Why we urgently need to reform investor compensation rules to ‘transition away’ from fossil fuels

The agreement at COP28 to ‘transition away from fossil fuels’ to achieve net-zero emissions by 2050 is undoubtedly a historic moment for international climate negotiations.

However, while many have welcomed this agreement as ‘the beginning of the end’ for fossil fuels, its implementation could face significant legal and financial obstacles, if states decide to act and terminate existing fossil fuel licenses.

With all focus on the drafting of the fossil phase out provision, and the interpretation of its exact meaning in the aftermath of COP28, analysts have not paid sufficient attention to the question of investor compensation for the termination of their oil, gas and coal exploitation rights. International investment treaties, e.g. the highly controversial Energy Charter Treaty, protect foreign investors against state interference with their investments, and allow them to sue states for compensation before international arbitration tribunals.

As illustrated by the ‘Rockhopper decision’, a €250m award in 2022 against Italy for cancelling an oil production right, a state’s decision to cancel existing licenses can be found to amount to an expropriation, requiring investor compensation. The fact that the damages by far exceeded the actual capital invested in the project generated strong criticism against the mechanism of investor-state arbitration. Transitioning away from fossil fuels, as agreed at COP28, can trigger significant compensation claims under international investment agreements.

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Aligning valuations to the net zero transition

International arbitration tribunals have, in a number of expropriation cases concerning oil and gas investments, based their valuation of these assets on the Discounted Cash Flow method. To simplify, this method bases compensation of oil and gas investors on the expected production volumes during the remaining lifetime of their oil and gas fields, and forecasts of international oil prices. With the help of damages experts, tribunals calculate a discount factor, that take into account the risks of the project, to bring the estimated net cash flow to its present value. This valuation method must be criticised for requiring states to pay international market prices for the fossil energy left in the ground.

Withdrawing from international investment treaties, as announced by a number of European member states and proposed by the European Commission, is unlikely to adequately address this risk in the short term, as most production of fossil fuels is located outside of the European Union and protected by a global web of bilateral and multilateral investment treaties. Furthermore, existing investments would remain protected for a duration of 20 years following withdrawal, based on the so-called sunset clause. At the same time, withdrawing from investment treaties would have the perverse effect of leaving clean energy investments unprotected, essentially denying them a useful de-risking tool, in particular in the riskiest jurisdictions where investors cannot rely on national courts to challenge state interference with their investments.

Instead, reforms of investment treaties are needed to ensure that damages calculation methods are aligned to the reality of the net-zero energy transition. These investor compensation reforms should first include a requirement for tribunals to adjust the valuation of hydrocarbon assets to net-zero emissions scenarios.

Using the low oil price forecasts of the International Energy Agency in its 2050 Net Zero Energy Roadmap (USD24/barrel in 2050) would significantly reduce the expected revenues of oil investments. Pricing the direct emissions of oil and gas production sites at the carbon price of USD250/tCO₂, expected by the IEA by 2050, would further result in significant downwards adjustments of the estimated net cash flow of these investments, in particular for the most carbon-intensive fields.

The remaining revenues would then have to be considerably reduced through the discount factor, taking into account the high legal and policy risks, including the risk of termination of licenses itself, that characterise the operation of fossil assets in the decarbonisation era. To facilitate states’ decisions to leave their fossil energy in the ground, the energy transition commitment agreed at COP28 must be accompanied by a commitment to reform investor compensation to align it to decarbonisation.

This contribution builds on Anatole Boute (2023) Investor compensation for oil and gas phase out decisions: aligning valuation methods to decarbonization, Climate Policy, 23:9, 1087-1100, DOI: 10.1080/14693062.2023.2230938