Q&A: Why shifts in energy transition policy are driving a new wave of disputes

How do shifts in energy policy drive litigation?

The first and perhaps most obvious way is where government decarbonization reforms upset existing interests in the conventional energy sector.

In January 2021, a German energy company filed a claim seeking compensation from the Netherlands government over its 2019 decision to phase out coal-fired power generation by 2030.

The company brought its claim under the Energy Charter Treaty (ECT), arguing that the law amounts to an indirect expropriation of its investment in a Dutch coal-fired power plant, which began operating in 2015 and has a design life of 40 years. 

Similarly, Canada faced a claim by a U.S. investor, Westmoreland Coal Company, under the North American Free Trade Agreement (NAFTA) following a scheme introduced by the Alberta government to phase out coal-fired power by 2030.

Although the claim was ultimately rejected on jurisdictional grounds, states look set to face further such claims when they implement initiatives to cut the use of fossil fuels.

What arguments are governments using to defend themselves?

The Netherlands and other states defending these claims will no doubt argue that they have the sovereign right, indeed an obligation, to adopt measures to protect the environment and public health in line with their commitments under the Paris Agreement.

They will also argue that any harmful impact of a measure on a private individual or entity must be weighed against the threat posed by climate change.

In that context, a state may argue that any given decarbonization measure must be considered proportionate and indeed necessary. Even if this defense is unsuccessful in an arbitration, it is conceivable that similar arguments may be used to resist the enforcement of the resulting award in national courts on the basis that the measures are required by overriding public policy concerns.

What challenges are those arguments likely to face?

These arguments could be deployed to defend ambitious measures of general application designed to phase out electricity generation from fossil fuels, but they may be less persuasive where governments adopt an inconsistent or erratic approach – for example by trying to prohibit a fossil fuel project that they have previously permitted or endorsed.

Some inconsistency in policy is almost inevitable in a democracy, where successive governments may not share the same outlook on the urgency of decarbonization and the appropriate means to achieve it.

Moreover it is also common for municipal, regional and national arms of governments to have opposing views on how to regulate fossil fuels.

Is this inconsistency in policy also driving litigation?

Yes. Where a project is adversely impacted by inconsistent policy, the project’s stakeholders may bring claims against the government.

One such claim was brought against Italy by Rockhopper Exploration Plc, a British company involved in the exploration and development of offshore oil and gas.

In 2014, Rockhopper invested in a project in the Adriatic Sea and subsequently secured an environmental impact assessment approval and a production concession from the Italian authorities.

However, in late 2015, the Italian parliament passed a law that banned all exploration and production activities within 12 nautical miles of the Italian coast, effectively preventing Rockhopper from developing the project and rendering its investment worthless.

Rockhopper's claim against Italy under the ECT resulted in a 2022 arbitral award ordering Italy to pay EUR190 million in compensation.

However the Keystone XL pipeline in North America is perhaps the best example of policy inconsistency driving litigation. Keystone XL was designed to transport up to 830,000 barrels of crude oil per day from the Alberta tar sands to refineries and ports on the U.S. Gulf Coast.

Amid opposition to the project from environmental groups and scientists, in 2015 the Obama administration rejected the pipeline on the basis that it would not serve the national interest of the United States.

In response, the pipeline’s owner, TransCanada, sued the U.S. government for allegedly violating the U.S. Constitution and the NAFTA.

TransCanada's claim was then discontinued after President Trump issued a new presidential permit for the pipeline, citing its potential benefits for energy security, jobs, and trade.

In 2018, a federal judge in Montana blocked construction on the basis that it failed to comply with federal environment regulations. President Trump responded by issuing a new presidential permit authorizing construction.

Subsequently, on his first day in office, President Biden signed an executive order revoking the permit. President Biden’s order stated that the pipeline “disserves the U.S. national interest” and that the U.S. “must prioritize the development of a clean energy economy.”

As a result, the U.S. has received notice of a further claim, which would be brought as a NAFTA legacy arbitration under the new U.S.-Canada-Mexico agreement.

What does this show? That projects caught in the crosshairs of changes to decarbonization policies will, if negatively impacted, give rise to multiple claims.

We can expect more of these cases as governments grapple with competing economic, environmental, and other priorities.

What about emissions-reduction measures? Can they be a source of disputes?

Again, yes. Governments will likely be exposed to claims where policies aimed at reducing carbon emissions are deemed to be disproportionate or discriminatory by the affected parties.

Moreover, attempts to modify these policies to alleviate the burden on those affected may serve only to trigger claims elsewhere.

The European Union is a good example – one of the instruments the EU uses to regulate and price carbon emissions is the EU Emissions Trading System (ETS), which covers around 45% of the bloc’s greenhouse gas emissions.

The ETS sets a cap on the total emissions permissible for participants in the scheme and allocates a certain number of emission allowances that can be traded on a market. If participants emit more than their allocated allowances, they have to buy more from the market or face a penalty.

This has generated complaints from EU-based companies who argue the ETS increases the costs of goods manufactured in Europe and gives a competitive advantage to competitors who operate in third countries without such rules.

To try to address this, the EU is now close to adopting a Carbon Border Adjustment Mechanism (CBAM) which will require importers of certain energy-intensive goods (including iron, steel, cement, fertilizers, aluminum, electricity and hydrogen) to pay a levy that corresponds to the price of emissions allowances under the EU ETS.

Reporting obligations under the CBAM will apply from October 1, 2023, while the obligation for importers to pay will begin in 2026.

The overarching rationale of the regulation is to address the risk of “carbon leakage”, whereby the emissions reductions achieved within the EU under the ETS could be offset by covered operators shifting their activities to jurisdictions outside the scope of the ETS and/or by EU firms increasing their imports from these jurisdictions.

While this may solve the existing problem, some claim it may violate the rules of the World Trade Organization, illustrating the difficulty of calibrating an ambitious decarbonization policy that is entirely free of controversy.

How about changes to renewables incentives, or the imposition of windfall taxes?

Another source of litigation risk comes where governments induce investment in renewable energy projects and then seek to unwind incentive schemes as circumstances or their priorities change.

This has happened in a number of countries (including Spain, Italy, the Czech Republic, Poland, Hungary, Romania, France and Mexico), which secured vast sums of private investment in wind farms, solar parks, and hydro projects through ambitious support schemes only to implement or announce retroactive cuts to those regimes.

These shifts can destroy the financial viability of renewable energy plants and have resulted in an avalanche of arbitral awards granting billions of dollars in compensation to affected investors.

In most instances, governments enacted the cuts following the 2008 financial crisis. Faced with gaps in their budgets, they elected to abandon expensive renewables subsidies to help balance the books.

More recently, the spike in energy prices following Russia's invasion of Ukraine has caused a number of European counties to implement windfall taxes on energy companies.

In response, affected parties have indicated their intention to challenge these measures on the basis that they improperly discriminate against them.

Given that energy projects tend to have a design life of several decades, they will continue to be buffeted by myriad policy changes in response to evolving economic and geopolitical conditions.

States will be forced to defend claims where their responses to those changes are perceived to be erratic, too abrupt, or inconsistent with their existing obligations.

Any other areas of emerging risk?

Claims against governments may also arise from a new wave of “resource nationalism” linked to decarbonization. Lithium is a good example – the mineral is a key component of rechargeable batteries and will therefore play a critical role in decarbonization, both as part of the electrification of transport and in the storage of electricity generated by intermittent renewable sources such as wind and solar power.

According to some estimates, compared to 2019 levels, global demand for lithium could more than triple by 2025 and continue to increase beyond that.

Not surprisingly, the price of lithium has skyrocketed, and in August 2022 the Mexican government issued a decree reserving to the people of Mexico the exclusive right to exploit all lithium resources within the country.

This may lead to the nationalization of existing lithium development projects in Mexico, a move that is likely to trigger claims against the government.

That’s not to say that local communities always welcome new mining projects, no matter how valuable they might be. Take the development of the San Jose lithium deposit in Caceres, Spain.

The mine is touted by its developer as a crucial source of lithium for the European market and a major boost to the local economy.

However, it faces opposition from residents, environmental groups and cultural associations who claim that it would cause irreversible damage to Caceres, a UNESCO World Heritage Site. If that opposition results in the project being cancelled, significant litigation would follow.

In a sense, the litigation generated by the extraction of minerals necessary for decarbonization are an extension of familiar disputes provoked by the siting of renewable energy plants.

Wind turbines have long been the subject of opposition over their impact on the landscape, and as a result, the construction of wind turbines anywhere near urban areas has long been difficult.

Indeed, it has been reported that an informal rule exists in the wind power sector whereby developers will not plan a turbine within 30 miles of a Starbucks, the presence of which suggests a well-resourced local population with the potential to block the granting of planning permission.

This also applies to the construction of the transmission lines required to transport electricity from a renewable energy plants to consumers.

In January 2021, the U.S. Department of Energy issued a Presidential permit for the New England Clean Energy Connect transmission line, which aims to deliver hydroelectric power from Quebec, Canada, to the New England grid via a 145-mile corridor through Maine.

In November that year, voters in Maine approved a referendum halting construction of the project on the grounds that it would result in the loss of a 53-mile section of forest, sparking, you guessed it, litigation.

Are steps being taken to reduce the risks governments face?

Given the vast potential for decarbonization policies to result in claims against states, governments have recently taken steps to reduce their exposure.

The attempt to “modernize” the Energy Charter Treaty (ECT) foresees amending it to carve out from its scope of protection: (a) new fossil fuel investments made after August 2023; and (b) all fossil fuel investments 10 years from the date on which the amendment takes effect.

This would avoid liability under the ECT for the future phase-out or cancellation of fossil fuel projects.

Spain, the Netherlands, France, Poland, Slovenia, Germany and Luxembourg deemed this to be insufficient and have recently declared their intention to withdraw from the treaty altogether.

This has prompted the European Commission to call for a coordinated withdrawal from the ECT by all EU Member States, and the EU itself. Although withdrawal should not eliminate their exposure under the ECT entirely, given that its protections remain applicable to existing investments for a further 20 years following withdrawal, it has been argued that states may agree among themselves to disapply such “sunset clauses” by mutual agreement.

In any event, there exist multiple other international, regional, and domestic fora where adversely affected parties can challenge decarbonization policies. As such, while the decarbonization of the global economy is critical, it will also remain highly contentious.