ISDS measures could sink TTIP and their benefits are insufficient to warrant the risk – so free-traders should advocate dropping them from negotiations.

In our latest policy brief on the Transatlantic Trade and Investment Partnership (TTIP), we laid out our recommendation for a narrow TTIP that removes all tariffs and sets common standards in areas in which convergence can easily be achieved, but that leaves out contentious issues. Specifically, the European Commission should drop investor protection (or in technical terms, the provisions for investor-state dispute settlements, ISDS) from the negotiations.

Even before the publication of the brief, we experienced quite a lot of pushback on this recommendation. In particular, policymakers who see themselves as proponents of free trade felt that our proposal was something like treason to the case of transatlantic trade liberalisation. Many comments defended the inclusion of ISDS in TTIP.

The constraints of space prevented us from going into greater depth on the ISDS issue in the original policy brief, so this post is intended to explain our reasoning in detail.

Why drop ISDS from TTIP?

We argue that the planned ISDS provisions are problematic and that their benefits are far from clear. Because of this, ISDS will be a highly contentious issue not only in the negotiations, but also in the ratification process. Including ISDS gives NGOs a rallying point against TTIP, and also ensures that the agreement will be a “mixed agreement”, meaning that it will have to be ratified by all 28 EU member states in order to come into effect. It is not difficult to imagine scenarios in which at least one of the national parliaments does not accept the provisions and so does not ratify the whole agreement.

Trying to negotiate an ISDS that actually counters all the criticism (some of it justified – see below) would likely take several years. With presidential elections approaching in the United States in 2016, such a delay would put TTIP as a whole in jeopardy.

Trying to negotiate an ISDS that actually counters all the criticism would likely take several years.

Moreover, ISDS carries a large reputational risk for the European Commission and for the broader case for free trade. Suppose a TTIP that included ISDS provisions were to be pushed through against the vocal warnings of NGOs, and that a few years later, a case turned up in which a US company sued a European local or national government over a regulation that the population saw as completely legitimate. The European Commission and the European Union as a whole would be further discredited. Having lost a lot of public trust during the euro crisis, this is something the EU cannot afford. And because TTIP/ISDS proponents have repeatedly tried to link trade liberalisation and investor protection in the public debate, any such controversy would also sour public opinion against future trade liberalisation.

The problems with ISDS provisions in older investment treaties

Existing ISDS treaties have a number of problems. They usually allow companies to sue a government for compensation if they feel that they have been directly or indirectly expropriated. “Indirect expropriation” can include all kinds of regulations that hurt a company’s expected profits. Companies can usually sue without having to first go through the national court system.

Disputes are then decided by international arbitration panels. The dispute process is often criticised because panels are put together in an ad hoc fashion and it is possible for a panel member to have (quite recently) worked as a lawyer for the company concerned, or that s/he will represent the company shortly after the panel has ruled. And under many treaties, appeals are not allowed.

Other critics have pointed out that ISDS provisions create an uneven playing field between national and international corporations and put small- and medium-sized companies at a disadvantage. Under ISDS provisions, international companies can resort to more advantageous international arbitration rules, while nationally-owned companies have to go through the national court systems. Moreover, the legal cost of bringing a suit before international arbitration panels can easily run into millions of dollars, so they are not really an option for small- and medium-sized companies involved in a dispute about their (usually) small-scale investment.

Critics of the ISDS system claim that even if awards in favour of big corporations are not granted, policymakers’ fear of them can lead to “regulatory freeze”.

Most ISDS provisions, while calling for “fair and equitable treatment” for investors, do not define what a legitimate public interest is. Therefore, the panels are allowed a broad interpretation of when “fair and equitable treatment” of an international investor is violated.

A number of recent cases have made headlines because they are seen as examples of a government’s legitimate policy space to regulate being constrained. One prominent case is the suit brought by the tobacco company, Philip Morris, against the Australian government, which passed a law in 2011 banning the use of tobacco logos on cigarette packets. Philip Morris has also sued the Uruguayan government under a separate investment protection treaty after Uruguay increased the size of health warnings legally required on cigarette packaging.

Critics of the ISDS system claim that even if awards in favour of big corporations are not granted, policymakers’ fear of them can lead to “regulatory freeze”. As an example, they cite New Zealand, which ditched plans to follow Australia in limiting tobacco logos on cigarette packages after Philip Morris claimed damages against the Australian government.

Recent treaties still have problems

It is often claimed that all these issues could be remedied by wording ISDS provisions carefully, by making procedures more transparent, and by changing the rules for panel appointments and proceedings. However, it is highly questionable whether such measures could really solve the problem.

The Canada-EU Comprehensive Economic and Trade Agreement (CETA), for example, is often referred to as a potential blueprint for TTIP rules. But CETA still defines investment very broadly, including bonds and bank deposits in the definition. Including these instruments risks severely limiting policy space in the future. For instance, if bonds were included in investment protection provisions, debt restructuring like that involving Greece in 2012 would be problematic, since international bond-holders could apply to international arbitration panels for compensation. Another issue that could lead to litigation is the EU’s scheme under the banking union proposal to tighten bail-in rules for large bank deposits.

Even an agreement like CETA does not create firm and clearly defined rules that strike a balance between the interests of investors and the host country’s legitimate interest in public regulation. Instead, CETA relies on a broad “fair and equitable treatment” clause.

In principle, it might be possible to design a set of ISDS rules that strikes a good balance between public and private interests – but it is not clear that this can be achieved in practice.

As compared to national law, provisions in recent treaties still tilt the balance of power away from governments and towards global corporations. For example, the German constitution includes a clause protecting private property. In cases of expropriation, the constitution calls for compensation. This compensation must take into account the private owner’s interest as well as society’s legitimate interests. The compensation principle in CETA is different: under the treaty, compensation is set based on the market value of lost profits – which constitutes an absolute investor protection without any concern for the public interest.

In principle, it might be possible to design a set of ISDS rules that makes the system neat and strikes a good balance between public and private interests. But it is not clear that this can be achieved in practice. First, what constitutes a justified regulatory step (one that would not warrant compensation even if an investor’s profits were hit) would have to be defined in detail. To date, this has never been done. Secondly, investment protection treaties are extremely complicated legal documents. It can easily happen (and it has often happened in the past) that wording slips through that later allows clever corporate lawyers to exploit a well-intentioned treaty. And unlike national law (in which things like this also happen regularly), a treaty cannot be easily changed by a vote of parliament.

It seems completely unrealistic to think that such a complicated framework could be constructed, while still adequately involving the stakeholders, promptly enough to come to a timely conclusion of the TTIP negotiations.

ISDS benefits are illusory

Most experts agree that ISDS clauses are not really necessary for the EU and the US. In both areas (at least for the vast majority of EU member states), judicial systems are mostly independent and the rule of law is strong. Looking at transatlantic investment in recent years, it is difficult to come up with cases in which an objective person could conclude that a company’s investment was unfairly expropriated, when both private property rights and society’s legitimate interest in regulation are taken into account.

Most experts agree that ISDS clauses are not really necessary for the EU and the US.

Furthermore, empirical economic research has been unable to show that bilateral investment treaties (BITs) have a stable and statistically significant impact on flows of foreign direct investment. Studies that have claimed to find such effects have been criticised for methodological shortcomings and/or have found only minor effects. The United Nations Conference on Trade and Development (UNCTAD) published an up-to-date study on this subject in its annual Trade and Investment Report 2014.

Escaping a broken model

It has often been said that it is strange that Germany should be particularly opposed to ISDS, since the country has since 1959 signed many BITs to protect its own companies’ interests, especially in developing countries. EU member states have already signed hundreds of bilateral investment protection treaties, mostly with poorer countries. If we have imposed these rules on other countries, should we not hold ourselves accountable to the same standards?

This argument is only superficially convincing. There is growing evidence that something is broken in the current system of ISDS. The number of international litigations under BITs has skyrocketed over the past few years. NGOs have no trouble filling whole books with cases in which claims have been brought by investors after a government has passed regulations that the average person would consider as falling squarely within the bounds of national political decision-making. Emerging markets and developing countries are increasingly discontented with the agreements, believing their own policymaking capacity to be unduly limited by the treaties. South Africa has – after a thorough review – begun to cancel agreements, and Brazil has never ratified them.

If you find that you have exploited international rules to the disadvantage of others, the solution cannot be to allow yourself to be exploited.

If the system is so broken, and we are now aware of the problem, it would help nobody to extend the same rules to investment flows between the US and the EU (which constitute a very significant share of international investment flows even without an overarching investment protection treaty). Instead, the logical solution would be to conduct a thorough overhaul of the existing framework and to place a moratorium on signing new investment protection agreements before the revision of the system.

If you find that you have exploited international rules to the disadvantage of others, the solution cannot be to allow yourself to be exploited. To provide an analogy: for a number of years, German companies were allowed to expense bribery payments abroad for national tax purposes. At the same time, bribery was illegal in Germany. Of course, this was hypocritical. But it would have been wrong to conclude that, so as to be equitable, German companies should also be allowed to expense domestic bribes. Instead, the correct solution (which was chosen) was to cancel the favourable tax treatment for bribes paid abroad.

The interests of Central and Eastern European countries

Some Central and Eastern European countries have signed their own BITs with the US, which now appear to them to excessively favour the US. They hope to replacethe existing rules with investment protection rules in TTIP. While this is a legitimate desire, we do not believe that TTIP is the best solution for the problem. If these countries are really unhappy with their (freely agreed) BITs, they should try to renegotiate them. In the most extreme cases, they should cancel them. After all, only about 20 percent of the EU’s population live in Central and Eastern European countries. To force the other 80 percent into a disadvantageous investment protection regime in order to provide 20 percent with an easy exit from their own investment treaties just does not seem to be an adequate answer.

Missing a chance to reform the global ISDS system?

It is often argued that TTIP would provide the chance to create a new model for investment protection rules, which could then be transferred into existing BITs and thereby correct the shortcomings of the current system.

Free trade between the US and the EU promises real benefits.

At first glance, this looks like a very good argument. But, again, it is less convincing when the details are examined. Just because the US and the EU have agreed on a certain type of dispute settlement between themselves, it is not clear that any of the developed countries would agree to renegotiate their own BITs with developing countries to make them less favourable to their own companies (and hence “fairer” to the governments in poorer countries). After all, any such attempt would be met with fierce lobbying resistance from corporations that feared their investment protection being watered down.

This does not mean that there is not a good case for pushing for a global, coherent system of investment protection, including predictable, transparent, and balanced procedures for dispute settlement between governments and foreign investors. However, if such a blueprint for global use is to be negotiated, the developing countries should be at the table as well. TTIP just does not seem to be a good starting point.

Abandoning ISDS is a vote for free trade

Free trade between the US and the EU promises real benefits. Even though tariffs for transatlantic trade on average are low, tariffs for the main exports of some member states are still high. These countries could benefit substantially even from a tariff-only agreement (assuming the rules of origin were formulated in a way that would allow for high utilisation rates).

True free-traders should be able to see the political limitations of ISDS and, therefore, should aim for what is feasible.

Given the political realities in Europe, the momentum of public debate, and the risks involved with ISDS, including investment protection in TTIP carries serious risks of derailing the entire negotiation and ratification process.

To put it more bluntly: we believe that if you are against transatlantic free trade, the best way to prevent significant liberalisation is to insist on inclusion of ISDS in a TTIP agreement as a sine-qua-non. True free-traders should be able to see the political limitations of ISDS and, therefore, should aim for what is feasible – a limited TTIP with all tariffs removed and some harmonisation of standards, leaving open the potential for more in the future.

Read more on: European Power, EU instruments, Geoeconomics, TTIP