute revolved around a French legislative proposal to ban the extraction of fossil fuels by 2040. Vermillion’s position was that the proposed legislation violated the obligation to protect legitimate expectations under the EC Treaty. In response, and fearing a dispute, France amended the proposed legislation (White & Case, 2022). The situation is a prime example of how the ISDS mechanism can create a chilling effect on governments when implementing vital environmental regulations due to the fear of costly disputes (Pearsall et al., 2023). In contrast, the Netherlands has already faced two claims from German energy companies based on the ECT regarding its decarbonization policies (Pearsall et al., 2023).
The debate about the ECT reflects the broad tension between the two diverging interests. Some see the ECT as an obstacle to achieving climate targets, while others believe that the treaty, if reformed, could still play a role in promoting investment in renewable energy, as it does not only protect legacy infrastructure investments (Pearsall et al., 2023). In fact, the majority of claims filed against EU Member States on the basis of the ECT have come from investors in the renewable energy sector (Freshfields, 2024).
Modernization of the Energy Charter Treaty and protection beyond
The global context has changed dramatically since the signing of the ECT in 1994 which highlights the need for modernization. The main driver for change was the desire for having a more balanced system, which satisfies both, the host states and the investors. One of the most discussed aspects of modernization was the proposal to exclude investments in fossil fuels from the protection of the ECT, especially after RWE used the ECT to demand € 1.4 billion in compensation from the Netherlands due to its plan to phase out coal by 2030 (Serdarević, 2023). The modernized ECT includes exceptions to fair and equitable treatment, granting the state a certain degree of flexibility in its regulatory actions (Monti & Fermeglia, 2024).
Withdrawing from the ECT ended protection for future investments in fossil fuels but also in investments in renewable energy sources. Due to the sunset clause in Article 47(3) ECT, existing investments are protected for another 20 years. As a withdrawal could enshrine protection for investments in fossil fuels, which should be phased out, critics argue that a reform of the treaty would have been a better option than a withdrawal. -While the EU is exploring ways to limit the sunset clause’s application among member states, it remains uncertain whether such changes would be upheld by arbitral tribunals, which have previously been skeptical of inter-se modifications (Eichberger, 2023).
With the withdrawal from the ECT, legal protection for investments in fossil fuels under this framework ended. At the same time, Germany for example is building new LNG infrastructure to reduce reliance on Russian gas. This raises the question who will invest in these legacy infrastructure projects that are of high importance at the moment to secure energy security when there is no legal protection, and regulatory changes towards greener policies could make these investments unprofitable in the near future? One way to mitigate risk could be to restructure investments with the help of entities outside the EU, e.g. in Switzerland or the UK, which are countries with strong treaties for investment protection. In addition, investors should explore the possibility of negotiating new investment contracts or amending existing ones with the relevant EU Member State or the respective agencies to incorporate arbitration clauses and substantive protections. In this regard, it is important to agree on a seat of arbitration outside the EU. In addition, investors should thoroughly examine the various legal options to protect their investments under national law, other EU law provisions, other investment protection treaties, or the European Convention on Human Rights. Furthermore, the costs associated with arbitration, together with the potential for reputational harm, may encourage states to settle disputes with investors cooperatively (Freshfields, 2023). Another option for investors could be to obtain political risk insurance (Collins, 2024).
A promising and relatively new approach being considered in Germany is the transformation of LNG infrastructure into hydrogen infrastructure, which could align the associated investment with future energy goals while providing a path to profitability (New York Times, 2022).
Conclusion
The big challenge in the upcoming years will be to encourage a state to regulate in the public interest and meet its climate commitments without undermining the security of investments or triggering a legitimacy crisis. To meet this goal and combat regulatory chills, it is important to adapt treaties like the ECT and acknowledge the big impact of geopolitical shifts. It remains particularly interesting to see if current approaches of converting existing infrastructure (e.g. LNG into hydrogen) have potential in the future and if innovative ideas will help to ensure that future energy targets can be met while maintaining investment viability.
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