Council of Foreign Relations | 9 June 2025

Trade tools for climate action: investor-state dispute settlement reform

by Jennifer Hillman, Helena Kopans-Johnson, and Inu Manak

Reducing fossil fuel production and consumption is imperative if countries hope to meet their climate change–mitigation objectives. Fossil fuels account for 90 percent of all carbon dioxide emissions, with coal being particularly problematic. In 2022, demand for coal reached an all-time high at 8.42 billion tons, accounting for 36 percent of global electricity generation, largely driven by growth in Asia, particularly China, India, and Indonesia. Alongside usage, foreign investment in the coal sector continues, and it has even seen an increase in some regions, particularly China, despite growth in clean energy projects.

Although targeted action to phase-out of fossil fuels is sorely needed, protections granted to fossil fuel investments through Investor State Dispute Settlement (ISDS) provisions present a roadblock to success. ISDS protections enable foreign investors to file billion-dollar claims directly against governments if their investments are adversely impacted by policy changes. This legal threat can create a chilling effect on efforts to reduce reliance on fossil fuels or transition to cleaner energy sources. When claims are successful, they divert substantial public resources away from critical climate action. To date, there have been at least 349 investor-state disputes related to fossil fuel projects, accounting for 20.3 percent of ISDS cases, with fossil fuel corporations receiving upwards of $82.8 billion through ISDS awards.

With an estimated 2,463 investment treaties covering approximately 62 percent of fossil fuel assets owned by foreign companies, and over 75 percent of foreign-owned coal plants requiring early retirement to meet climate-mitigation targets, the scale of this challenge is significant. In this context, estimates suggest that global measures to combat climate change could generate over $340 billion in ISDS claims from fossil fuel corporations. Simply put, ISDS reform is essential for supporting decarbonization efforts in the coal sector. A number of actions could be pursued to that end, such as excluding coal-fired power from ISDS protections, developing an alternative international-claims process for investors in coal plants, and integrating investor obligations into investment treaties.

What Is at Stake

Initially constructed to assist multinational corporations in countries where legal protections were perceived as inadequate, ISDS has since evolved into a widely used tool for challenging government action. Though the specifics of investment treaty provisions vary, they typically grant foreign investors the right to initiate international arbitration proceedings against host states should government action unfairly harm their investments. At first, ISDS cases were interpreted narrowly, covering mostly cases of arbitrary, discriminatory, or unreasonable state conduct, as well as explicit, direct expropriation. They have since expanded to cover instances of indirect expropriation—instances where investors argue that policies in the host state fundamentally transform the investment environment beyond investors’ “legitimate” expectations, impeding a project’s operations and profitability. Consequently, measures taken for public welfare reasons—whether they be climate, environmental protection, or public health—can be legitimate grounds for investment claims.

The 1997 Metalclad Corp v. Mexico case is a good example. In 1997, U.S.-based company Metalclad filed a claim after a Mexican municipality denied a construction permit for a hazardous waste facility. Though the Mexican municipality was concerned that the project posed environmental risks and potential contamination of the local water supply, Metalclad argued that Mexico’s actions violated the obligation to provide fair and equitable treatment and effectively amounted to an expropriation of its investment. The tribunal decided in Metalclad’s favor, stating

...expropriation under NAFTA includes not only open, deliberate and acknowledged takings of property, such as outright seizure or formal or obligatory transfer of title in favor of the host State, but also covert or incidental interference with the use of property which has the effect of depriving the owner, in whole or in significant part, of the use of reasonably-to-be expected economic benefit of property even if not necessarily to the obvious benefit of the host State.

Metalclad Corp v. Mexico has come to exemplify how ISDS can impact a country’s ability to enact regulations in the public interest, particularly those aimed at protecting the environment. The uncertainty surrounding which actions are permissible and which will be challenged can have a chilling effect on government regulation.

Key Issues for Consideration

The weaponization of ISDS against measures to wean off fossil fuels and deploy renewable power could seriously undermine or constrain states’ climate policy. Evidence of this dynamic is already apparent: following Germany’s decision to phase-out nuclear power in the wake of the 2011 Fukushima Daiichi nuclear disaster, Swedish energy company Vattenfall initiated a claim, arguing that Germany failed to provide adequate compensation for the early, unpredictable shutdowns of its facilities. Vattenfall v. Germany II took ten years to arbitrate before being settled in March 2021, when Vattenfall received approximately $1.9 billion to cover the company’s “sunken investment” and legal fees.

Although the case concerned the phase-out of nuclear power, not fossil fuels, the German Ministry of Finance warned the chancellor’s office in 2019 that using regulation to phase out coal would create an “increased risk of litigation, especially international litigation based on the ECT” (Energy Charter Treaty), which was signed in 1994 to foster energy security and integration among its state signatories in the aftermath of the Cold War. The ECT has grown to include fifty-three countries, all of which are subject to its comprehensive ISDS provisions. This experience prompted the German government to preemptively compensate fossil fuel companies to avoid litigation.

A similar story unfolded in the Netherlands. In 2021, the Dutch government capped coal-fired power stations operations to 35 percent of their maximum capacity and mandated a switch to cleaner fuels by 2030 through the Prohibition of Coal in Electricity Production Act. Though the Dutch government offered compensation to adversely affected companies, including the German-owned RWE and Uniper—amounting to €512 million and €351 million (about $600 million and $412 million respectively)—the sums were deemed inadequate, leading the companies to file disputes both domestically and under the ECT. In the following months, when the Dutch minister and state-secretary of economic affairs and climate were asked about further accelerating the decommissioning of coal and gas fired power stations, they stated that “further intervention in the coal sector entails major legal risks in the context of pending claims.” Even though both ISDS claims were ultimately discontinued, they demonstrate that the mere prospect of a major ISDS loss can create a chilling effect.

The high costs and risks involved in this case prompted the Netherlands to join other EU countries in withdrawing from the ECT. On April 24, 2024, the European Parliament approved the EU’s formal withdrawal from the ECT, following several member states’ unilateral action and recognition that protections granted to the fossil fuel industry under the ECT impeded emission reduction targets.

Critically, countries do not need to directly experience ISDS claims to rethink their approaches. Notably, while facing no publicly known claims, Denmark’s government determined that phasing out fossil fuels at a rapid enough pace to achieve climate neutrality before 2050 would leave Denmark liable for paying “incredibly expensive” compensation on foreign-owned fossil fuel companies’ “stranded assets” due to ISDS provisions. Danish Climate Minister Dan Jorgensen clarified that “[if] [Denmark] were to say to companies that already had the permissions, ‘we’re taking them away from you,’ the price tag on that is one that no government would be able to bear.”

The effect of ISDS on constraining EU member state action is likely to be amplified in developing and least-developed countries where the risk of ISDS claims is just as high, and potential awards can comprise a considerably larger portion of the national budget. For example, the total net present value of Mozambique’s treaty-protected oil and gas assets is nearly double its gross domestic product (GDP) at $29 billion.

Despite the apparent need for reform, there are significant challenges. One key concern among governments is that ISDS reform could deter investors, particularly in countries that rely heavily on foreign direct investment and lack strong domestic legal systems to reassure investors. Multinational corporations and industry groups often push back against any attempt to limit investor protections, arguing that such changes would undermine investor confidence and global competitiveness.

Additionally, many investment treaties include so-called sunset clauses, which allow ISDS protections to remain in force for years (even decades) after a treaty is denounced, prolonging exposure to claims. Efforts to reform ISDS also need to strike a careful balance: even though safeguarding the right to regulate in the public interest is crucial, especially in environmental protection and climate action, there is also a legitimate need to ensure investors are protected against arbitrary or discriminatory treatment. Navigating this balance remains one of the most complex and politically sensitive challenges to ISDS reform.

Opportunities for Action

Recognizing the risks posed by ISDS to climate action, international organizations and policymakers have begun exploring ways to reform or limit its scope. Alongside the EU’s coordinated withdrawal from the ECT—long considered one of the most problematic treaties with ISDS—the Organization for Economic Cooperation and Development (OECD) has been discussing a proposal to exclude climate-related measures from ISDS. The aim is to quickly resolve investor challenges without full litigation, ensuring states retain control over their climate measures while minimizing potential abuse.

This approach can be combined with sector-specific exclusions, such as fossil fuel investments, and implemented through a plurilateral treaty that modifies existing bilateral investment treaties (BITs) and free trade agreements (FTAs). Meanwhile, although Working Group III of the UN Commission on International Trade Law has been reviewing problematic features of the ISDS regime, those efforts have been directed mainly at reforming procedural aspects of ISDS. And although procedural improvements can enhance transparency and fairness, they do little to resolve the core issue of ISDS as a tool to obstruct climate policies.

To prevent the ISDS treaty network from hindering states’ climate measures (particularly their efforts to phase out coal) while providing a legal pathway for resolving differences arising from the investor rights recognized in BITs and FTAs, several options can be explored, including

• excluding fossil fuel investments, particularly coal-fired power, from ISDS protections, such as through amendments of existing treaties to remove ISDS protections for coal-related investments, thus preventing arbitration claims against coal-related climate policies;
• developing an alternative international-claims process for investors in coal plants, which could include the establishment of a framework for determining compensation for investors affected by coal phase-outs that also integrates a consideration of the environmental costs they inflict; and
• integrating investor obligations into investment treaties and contracts that would require investors to contribute to their host state’s commitments to reduce greenhouse gas emissions.

Although those options seek to mitigate the role of ISDS in obstructing coal phase-outs, they remain limited in scope, primarily targeting investments in coal-fired power plants. Broader ISDS reforms will be complex and time-intensive, and require multilateral consensus that can delay implementation. Given the immediate urgency of climate change, a targeted approach on coal plant phase-outs could be more feasible, delivering faster, tangible impacts, while also helping develop a scalable model that could be instructive for other sectors that governments seek to regulate to promote decarbonization.