An emerging tipping point for government incentives and private investment

April 2024  |  SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2024 Issue

In late February 2024, the UK government announced that it would withdraw from the Energy Charter Treaty (ECT), describing it as “outdated”. Signed in 1994, the ECT sought to encourage global investment in the energy industry but has come under criticism for its perceived bias against renewable energy technologies. The reality of this is hotly debated: while the ECT contains no wording targeting renewable energy technologies, the way in which such technologies are incentivised and prioritised by European governments has catapulted it to the centre of several recent cases against states. This trend has led the European Commission (EC) to recommend coordinated withdrawal from the ECT after negotiations to reform it stalled, with nine member states having done so thus far.

These events come at a time of profound change in international infrastructure and investment policies. In the aftermath of the coronavirus (COVID-19) pandemic, the ongoing illegal Russian invasion of Ukraine, and trade rows with China, several major economies are now placing a policy emphasis on the energy transition to net zero as not only a way to meet ever-pressing climate targets under the 2015 Paris Agreement, but as a counterweight in the areas of energy and supply chain security. Pre-existing trade concerns also led the US and other countries to begin blocking all appointments to the World Trade Organization (WTO) Appellate Body, preventing it from hearing any WTO trade disputes since 2019. These environmental and trade issues feature in the US Inflation Reduction Act (IRA), which subsidises clean energy but also promotes US-made polices.

Such moves stand to upend the longstanding international consensus on competition, industry subsidies and associated investor-state dispute resolution. It is unclear what the effect of this will be, and how the common rulebook for such matters will be rewritten. Understanding the recent past, current trends and legal and financial stand-ins for longstanding considered policy is therefore critical for any private international investor.

Subsidies as incentives for private investment and sign of global policy change

Classical economic theory has long portrayed state subsidisation as the bane of positive international competition, with investment treaties, including the ECT, promoting neutrality. However, an exception to this principle was the argument that subsidisation is required to allow new technologies to develop, upscale and become competitive.

It is following this logic that a renewables subsidies ‘race’ has emerged among major economies. Since the passing in 2022 of the IRA in the US, which is estimated to allocate $369bn of state funding to clean energy, the bar is high for governments seeking to attract private renewables and low-carbon investment through subsidisation, such that the £4.5bn announced for UK industry in the 2023 autumn statement has been described as “lagging” after the UK admitted it could not go “toe to toe” with the US.

Consequently, the EC – which has historically enforced tight restrictions on state aid – has amended the rules for its Green Deal in direct response to the IRA, admitting such state aid rules “may evolve until 2026”. While the EU’s aim remains to “design [state aid] measures within the applicable rules”, given the size of the subsidies that it is responding to and deploying, as much as differing levels of enthusiasm of EU member states, such restrained ambition may prove difficult to maintain.

Protectionism intensifies globally

Along with the effect of the IRA in triggering an international flurry of state subsidies, it has been feared that it could similarly lead to an increasingly protectionist stance being taken across the world. It is plainly possible that renewables and low-carbon investors may now see the US as a more attractive place to invest, and as other nations seek to protect their own manufacturing industries and drive toward energy independence, they may also adopt similar policies to retain investment in these industries. Traditional economic wisdom warns against such moves; however, this rulebook is ripe to be torn up in the current period of economic upheaval.

Such a shift is made even more likely by the IRA’s terms that promote domestic industry. Policies include tax breaks for electric vehicles (EVs), solar panels and wind turbines, but typically only to those which are assembled and partly produced in the US. Such rules may breach WTO norms and, if so, would be a serious transgression passed by the US since it became a founding member. The IRA is conspicuously the policy of the third consecutive US president to challenge the WTO, with the policies of all three together leaving its Appellate Body rudderless. The absence of sanctions for breaches within the backbone of globalisation – recalling that China became a WTO member in December 2001 and alleged violator less than a decade later – is a notable canary in the coal mine for the direction of global trade policy.

In this respect, the EU’s Green Deal Industrial Plan has set targets for the proportions of natural resources and production it wishes to take place within member states’ borders by 2030. These targets indicate that lessons have been learned from the COVID-19 pandemic and illegal invasion of Ukraine by Russia – which together led to shortages of materials and energy – but fears persist that such events are providing cover for wider policy changes that will have long term and distorting effects on local economies and their global integration.

China’s stated view is that such measures are protectionist, which is curious given the subsidies it has historically offered to all manner of industries, including EVs and renewable energy technologies. It is unmistakable that, whether as a result of this, or because of its sheer size – or both – China is becoming a world leader in renewables and associated technologies, accounting for more than 80 percent of global solar cell exports and more than 50 percent of lithium-ion batteries. However, the extent to which China can leverage this on the world stage will depend on a return to global economic harmony of the kind currently being disrupted.

Policy changes realised – the fall of the ECT and implications for the future

Whereas subsidies and similar interventions promoting private investment were personae non grata only a short time ago, they now form the bedrock of government policy in many developed economies. While the focus may superficially appear narrow – on renewables and low-carbon technologies – the effect is wide-ranging, given the scope and intricacies of global energy and supply chains.

The ECT is another major victim of this international policy shift. Written at a time when renewable energy made up only a small proportion of international capacity, it created provisions which entitle foreign investors in energy to fair and equitable treatment. Renewables and environmental policies, to the extent they suppress traditional energy consumption and allow renewables to become competitive, were thus in the crosshairs of investors and became the subject of compensation claims. Such claims were believed to be hampering the energy transition and thus drove many states’ departure from the ECT.

While many may celebrate the weakening grip of the ECT on European economies as a victory in the fight against climate change, it remains true that the ECT had been effective in fostering collaboration among states to guarantee energy security, and a revised treaty could have served as a tool for advancing clean energy initiatives. With no similar protections to replace the ECT, private investors may be wary to commit funding to new energy projects. Moreover, the rise of subsidies and shifting rules for state aid in the EU create unpredictability of the kind that can stop the flow of capital from private investors or direct it in ways unknown as states introduce uncoordinated subsidy packages.

This is problematic, given that UK’s Harrington Review of Foreign Direct Investment determined in 2023 that “£1 of government investment can unlock between £7 and £9 of private sector investment” but only when policy is clear. Relevantly, incentives always had a place for the purpose of the ECT and international investment laws, provided they were predictable, fair and equitable, and not a tool of domestic favouritism or war (both real and trade-related).

Future direction beyond the tipping point

Events over the past decade may have caught the world’s policy and political class off-guard. Action on climate change in the 2015 Paris Agreement has divided the leadership of three US presidents and coincided with pandemic, war, global uncertainty and the onset of subsidies designed on the hoof in the face of all of these.

2024 brings a fresh presidential election in the US and again puts the Paris Agreement in the balance at a time when the ECT has been all but abandoned and the functioning of the WTO regime stands corroded by its most powerful members. The ultimate resolution of these matters will help international investors navigate the road ahead, which will likely see a return to calm, eventually.

Upon stepping down as the US climate envoy, John Kerry recently said that “[w]hile someone could disrupt and get in the way a bit, they’re not going to end this transition”. If that is right, by analogy the same will be true for the global investment landscape, for which Mr Kerry also added: “helping to deploy the money necessary to do the R&D… to accelerate the transition… that’s where the action is”. With estimates of trillions annually being required for such research and development and technology deployment, much is riding on that being true and, importantly, helped by the world’s policymakers working together.

Adam McWilliams is a partner and Miles McCollum is a legal assistant at Quinn Emanuel Urquhart & Sullivan UK LLP. Mr McWilliams can be contacted on +44 (0)20 7653 2052 or by email: adammcwilliams@quinnemanuel.com.

© Financier Worldwide

BY

Adam McWilliams and Miles McCollum

Quinn Emanuel Urquhart & Sullivan UK LLP

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