Investor compensation for oil and gas phase out decisions: aligning valuation methods to decarbonization

Decisions by states to cancel oil and gas licenses in the transition to net-zero emissions can trigger investment arbitration claims. Given the massive damages that arbitration tribunals can award to investors, investment arbitration is increasingly being criticized as an obstacle to climate change mitigation and the just energy transition. Under the Discounted Cash Flow (DCF) method, tribunals have based their valuation on the expected production volumes during the remaining lifetime of oilfields and forecasts of international oil prices, essentially requiring states to compensate companies at market conditions for all energy left underground. With an increasing number of carbon neutrality pledges at the global level and states’ due diligence obligation to reduce emissions, this article argues that tribunals can no longer ignore decarbonization considerations in the application of the DCF method. Damages decisions must instead account for the price, production cost and risk expectations under net-zero pathways. Significant downward adjustments to the estimated future income of hydrocarbon assets can be achieved by using the lower oil price forecasts in net-zero emissions scenarios, instead of current market conditions. Adjusting future cash flow projections and the discount rate to reflect carbon pricing and other climate policy risks can significantly lower the present value of hydrocarbon assets. As arbitration tribunals have so far ignored decarbonization in their oil damages calculations, legal reforms are needed to require the alignment of investor compensation to decarbonization and ensure a just energy transition.The large damages awarded in the fossil energy sector can create energy injustices and potentially chill the adoption of fossil energy phase out decisions.Damages are generally large due to calculation methods based on estimated reserves and current international price levels.Tribunals must take into account states’ carbon neutrality pledges and emission reduction obligations; this can be done by using net-zero fossil energy prices and climate policy risks, triggering significant downward adjustments to cash flow projections.To limit the risk of regulatory chill for fossil energy phaseouts, and the creation of energy injustices, investment treaty revisions should require the inclusion of decarbonization concerns in damages calculation, in addition to stronger guarantees for states’ right to regulate.