An optimal investor-state dispute settlement mechanism

Journal of Economics https://doi.org/10.1007/s00712-022-00800-z (0123456789().,-volV)(0123456789().,-volV) An optimal investor-state dispute settlement mechanism Frank Stähler1 Received: 19 January 2021 / Accepted: 27 June 2022 © The Author(s) 2022 Abstract Many investment treaties include investor-state dispute settlement (ISDS) provisions which are supposed to protect a foreign investor against opportunistic behavior of a host country. This paper scrutinizes the optimal design of ISDS provisions that solve the holdup problem. It shows that an efficient investor protection mechanism requires an arbitrator as established in investment treaties. However, this arbitrator does neither have to learn nor to evaluate the circumstances of the dispute. Furthermore, any ISDS compensation from the government to the investor should not be based on reductions in investor profits but on the host country’s welfare effects. Keywords Investor state dispute settlement · Foreign direct investment · TTIP · TPP JEL Classification F21 · F23 · F53 · F55 · D82 · H13 1 Introduction Investor-state dispute settlements (ISDS) provisions seem to be the most controversial policy issue in international trade policies in recent times. ISDS provisions are blamed to undermine national sovereignty as they allow foreign investors to take any kind of apparently unfair treatment to a tribunal. This tribunal may rule that the host country of the investment will have to indemnify the foreign investor if they find that the host country government policies have caused “unjustified” harm equivalent to expropriation. While ISDS provisions can be found in many bilateral investment treaties (see OECD 2012), the political opposition against ISDS provisions gained momentum when it became clear that they were supposed to become an integral part & Frank Stähler 1 University of Adelaide, University of Tübingen, CESifo and NoCet, Mohlstr. 36 (V4), 72074 Tübingen, Germany 123 F. Stähler of both the Transatlantic Trade and Investment Partnership (TTIP) and the TransPacific Partnership (TPP) Agreement.1 For example, Article 9.8 of the TPP draft (2016) specified that “[n]o Party shall expropriate or nationalize a covered investment either directly or indirectly through measures equivalent to expropriation or nationalization (expropriation) ...” Regulatory chill is a further concern and means that national governments, anticipating potential compensations, will constrain themselves and may not pursue any policy that might affect future multinational profits, leading to lower regulatory standards in host countries. Although the Trump administration abandoned both TTIP and TPP, ISDS provisions can be expected to become an integral part also in future agreements, both bilateral and multilateral.2 The economic reasoning behind ISDS provisions is the well-known holdup problem that may arise in the context of foreign direct investment (FDI). Due to incomplete contracts, a government cannot credibly promise investor-friendly policies if the investment is very specific such that it has little or no value when relocated to another country.3 As a consequence, some beneficial investment may not take place as the foreign investor will correctly anticipate her exposure to the holdup problem. International investment treaties specify rules by which disputes should be resolved.4 This paper scrutinizes how these rules should be specified. There is a substantially large literature that investigates empirically the effects of international investment treaties on foreign direct investment. This literature finds that they increase investment (see Busse et al. 2010; Egger and Merlo 2012; Egger and Pfaffermayr 2004; Haftel 2010; Neumayer and Spess 2005; Rose-Ackerman and Tobin 2009, 2011), but the impact of ISDS provisions on FDI activities is unclear (see Berger et al. 2011). The theoretical literature on ISDS is not large. There is, however, a related literature on compensations for regulatory takings, see Blume et al. (1984), Hermalin (1995), Miceli and Segerson (1994) and Nosal (2001). As for ISDS, Kohler and Stähler (2019) find that an ISDS provision may improve aggregate welfare generated by a relationship between a foreign investor and a host country if strategic ownership changes could be ruled out. However, the ISDS provision will lead to further distortions and can never achieve the first best. Aisbett et al. (2010a) show that taking out some well-defined policies from any potential compensation claim (so-called “police powers carve-outs”) can improve even the host country’s welfare. Janeba (2019) discusses under which conditions ISDS can lead to regulatory chill, and he shows that a unilateral domestic ISDS provision 1 TTIP was negotiated between the US and the EU, and TPP was already ratified by several Pacific rim countries, including the US, Canada, Australia and Japan. 2 TTP came into force as TTP-11, i.e., without the US, but TPP-11 does not contain any ISDS and intellectual rights provisions that the TPP draft suggested. CETA, an agreement between Canada and the EU, came into force, and it includes an ISDS provision. 3 See Navaretti and Venables (2006) for an exposition of the standard holdup problem. The allocation of property rights can mitigate the holdup problem as shown by Antràs (2003), Antràs and Helpman (2004) and Antràs and Chor (2013). 4 These provisions refer to legal rules as they are either set by the United Nations Commission On International Trade Law (UCITRAL) or the International Centre for Settlement of Investment Disputes (ICSID) which is part of the World Bank. 123 An optimal investor-state dispute settlement... reduces domestic welfare, but a bilateral ISDS provision may (or may not) increase welfare. Konrad (2017) develops a model with strategic interactions between a domestic and a foreign firm, but without an opportunistic government. In his model, the domestic firm will strategically over-invest without ISDS, and an ISDS provision will ensure equal treatment of the domestic and the foreign firm, leading to even more over-investment and overly permissive regulation. Schjelderup and Stähler (2021) show that an ISDS provision in an agreement among institutionally strong countries makes multinational firms more aggressive in terms of investment and market behavior. Overall, most of the empirical and the sparse theoretical literature has discussed the issue of investor protection only by looking upon the implications of past provisions and the expected effects of ISDS provisions for future multilateral agreements. This paper will not take ISDS provisions as given, but will develop a simple optimal mechanism that is able to solve the holdup problem. Consequently, the innovation of this paper is that it outlines how an ISDS provision should be designed that may not only mitigate the holdup problem, but will solve it. Aisbett et al. (2010b) consider the efficient compensation of (domestic and foreign) investors, (...truncated)