The real costs and benefits of investment treaties

Author: Jonathan Bonnitcha, ANU and University of Oxford

Over the past three decades countries have signed a great number of international investment treaties (IITs). There are now close to three thousand such treaties worldwide. While most IITs are bilateral there are some multilateral IITs, such as the Energy Charter Treaty to which Australia and fifty other states are signatories. Common IIT provisions are also contained in investment chapters within some trade agreements, within NAFTA and the US-Australia FTA for example.

Many IITs include dispute settlement provisions that allow foreign investors to bring claims against host states before international arbitral tribunals, relying on the rights contained in the relevant treaty. If successful, the investor-claimant is entitled to a monetary award of damages.

The basic function of IITs is investment protection. IITs place obligations on host states to guarantee certain standards of treatment to foreign investment owned by nationals of another state-party to the treaty. Few grant pre-establishment rights of entry to foreign investors. The post-establishment protections granted by IITs normally include rights to ‘fair and equitable treatment’ and compensation for ‘indirect expropriation’. These rights, as interpreted by arbitral tribunals, often go beyond what investors – whether local or foreign – would otherwise be entitled to under the domestic law of the host state. (This contrasts with international trade law, which is based on the basic principle of national treatment – that is, equal treatment of foreign and local goods under domestic law). In light of current discussion about the inclusion of an investment chapter in a future Australia-China FTA, it is timely to reflect on the costs and benefits of entering IITs.

There are at least two plausible ways in which signing an IIT might benefit a host state. The first is by increasing inflows of private foreign capital. In the social scientific literature, this is widely assumed to be the primary purpose of IITs. There are a number of obstacles to empirical investigation of the relationship between IITs and foreign investment, for instance the difficulty in controlling for reverse causality and endogeneity. However, to the extent that empirical investigation has been conducted, IITs do not appear to encourage inflows of private investment.

Alternately, IITs might benefit host states by leading to more efficient allocations of resources. Allowing foreign investors to compete on a level playing field with domestic investors is likely to lead to more efficient allocative decisions in the product and service markets in which foreign investors operate. But the conferral of rights on some foreign investors that go beyond the rights of other investors is likely to be market-distorting and inefficient. In this respect, the efficiency effects of IITs will depend foremost on whether they confer rights on foreign investment that go beyond national treatment.

It has also been argued that granting legal protection to investment – of any nationality – can encourage governments to make more efficient regulatory decisions. This argument raises more complex issues. The signing of an IIT would only lead to more efficient regulatory decision-making if the risk of liability to foreign investors led government decision-makers to more accurately assess the overall private costs of regulations under consideration, and not just the private costs to the foreign investor. This efficiency gain would then have to outweigh any efficiency loss due to the moral hazard of insuring foreign investors for foreseeable risks of their own investment decisions. Without wanting to over-simplify, it seems unlikely that making decision-makers more sensitive to the impact of their decisions on foreign investors will lead them to better assess the overall costs and benefits of regulations, most of which will not normally fall on foreign investors.

What then are the costs to a state of entering into an IIT? The first is a distributive cost. IITs prescribe liability rules that distribute losses between host states and foreign investors. The immediate consequence of entering an IIT is to require a state to compensate foreign investors for certain classes of loss. If these classes of loss are broader than the losses for which the state would have been liable under its own laws, then the IIT will engender a transfer of wealth from host state to foreign investor. The wider the legal protections granted to foreign investors by an IIT, the greater the transfer of wealth from the host state to private foreign investors.

A second cost to a host state flows from the impact of the risk of liability under IITs on public policy making. This issue has received a great deal of attention from academics and NGOs critical of IITs. Their criticisms are supported by a number of high profile IIT cases in which foreign investors have sued governments for the impact of public health and environmental regulations on the value of their investments. However, the precise nature of criticism has not always been clearly articulated. The fact that IITs may affect a host state’s environmental regulations – to choose an example – is not, of itself, a coherent criticism of IITs. It is the extent to which the risk of liability under an IIT makes a state less likely to introduce efficient, effective or otherwise socially desirable environmental regulations that constitutes a cost of entering these treaties. Evaluating the scale of this cost raises difficult theoretical and empirical questions, but that is no reason to shirk from trying to identify it.

In summary, the net benefits of entering an IIT may be lower than is widely supposed. In particular, provisions of IITs that go beyond guarantees of non-discrimination to grant positive discrimination in favour of foreign investors are less justifiable on efficiency grounds and are likely to incur distributive and public policy costs to a host state. Negotiators should be particularly careful in assessing the marginal benefit of adding IIT provisions that go beyond a right to national treatment.

Finally, there is different type of benefit that states may seek in negotiating IITs, variously described as ‘building confidence’ or ‘signalling friendly economic relations between states’. This objective may be furthered by entering into an IIT, but there is no obvious reason why it would be advanced by allowing investors to enforce treaty rights directly against host states through investor-state dispute settlement. Omitting the investor-state dispute settlement mechanism from IITs would allow states to avoid the costs of entering into IITs outlined above, all of which flow from the direct enforceability of IITs. If the primary purpose of including an investment chapter in a future Australia-China FTA is confidence building, then negotiators should consider omitting investor-state dispute settlement, as was done in the US-Australia FTA.

Jonathan Bonnitcha is a Rhodes Scholar and a Visiting Fellow at the Australian National University.