What does the future hold for a post-Energy Charter Treaty world, with sunset clauses guaranteeing the international framework a place on the world scene for years to come, asks Alex Lee and Matt Riding.

First published by the Commercial Dispute Resolution Magazine, July 2024.

The signing of the Energy Charter Treaty (ECT) in 1994 was a pivotal moment within the energy sector. In the geopolitical context following the fall of the Soviet Union (USSR), it aimed to promote international energy cooperation, securing hydrocarbon energy supplies from countries in Central Asia and the former Soviet bloc in exchange for foreign investment and technical cooperation^[1]https://www.euractiv.com/wp-content/uploads/sites/2/2019/09/Report-ECT.pdf. The agreement entered force in 1998; however, with shifts in global energy and environmental policy in the years that have ensued, coupled with the apparent inflexibility of the Treaty to modernisation, it now increasingly finds itself standing distant and outdated compared to contemporary laws and thinking. How nations and investors within the energy sector act in response to this, however, could come with a significant, long-lasting sting.

Under the ECT, host states are subject to broad obligations, which investors can enforce through binding international arbitration. This is achieved through an inbuilt investor-state dispute settlement (ISDS) mechanism (article 26(2)C), whereby investors can seek compensation before an international arbitral tribunal if they believe their rights under the Treaty have been violated. If an amicable settlement cannot be reached within three months, the investor can escalate the dispute to the courts or administrative tribunals, either nationally or internationally, the latter mainly relating to investment protection, expropriation and compensation^[2]https://www.taylorwessing.com/en/insights-and-events/insights/2024/03/uk-announces-withdrawal-from-energy-charter-treaty.

As of the end of 2021, out of over 1,100 global ISDS proceedings, more than 145 were brought about due to the ECT^[3]https://www.oecd.org/investment/investment-policy/OECD-investment-treaties-climate-change-consultation-responses.pdf; the highest number of all investment protection agreements. It is little wonder that the ISDS mechanism is the most contentious issue under the Treaty, with some arguing that it amounts to the over-protection of the economic interest of foreign investors, of which fossil fuels represent over half the total protected investment.

As it stands, there are concerns with the Treaty for both investors and signatory states. With the adoption of the Paris Agreement, Sustainable Development Goals (SDGs), and net zero ambitions within the EU by 2050^[4]https://climate.ec.europa.eu/eu-action/climate-strategies-targets/2050-long-term-strategy_en#:~:text=The%20EU%20aims%20to%20be,to%20the%20European%20Climate%20Law%20, climate change and sustainable development are now intrinsically interwoven and inseparable. The aim of limiting the global average temperatures to below 2°C above pre-industrial levels means that some parties argue that the available global fossil fuel reserves should remain in the ground. An inevitable consequence of meeting these objectives is potentially to turn the reserves and investments made in extractive infrastructure into stranded assets; those which cannot be developed, extracted or used due to changes in environmental and societal norms^[5]https://www.sciencedirect.com/science/article/pii/S2214629618305383.

The lack of compatibility between the ECT and the EU’s climate goals was highlighted in April 2021, when the Netherlands passed a law banning coal-fired power plants from 2030 and was sued by RWE and Uniper for EUR 2.4 billion^[6]https://www.europarl.europa.eu/RegData/etudes/BRIE/2023/754632/EPRS_BRI(2023)754632_EN.pdf. Similarly, the cancellation of permits for the Keystone XL Pipeline resulted in USD16.3 billion in claims by TC Energy and the Province of Alberta against the United States. Such compensation is often based on hypothetical incomes over the lifetime of the asset and can easily reach exceptionally large liabilities for states.

The scale of potential future ISDS if counties are to move toward net zero goals is staggering. In 2020, the ECT protected around 51 coal power plants that were at risk of being stranded assets in a scenario compliant with the Paris Agreement^[7]https://www.iied.org/sites/default/files/pdfs/migrate/17660IIED.pdf, with an estimated total of EUR 345 billion of fossil fuel assets in the EU, UK and Switzerland currently protected^[8]Olivier Moldenhauer, Nico Schmidt, “ECT data analysis: results and methods”, Investigate Europe, 23 February 2021, https://www.investigate-europe.eu/en/2021/ect-data/. These, therefore, represent a large and potentially debilitating legal threat to governments; they may be a driver for climate inaction, risking states falling behind on their climate ambitions, and failing to protect the interests of the public, who will ultimately bear the long-term cost of carbon targets.

In the wake of the Paris Agreement, proposals to modernise the Treaty for states wishing to adopt cleaner technologies were made, as well as those aimed at removing the risk of ISDS against contracting states. In June 2022, a modernised text was announced, but EU Member States failed to agree on a common stance. Differences in the climate ambitions of ECT signatories, combined with the unanimity required to make changes to the Treaty, led to the postponement of modernisation. This left many countries with carbon targets reconsidering their position within the ECT.

As of June 2024, there are 50 contracting members of the ECT^[9]https://www.energychartertreaty.org/treaty/contracting-parties-and-signatories/. The UK submitted written notice of formal withdrawal on 28th May 2024^[10]https://www.energycharter.org/media/news/article/written-notification-of-withdrawal-from-the-energy-charter-treaty-4/, concerned that modernisation would not occur and that still being a member would hinder the UK’s transition to cleaner, cheaper energy and possibly even penalise efforts to deliver net zero. Such sentiments appear widely held. The Russian Federation, Italy, France, Germany and Poland have already formally withdrawn. Others, including Luxembourg, have given notice of withdrawal, and Spain and Slovenia have announced their intention to do so. Denmark, Ireland and Portugal have also announced their intentions to withdraw unilaterally. A leaked paper from the European Commission has commented that ‘re-negotiating the outcome of the modernisation process does not seem feasible’ and that ‘a withdrawal of the EU and Euratom from the Energy Charter Treaty appears to be unavoidable’^[11]https://www.euractiv.com/wp-content/uploads/sites/2/2023/02/Non-paper_ECT_nextsteps.pdf.

Yet, from the perspective of former signatory states, once formal notification of withdrawal has been made, the risk of ISDS does not disappear immediately. To ensure long-lasting cooperation between states and investors, two sectional sunset clauses were included within the Treaty. The first extends the validity of the Treaty for an additional year from the date notice to withdraw is received; new energy investments would still be covered under the ECT for one year, and still afforded the same access to recourse by the ISDS mechanisms until the end of the sunset clause. The second requires signatory states to adhere to provisions applying to existing investments for 20 years post-withdrawal. Therefore, even after unilaterally leaving the Treaty, parties are bound to honour the provisions for up to 21 years. The possibility of abandoning these provisions within the sunset clause is the subject of much legal uncertainty^[12]https://arbitrationblog.kluwerarbitration.com/2022/11/04/withdrawing-from-the-energy-charter-treaty-the-end-is-not-near/^[13]https://www.ashurst.com/en/insights/the-uk-and-others-exit-the-energy-charter-treaty-what-does-this-mean-for-energy-sector-investors/.

Instances where climate change regimes and the ECT’s investment protection interests conflict materialise in disputes already, but with the increasingly strict climate mitigation rules, their numbers are expected to increase. In future disputes, we foresee and have seen states presenting arguments for consideration and integration of climate obligations in the context of the ECT and the specific dispute, but ultimately, will have to rely on international climate obligations being taken into account by an arbitrator^[14]https://www.mdpi.com/2075-471X/13/2/24.

Meanwhile from the perspective of those who have or are considering future investments within countries that have withdrawn or are soon to withdraw from the ECT, efforts should be made to ensure planned investments are made as soon as possible to attain the protection of the ECT, and alternative treaties or contractual protection mechanisms should be considered. Furthermore, as time fades for resolution under the neutral dispute forum provided by ECT, disputes should be raised and arbitration sought promptly.

HKA has been involved in the provision of several recent ECT disputes that have pivoted on the impact of the infrastructure being inconsistent with nationally determined climate contributions. It is worth noting that governments and states are responding not just to climate policy but to varying degrees of public pressure as to what is acceptable to society. The term social licence (or social licence to operate) refers to the level of ongoing approval a nation or community gives to an industry or project. A social licence gives legitimacy to operate beyond something simply being legally allowed. It is based on the idea that organisations and companies don’t just need regulatory permission but also ‘social permission’ to operate their business.

A social licence can never be self-awarded, it requires that an activity enjoys sufficient trust and legitimacy and has the consent of those affected. As described briefly by the McKinsey Group:-^[15]https://www.mckinsey.com/capabilities/sustainability/our-insights/does-esg-really-matter-and-why

“Social license is not static, and companies do not earn the continued trust of consumers, employees, suppliers, regulators, and other stakeholders based merely upon prior actions. Indeed, earning social capital is analogous to earning debt or equity capital—those who extend it look to past results for insights about present performance and are most concerned with intermediate and longer-term prospects. Yet unlike traditional sources of capital, where there are often creative financing alternatives, there are ultimately no alternatives for companies that do not meet the societal bar and no prospect of business as usual, or business by workaround, under conditions of catastrophic climate change.”

CONCLUSION

In conclusion, although many now seek to depart the ECT, the fading of its sun to disappearance is to be slow. Environmental triggers may even, at times, depict a resplendent sunset as the number of cases increases within the 20-year window. We envisage pressures arising from social licence and evolving climate (and environmental) legislation as catalysts for more such cases. Investors may also seek to pursue their cases early to avoid missed opportunity in a closing window. Needless to say, such complex cases have and will require a depth and mix of the best environmental experts to aid the tribunal.

If you would like to know more about HKA please visit www.HKA.com. If you would like to explore ECT or otherwise discuss how HKA Environment and Climate experts can help you in times of dispute or advisory, then please contact Dr Alexander Lee (alexlee@hka.com), who would be delighted to listen and discuss.