An optimal investor state dispute settlement mechanism Frank St - - PowerPoint PPT Presentation

An optimal investor state dispute settlement mechanism

Frank St¨ ahler University of T¨ ubingen, University of Adelaide and CESifo Norwegian School of Economics May 19, 2016

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 1 / 20

Background and motivation I

Trade and Investment Partnership (TTIP) and the Trans-Pacific Partnership Agreement (TPP): investor protection through an ISDS provision. ISDS: compensate foreign investors if host country government policies are causing “unjustified” harm. If there is a case for (special) foreign investor protection: existence of a holdup problem; the investor is “locked in” after the investment has been made. Two conditions: (i) incomplete contracts; (ii) relation-specific investment. OECD (2012): ISDS provisions to be present in as many as 93%, or some 3.000 agreements. Explanation: developing countries compete for FDI with ISDS provisions. Literature: BITs increase FDI, but ISDS provisions do not.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 2 / 20

Background and motivation II

Kohler and St¨ ahler (2016): compare an ISDS provision with a national treatment provision. Here: ISDS provision not given. Q: How should it be designed? In particular:

Q: Does an optimal ISDS mechanism exist that does not rely on third party verification? A: Yes! Q: Does this mechanism need an arbitrator? A: Yes! Q: Has this mechanism much in common with recent ISDS designs? A: No! Implication: an active role of supranational institutions is needed for efficient investor protection.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 3 / 20

The model I

Prior to the game played here, there has been an investment stage that we do not consider in detail. For now, we assume that the investment has been made. Maximized investor profit depends negatively on the activity level a: π(a) : π′(a) < 0, π′′(a) ≤ 0, ∃¯ a > 0 : π(¯ a) = ¯ π ≥ 0. Implication: investor leaves the country if a > ¯ a. Marginal domestic welfare depends positively on the realization of a stochastic variable θ that measures the degree of intervention necessity. Both the government and the investor anticipate that θ ∈ [θ, θ], 0 < θ < θ < ∞ and is distributed according to the c.d.f. G(θ).

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 4 / 20

The model II

Importantly, this realization becomes known at least to the government and the investor, but cannot be verified by the arbitrator

• r any other third party.

Domestic welfare: W =

• if π(a) < ¯

π, v(θ, a) > 0 if π(a) ≥ ¯ π, where v(θ, a) : va(θ, 0) > 0, vaa(·) < 0, vθa(·) > 0, ∃˜ a(θ) > 0 : va(θ, ˜ a(θ)) = 0. Holdup problem: Without any investor protection, the government and the investor play a two-stage game: in the first stage, the government sets a, and in the second stage, the investor decides whether to leave or to stay. Implication: If ¯ a < ˜ a(θ), the government will set a = ¯ a, and if ¯ a ≥ ˜ a(θ), the government will set a = ˜ a(θ).

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 5 / 20

The model III

The investor, anticipating this outcome, may not make any investment to begin with. What if contracts were complete and enforceable? Both parties maximize aggregate welfare such that va(θ, a∗(θ)) + π′(a∗(θ)) = 0, ∀θ ∈ [θ, θ] holds. Note that a∗′(θ) > 0. If the optimal policy could be implemented, the entry decision would also be optimal at the investment stage.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 6 / 20

An optimal ISDS mechanism I

The proposed mechanism is an extension and modification of a mechanism suggested by the implementation literature (see Moore and Repullo, 1988, and Maskin and Tirole, 1989). Basic idea: the government will announce an intervention necessity ˆ θ. The true θ can be observed at least by the government and the investor, but ˆ θ cannot be proven true or false by any third party. However, the investor, being familiar with the implications of her investment, can challenge this announcement, and any challenge will have implications for both the investor and the government that will be managed by the arbitrator. Here are the details (ISDS mechanism I):

Stage 1: The government and the investor agree on the optimal action plan a∗( ˆ θ), on alternative action plans a2( ˆ θ) and a1( ˆ θ) and transfer schemes F1, F2, T( ˆ θ). The alternative action plans fulfil the following

• requirements. ∀ ˆ

θ ∈ [θ, θ] :

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 7 / 20

An optimal ISDS mechanism II

a∗( ˆ θ) ≥ a2( ˆ θ) > a1( ˆ θ), and a′

2( ˆ

θ), a′

1( ˆ

θ) > 0.

Stage 2: The government announces ˆ θ. Stage 3: The investor may challenge the announcement ˆ θ.

If she does not, action plan a∗( ˆ θ) is implemented, no transfers are paid and the game is over. If she does, the government has to make an upfront payment of size F1 to the arbitrator.

Stage 4: If ˆ θ has been challenged, the government is offered to continue with action plan a1( ˆ θ) for which it will receive a transfer T( ˆ θ) from the arbitrator. Otherwise action plan a2( ˆ θ) is implemented.

If the government accepts, action plan a1( ˆ θ) is implemented, the government receives T( ˆ θ) from the arbitrator and the investor receives F1 − T( ˆ θ) from the arbitrator. If the government rejects, a2( ˆ θ) is implemented and the investor has to pay F2 to the arbitrator.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 8 / 20

An optimal ISDS mechanism III

Suppose that the transfer in Stage 4 to the government when accepting a1( ˆ θ) is given by T( ˆ θ) = v( ˆ θ, a2( ˆ θ)) − v( ˆ θ, a1( ˆ θ)) > 0. (1) T( ˆ θ) depends only on the announcement, and since va(·) > 0 and a2( ˆ θ) > a1( ˆ θ), T( ˆ θ) is unambiguously positive.

Proposition

If T( ˆ θ) is set according to (1) and both F1 and F2 are sufficiently large, ISDS mechanism I will imply the optimal action plan a∗(θ) as a subgame-perfect equilibrium.

Go to details

Obvious: the government has no incentive to under-report θ.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 9 / 20

An optimal ISDS mechanism IV

Hence, the government should only be challenged if ˆ θ > θ (appropriate challenge) and should not be challenged in all other cases (inappropriate challenge). The transfer scheme T( ˆ θ) is designed such that only appropriate challenges will be accepted: The government will accept the offer to continue with action plan a1( ˆ θ) only if v(θ, a1( ˆ θ)) + T( ˆ θ) > v(θ, a2( ˆ θ)) ⇔ v( ˆ θ, a2( ˆ θ)) − v( ˆ θ, a1( ˆ θ)) > v(θ, a2( ˆ θ)) − v(θ, a1( ˆ θ)) ⇔ ˆ θ > θ, where the last line follows from vθa(·) > 0: let φ(x) = v(x, a2( ˆ θ)) − v(x, a1( ˆ θ)). Then,

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 10 / 20

An optimal ISDS mechanism V

φ′(x) = vx(x, a2( ˆ θ)) − vx(x, a1( ˆ θ)) > 0 because vxa(·) > 0 and a2( ˆ θ) > a1( ˆ θ). Thus, φ(x) increases with x and φ(x) > φ(θ) for all x > θ. Consequently, an inappropriate challenge will never imply the alternative action plan a1( ˆ θ) but a2( ˆ θ). Let us check now the conditions: Appropriate challenge condition: The investor will challenge the government if π(a1( ˆ θ)) + F1 − T( ˆ θ) ≥ π(a∗( ˆ θ)). (always fulfilled since F1 ≥ T( ˆ θ) and π(a1( ˆ θ)) > π(a∗( ˆ θ))). Inappropriate challenge condition: The investor will not challenge the government if π(a2( ˆ θ)) − F2 ≤ π(a∗( ˆ θ)),

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 11 / 20

An optimal ISDS mechanism VI

Truth-telling condition: The government will not over-report if v(θ, a∗(θ)) ≥ v(θ, a1( ˆ θ)) + T( ˆ θ) − F1 A sufficiently large F1 and F2 do the job.

Go to details

Here: transfer is paid for a less ambitious action plan a1. Q: Is it possible that the government, after being challenged, will be offered to return to the more ambitious action a2 by paying instead of receiving a transfer?

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 12 / 20

An optimal ISDS mechanism VII

A: Not feasible: The government will be willing to pay this transfer if v(θ, a2( ˆ θ)) − τ( ˆ θ) > v(θ, a1( ˆ θ)) ⇔ v(θ, a2( ˆ θ)) − v(θ, a1( ˆ θ)) > τ( ˆ θ) holds where τ( ˆ θ) denotes the transfer from the government to the

• arbitrator. No τ( ˆ

θ) exists that will make the government accept this deal if and only if it has over-reported, that is, if and only if ˆ θ > θ. Possible: design such that the government will refuse to pay a transfer after an appropriate challenge has been made. ISDS mechanism II

Stage 1, Stage 2 and Stage 3 as in ISDS mechanism I. Stage 4: If ˆ θ has been challenged, the government is offered to continue with action plan a2( ˆ θ) for which it will pay a transfer τ( ˆ θ) to the arbitrator. Otherwise action plan a1( ˆ θ) is implemented.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 13 / 20

An optimal ISDS mechanism VIII

If the government accepts, action plan a2( ˆ θ) is implemented, the government pays τ( ˆ θ) to the arbitrator and the investor pays F2 to the arbitrator. If the government rejects, a1( ˆ θ) is implemented and the arbitrator pays F1 to the investor .

Proposition

If τ( ˆ θ) = T( ˆ θ) and both F1 and F2 are sufficiently large, ISDS mechanism II will imply the optimal action plan a∗(θ) as a subgame-perfect equilibrium. Comparison with ISDS provisions under TPP

Article 9.8 of the TPP draft specifies that “[n]o Party shall expropriate

• r nationalise a covered investment either directly or indirectly through

measures equivalent to expropriation or nationalisation (expropriation) . . . ”

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 14 / 20

An optimal ISDS mechanism IX

Optimal design: no compensation in equilibrium. If the government did

• ver-report the intervention necessity, the compensation would be

equal to F1 − T( ˆ θ) under ISDS mechanism I (and F1 under ISDS mechanism II). Both F1 and T( ˆ θ) are determined by domestic welfare effects only. Any design that wants the government to truthfully report the intervention necessity must rely on domestic welfare effects only. The foreign profit plays a role only for F2 that should keep the investor away from an inappropriate challenge.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 15 / 20

An example I

Assume that domestic welfare can be approximated by a linear-quadratic function, and maximized profit can be approximated by a linear function: v(θ, a) = θa − a2/2 + δ − γθ, π(a) = π0 − βa, where ¯ π = 0, β < θ, δ > γθ, π0 > βθ, γ > 0. a∗(θ) = θ − β. Simple reduction method: ai( ˆ θ) = a∗( ˆ θ) − αi, a∗(θ) > α1 > α2 ≥ 0, θ − θ > β + α1.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 16 / 20

An example II

Transfer according to (1): T( ˆ θ) = ¯ T = (α1 − α2)(2β + α1 + α2) 2 . The inappropriate challenge condition for both mechanisms: F2 ≥ βα2, so there is no such requirement if α2 = 0! Q: What is the optimal defection option of the government? A: Since transfers do not depend on ˆ θ, the government will do best if it chooses ˆ θ as to maximize v(θ, a1( ˆ θ)) with respect to ˆ θ subject to ˆ θ ∈ [θ, θ], given that it decides to over-report.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 17 / 20

An example III

Optimal announced intervention necessity: ˆ θ∗(θ) = min{θ + β + α1, θ}, leading to v(θ, a1( ˆ θ∗(θ))) − v(θ, a∗(θ)) =    β2/2 if θ ≤ θ − β − α1, β2 − θ2 + (θ − β − α1)2 2 if θ > θ − β − α1. Maximum: β2/2. The true revelation condition for ISDS mechanism I is given by F1 ≥ F I(α1, α2) = ¯ T + β2 2 = (α1 + β)2 − 2α2β − α2

2

2 , where F I

α1(·) = α1 + β > 0, F I α2(·) = −(α2 + β) < 0.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 18 / 20

An example IV

The true revelation condition for ISDS mechanism II is less demanding and given by F1 ≥ F II = β2/2.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 19 / 20

Concluding remarks I

The optimal ISDS mechanism has little in common with the recent designs as found in bilateral and multilateral investment treaties:

ISDS compensation should be based on the host country’s welfare effects, and not on any foregone profit. Efficient investment protection must involve three parties and therefore needs to be managed credibly by supranational institutions.

Requirements: thorough cost-benefit analysis, commitment to a transfer scheme and action plans, and arbitration. Comparison with holdup problems between firms: markets in which arbitrators offer their services to solve a unilateral holdup problem efficiently do not exist. Here: Supranational institutions like the International Centre for Settlement of Investment Disputes (ICSID), a part of the World Bank Group, and the WTO’s Dispute Settlement Body (DSB) already exist.

St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 20 / 20

Appendix

Let ¯ T = max ˆ

θ T( ˆ

θ) > 0 denote the maximum transfer. Furthermore: ΨI = max

ˆ θ∈[θ,θ]

• π(a2( ˆ

θ)) − π(a∗( ˆ θ)) ≥ 0 and ΨR = max

θ, ˆ θ∈[θ,θ]

• v(θ, a1( ˆ

θ)) − v(θ, a∗(θ))

• .

I → inappropriate challenge, R → true revelation ΨI ≥ 0: difference in profits between the optimal action plan and the disagreement plan a2( ˆ θ) for which a2( ˆ θ) ≤ a∗( ˆ θ). ΨR: difference between domestic welfare of the action plan after an

• ver-reported intervention necessity has been successfully challenged

and domestic welfare of truthfully announcing the intervention necessity (ΨR >< 0). F2 ≥ ΨI , and F1 ≥ ¯ T + ΨR if ΨR ≥ 0 or F1 ≥ ¯ T if ΨR < 0

Go back to Proposition Go back to Condition Go back to Concluding remarks St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 1 / 1