Should Australia agree to investor-state dispute settlement in the

Trans-Pacific Partnership?

Prof. Emma Aisbett

Asia & the Pacific Policy Society Lecture

July 28th, 2015

Argument Outline 1. TPP is special.

2. ISDS hands interpretation and evolution of international investment law to MNCs and arbitrators.

3. What is good for MNCs is not necessarily good for the rest of society.

4. Avoiding a regulatory takings doctrine is important to institutional legitimacy.

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What is Investor-State Dispute Settlement?

• Investor-State Dispute Settlement (ISDS) allows foreign investors to bring claims against a host state (usually for breach of an investment agreement) to binding international arbitration.

• Usually arbitration follows ICSID or UNCITRAL rules.

Typically 3 arbitrators per panel

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Source: UNCTAD Investment Policy Hub, Feb 18, 2015

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Argument Outline 1. TPP is special.

2. ISDS hands interpretation and evolution of international investment law to MNCs and arbitrators.

3. What is good for MNCs is not necessarily good for the rest of society.

4. Avoiding a regulatory takings doctrine is important to institutional legitimacy.

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Why is TPP special?: the US is special

• US investors are highly litigious and relatively successful:

Over a quarter of the 375 known cases up to 2012 were brought by US investors

21 for investor, 16 settled, 21 for state

• US Government doesn’t loose:

“… foreign investors rarely pursue arbitration against the United States and have never been successful when they have done so.” US State Department Website.

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A special time for IIAs and ISDS

• Europe is NOT agreeing to business-as-usual ISDS in TTIP.

• Trans-Pacific Partnership (TPP) and Trans-Atlantic Trade and Investment Partnership (TTIP) will establish global norms of investment law.

• Backdrop of increasingly polarized view of investor-state dispute settlement.

States often do not like what they learn.

• South Africa, Latin America, Germany, Australia

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Average rate of Participation in Bilateral Investment Treaties falls steeply after first claim against country. Source: Poulsen & Aisbett WP, 2013

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Argument Outline 1. TPP is special.

2. ISDS hands interpretation and evolution of international investment law to MNCs and arbitrators.

3. What is good for MNCs is not necessarily good for the rest of society.

4. Avoiding a regulatory takings doctrine is important to institutional legitimacy.

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Institutional Evolution through Litigation

• Laws always need interpretation and IIAs have proved wide open to various interpretations,

• Cases brought can affect the evolution of laws and rules: This is well established for the case of WTO law.

• States will bring cases which they think will not have a detrimental effect on the evolution of the law,

• Firms will bring cases which further their own interests.

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Argument Outline 1. TPP is special.

2. ISDS hands interpretation and evolution of international investment law to MNCs and arbitrators.

3. What is good for MNCs is not necessarily good for the rest of society.

4. Avoiding a regulatory takings doctrine is important to institutional legitimacy.

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The Belief that IIAs can do no Harm

• “Stimulate foreign investment”

• “Extend the rule of law”

• Both of these things are assumed to be unambiguously good for all of society.

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The “tough love” Argument for ISDS 1. Corruption, favouritism or simple mistakes on

behalf of governments means that foreign investments which would be globally welfare improving sometimes do not take place or are regulated more harshly than is globally efficient.

2. National courts cannot be relied upon to remedy these problems.

3. ISDS in IIAs provides such a remedy. 1. Foreign firms who are unfairly treated can seek

compensation. 2. Knowing this they are more likely to invest in

politically risky countries. 3. This is good for the countries (“tough love”).

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The Counter-argument “Tough but no love”

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1. Corruption, nepotism or simple mistakes on behalf of governments means that foreign investments which are globally immizerizing often do take place or are regulated less strictly than is nationally or globally efficient.

2. National courts cannot be relied upon to remedy these problems.

3. ISDS in IIAs exacerbates a market failure and reduces both global and national welfare.

The Economic Approach

• IIAs & ISDS are a form of regulation.

• Regulations should only be introduced if they improve national welfare c.f. helping lobby interests but causing net harm.

• A necessary (but not sufficient!) condition for regulation to be welfare improving is that it either: Improves distribution

• (e.g. progressive taxation and welfare payments), or

Ameliorates a market failure.

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What Problems might IIAs help solve?

1. The hold-up problem

2. Regulatory takings

3. Discrimination against foreign firms

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The Hold-up Problem: Definition

• Dynamic inconsistency of optimal policy

Even with perfect information and no uncertainty.

• Hold-up problem can only arise if the government wishes to capture some (or all) of the value of the firm’s investment.

• Yes: Gazprom and Shell in the Sakhalin

• No: German withdrawal from nuclear energy

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Hold-up Problem: Analysis

• If it exists, hold-up reduces both host and investor welfare: Investor will not invest.

• Hold-up problem is ameliorated by: Repeated interactions, and Reputation effects.

• Countries like Australia generally do not suffer from a hold-up problem.

• For countries which do have a hold-up problem, commitment to compensation supported by extra-national arbitration can theoretically help.

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Two-sided Hold-up

• Two-sided hold-up occurs when both partners have made investments in a relationship.

• Two-sided hold-up is a problem for construction projects and natural monopolies. For example a construction firm claims costs are

higher than expected half-way through a project and refusing to complete until payment is increased.

Water provision projects have been led to some of the most controversial ISDS cases.

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Water, sanitation and flood protection account for 6% of ICSID (ISDS) Cases, Construction:7%, Transport: 10%, Electric power & energy: 14%. 20

Regulatory Takings

• “Regulatory takings” as coined by Richard Epstein occurs when a regulatory change negatively affects the value a private investment.

• According to this definition, plain packaging legislation and accelerated nuclear withdrawal are regulatory takings.

• If mining permits are granted to no one it could be regulatory takings but not hold-up.

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Regulatory Takings & the Efficient Government

• According to Epstein’s definition, regulatory takings may even be said to occur when the government had acted efficiently, E.g. when an unbiased CBA favoured regulation.

• In such cases regulatory takings is NOT an example of market failure, There is no argument for preventing regulatory takings on

efficiency grounds.

• Compensating investors for regulatory takings induces an inefficiency by providing insurance against the possibility that the investment is found to be socially undesirable (BRS, QJE, 1984). Compensation for regulatory takings induces over

investment in socially risky sectors.

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ICSID (ISDS) Cases by Sector: Sensitive industries such as Finance, Agriculture, Natural Resource Extraction and Tourism account for almost half of all cases. 23

Regulatory Takings and Undervalued Foreign Investor Welfare

• If the state undervalues the welfare of the foreign investor compared to: the welfare of domestic constituents, or

revenue,

• Then the government may regulate more often than is globally efficient.

• In this case, requiring the state to compensate the investor for regulatory takings will induce the globally efficient level of regulation.

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Regulatory Takings and Undervalued Foreign Investor Welfare: Caveats

• Compensation will still induce over-investment: Net impact on global welfare ambiguous.

• It seems likely that the welfare of multinational investors is weighted at least as much as that of the environment or indigenous groups: In which case, compensation requirements

exacerbate a market distortion and reduce global welfare.

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Discrimination Against Foreign Firms

• Proponents of IIAs and ISDS claim foreign firms are discriminated against are “politically disenfranchised”.

• Political economy models of lobbying and “political contributions” predict otherwise.

• Empirical evidence from World Bank Business Environment Surveys suggest: MNCs are influential, Foreign firms no less influential than domestic, Foreign firms no more constrained and sometimes

less constrained by regulation, Foreign firms more likely to report courts are “fair,

impartial and uncorrupted.”

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National versus Global Welfare

• Whether the welfare of foreign investors is systematically undervalued relative to domestic constituents is clearly debatable.

• Let’s assume for sake of argument that their welfare is undervalued. Would altering state behaviour through ISDS be welfare improving for the state? Yes, in the case of one-sided hold-up, No, in the case of regulatory takings or discrimination.

• IIA provisions aimed at correcting anti-foreign bias help outward-investing firms and hurt rest-of-society.

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What about positive spillovers from foreign investment in Australia?

• Some types of foreign investment generate positive rather than negative externalities Often called spillovers

• Subsidizing such investments could theoretically increase national welfare.

• The principle of targeting says the subsidies should be targeted directly at the positive spillovers.

• Compensation for regulatory takings provides the greatest subsidies to the investments generating the most negative externalities.

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Argument Outline 1. TPP is special.

2. ISDS hands interpretation and evolution of international investment law to MNCs and arbitrators.

3. What is good for MNCs is not necessarily good for the rest of society.

4. Avoiding a regulatory takings doctrine is important to institutional legitimacy.

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Regulatory Takings and Legitimacy of the Institution of IIAs and ISDS

• Net capital importers cannot be expected to continue to support the institution of IIAs if regulatory takings are allowed since compensation for regulatory takings benefits

investors at the expense of rest-of-society

• Thus it is in Australia’s strategic interest to ensure a regulatory takings interpretation is excluded if Australian investors want protection from hold-

up.

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Conclusion • Australia should not agree to ISDS in the TPP

because:

ISDS allows international lawyers and MNCs to shape TPP,

TPP text is likely to leave open the possibility of compensation claims for regulatory takings,

Compensating foreign investors for regulatory takings:

• is not in our strategic interests,

• subsidizes socially risky investments, and is

• not necessarily globally welfare-improving. 31

• THANK YOU FOR YOUR ATTENTION

• QUESTIONS AND COMMENTS WELCOME!

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Weighing benefits to MNCs against costs to Rest of Society

• There is substantial empirical evidence that governments place more weight on the welfare of large firms and industries than on the rest of society. Consider trade policy, for example. MNCs are particularly influential.

• What are the implications of governments with such politically weighted social welfare functions negotiating IIAs? We would expect them to negotiate IIAs which are too

favourable to firm’s interests at the expense of the ROS.

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What about Reciprocity?

• “Isn’t it common at the WTO for members to sacrifice tariff protection (which they value) in order to gain from reciprocal reductions from other members?”

• No. There is a large body of theory and evidence which suggests countries only use trade agreements to solve the “prisoners’ dilemma” induced by terms of trade effects of trade protectionism. i.e. the same world relative prices are achieved with lower

cost to states,

There is no evidence that gains for exporters are traded against losses for import-competing industries.

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A WELFARE ECONOMIC APPROACH TO GOVERNMENT INTERVENTION: APPLICATION TO INVESTMENT AGREEMENTS

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IIAs and ISDS are Regulatory Interventions

• Economists see IIAs and ISDS as an extra layer of “government” or regulatory intervention.

• As such, we should subject them to the same rules which to which other regulatory measures are subjected.

• A necessary condition for an intervention to be welfare improving is that it either: Improves distribution of wellbeing, or

Improves efficiency (in a welfare-economic sense).

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The Necessary Condition for Efficiency Gains: Existence of a Market Failure

• The First Welfare Theorem: market will achieve the efficiency in the absence of market failures.

Corollary: existence of a market failure is a necessary condition for intervention to be efficiency improving.

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ISDS and International Investment Agreements (IIAs)

• IIAs can be a chapter within a broader economic partnership agreement, E.g. the Trans-Pacific Partnership, China-AusFTA

• IIAs can also be stand-alone agreements E.g. Investment Protection and Partnership

Agreements (IPPAs)

Aust. has ?? IPPAs

• All IIAs contain provisions for state-state dispute settlement.

• Most also contain provisions for ISDS.

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