Balancing the Scales: Why Investor-State Disputes Are Leading to Massive Compensation Awards and What Needs to Change

The article examines the challenges posed by the rising compensation awards in Investor-State Dispute Settlement (ISDS) cases, as detailed in the UNCTAD report Compensation and Damages in Investor-State Dispute Settlement Proceedings. It highlights the flaws in old-generation investment treaties that contribute to inconsistent and inflated awards, particularly through speculative methods like discounted cash flow (DCF). The article also discusses recent reforms aimed at providing clearer compensation rules, limiting speculative claims, and protecting state sovereignty.

In recent years, the size of damages awarded in Investor-State Dispute Settlement (ISDS) cases has ballooned, leaving governments, especially in developing countries, grappling with billions of dollars in compensation claims. This troubling trend has brought to light significant shortcomings in old-generation International Investment Agreements (IIAs), which govern most of these cases. The report, Compensation and Damages in Investor-State Dispute Settlement Proceedings by UNCTAD, dive into the root causes of these oversized awards and highlights the urgent need for treaty reforms to address these issues.

The Growing Burden of ISDS Awards

Investor-State Dispute Settlement (ISDS) mechanisms allow investors to seek damages from states when they believe their investments have been harmed due to breaches of international treaties. Traditionally, these awards were modest, but in recent years, the sums have skyrocketed. The report notes that more than a quarter of ISDS cases won by investors now involve awards exceeding USD 100 million, with some reaching as high as USD 1 billion or more.

This surge in compensation is not just an isolated issue; it reflects deep flaws in the legal framework that underpins ISDS cases. Many of the treaties that govern ISDS claims are outdated, providing little to no guidance on how compensation should be calculated. As a result, arbitral tribunals often rely on broad interpretations of customary international law, which opens the door for speculative methods of calculating future profits, driving compensation amounts to unprecedented levels.

The Pitfalls of Old-Generation Treaties

One of the main reasons for these outsized awards lies in the structure of old-generation IIAs. These agreements, many of which were signed decades ago, lack precise definitions and standards for determining compensation in cases of treaty breaches. Approximately 98 percent of ISDS cases are governed by such agreements, leaving the tribunals with considerable leeway to decide on compensation amounts. This has created a highly inconsistent system where the same breach can result in wildly different awards, depending on the tribunal's interpretation.

The report highlights that most IIAs fail to adequately address key factors such as future profit estimation and valuation techniques. This has led to tribunals increasingly relying on speculative techniques like the discounted cash flow (DCF) method, which estimates the present value of future income. While the DCF method can be useful in some cases, its application in disputes where profits are hypothetical or uncertain has led to inflated compensation claims.

For instance, in cases where a project never became operational, such as in the case of Tethyan Copper v. Pakistan, the tribunal awarded over USD 4 billion based on the DCF method, despite the project never getting off the ground. This reliance on speculative projections poses a significant financial risk to states, particularly those with developing economies.

A Push for Reform

In response to these concerns, many states are now looking to modernize their investment treaties. The report outlines several strategies that states have adopted to curb excessive compensation awards. One of the most effective approaches is to limit the types of damages that can be claimed, particularly when it comes to hypothetical future profits. Some treaties now explicitly prohibit tribunals from awarding compensation for speculative or windfall profits, helping to bring compensation amounts more in line with actual losses.

Other reforms include providing tribunals with clear guidance on the valuation techniques they should use when determining compensation. This includes prioritizing asset-based methods over speculative income-based methods like DCF, which have proven to be problematic. By offering clearer rules, states can ensure more predictable and fair outcomes in ISDS proceedings.

Additionally, there is growing recognition that compensation should take into account the broader public interest, not just the investor's losses. Some recent treaties now require tribunals to balance the interests of the state and the investor when awarding compensation, considering factors such as the public purpose of the state's actions and the investor's conduct. This more holistic approach ensures that states are not unduly penalized for implementing legitimate public policy measures.

The Road Ahead: Reforming Old-Generation Treaties

While these reforms are a step in the right direction, much work remains to be done. The report stresses the need to reform the vast majority of old-generation treaties, which continue to dominate the ISDS landscape. Without clear, updated rules on compensation, states will remain vulnerable to excessive awards that can strain public finances and exacerbate economic challenges, particularly in developing countries.

UNCTAD’s "Compensation and Damages in Investor-State Dispute Settlement Proceedings" offers a roadmap for future treaty negotiations, encouraging states to adopt clearer standards for compensation, limit speculative claims, and provide tribunals with better guidance on valuation techniques. By modernizing these treaties, states can protect their right to regulate in the public interest while ensuring that investors receive fair compensation for legitimate losses.

In conclusion, reforming ISDS compensation rules is critical to maintaining the balance between investor protection and state sovereignty. With clearer guidance on compensation and valuation, future ISDS cases can be resolved in a manner that is fair, predictable, and aligned with sustainable development goals.