![Sample our Engineering & Technology journals, sign in here to start your access, latest two full volumes FREE to you for 14 days]({"type":"image" , "src" : "/sda/5933/TOC-Subject-Sample-2021-Engineering-Tech.jpg"})
ABSTRACT
Decisions by states to cancel oil and gas licenses in the transition to net-zero emissions can trigger investment arbitration claims. Given the massive damages that arbitration tribunals can award to investors, investment arbitration is increasingly being criticized as an obstacle to climate change mitigation and the just energy transition. Under the Discounted Cash Flow (DCF) method, tribunals have based their valuation on the expected production volumes during the remaining lifetime of oilfields and forecasts of international oil prices, essentially requiring states to compensate companies at market conditions for all energy left underground. With an increasing number of carbon neutrality pledges at the global level and states’ due diligence obligation to reduce emissions, this article argues that tribunals can no longer ignore decarbonization considerations in the application of the DCF method. Damages decisions must instead account for the price, production cost and risk expectations under net-zero pathways. Significant downward adjustments to the estimated future income of hydrocarbon assets can be achieved by using the lower oil price forecasts in net-zero emissions scenarios, instead of current market conditions. Adjusting future cash flow projections and the discount rate to reflect carbon pricing and other climate policy risks can significantly lower the present value of hydrocarbon assets. As arbitration tribunals have so far ignored decarbonization in their oil damages calculations, legal reforms are needed to require the alignment of investor compensation to decarbonization and ensure a just energy transition.
Key policy insights
The large damages awarded in the fossil energy sector can create energy injustices and potentially chill the adoption of fossil energy phase out decisions.
Damages are generally large due to calculation methods based on estimated reserves and current international price levels.
Tribunals must take into account states’ carbon neutrality pledges and emission reduction obligations; this can be done by using net-zero fossil energy prices and climate policy risks, triggering significant downward adjustments to cash flow projections.
To limit the risk of regulatory chill for fossil energy phaseouts, and the creation of energy injustices, investment treaty revisions should require the inclusion of decarbonization concerns in damages calculation, in addition to stronger guarantees for states’ right to regulate.
Acknowledgment
Many thanks to three anonymous reviewers, as well as Benoit Mayer, Oliver Hailes, John Paterson and Yueming Yan for most useful comments, and to Yawen Zheng for her assistance with an earlier draft.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Notes
1 See also Bois von Kursk et al., Citation2022 (‘according to a large consensus across multiple modelled climate and energy pathways, developing any new oil and gas fields is incompatible with limiting warming to 1.5°C’).
2 A government keen to develop its fossil fuel resources might therefore invoke the principle of permanent sovereignty to support its extraction policy.
3 See also Muttitt and Kartha (Citation2020), noting that ‘fairness may require removing corporate protections in order to apply protections to the workers, communities and societies that do not currently enjoy them’.
4 See also Tethyan Copper v. Pakistan (Citation2019).
5 Venezuela only offered book-value instead of fair market value to the investor (ConocoPhillips, Citation2013).
6 The tribunal relied on the actual production profile of the projects, sales record, the use of new extraction techniques, and the repairment or addition of wells, and factored in a certain decline towards the end of each project in 2026 and 2036.
7 The tribunal, therefore, relied on Al-Balhoul v. Tajikistan (Citation2010), where the absence of production was in principle found not to prevent the use of DCF as ‘there [were] numerous hydrocarbon reserves around the world and sufficient data allowing for future cash flow projections’.
8 For instance, in his Individual Opinion in Rockhopper v. Italy, Arbitrator Dupuy (Citation2022) considered as ‘inequitable’ the claimant’s damages calculation that were based on a long-term oil price forecast of approximately USD 80/barrel, reserves totaling 25.1 million barrels and a discount rate of approximately 10%.
9 Given the legality of the expropriation in Venezuela Holdings (2014) (as Venezuela made proposals of compensation to the investor), the compensation was set to represent the value of the investment before the expropriation, thus excluding the significant oil price increases after 2007 (Weiniger & Villaggi, Citation2014).
10 On the shift in paradigm with peak oil demand, see also Dale and Fattouh (Citation2018), who explain that ‘one key implication of this paradigm shift is its impact on long-run price trends. The move to oil abundance is indeed likely to herald a more competitive market environment’, with the important nuance that ‘it is not enough simply to consider the marginal cost of extraction, developments in these “social costs” of production are also likely to have an important bearing on oil prices over the foreseeable future’.
11 According to the IPCC (Citation2022), ‘owing to climate constraints [large reserves of fossil fuels] may become stranded’.
12 See, however, Hailes (Citation2022) (‘it might be objected that a better way to prevent any windfall for claimants would be to apply a higher risk premium to the discount rate within a DCF method, treating the risk of asset stranding as an incident of country risk. But the appropriate premium for climate-related regulatory risk would be highly contested by expert evidence, inflating the costs of arbitration and hardly mitigating the widespread concern that investor – State arbitration is raising the cost of climate action’.).