Re gulatory Takings and Environmental Regulation inNAFTA’s Chapter 11∗Emma Aisbett†,LarryKarp‡, and Carol McAusland§October 25, 2005AbstractExpropriation clauses are ubiquitous in international investment treaties, and have promptedseveral compensation claims from investors hurt by new en vironmental regulations. An ar-gument in favor of expro priation clauses is that they solve several post-investment moralhazard problems such as hold-ups. However, we show that expropriation clauses can alsointeract with co-existing National Treatment clauses in a manner that hinders investment.We sho w that a police powers carve-out for environmental regulation can recover some ofthese investment opportunities.Keywords: foreign direct investment, regulatory takings, expropriation, NAFTA, NationalTreatment, environmentJEL classification numbers∗Our thanks to Jon Sonstelie for helpful suggestions, and to the Institute for Global Conflict andChange for financial support.†emmas address‡larry’s address§carol’s address1IntroductionMore than a decade after its passage, one of the most controve rsial elements of the NorthAmerican Free Trade Agreement (NAFTA) is its chapter on investment: Chapter 11. Theoriginal aim of Chapter 11 was to promote investment, particularly in Mexico, by providingincreasedsecurityandtransparencytoforeigninvestors. The “investor-to-state” provision ofthe chapter entitles investors to take expropriation claims against the host country directly tointernational courts. On paper, NAFTA’s Chapter 11 defines expropriation broadly: it includesnot only direct measures such as nationalizing industries, but also ‘creeping’ expropriation, or‘regulatory takings’, that arise when governments impose new regulations and restrictions onfirms’ activities. This broad definition of expropriation has led to gov ernments being sued forsuch actions as banning a polluting petrol additive (Methanex vs. US) and refusing to permit ahazardous waste facility (Metalclad vs. Mexico).Not surprisingly, the expropriation clause has been contentious. Critics contend that it bene-fits large multinational corporations at the expense of states’ sovereign rights, the environment,and the public good. Sensitive to the political implications of their decisions, many of the tri-b unals adjudicating the NAFTA cases have been reluctant to apply the broadest definition ofexpropriation. Some tribunals have accepted a ‘police powers carve-out’ from the definition ofexpropriation, which means that states do not have to compensate foreign inv estors for injuryarising from bona fide, non-discriminatory regulation for the public good.This paper e xamines the equity and efficiency implications of a police powers carve-out.Although we dra w much of our motivation from NAFTA, there are currently over 2200 bilat-eral inve stment treaties (BITs) globally1andsowesetouranalysisinthe institutional conte xtof modern investment treaties. Almost without exception, these treaties contain clauses man-dating equitable treatment, i.e. Most Favored Nation (MFN) and National Treatment clauses.These clauses can interact with expropriation clauses to create barriers to efficient bargain-ing between host and inv estor in the pre-investment stage. Inefficient bargaining can, in turn,pre vent investors and host governments from undertaking and allowing, respectiv ely, some mu-tually beneficial projects. We show that a police powers carve-out can recover some of theseopportunities, and may promote welfare and be both Pareto welfare-improving.1Almost all of these 2200 BITs contain expropriation clauses similar to that in N AFTA, as do the recentlysigned Central American - Dominican Republic Free Trade Agreement (CAFTA-DR) and the draft Free TradeAgreement of the Americas (FTAA)1The basis for this result is straightforward. U.S. courts (for example) have largely rejectedthe theory of regulatory takings. If international tribunes accept this doctrine by adopting abroad interpretation of expropriation, the investor-to-state provision of BITs wo uld give for-eign investors rights not enjoyed by domestic investors. Foreign investment would then createmore risk for the host (relati ve to domestic investment), because the need to provide compensa-tion makes re gulating foreign investment more costly. The requirement of National Treatmentmakes it difficult for the host to require a side-payment in order to offset this additional risk.Thus, even though a strict definition of expropriation and a requirement of National T reatmentboth solve incentive problems when viewed individually, their combination can create ineffi-ciencies.The most familiar argument for including an expropriation clause in an inv estment treatyis that it solves the hold-up problem. The hold-up problem occurs when the host w ants toexpropriate the assets of foreign inv estors after they sink their up-front costs. Wary of hold-ups, investors may forego investment in the first place. Signing a treaty with an expropriationclause is one way a government can pre-commit not to expropriate foreigners’ assets. Markusen(2001) discusses the costs and benefits of commitment for developing countries wishing to gainfrom Foreign Direct Investment (FDI).The hold-up problem occurs where the host attempts to capture rent from a project. Evenwhen the host’s objective is to solve a legitimate public problem, and not to capture rent, it maybehav e inefficiently when the investor is a non-citizen. Consider environmental regulationsthat decrease a firm’s profits, which investors may label creeping expropriation or regulatorytakings. When a government weighs the benefits and costs of a new regulation, it may ignorethe regulation’s impact on profits repatriated by foreigners. Consequently, when viewed froma global welfare perspective, governments may regulate foreigners’ activities with excessivezeal. By forcing gov ernments to compensate inv estors for any costs arising from regulation,expropriation clauses can induce cost-internalization, eliminating excess regulation and therebypromoting investment. Cost-internalization is the leading justification among legal scholars forU.S. Fifth Amendment’s compensation mandate (Been and Beauvais, 2003). The need to createincentives for cost-internalization is likely to be greater when dealing with foreign (relative todomestic) investment.The hold-up and cost-internalization problems can be obstacles to governments
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