Arbitration and Regulatory Chill: High Carbon Industries and Climate Regulations

• In Event: Multinational Firms and the Politics of Arbitration

Abstract

Flows of foreign direct investment (FDI) to developing countries have risen dramatically over the past few decades, totaling $650 billion in 2017. FDI is currently the largest source of external financing for developing countries, far exceeding flows of official development assistance ($146 billion) or portfolio equity investments ($60 billion). Unsurprisingly, competition to draw FDI has been very strong amongst developing countries. Governments of developing countries use various different strategies to attract foreign investors, such as offering investors large fiscal and financial incentives. One of the more controversial methods has been the provision of the option of international arbitration when there is a dispute between a foreign investor and the government. This is typically done by signing a bilateral investment treaty or passing a national investment law. Foreign investors prefer international arbitration (at a venue such as the International Centre for Settlement of Investment Disputes) over litigation through the host country’s domestic court system, because arbitration is seen as a more neutral and expeditious form of dispute resolution.

International investment arbitration has increasingly involved cases of “indirect expropriation” where governments instigate changes in laws and regulations that are supposedly detrimental to the business operations of foreign investors (as opposed to “direct expropriation” where the government seizes or nationalizes the assets of an investor). Today, over 70% of all investment disputes involve allegations of indirect expropriation, and many of these involve environmental or social regulations. For example, when South Africa passed a law in 2004 decreeing that all mines had to be under 26% black ownership, a group of Italian investors filed an arbitration claim, arguing that they were being forced to divest from their company.

Observers have noted instances in which the threat of arbitration has resulted in “regulatory chill.” In other words, governments will lower their regulatory standards because they fear that their policies will be challenged by foreign investors through arbitration. For example, Indonesia under Suharto allowed foreign investors to engage in open-pit mining in its forests, and when a newly-democratized Indonesia later passed a law banning open-pit mining, foreign investors threatened to file an arbitration claim against the government. Ultimately, the government carved out an exemption for a dozen foreign firms already operating in the country.

In this paper, I examine whether the implicit threat of arbitration that FDI recipient countries face has resulted in a systematic weakening of these countries’ regulatory policies, focusing in particular on environmental regulations on climate change. I hypothesize that countries that are more likely to have their climate change regulations challenged through arbitration will pass fewer laws and regulations addressing climate change.

Empirically, I measure the threat of arbitration by the number of foreign affiliates in industries associated with high levels of carbon emissions. I find that the larger the number of foreign affiliates in high carbon-emission industries, the fewer the number of climate change regulations passed in the country. This supports my argument that countries will weaken their environmental regulations when they are concerned about the threat of international arbitration.

However, I also find that this effect is mitigated by the presence of a robust civil society in the host country. This suggests that while arbitration does have a negative effect on regulations, governments are also sensitive to the pressures of domestic interest groups.

Author

• Youngchae Lee