Opinion - 04/February/2019

Energy Charter Treaty and the energy transition: reform, then exit?

Set up at the end of the Cold War, the Energy Charter Treaty, without significant reform, is now largely irrelevant and doing more harm than good to the energy transition, argues Sarah Keay-Bright, independent consultant and previously expert at the Energy Charter Secretariat

Members of the Energy Charter Treaty (ECT) should consider leaving the international investment agreement if radical reform to bring its ambitions and actions in line with the energy transition is not undertaken, says Sarah Keay-Bright, independent consultant and previously expert at the Energy Charter Secretariat

 

In 2019, members of the Energy Charter Treaty (ECT), the world’s most invoked international investment agreement (IIA), will discuss policy reform options and the entire organisation will undergo a review. If the aim is to facilitate the energy transition, major reforms to the ECT are necessary to rebalance the rights of states and investors, ensure equal treatment of investors and energy resources, and improve the dispute settlement process, among other things. Current discussions are based on the assumption that an investment treaty dedicated to the energy sector is necessary and beneficial. This can and should be challenged. Member countries should properly evaluate the ability of the Energy Charter process, and the ECT in particular, to deliver on energy transition objectives compared with alternatives.

The Energy Charter process was set up at the end of the Cold War to enable economic cooperation in the energy sector between the former Soviet Union, its Central and Eastern European satellite states and the EU. Protecting western investments in the East and securing energy flows from east to west were priorities. Adoption of the political declaration, the European Energy Charter, in 1991, initiated this process and provided the basis for the ECT and the Protocol on Energy Efficiency and Related Environmental Aspects, both signed in 1994. In 2015, a non-binding political declaration, the International Energy Charter, was adopted to help modernise the process.

The majority of the ECT is non-binding soft law and not easily enforceable. The hard law part, which has frequently provided the basis for litigation, relates to investment protection. The Treaty provides the latter by granting investors with rights that safeguard against specific political risks. These include discrimination between foreign and domestic investors, expropriation and nationalisation, breach of individual investment contracts, damages due to war and similar events, and unjustified restrictions on the transfer of funds. Investment protection and investors’ rights are enforced through the state-state and investor-state dispute settlement (ISDS) provisions of the Treaty.

The ECT has attracted fierce criticism from a number of high profile academics and NGOs such as the International Institute for Sustainable Development and the Transnational Institute, which last year issued the damning report “One Treaty to Rule Them All”. Concerns relate primarily to the imbalance of investors versus states rights and the legitimacy, transparency, impartiality, independence, accountability and high costs regarding investment protection and the ISDS process.

The ECT is just one of thousands of IIAs. Latest figures from the UN Conference for Trade and Development (UNCTAD) count 2369 bilateral investment treaties and 311 Treaties with Investment Provisions in force at the regional, plurilateral or multilateral governance level. The landscape for international investment is messy and a legal minefield due to overlaps, divergences and inconsistencies in these IIAs. UNCTAD, which places sustainable development at the heart of its agenda, leads the international effort to reform them. Highly active over the last five years, the institution has produced a detailed roadmap and action plan for reform, as well as numerous papers and updates in its annual investment report. As regards modernising existing treaties such as the ECT, UNCTAD recommends that countries look at the pros and cons of various options including amending treaty provisions, replacing outdated treaties, referencing global standards, terminating existing old treaties and withdrawing from multilateral treaties. Members of the ECT have stated that international trends will be primary references for their reform discussions.

 

 

In developing negotiating positions for reforms, countries would be wise to consider existing investments separately from future ones. This is because the Treaty only protects investments once they have been established and the ECT contains a 20-year sunset clause under which investments are protected, even if the country leaves the ECT during this time. Countries wanting to limit the potential costs and damages of disputes relating to existing protected investments therefore have an interest to see negotiations through to the end even if they do not want to use the ECT in future. Although most recent disputes involve renewable energy and retroactive policy change, most investments currently protected by the ECT are associated with fossil fuel infrastructure. Some of these assets may need to be retired early to ensure compliance with the Paris climate agreement, potentially leading to disputes.

Limiting dispute-related damages would require amending a number of Treaty articles. Ensuring a state’s right to regulate to protect society, the environment, and to achieve the goals of the Paris agreement, is crucial. From an investor’s perspective, policy change needs to be predictable, transparent, based on sound principles and coherent with international commitments. With this in mind, the methodology for calculating dispute-related compensation needs close scrutiny and reform to ensure a fair allocation of risk and costs between investors and states, with consideration for energy consumers’ rights and the ECT’s purpose to promote competition. Preventing disputes, resolving them amicably and reducing the time and cost of the dispute settlement process will also be priorities.

 

Supply and demand side

Turning to future investments, unleashing the potential for the ECT to facilitate foreign direct investment (FDI) flows into sustainable energy will require reforms that go beyond improving the dispute settlement process and ensuring a government’s right to regulate. These must target promoting investment in sustainable energy, prevent the lowering of environmental and social standards, ensure compliance with domestic laws and strengthen corporate social responsibility. Investment protection provisions would also need to be extended to include all sustainable energy resources, particularly those on the demand-side of the energy system, and different investor types. Achieving a level-playing field between different types of investor and energy resources is a prerequisite to affordable and secure sustainable energy.

Demand-side management (DSM), involving energy efficiency, demand response and storage, is widely recognised as a crucial pillar of a least cost energy transition. Consumers can be compensated for their energy production and flexible or reduced consumption, but to achieve this at scale, the private sector and foreign investors need to be well engaged. Small energy loads and investments must be aggregated to be able to access energy markets, major investors and finance. In jurisdictions with effective policy frameworks, this is beginning to happen. The economic activity of energy market actors will increasingly include managing energy demand.

To fall within the ECT’s protection provisions, an investment must be associated with an economic activity related to supplying “energy materials (or) products”. These are a defined list including coal, gas, electricity and nuclear fuel, which needs to be updated to include renewable energy sources. Particularly problematic is the fact the definition makes no reference to managing the consumption of these materials or products, implying there is no value to energy sector market actors in doing so.

Yet the investment needed on the demand-side of the energy system is huge and cannot be delivered without the help of the private sector. The International Energy Agency (IEA) modelled a least cost investment scenario assuming a 66% probability of limiting the global average temperature rise to 2oC above pre-industrial levels. The modelling suggests demand-side investment in efficiency and low-carbon technologies should ramp up from a meagre $0.25 trillion a year and surpass annual supply-side investment by 2030, reaching almost $3 trillion a year in the 2040s. Unfortunately the Energy Charter Conference narrative reinforces the thinking underpinning the ECT that FDI is only needed and possible on the supply-side. The 2018 Bucharest Energy Charter Declaration, for example, states: “In particular, decarbonisation, digitalisation and electrification require important alignment and, therefore, considerable targeted investments are needed to enable a safe energy supply to the final consumer at affordable prices.”

This thinking is out-dated. The energy sector must be thought of as a system, where investments in both the supply-side and the demand-side — involving an important contribution from the private sector, including foreign investors — are integrated and optimised to deliver reliable and sustainable energy services at affordable prices for consumers and prosumers.

The ECT does incorporate a “charter efficiency project” concept to enable the protection of demand-side energy efficiency investments. It is unworkable, however, as countries must notify each investment to the Energy Charter Secretariat and there exists no functional mechanism to enable such notifications. Indeed, the approach is surely impractical given the scale of DSM investment needed and furthermore unfair as this requirement is not imposed on supply-side energy resources.

 

Potential solutions

One potential solution could be to update the definition of economic activity in the energy sector to include consumption. But this would not be straightforward. The complexity and integrated nature of demand-side energy markets and investments makes it difficult, if not impossible, to draw a boundary around the energy sector. In delivering sustainable energy investments, the dividing lines between economic sectors are becoming increasingly blurred as end-use sub-sectors of the energy sector expand and all sectors begin to invest in sustainable energy. This is a good reason not to delineate an energy sector boundary for the purposes of applying investment protection provisions and begs the question of whether an investment treaty dedicated to the energy sector is needed.

The major role of domestic investors in demand-side energy markets also raises concerns in relation to ISDS if this mechanism gives foreign investors more favourable rights or conditions compared to domestic investors. In addition, small investors cannot afford to access ISDS involving arbitration. The legal rights of different investor types (domestic versus foreign, incumbents versus new entrants, large versus small) and of key stakeholders (investors, states, consumers, prosumers, communities, citizens, the environment, future generations) must be recalibrated to enable genuine competition while providing safeguards, giving a fair voice to all with an interest in investment for a sustainable energy future.

Numerous and substantial amendments would be needed to align the Treaty with a sustainable energy vision. Treaty amendments can only be adopted if members present and voting are unanimous in their support. Negotiated outcomes will likely be compromises reflecting the position of the lowest common denominator — current ECT members include fossil fuel producers with strong interests in ensuring security of energy demand.

 

 

 

Effective alternatives

There exist effective alternatives to the ECT for managing political risk. Countries could use contractual provisions and alternative multilateral, plurilateral or bilateral economy-wide IIAs aligned with UNCTAD’s reform agenda. Investors also already have access to a political risk insurance industry and can employ the services of public or private providers. Development banks, such as the World Bank, have made great strides in developing and delivering investment insurance facilities and products for developing countries that address political risk among other things.

It should be borne in mind that investment protection or political risk insurance is just one of many considerations for investors and there are many tools governments can use and actions they can take to ensure a favourable investment climate for sustainable energy. Furthermore, IIA investment protection provisions do not guarantee FDI flows and countries such as Brazil and South Africa prove that FDI can be secured in the absence of IIAs.

The ECT does provide more than investment protection, promoting investment, open and competitive markets, transit, trade, market-based regulatory approaches and energy efficiency. These can all help lower the cost of the energy transition, crucial for securing political support and public acceptance. Most of the ECT’s provisions, however, are soft law and are not effectively monitored or enforced due to the Treaty’s exceptionally broad agenda that is not matched with appropriate resources or institutional infrastructure.

And outcomes in these areas are being effectively delivered by regional economic organisations, regional power markets, the World Trade Organization (WTO), development banks, the International Renewable Energy Agency, the IEA and Sustainable Energy for All. Indeed, the Energy Charter Secretariat’s efforts often overlap with those of other institutions, which often have greater resources and more political and financial leverage. The activities of international institutions must be streamlined, consolidated, coordinated, more closely scrutinised and challenged to ensure real outcomes of value to the energy transition are delivered and that overworked ministers and officials, especially in developing countries, can fully engage. Processes and streams of outputs that fizzle into thin air are no good.

The political value of the Energy Charter process has diminished since Russia left the ECT in 2009 and Italy in 2016, though the process enjoyed a resurgence in political interest following the adoption of the International Energy Charter declaration in 2015. That the latter boasts 91 members while the ECT has 53 members illustrates that countries are cautious to accede. While ECT membership has expanded globally since its establishment, little more than a quarter of the world’s countries and just six members of the G20 are members. Over the same time period, membership of the WTO has expanded to 164 countries, covering 98% of global trade and leaving the ECT with less of a role in facilitating trade cooperation.

ECT members must, this year, critically assess what the Treaty and associated process is accomplishing and whether alternatives can better deliver their energy transition objectives. Countries must identify the instruments, mechanisms and fora that are effective and should enhance and better focus these and scale back or quit those that are ineffective. In reforming the ECT, members hosting investment will need to mitigate costs and negative aspects associated with investment protection and ISDS that could set back energy transition progress. To tap the ECT’s potential to facilitate FDI flows into sustainable energy at the needed pace and scale, reforms must target the promotion of investment in sustainable energy, prevent the lowering of environmental and social standards, ensure compliance with domestic laws and strengthen corporate social responsibility. A reformed ECT must also be non-discriminatory towards different types of investor and energy resource.

The needed reforms, however, are unlikely to be adopted and if so, with effective alternatives available, countries should be ready to question their ECT membership.

 


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