EJIL: Talk! | 19 January 2023
Polluter doesn’t pay: The Rockhopper v Italy award
by Toni Marzal, Senior Lecturer at the University of Glasgow
Last August, an ICSID tribunal handed down its much-anticipated ECT-based award in the dispute between Rockhopper, a British oil and gas company, and the Italian Republic. Rockhopper had been denied a licence to exploit an offshore oilfield, due to legislation banning oil production concessions within a certain distance from the coastline. The ban was adopted as a result of intense popular campaigning from regional and local authorities, and environmental, religious and civic associations, who had successfully requested a referendum on the matter. According to the award, which was only published in November, Rockhopper had met all the conditions set by Italian law to be granted the licence, so the denial amounted to an unlawful expropriation. It therefore awarded €185 million in compensation (over €240 million with interest).
Given these ingredients (democratic politics, climate change legislation, fossil fuel corporate power), it is not surprising that the dispute has generated huge interest, with the press reporting on the ‘outrage’ sparked by Rockhopper’s claim, and on the widespread criticism immediately met by the award. The decision has quickly become symbolic of the incompatibility of the ECT with efforts at tackling the climate crisis (Italy had already withdrawn from the ECT in 2015, but Rockhopper benefitted from the treaty’s sunset clause, which extends its application to pre-withdrawal investments for a further 20 years).
The award itself, however, was only published more recently, in November. It goes to great lengths to persuade us, in a strikingly defensive tone, that any criticism of the decision based on environmental considerations is fundamentally misguided (although revealingly, no such efforts are made with regards to the democratic dimension of the affair). The Tribunal majority, composed of experienced arbitrators Klaus Reichert and Charles Poncet, thus signal that the Tribunal ‘appreciates and is acutely sensitive to the fact that there are strongly-held environmental, civic and political views about offshore production’, but insist that ‘the outcome of this case passes no judgment whatsoever on the legitimacy or validity of those views’, and that the award ‘is not a “victory” for one side or the other in that environmental debate’ (para. 10). These disclaimers were insufficient for the State-appointed arbitrator, the respected professor of international law Pierre-Marie Dupuy, who sides with his co-arbitrators on every substantive issue but nevertheless regrets, in his brief individual opinion, that more ‘emphasis’ was not given to the context of the dispute, whilst reminding us of his own ‘long-standing commitment to the defence of international environmental law’ (p. 1), and underlining that ‘there can be absolutely no doubt about the power of the host State to amend its legislation, […] nor [about] the public interest nature of the reasons that led Italy to adopt this new legislation’ (p. 5).
In short, the arbitrators contend that the State’s sovereign powers to regulate the fossil fuel industry are in no way affected by the oil company’s right to obtain compensation for the negative consequences it might suffer as a result. If this were true, then no ISDS award would ever curtail regulatory powers, monetary compensation being really the only remedy available. Nor would speeding tickets have any effect on driving, damages for medical negligence on medical practice, etc. But of course, it isn’t true. Driving up the cost of keeping fossil fuels underground can only result in more fossil fuels coming out of the ground – exactly what must not happen, if global warming is not to exceed 1.5 °C. In fact, the award reports that Italian authorities had initially hesitated about carving out exceptions for the offshore ban, due to fears of potential claims for compensation (para. 102).
Rather than a disingenuous denial of the ‘regulatory freeze’ effect of ISDS awards (which is very real), the arbitrators’ defensive reasoning hinges mainly on a subtler proposition: that environmental norms and considerations are irrelevant to determining, from a strictly ‘legal’ point of view, first whether an expropriation took place, and second the amount of compensation owed to the investor. Indeed, the Tribunal treats both as objective questions of fact, independent of any environmental rationale. It is here that the decision should be seen, in spite of the arbitrators’ efforts to argue otherwise, as deeply troubling. Turning a blind eye to the environmental dimension of the affair is profoundly objectionable, and has the effect of rendering climate legislation significantly more costly. The fact that the decision was supported by the three members of the Tribunal, all prestigious figures in the world of investment arbitration, only serves to underscore how deeply ingrained these views are among that community.
The expropriation claim
Let us turn, first of all, to the initial issue: did the investor suffer an expropriation? The difficulty here came from the fact that the production concession had not yet been granted, and so the State argued that there was no ‘extractive business’ that ‘could be expropriated to begin with’ (para. 189). It was nevertheless claimed by the investor that it had satisfied all the necessary tests (critically, that Italian authorities had already approved the project’s environmental compatibility), so all that was left was for the concession to be formally granted, which according to Italian law would be done a mere 15 days after Rockhopper’s formal application (in August 2015). The Tribunal found this persuasive: once those 15 days had elapsed, the investor gained a right to be granted the production concession (even if not ‘an actual production concession’, para. 191). The ulterior adoption of the offshore ban (in late 2015), leading to the concession refusal, thus meant that Rockhopper ‘went, in one fell swoop, from a position where they had rights to a valuable production concession which would actually lead, under Italian law, to such production concession, to essentially nothing at all’, which amounts to ‘an immediate and complete deprivation of the Claimants’ investment’ (para. 194). This happened as a matter of fact, regardless of whether the offshore ban was motivated or not by legitimate environmental concerns.
The problem with the Tribunal’s reasoning is that it ignores a fundamental question, to which such concerns are indeed relevant. For a right to be the object of expropriation, that right must possess a proprietary nature. This means that the interest held by Rockhopper under Italian law should have a certain consistency. However, what characterises that interest in the present case is precisely that it is a highly fragile one – remember, not the concession itself, as the Tribunal keeps insisting, but a mere right to that concession. In other words, it is implied, but not justified, that expropriation is possible not only with regards to contractual rights, but also to more preliminary rights to a contract. This is already a highly debatable, but the environmental context renders the quality of Rockhopper’s legal position even more precarious – and therefore its susceptibility to expropriatory action. Indeed, the possibility that the actual concession would be awarded was called into question by the well-known concerns about offshore drilling in the context of the dispute. Prof. Dupuis himself highlighted the tenuousness of any such expectation, pointing out that ‘the Claimant could not ignore that the entire area in question had previously been considered off-limits to drilling because of its immediate proximity to the coast and the very serious concerns that could rationally be entertained with regard to its ecological harmlessness’, that any exceptions to this prohibition ‘were precarious and reviewable’, and that the ‘intrinsic profitability of the project itself’ was always in serious doubt. As Anil Yilmaz-Vastardis explains here very well, it is confusing that Prof. Dupuis only reasoned this way in relation to the separate claim for breach of fair and equitable treatment (which the tribunal majority left unaddressed), instead of concluding that these observations undermined all of Rockhopper’s causes of action.
The award, however, is most significant in relation to the second aspect – how compensation is calculated, or so-called ‘quantum’. The approach followed by the Tribunal, which is relevant to any case involving the calculation of compensation, insulates this assessment from any environmental considerations and leads to a huge inflation of this and potential future awards.
The key issue here was the choice of appropriate valuation method, to determine the measure of the investor’s loss. The State defended either a ‘sunk costs approach’ based on the costs actually incurred by the investor (which came up to no more than €2 million), or a ‘market-based’ approach based on the amount paid by Rockhopper to acquire the investment only 17 months before the alleged expropriation (€36 million). The Tribunal chose instead to resort to DCF valuation (discounted cash flows), as argued by claimant. This is a valuation method that locates value in an asset’s future profitability (rather than historic costs). It works by adding up the expected cash flows, but subject to a discount factor in order to reflect associated risk. In this case, as generally in ISDS, the use of DCF resulted in a much higher valuation (€185 million). There is really only one reason offered by the Tribunal to support the use DCF – its widespread presence in financial practice. It thus noted that the fossil fuel industry usually uses DCF, that the Italian government sometimes uses DCF, and that financial services companies Rothschild and Canaccord used DCF to value the disputed concession.
The fact that in all these instances DCF is used to support investment decisions, rather than adjudicate claims for compensation, is not at all considered. It is regrettable that the Tribunal treated valuation as a purely financial issue, as ISDS Tribunals unfortunately tend to do, rather than one deeply entangled with the environmental preoccupations that lied behind the offshore ban (although in its defence, it is not obvious that the legal team for the Italian State drew attention to these matters).
To begin with, the use of DCF rests on the assumption that, from a legal point of view, the claimant has a right to the future profits that happened to be projected at the valuation date, and therefore to compensation for their loss. The existence of this right is taken for granted by the Tribunal, without any justification. But is it really true that oil companies are legally entitled to those predicted income streams? Such a right is dubious in any sector of the economy. Indeed, corporate margins are shaped decisively through regulation, as there is no question that the State can legitimately increase taxes or adapt its regulations to make operation more costly. The right to future profits of the fossil fuel industry is even more questionable in the context of the climate emergency, given the pressing need to adopt regulations to transition to cleaner sources of energy. If the Tribunal had taken seriously the idea that the State has the power to pursue such policies, it would naturally have been more circumspect in awarding compensation for the loss of future profits. At most, as argued here and here, such compensation should have been limited to a reasonable rate of return.
Second, and perhaps more fundamentally, the climate crisis has transformed our relationship to the future. In particular, anthropogenic global warming has resulted in a huge increase in uncertainty, with the emergence of massive new risks looming over corporate profits (and of course all of us). Such risks include not only the possibility of so-called natural disasters, but also those associated with regulatory change (i.e. the efforts to combat climate change already alluded to). As excellently explained here by Tienhaara, Johnson and Burger, this realisation ought to lead to changes in how we value fossil values, of which two are most relevant to the Rockhopper case – but unfortunately entirely ignored by the Tribunal.
The first possibility would be to factor in these additional risks within the operation of the DCF method itself. As explained above, the discount factor is meant to reflect any uncertainty surrounding the realisation of projected cash flows. To take the climate emergency seriously requires, therefore, a considerably inflated discount factor, resulting in a depressed valuation. Sadly, however, the award does not engage at all with this issue. Indeed, it is not even transparent about the specific discount factor used (its discussion of the parties’ arguments does suggest, however, that it hovers around 10% or slightly above – an very low rate, indeed a lower measure of risk than the one used in other ISDS cases). Rather than considering the transformations brought about by climate change, the Tribunal justifies its final valuation by focusing exclusively on the perspective of the oil company’s shareholders (para. 287).
There is a second, more convincing possibility, which relates to the appropriateness of DCF itself. The main argument against using this valuation method in international adjudication is its fundamentally speculative nature, as it is in tension with the well-established norm under international law prohibiting compensation for ‘speculative losses’. Indeed, DCF necessarily involves unreliable predictions about what the future will bring (e.g. how will oil prices evolve?). It is also notoriously prone to manipulation, as small tweaks in any of the formula’s inputs may lead to huge variations.
What is striking about this case is that both reasons were intensely relevant. The investor’s own expert had inadvertently demonstrated the manipulable nature of DCF, by producing various valuations that ranged from a mere €68.3 million to a whooping €1.5 billion (para. 228-9). Furthermore, production had not begun, so there was not yet any history of profits with which to reliably project future cash flows. If ever there was an easy case to refuse DCF, this was it. What is more, the climate emergency makes the case against DCF even more compelling. Indeed, the additional risks that we have already mentioned are not simply bigger – they are of a radically incalculable nature. The sheer unpredictability of the realisation and magnitude of the dangers that it entails make it impossible to translate them neatly into any percentage figure. This consideration should have pushed the Tribunal to justify limiting compensation to amounts actually spent by the investor.
Ultimately, the way in which the reasoning of the Rockhopper award expels any environmental considerations has the effect of making climate change interventions considerably more costly – by increasing the scope of regulations considered to be expropriatory, and by inflating the amounts that will need to be paid in compensation. In short, the decision increases the (public) price of keeping oil underground, with all the consequences this will have on future attempts at doing so.
Beyond its regulatory effects, however, the decision is also fundamentally wrong as a matter of principle. As we have seen, such environmental considerations were indeed pertinent, to both the existence of an expropriation and the quantum assessment. In brushing away these considerations as relevant only to ‘civic or political debates’ rather than ‘the legal issue at hand’ (para. 10), the award rests on the assumption that the costs of the climate transition must, from a legal perspective, not be borne by fossil fuel companies – those companies must instead be insulated from the risks of climate change. In short, the costs must fall on the public – not on the polluters.
For these reasons, the arbitral decision can only be read as disastrous for the environment. It makes the ECT’s fundamental incompatibility with the need to address the climate emergency so glaring, that it might actually help spur European governments, who heretofore have usually not been on the receiving end of ISDS claims by the fossil fuel industry, to finally give up on the treaty, rather than engage in its so-called modernisation. That might be the only saving grace of the Rockhopper v Italy award.