Investor State Dispute Settlement (ISDS) provisions, part of many bilateral and multinational free trade agreements, are highly debated. They enable foreign investors to sue host country governments at international arbitration tribunals and demand compensation, claiming damages for regulatory policies implemented by the host country after an investment has been made. A prominent example is the claim of the Swedish energy firm Vattenfall against Germany to the amount of US $5.8 billion plus 4 percent interest, arising out of Germany’s enactment of legislation to phase out nuclear power plants. While the positive effects of ISDS regimes that have been identified in the literature rely on a well-functioning mechanism, criticism mostly relies on possible deficiencies or the malfunctioning of the regime with ISDS. So, is the desirability of ISDS a question of the quality of its design?

Kai A. Konrad shows that ISDS may have a dark side, even under rather ideal conditions with an efficiency-oriented, transaction-cost free mechanism, and untouchable, fully reliable and unbiased judges. The reason is strategic investment: In general, high investment with major set-up costs protects domestic firms from regulatory expropriation and this induces strategic investment. A regime with an ISDS strengthens this effect, as the threat to the host country’s government of having to compensate foreign direct investor under ISDS makes a regulatory ban even more expensive. Consequently, not only domestic but also foreign investors have an incentive to overinvest. While the time-consistent regulatory policy might already be overly permissive, the introduction of an ISDS makes it even more permissive. The adoption of an ISDS might reduce global welfare.

Veröffentlichung:   European Economic Review, 2017, Vol. 98, 341–353