Abstract
The proliferation of international investment agreements (IIAs) in the last thirty years has been accompanied by the ever-evolving interpretation of arbitral tribunals on the rights and obligations contained in these treaties. However, the fundamental question of what constitutes an “investment” for these purposes is the subject of renewed scrutiny because of the implementation of market-based strategies to achieve global climate change and sustainable development goals. An ICSID tribunal is set to determine for the first time whether the trade of carbon emission allowances on primary and secondary emissions markets can be considered an “investment” for jurisdictional purposes under Article 25 of the ICSID Convention and for treaty protection purposes under NAFTA’s Chapter Eleven in a dispute between Koch Industries and Canada following the cancellation of Ontario’s cap-and-trade program in 2018. This article offers a cursory review of the principal jurisdictional issue in Koch v. Canada and relevant global policy on environmental protection. Ultimately, this review aims to establish that the tribunal’s determination in Koch v. Canada will prove to be significant for the future of market-based strategies to combat climate change and achieve sustainable development.
Introduction
“For far too long, many have believed economic interests and environmental interests to be intrinsically opposed. The world is slowly waking from this outdated belief, coming to recognize that both commerce and the conservation of natural resources are actually just means, rather than ends unto themselves. The common aim of their different labours is human well-being.”
~Oscar Arias (Former President of Costa Rica, in Marie-Claire Cordonier Segger & Maria Leichner Reynal, Beyond the Barricades: The Americas Trade and Sustainable Developent Agenda)
International investment agreements (IIAs) like bilateral investment treaties (BITs) are ubiquitous, withover 2200 such agreements currently in force. However, the content of some of these agreements has struggled to keep up with significant changes in global policy and technology that are determinative of the rights and obligations set out in the majority of IIAs. When we consider that these treaties have become the foundation for the promotion of foreign direct investment, it becomes apparent that IIAs should also be inclusive of ongoing efforts to achieve sustainable development, with the idea of the creation of a system where the global flow of capital coincides with global goals of economic development, environmental protection, and even social well-being.
However, the inescapable fact is that these treaties are agreed upon by States at specific points in time, with an understandably limited view of what should constitute an “investment” in the future (or in the context of certain transactions). Therefore, while the drafters and negotiators may intend to draft a BIT with the specific purpose of guaranteeing the protection of covered investments, oftentimes, the course of dealings between a host State and an investor can result in a dispute as to the applicability of protection to an investor’s property. Thus, these disputes often begin with a preliminary question: Is the property right at issue an “investment” for the purposes of the applicable agreement?
This is precisely the issue that an ICSID tribunal is set to determine in an ongoing arbitration between Koch Industries and the Government of Canada on the basis of a NAFTA legacy claim by Koch alleging that the Province of Ontario took summary and arbitrary measures against a Koch subsidiary (Koch Supply & Trading, LP (KS&T)) when it cancelled its carbon emissions cap-and-trade program in 2018.Koch claims that these measures had the effect of wiping out KS&T’s carbon allowances trading business in Ottawa and arbitrarily and illegally stripped KS&T of purchased allowances valued at over thirty million dollars. Canada has countered that the tribunal does not have jurisdiction to hear the claim because carbon emissions allowances do not constitute an “investment” for the purposes of Article 25 under the ICSID Convention and that these allowances are not protected investments for the purposes of protection under NAFTA’s Chapter Eleven. As will be explored below, although the tribunal’s decision will not have binding authority in similar disputes, the determination of this question will be significant because of the possible implications for investors and States engaged in cap-and-trade programs as part of the global agenda on climate change and sustainable development.
What is Carbon Emissions Trading?
Carbon emissions trading as a concept emerges from theKyoto Protocol, namely, from the proposition in Article 3 of the Protocol that establishes the use of market-based strategies, like carbon credit trading between the global South and the global North as an important mechanism to harmonize international climate change efforts and reduce global greenhouse gas (GHG) emissions.Emissions trading programstypically have two key components: (1) a limit (or cap) on pollution and (2) tradable allowances equal to the cap that authorize allowance holders to emit a specific quantity of the pollutant.
Emissions allowances are sometimes distributed at no cost by governments to incentivize participation in the program. However, allowances may also be purchased from the government at auctions and can generate significant revenue for these governments upon sale (as was the case in Koch v. Canada). Moreover, because of the nature of how emissions allowances are utilized by capped entities, including the fact that some entities may underuse their allowances, a secondary market for the sale and purchase of emissions allowances exists to facilitate trading and efficient use of allowances between capped entities themselves. Therefore,as articulated by counsel for Koch, emissions allowances effectively become a tradable property right.
At issue in Koch v. Canada is whether allowances, even if considered tradable property rights, should be recognized as an “investment” for the purposes of protection and compensation under an investment treaty {in this case, the North American Free Trade Agreement (NAFTA)}.
The outcome of Koch v. Canada is potentially significant, particularly because cap-and-trade programs, in conjunction with other similarly purposed programs, will almost certainly see extensive use as States and the international community continue their uphill battle to combat the effects of climate change.An expert in the Koch v. Canada arbitration explains that, including carbon tax policies, there are currently 64 carbon-pricing policies covering 22 per cent of GHG emissions. Just earlier this year, the Government ofGujarat announced the launch of a cap-and-trade market for carbon emissions that are set to be the first of its kind among today’s emerging economies. Therefore, it is clear that the circumstances which underlie the dispute between Koch and the Canadian Government have the potential to reemerge as more States and local governments seek to implement similar cap-and-trade systems as a part of their climate strategies.
The core of this dispute emerges from a decision by the province of Ontario to cancel its cap-and-trade program after a highly politicized campaign to end the program by the local government. Koch alleges that the cancellation of Ontario’s Cap and Trade program itself served no public purpose and that the decision was instead motivated by the political interests of the incoming conservative government.
Ontario’s cap and trade program operated as part of a wider regional system, theWestern Climate Initiative (WCI), and under the auspices of which the Government of Canada developed a cap-and-trade system to reduce GHG emissions. Under this regional commitment, the governments of Ontario, three other Canadian provinces, and seven Western U.S. states agreed to develop a regional target for reducing GHG emissions in the WCI region, participate in a multi-state registry, to track and manage GHG emissions in the region, and the parties further agreed to develop a market-based program to reach their GHG reduction target. As part of the WCI’s recommendations in 2008, the WCI participating jurisdictions proposed a broad cap-and-trade program operate as part of a regional effort to reduce GHG emissions, with the idea being that each jurisdiction would recognize allowances issued by other WCI members so that WCI allowances purchased in one jurisdiction (e.g., Ontario) would be “of equivalent use and fungible throughout the WCI region.”
Ontario began planning its cap-and-trade program in 2008 on the heels of the WCI’s recommendations, and by May 2016, the Cap-and-Trade Act and Regulations were enacted.Koch argues that there were significant early efforts on its behalf to develop KS&T’s business in Ontario’s primary and secondary emissions trading markets, including KS&T’s participation in the public auctions of allowances from the very beginning of the program in early 2017. The company continued to participate in these public auctions until the last auction in May 2018. KS&T further explains that the process of participating in Ontario’s auctions required specialist expertise, the commitment of substantial capital and the undertaking of risk because of the nature of its enterprise. On 22 September 2017, Ontario signed an agreement with California and Quebec to harmonize and integrate their cap-and-trade programs (also known as “linkage”). Once these markets were linked, KS&T could exchange and use the allowances it purchased in Ontario with entities in California and Quebec.
By June 2018, after KS&T purchased allowances in the May 2018 auction, but before Ontario had delivered them, Doug Ford was elected as Premier of Ontario on behalf of the Ontario Conservative Party. Historically, the Ontario Conservative Party was opposed to the Cap-and-Trade program, and the Party executed a highly politicized campaign that promised the eradication of the program after the election. Although Ontario’s cap-and-trade program was set to be in force until 2030 under its governing regulation, after the new Premier’s election, the incoming government took immediate action to withdraw Ontario’s commitments to the program without consulting or giving prior notice to the carbon emissions market participants (or its partner jurisdictions Quebec and California). These measures culminated in the passage of theCap and Trade Cancellation Act.
KS&T alleges that the effect of the actions taken by the incoming government in Ontario was devastating, and the loss suffered was clear and immediate. The company found itself unable to trade any allowances and could not fulfill its existing contractual obligations, in addition to the loss of future business from ongoing negotiations between KS&T and prospective purchasers. The Ontario government froze and liquidated the value of millions of carbon allowances that KS&T had acquired before the election in June 2018 at the cost of over thirty million dollars, and the company further alleges that Ontario expressly denied it any access to domestic courts to seek compensation. [1] However, the cancellation of Ontario’s cap-and-trade program had a significant impact beyond that experienced by Koch and KS&T, as billions of dollars in emissions allowances were at risk of annulment without compensation when the cap-and-trade program was cancelled in June 2018.
Are Carbon Emission Allowances “Investments” for Purposes of Investment Treaty Protection?
A dispute before an ICSID arbitral tribunal (like Koch v. Canada) typically entails two separate examinations of the existence of an “investment”, otherwise known as the “double-barreled test”, which requires the Claimant to establish there is an “investment” both as defined under Article 25 of the ICSID Convention and in the applicable BIT or investment agreement. [2] Although IIAs operate as lex specialis, there can be similarities between IIAs as to the threshold for what constitutes an “investment”, and there is a general consensus in the body of international investment law on what can be considered an investment for purposes of the ICSID Convention.
The four basic requirements for an “investment” are (1) a substantial contribution; (2) a certain duration of the operation; (3) an element of risk; and (4) contribution to the host State’s development. In Koch v. Canada, the Canadian Government submits that the emissions allowances in Ontario’s cap-and-trade program fail all four requirements.
One reason why this is set to be a contentious issue is that so many BITs and investment agreements ensure protection for intangible assets like legal rights or shares, effectively treating these assets as “investments” for the purposes of investment protection (and compensation in the event of a dispute). Nevertheless, two of the arguments put forward by Canada as to why KS&T’s acquisition of emission allowances does not qualify as an “investment” is that there must be “a contribution of economic value” and the venture “should be significant to the State’s development.”Canada’s position is that the purchase and trade of emission allowances do not suffice as a contribution to an economic venture because “an investment, in the economic sense, is linked with a process of creation of value, which distinguishes it clearly from a sale.”
Although the exact amount of revenue received by the province of Ontario from KS&T’s purchase of the emission allowances is unknown (as it is not public information), the province did, in fact, utilize the revenue generated from all emission allowances toward funding several local eco-friendly initiatives like the construction of cycling paths, energy rebates for consumers, and even funding for local public transit. Moreover, it is difficult to reconcile the figures because emissions allowances “[do] not bring about a qualitative change in the economic benefit that all legitimate trade brings in its train.” If ICSID tribunals generally consider that to qualify as an investment, the venture should be significant to the State’s development; then due consideration should be given to the utilization of the proceeds from allowance auctions for funding of critical local initiatives (like Ontario’s use of its auction revenues to fund public transit) by the government.
Concluding Remarks: What does this mean for the Future of Environmental Protection?
It seems fitting that this dispute should coincide with the fiftieth anniversary of theStockholm Declaration on the Human Environment, in which the international community agreed for the first time that development planning should coincide with environmental protection (Principle 13).Agenda 21 was subsequently adopted by 185 States in 1992 at the United Nations Conference on Environment and Development (UNCED), and thereinthe signatory States agreed to integrate environmental concerns fully into all their decision-making processes and activities. To that end, individual States and regional organizations like the EU have taken steps to ratify the global agenda on the environment and climate change as a matter of domestic policy. Recently,the Court of Justice for the European Union (CJEU) issued an opinion whereby the Court recognized that “[…] the guarantee of adequate social protection and environmental protection requirements must be integrated into the definition and implementation of the Union’s policies and activities, in particular with a view to promoting sustainable development.”
Therefore, one of the key questions that arise from the Koch v. Canada dispute is what impact can be expected on the global effort to integrate environmental protection and sustainable development in States’ domestic frameworks if the flow of capital into climate-friendly mechanisms like emissions trading systems cannot be considered an “investment” for the purposes of investment treaty protection. At the very least, it seems counterintuitive to the goals and strategies that States have agreed to pursue as part of the global agenda to combat climate change and achieve sustainable development. But beyond this, the failure to recognize emissions allowances as an investment could severely disincentivize potential investors from participating in emissions trading altogether, possibly even leading to a gap in the enforcement of caps on emissions on the biggest GHG producers around the world.
However, this dispute is also significant because it illustrates the ongoing transition from the implementation of the Kyoto Protocol system to the new Paris Agreement system, a move which has sparked some uncertainty with respect to the future of environmental protection, not least because the Paris Agreement system relies almost exclusively on individual State determination of the nature of their emission commitments, making it even more challenging to create a legally binding system underthe Agreement. This shift toward a State-centric approach in the Paris Agreement likely reflects individual State practice. For example, the aforementionedWestern Climate Initiative has seen the number of its participating jurisdictions dwindle in the past fifteen years from eleven participating jurisdictions to only four current partners (California, Quebec, Nova Scotia, and Washington) and is seemingly representative of a new era of environmental protection strategies.
Another key takeaway from this arbitration perhaps strikes closer to home for investors that are contemplating their entry into the carbon trading market. The underlying decision by the local government in Ontario certainly serves as a stark reminder of the role played by domestic policies and legislation in the global flow of FDI, as governments can and do change their priorities over time (and sometimes to the detriment of foreign investors in their territory). However, for those that are in the business of emissions trading, the failure to recognize emissions allowances as investments means that a foreign company that purchases these allowances at a state auction will be severely limited in its options for redress should the State suddenly change its policies on cap-and-trade programs or choose to eliminate these programs altogether. In short, absent a prior agreement between the host State and the State of the foreign owner of the allowances, the investor would be restricted to the host State’s domestic courts and remedies. Not only is this problematic for investors, but it would place additional pressure on a State’s domestic courts with no regard for the capacity and resources of these courts to adjudicate these cases. An Ontario government member voiced similar concerns during the legislative debates on the Cancellation Act, noting: “The act retroactively terminates crown liability to pay compensation for breach of contract…It basically means the government is giving themselves the right to expropriate private property without compensation…There’s so much that’s unclear about this bill. We don’t know whether Ontario is opening itself up to challenges by Quebec and California. We have no idea”.
Whilst it is clear that the threat posed by climate change is such that it requires harmonization of interests, the extent of harmonization that States are willing to commit themselves to remains unclear even fifty years after the international community first agreed that environmental protection should be at the forefront of all decisions. If States continue to promote the growth of market-based strategies as part of their national climate policies, there must be an appropriate remedy for disputes available to the private parties that are doing business abroad in these growing sectors, but just what that remedy is remains to be seen. Koch v. Canada not only illustrates the consequences of a change in State policy and priorities, but it demonstrates that there is a gap in our current understanding of what is appropriately considered an investment under international investment law. This is true if we consider certain factors that are probative of an “investment” under the Salini test, and particularly the requirement that the project contributes to the host State’s economic development.
There is already evidence of States allocating significant revenues from their emissions auctions toward local infrastructure and community initiatives, and the coming years will likely witness a growth in the implementation of similar programs in other States (and particularly emerging economies), so a determination on whether this activity can be considered as part of a host State’s economic development is going to be extremely important. States and investors alike will no doubt want to monitor the outcome of this decision, for although the tribunal’s award does not have precedential authority, its decision will nevertheless prove to be significant against the bigger picture of ongoing efforts to mitigate global climate change and work towards the achievement of sustainable development.
About the Author
Ms. Yesenia Alfonso is a J.D./LL.M. Candidate at the University of Miami School of Law. She completed her LLB (Hons.) degree at Queen Mary, University of London.
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Preferred Method of Citation
Yesenia Alfonso, “Emission Allowances: An Investment by Any Other Name?” (IJPIEL, 21 September 2022)
<https://ijpiel.com/index.php/2022/09/21/emission-allowances-an-investment-by-any-other-name/>
Endnotes
[1] Koch v. Canada, Claimant’s Memorial on Jurisdiction and the Merits, para. 3, p. 1.
[2] Rudolf Dolzer, Christoph Schreuer, Principles of International Investment Law (3rd edition), p. 84.
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