This article was featured in our 2023 Energy Arbitration Report, which is part of a series of industry-focused arbitration reports edited by Jus Connect and Jus Mundi.
This issue explores the energy industry, encompassing information on electricity & renewables, based on data available on Jus Mundi and Jus Connect as of September 2023. Discover updated insights into energy arbitration and exclusive statistics & rankings, as well as in-depth global and regional perspectives on energy projects, disputes, & arbitration from leading lawyers, arbitrators, experts, arbitral institutions, and in-house counsel.
THE AUTHORS:
Richard Caldwell, Principal & Practice Leader: International Arbitration at The Brattle Group
Dr. Fernando Bañez, Associate at The Brattle Group
In the last 10 years, many investor-State arbitrations have involved renewable energy sources (RES) – including claims brought under the Energy Charter Treaty (ECT) and various bilateral investment treaties related to regulatory changes in countries such as Spain, Italy, the Czech Republic, Romania, Japan, and Bulgaria. These arbitrations typically concern reductions in the financial incentives provided to promote RES investments that would otherwise not have been viable, raising issues around a sovereign State’s right to regulate. The at-issue regulatory measures commonly commenced in the early 2010s, in the aftermath of the 2008 Financial Crisis and Great Recession.
This series of RES arbitrations has seen a variety of outcomes, including substantial financial awards to investors. For example, between 2018 and 2020, three different ICSID tribunals awarded more than €290 million in damages to Nextera Energy, €112 to Antin, and €77 million to Watkins Holdings S.à.r.l. and others.
Several awards have found particular regulatory changes to be incompatible with the ECT (e.g., Antin v. Kingdom of Spain award; the Watkins Holdings Sarl and others v Kingdom of Spain award; or the Masdar Solar & Win Cooperatief UA v Kingdom of Spain award). Others have permitted sovereign states to alter financial support to RES as long as investors were able to earn a reasonable return (e.g., Nextera Energy Global Holdings BV and Nextera Energy Spain Holdings BV v Kingdom of Spain award; the RREEF Infrastructure (G.P.) Limited and RREEF Pan-European Infrastructure Two Lux S.à.r.l. v. Kingdom of Spain award – “RREEF Award”; or the PV Investors v. The Kingdom of Spain award – “PV Investors Award”).
Energy markets have once again seen regulatory measures, raising the related concerns about the ability of RES investors to earn reasonable returns. We identify four recent market developments:
- A steep decline in the costs of certain RES technologies. For example, the levelised costs per MWh of the most widely deployed RES technologies (aside from hydropower), solar PV and onshore wind, have declined by about 90% and 70%, respectively (see, IRENA (2022), “Renewable power generation costs in 2022”,International Renewable Energy Agency, Abu Dhabi, Figure S.4.). Many new RES projects are now viable without financial support from States.
- Policy commitments to progress towards net zero emissions, involving ambitious expansion of RES targets.
- Increased short-term volatility of energy and electricity prices, with a general upward price trend (see the electricity markets report for Q4-2022, the “EC 2022-Q4 Report”, Figure 11 and Figure 29). Price volatility has been particularly extreme since the Russian invasion of Ukraine.
- Growing pressure on consumer bills (“EC 2022-Q4 Report”, Figure 67) through both increased energy prices and the gene- ral cost of living crisis. The resulting affordability concerns have prompted several European states to shield consumers from the direct impact of rising prices. Since mid-2021, European countries have allocated €651 billion to this aim.
Several recent regulatory measures explicitly aim to reduce consumer bills while maintaining a “reasonable return” for investors. For example, the EU electricity price cap “intends to minimise the impact [of] marginal sources like coal or gas […] on the final price of electricity while still ensuring a reasonable return on investment for the technologies covered”, such as RES and nuclear. However, the application of a reasonable return framework can involve significant interpretative issues, which introduce uncertainty to RES investments.
First, some applications will involve no clear ex ante definition of “reasonable return.” Does a reasonable return refer to the return that a particular investor or industry would have considered reasonable at the time investments are sunk, or is it a return that could be considered “reasonable” at the time of a regulatory change? Does reasonable return refer to a particular financial measure such as the “internal rate of return,” the “cost of capital,” or an accounting measure of profitability? Does it refer to a specific percentage number or a given range?
Second, upon what investment is the supposed reasonable return being earned? Since many regulatory changes have affected existing plants, several answers are possible. One answer could be a planned or actual investment amount incurred in the past; another could be a hypothetical industry-standard investment consistent with an efficiency benchmark.
Many energy investments are long-lived, involving significant upfront capital investment and extended cost recovery through their operating lifetime. Should a reasonable return consider amounts earned by long-term producing assets before a regulatory change? Should it consider differences in investment between countries or regions?
Different answers to these questions may have materially different economic consequences.
Unfortunately, existing RES arbitral awards are unable to provide further clarity since they have employed different interpretations. For example, the RREEF Award estimated an updated measure of reasonable return and applied it to the historical investment costs of a particular installation, while the PV Investors Award applied an ex ante measure of the reasonable return to industry standard investment costs. The lack of a clear ex ante definition, together with the diversity of arbitral practice, could leave the meaning of reasonable return hotly contested in future arbitrations.
Another issue is that a reasonable return framework entails a shift in risk allocation, potentially increasing the costs of future investments. As noted before, certain RES technologies can now compete in the market
without financial support from sovereign states. This represents a significant development from earlier generations of RES that required financial support to motivate any investment. The application of a reasonable return framework to the latest generations of RES risks limiting their ability to enjoy upside market price outcomes while exposing them to downside outcomes. Investors might come to expect that future regulatory measures will be introduced to limit upsides but that they will retain full exposure to downsides. The resulting asymmetry would raise uncertainty and increase the financing costs of new investments, to the detriment of consumers and sovereign states.
Similarly, a particular investor might seek to use innovation and effective management to drive down costs, increase production, or extend project lifetimes. This improved project efficiency would, in turn, enhance profitability and investment returns. A subsequent regulatory limitation of returns to a more “reasonable” level could inadvertently eliminate these potential efficiency benefits, undermining investors’ incentives to innovate and manage efficiently, again to the detriment of consumers and sovereign states.
The costs of RES have fallen over the past 10 years, due in part to the financial support from sovereign states to earlier generations of RES projects, allowing for technology innovation and mass production.
Substantial RES and grid investments are needed in the next decade to achieve the desired energy transition. Minimising investment uncertainty and maintaining efficient incentives would help contribute to this critical endeavour.
ABOUT THE AUTHORS
Richard Caldwell is a Principal in the London office of The Brattle Group and has been with the firm for just over 20 years. Richard is an economics and financial expert, with experience valuing businesses and financial instruments across a range of industries, from electricity to banking to telecoms, and in a range of settings. He routinely provides economic and financial advice concerning corporate finance and valuation, the pricing of securities and derivatives, and assessments of regulatory issues.
Fernando Bañez is an Associate at The Brattle Group with experience advising private and public sector clients on valuation, pricing, and regulatory matters for a wide range of industries, from energy to banking. He holds a PhD in Engineering from Comillas University, where his research focused on the integration of renewable energy and the benefits of the expansion of the electric power network. His work has appeared in scientific journals including Applied Energy and Energy.
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