The Debate on ISDS Climate Carve-Outs: Insights from APEP

Commentary by David Korn, Thibault Denamiel, andWilliam Alan Reinsch

Published July 31, 2024

Introduction

Investor-state dispute settlement (ISDS) mechanisms have reached a proverbial fork in the international economic policy road. Although international arbitration has long been praised as a "fundamental" safeguard for foreign investors, the future of ISDS appears in doubt, especially in the context of the Americas Partnership for Economic Prosperity (APEP), a Biden administration initiative in the Western Hemisphere. Ahead of this week's trade ministerial, hundreds of leading academics, several NGOs, and 47 Democrats in Congress have called on the Office of the United States Trade Representative (USTR) to seek the dispute settlement mechanism's removal from all international investment agreements (IIAs) among the 12 APEP member countries. Their arguments include the mechanism's alleged failure to facilitate increased foreign direct investment (FDI), the restriction of governments' "policy space," and obstruction of the clean energy transition. Meanwhile, congressional Republicans have been silent on the APEP ISDS debate, an indication that the historically business-friendly party may have adopted the Trump administration's views on the mechanism-namely, that the mechanism cedes U.S. sovereignty and eliminates the risk premium associated with offshoring. Now, as USTR embraces this bipartisan antipathy, the debate on the future of ISDS among APEP members is ostensibly a binary one: maintain or eliminate the mechanism.

The current ISDS debate overlooks the mechanism's many benefits. Its facilitation of increased FDI is real. Moreover, as discussed in a previous Scholl Chair commentary, ISDS mechanisms can play an important role in facilitating, rather than hindering, the clean energy transition. They may also bolster U.S. government efforts related to the nearshoring and de-risking of critical supply chains, from which APEP countries are well positioned to benefit. However, for those convinced that IIAs must be more environmentally friendly, the elimination of ISDS is not the only pathway, nor is it the right one. There is a vibrant ISDS reform debate and several proposals, including a carve-out to exclude climate-related cases from the jurisdiction of ISDS tribunals, are lauded for their alleged favorable environmental impact. This paper discusses such a carve-out in light of the APEP debate on ISDS.

A carve-out may unleash more costs than benefits, including the emergence of "green protectionism," energy insecurity, and FDI reductions in capital-scarce locales. However, its underlying motivation and several iterations are instructive and suggest that the issue deserves more than a simplistic "yes or no" debate. The mechanism should not be perceived as an incorrigible burden, but rather as a valuable tool with, perhaps, room for adjustment.

The APEP Debate on ISDS and the Potential Role of a Climate Change Carve-Out

The ISDS Debate

Advocates for the eradication of ISDS via APEP offer no shortage of criticisms. On a basic level, they fault "old-generation" IIAs-which account for most free trade agreements (FTAs) and bilateral investment treaties (BITs)-for their "climate neutrality," whereby foreign investors can sue states for treaty or agreement violations through arbitration, regardless of their investments' environmental impact. Critics also consider the international arbitration system a neocolonial tool that favors the interests of large firms and fossil fuel investors over those of states in the Global South-contradicting APEP's goal to facilitate "inclusive and sustainable trade." As several APEP countries face a debt crisis and ﷟require significant investments to fight climate change, the potential payout of multi-billion-dollar ISDS awards and litigation expenses is portrayed as even more harmful.

Critics of ISDS also bemoan "regulatory chill." Owing to uncertainty and the costs associated with adverse rulings, APEP policymakers are said to refrain from implementing environmental policies that are in their countries' interests. Concerns with this dynamic have arisen amid negotiations of multiple IIAs and are central to ongoing ISDS reform discussions. They are likewise expected to multiply as the climate emergency intensifies and governments consider bolder environmental measures.

These criticisms have prompted some congressional Democrats to urge USTR to seek the mechanism's removal from over 40 active IIAs among APEP members. Meanwhile, congressional Republicans, many of whom have long supported ISDS, are conspicuously silent on the APEP debate, perhaps reflective of the increased adoption of Trump administration criticisms. The private sector now appears as the mechanism's lone public advocate; however, its arguments have fallen on deaf ears. According to USTR Katherine Tai, President Biden "opposes the ability of private corporations to attack . . . environmental policies through ISDS" and has accordingly excluded ISDS from all ongoing negotiations.

Many of the alleged downsides of ISDS in the APEP context are exaggerated by the mechanism's opponents. For example, evidence of alleged regulatory chill across APEP countries focuses almost exclusively on anecdotal behavior in Canada, disregarding studies skeptical of the regulatory chill phenomenon and others that indicate that a country's regulatory response to an ISDS case depends on its bureaucratic capacity. Whereas countries with high bureaucratic capacity like Canada generally respond to cases with less environmental regulation, states with medium-to-low capacities, which encompasses many Latin American members of APEP, respond with more.

Critics also overstate the cost and scale of fossil fuel disputes in the Latin American context. Of the 174 ISDS cases featuring an APEP member respondent and a claimant from a different APEP member state, more than half were among parties to the North American Free Trade Agreement (NAFTA), and only 11 involved investments in the "extraction of crude petroleum and natural gas," according to a UN database. Of those 11 cases, only 6 were decided in favor of the investor, with 5 of those 6 arising from Ecuador, which has since adopted and reaffirmed a constitutional provision prohibiting the use of ISDS. The other dispute arose under NAFTA, whose successor agreement would likewise preempt such a case. Notably, of those 6 disputes, the most recently initiated one began 13 years ago, and their median award was $74.6 million, well below the $600 million average for successful fossil fuel disputes and 24 percent of what the median investor sought.

Critics likewise exaggerate the extent to which participation in third-party arbitration requires the delegation of U.S. sovereignty. "Ceding sovereignty" is only worrisome for countries that are found to violate binding commitments of still-enforceable IIAs by engaging in unfair or discriminatory actions against foreign investors. However, the United States has never lost an ISDS dispute. This success comes amid its agreement to over 50 IIAs and over 20 unsuccessful ISDS disputes launched against it.

ISDS can have drawbacks. Litigation expenses from a single ISDS dispute can cost a developing country government several million dollars, and ethical concerns of "double hatting" among arbitrators are well documented. A lack of transparency is another common critique. However, the benefits of ISDS are extensive and outweigh the criticisms. As discussed in a separate Scholl Chair commentary, ISDS is well suited to facilitate, rather than obstruct, the clean energy transition. As the European Union and United States adopt green subsidies to catalyze private sector investment, the legal certainty and stability provided by ISDS will be critical in encouraging cross-border investment. The mechanism will also help accelerate U.S. nearshoring and de-risking initiatives, likely to the benefit of several APEP members.

Moreover, the APEP-wide elimination of ISDS provisions based on neocolonial and antidevelopment characterizations offers the wrong prescription to serious challenges. Enhanced economic growth and employment throughout Latin America are two important goals, with vast ramifications for regional stability, immigration, and public safety. However, they will not be facilitated by curtailing investor rights and a likely reduction in FDI.

Examining an APEP-Wide Climate Change Carve-Out

As scrutiny of ISDS intensifies ahead of this week's APEP ministerial, it is worth examining a potential compromise. Several organizations have discussed proposals to "green" the mechanism, including a carve-out that would block disputes threatening climate goals from the jurisdiction of ISDS tribunals. Notably, IIAs have long included carve-outs, though their recent inclusion in the United States-Mexico-Canada Agreement (USMCA) and the Energy Charter Treaty (ECT) has fueled policymakers' appetite for an expansion in scope. According to the International Institute for Sustainable Development, such a carve-out, if "widely adopted, effectively implemented, and combined with other reform measures . . . could be a viable tool to protect governments' climate policy space against the looming threat of ISDS." Additional benefits may include reduced strains on public finances and enhanced sovereignty.

There are several ways to implement a climate change carve-out:

• Sectoral designations: The least intrusive approach embraces either "positive" or "negative" criteria that explicitly state the sectoral investments with or without access to the mechanism, respectively. In APEP's case, negotiators could curtail the jurisdiction of ISDS tribunals by exclusively covering sectors that are low emission or excluding those that are not, mirroring the USMCA's identification of covered sectors.
• Policy-specific designations: APEP members can also mimic a policy-specific carve-out, as employed in the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) in reference to tobacco control measures. Under this approach, government measures that seek to accelerate climate goals could not be challenged via ISDS by an investor from a fellow APEP country. While APEP governments would still be obligated to honor other commitments within IIAs and remain subject to state-to-state disputes, the main avenue by which those obligations are enforced would be eliminated. Alternatively, APEP members can exclude environmental policies from some, but not all, of their IIAs' various obligations, which is typical for taxation measures.
• Agreement-wide reforms: A third option that would additionally eliminate bilateral dispute settlement as a recourse for APEP investors is the complete removal of environmental policies from the scope of member countries' IIAs. This approach is not without precedent in the environmental sphere, as 2022 reforms to the ECT included an opt-in "flexibility mechanism" that will allow new fossil fuel investments to be removed from the scope of investor protections by 2032. Canadian IIAs likewise include treaty-wide carve-outs for cultural industries. Alternatively, APEP members could wholly terminate the 15 BITs and remove investment chapters from the 25 FTAs among themselves, an approach supported by several NGOs that would allow new fossil fuel investments to be removed from the scope of investor protections.

Nevertheless, the nascent status of APEP's "trade track" and member skepticism should temper expectations for a forthcoming deliverable on ISDS. USTR has announced its official position against ISDS expansion but has given little detail regarding its stance on the mechanism's elimination. The Biden administration is unlikely to push for unilateral elimination given that the legality of such a move is dubious. U.S. BITs are treaties, which require two-thirds Senate approval, and reforms to FTAs require Congress to approve changes in their implementing legislation. Legislative action on either is unlikely given Congress's current composition.

That said, there are two main routes for APEP members to implement a carve-out. They can conclude a plurilateral, opt-in treaty that modifies existing bilateral IIAs between countries that are party to the treaty, or they can embrace a piecemeal approach whereby countries amend (or forge new) bilateral IIAs. The latter approach offers faster implementation and country-specific flexibility; however, it risks insufficient environmental benefits if not widely adopted. By contrast, a plurilateral treaty would foster a more predictable investment environment across APEP and avoid regulatory divergences as members look for new and impactful ways to meet climate commitments. A tangible, APEP-wide outcome would also reaffirm the United States' role as an effective and responsive regional leader amid great power competition in the Global South. In either eventuality, U.S. participation is crucial, as its investors represent two-thirds of claimants in ISDS cases between APEP member states.

The USMCA may provide a roadmap for ISDS reform proponents. After 25 years of experience with NAFTA's ISDS mechanism, Canada and the United States sought significant changes via the USMCA that would address political priorities while supporting economic growth and continental integration. The United States, for example, looked to limit delegations of sovereignty by curtailing select investors' access to ISDS while enshrining additional protections for U.S. firms in "covered sectors" perceived to be most vulnerable to unfair treatment by the Mexican government. Canada, by contrast, exempted itself from the USMCA's investment chapter due to perceived U.S. abuses, leaving ISDS as a resource for Mexican investors in Canada, but not U.S. ones, via the CPTPP.

Concerns with an APEP-Wide Carve-Out

Before rushing to implement a climate change carve-out, APEP members should consider the recent failures of existing iterations. Although several "new-generation" IIAs include an environmental carve-out, ISDS tribunals have found states responsible for violations of investor protections and awarded compensation under them. APEP negotiators can devise a treaty that prevents arbitral tribunals from assuming jurisdiction over cases where the carve-out applies, but that is easier said than done.

APEP negotiators should likewise be wary of a carve-out's potential for abuse. Several Latin American states have a history of infringing upon foreign fossil fuel investors' rights, and green protectionism is on the rise. While a climate carve-out has lofty intentions, it may enable similar, unfair treatment of foreign investors. Realistic examples include stalling disputes, discriminatory taxes, and the sudden withdrawal of permits. Safeguards beyond the customary good faith principle of international law-such as a prohibition on the carve-out's unilateral invocation and a nexus requirement that a measure must be "related to" an environmental goal-can be incorporated to protect against these potential abuses. However, these safeguards are likely insufficient at curtailing exploitation, especially if environmental disputes are not covered by any dispute settlement mechanism.

The carve-out's potential reduction of regional FDI in fossil fuel projects should likewise be cause for concern-despite that outcome being a direct goal of anti-ISDS environmentalists. The empirical effectiveness of ISDS in facilitating FDI is questioned by some, but logic suggests that if foreign investors lose access to reliable legal remedies in countries with weak rule-of-law protections, those investors will flee. Thus, with the clean energy transition in its early stages and supplies of low-carbon energy alternatives insufficient to satisfy demand, disincentives for fossil fuel investment may curtail output just as demand is projected to peak. Absent offsetting investments in and production of low-carbon alternatives, a carve-out risks fueling additional energy insecurity, inflation, and dampened economic growth in APEP countries. Moreover, APEP countries with a dependency on resource-related sectors for tax revenue may face a lose-lose dilemma between greater indebtedness and social service cuts.

An ISDS carve-out also risks damaging APEP members' economies and U.S. economic security without corresponding environmental benefits. The partnership's 12 members maintain a collective 43 active ISDS provisions among them, a fraction of the 2,600 IIAs currently in force globally. The elimination of ISDS within APEP borders will do little to affect global practices and will perhaps redirect investments toward other resource-abundant countries.

Conclusion

ISDS faces serious criticisms, including expensive litigation costs, a lack of transparency, and ethical concerns. However, proponents of these criticisms-and less evidence-based ones-exaggerate the mechanism's flaws and overlook its many benefits. This dynamic is particularly evident in the APEP context, where the mechanism has had minimal adverse impact and may enable Latin American countries to capitalize on U.S. investments related to the clean energy transition and supply chain resiliency.

This week's APEP trade ministerial provides the United States with an opportunity to demonstrate leadership and produce consequential outcomes. Action on ISDS can be part of that, but before member states seek the mechanism's elimination, they should consider whether that outcome will be positive. The evidence suggests otherwise. As for reform options, a climate change carve-out likewise introduces several causes for concern and should be approached with caution; however, it would certainly be less harmful than outright elimination.

David Korn is an intern with the Scholl Chair in International Business at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Thibault Denamiel is an associate fellow with the Scholl Chair in International Business at CSIS. William Reinsch holds the Scholl Chair in International Business at CSIS.

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