March 17, 2021
The Energy Charter Treaty (ECT) is at a crossroads. The ECT was formed for the purpose of promoting and protecting investment centered on fossil fuels, but now that more than 20 years have passed since the treaty came into effect, the international community has shifted to "decarbonization" and the demands of the times. It is also conspicuous that it has not been answered.Nevertheless, the modernization of ECT has not progressed slowly, and even voices have begun to threaten the survival of the organization. Japan, which holds the largest share of the contribution ratio operated by the secretariat, is being questioned about the significance of continuing to join ECT. MIRUPLUS recently interviewed Dr. Masami Nakata (pictured), who was the former Assistant Secretary General of ECT and was in the number 2 position. (Photo courtesy by Dr. Nakata)
First of all, we want to ask what kind of treaty is the Energy Charter Treaty (ECT)?
The ECT is the only multilateral, energy-specific treaty. The primary purpose of the Treaty is to protect foreign investments in energy supply except in heat supply, but only investments in economic activities with fossil fuels such as oil, coal, and gas, and also electricity (without distinguishing between energy sources used for electricity production) are protected by legally binding provisions. ECT also includes provisions related to energy efficiency and environmental protection, but these are non-binding.
You might wonder why the Treaty protects investments in fossil fuels when we have to stop using them. The reason is that the Treaty was drafted almost 30 years ago. European countries (West) needed to protect their energy investments in Russia and former Soviet countries (East) and ensure a secure and reliable flow of Fossil Fuel energy resources from East to West. So the ECT also governs cross-border energy transit. I've known the Treaty since I worked for the East Asia Power Grid Connection in 2000, and at that time, ECT was considered one of the multilateral agreements that could apply for cross-border power trades in East Asia.
There are 53 member states, including Japan and all EU countries except Italy. The EU itself is a member. Although the ECT was created as the agreement between Europe and former Soviet countries, Russia has never ratified it. Russia applied it only provisionally until 2009, then stopped application. Russia officially left ECT in 2018, and Italy left in 2015.
Japan signed the ECT in 1995 and ratified it in 2002 with an expectation of promoting and protecting Japan's energy investments in ECT constituencies, including Russia. Except for Central Asian countries, Japan and Mongolia are the only member countries in Asia. Japan's financial contribution to the Secretariat is the largest share of the budget by country, but it seems that ECT is not well known, almost forgotten in Japan, even among energy experts.
So the ECT is not well known. Then, why people started talking about ECT now?
Increased number of Investor-State Disputes under ECT triggered the EU's concern that the ECT undermines the EU’s climate goals. Once the EU decided to take a closer look at this "forgotten" Treaty, it also became clear that the ECT is not compatible with the Paris Agreement. It is not compatible with the EU climate law, not with the multilateral development banks' climate lending policy, and conflicts with the Treaty for the Functioning of the European Union (TFEU), the main instrument for the EU internal energy market. That's why ECT is an issue now, and member states fully engage with "fixing" it.
Let me explain Investor-State Disputes Settlement, ISDS. ISDS is one of ECT's mechanisms to solve investment disputes between investors and a member state. In recent years, the EU has become aware of increased cases of ISDS invoked ECT between EU countries due to their energy policy changes. There are about 136 ISDS cases under ECT, including UK's Rockhopper against Italy, German Uniper against the Netherlands, etc. The most recent one is German energy company RWE suing the Netherlands because they were planning, as requested by the Dutch court, to phase out coal by 2030. All ISDS cases involve billions of euros of taxpayers' money, so the EU realized that they would potentially lose a massive amount of money if they try to align their energy policy with the Paris agreement. This situation has already caused "regulatory chill," which is that states cannot impose Climate Change policy due to their fear of being sued by investors.
Japanese solar companies are also suing Spain under ECT for their changes in incentives following the fall of PV costs. According to the Financial Times last month, Japan also now has its first ISDS case as a respondent, under which a Hong Kong energy company is suing Japan, although not under the ECT. I don't know the details, but if Japan loses, we taxpayers will need to compensate this Hong Kong investor's financial losses. If so, the Japanese media will pay more attention to ISDS. Initially, Japan has no interest in reforming ECT's ISDS mechanism, but Japan's first ISDS case might change Japan's position.
There are also opinions that ECT is protecting renewables because many ISDS cases under ECT are brought up by renewable energy producers including Japanese companies Tomen, etc.
Yes, some argue that ECT could also protect renewable energy investments because of the increased number of ISDS brought by renewable energy producers. I believed it to some extent when I joined the Secretariat, but I now have doubts. There are several reasons why;
There is no evidence so far that ECT encourages renewable energy investment. ISDS is a lengthy and costly process. Many Japanese companies want to avoid ISDS. Therefore the existence of the ISDS mechanism under ECT cannot be why those Japanese companies invested in renewables in foreign countries. Besides, the major destinations of renewable energy investment are India, China, and other non-ECT member states.
Second, it is said that ECT is more of a danger than protection because ECT even hinders renewable energy development. States could not optimize their renewable energy policy flexibly, adjusting new energy situations such as technological advancement because is is said that ECT does not respect the state's right to regulate.
Third, ECT protects "electricity generation," not "renewable energy."
Fourth, ECT only protects foreign investors. In Spain's case, Japanese companies sued Spain based on the alleged electricity breaches related to changes in incentives in electricity production from renewable energy sources. If Spain loses, Spain will compensate the companies' financial damages and losses with Spanish taxpayers' money. However, domestic producers in Spain who had the damage due to the same changes cannot use the ISDS mechanism under ECT.
We recognize that issues related to the operation of ECT have been pointed out as the times go changing.
The main issue is that ECT is outdated. As I said before, many ECT provisions are not compatible with other newer treaties and agreements. In particular, the EU is afraid that the incompatibility of the Treaty with today’s Climate Change situation seriously undermines global decarbonization efforts. Besides, many of the reasons why ECT was needed in the early nineties no longer exist.
That's why the ECT member states have started the process to "fix" the Treaty; they call the process "Modernization." Modernization includes clarifications and definitions of terms, identifying obsolete provisions to be updated, and amendments to the Treaty. There is a long list of Modernization topics to be discussed and negotiated among member states, not only issues related to fossil fuels. Modernization negotiations started in 2020, and they just finished the 4th round of negotiations early this month. I don't know the outcomes, but I haven't heard any positive progress until the 3rd round. It seems that member states, especially EU countries, are frustrated with the lack of progress. Just last week, the Luxemburg energy minister Mr. Turmes tweeted that no progress was made during the 4th round of the modernization on the phasing out of fossil fuels, but I don't know what was negotiated.
It is often said that Japan has the largest contribution ratio by country to the ECT. We know Japan has a big role to play, but what is Japan's position in ECT currently?
Japan contributes about 100 M yen per year to the operation of the ECT Secretariat. It's a relatively small sum compared with Japan's contributions to other international organizations. In terms of national contribution by country, Japan is the largest contributor, 20% of the total budget, but I don't think Japan has a significant role. The ECT is an EU-centric treaty. 66% of the budget comes from EU countries collectively. All modernization discussions are very much EU-centric. In my opinion, Japan has been sidelined in terms of Modernization, Expansion, or other ECT issues.
The current focus is ECT Modernization. Many articles published in the EU say that Japan blocks the EU's efforts to modernize ECT because of Japan's reluctance to change ECT. However, Japan's vote is still just one vote, no matter how much national contribution Japan made. There are other influential players such as oil-exported country Kazakhstan and other central Asian countries.
As the international community moves toward decarbonization, the EU, which is at the forefront of climate change issues, seems to be willing to withdraw unless modernization of ECT progresses. What is the actual situation?
The EU recently submitted the proposal to remove future investments in fossil fuels from a list of economic activities under ECT except those in gas power plants until 2040 and existing investments in all fossils will continue to be protected. NGOs criticized the proposal saying that "EU is not serious about decarbonization." However, even so, negotiation is going to be tough. First of all, all ECT contracting parties must agree with the EU's proposal to remove fossil fuel, because any amendment of the Treaty must be done unanimously, not by majority vote. Second, Japan is reluctant to do any amendment in the first place, but even if Japan compromises with the EU, there are fossil fuel exporting countries that might not agree with fossil fuel phase-out. There is also the UK, which may want to play a different role.
Furthermore, the definition of economic activities is only one of 25+ modernization topics. There are also other topics not related to Climate Change issues. As I mentioned before, the ISDS mechanism under ECT doesn't comply with the EU investment protection provisions. Intra-EU disputes under the ECT do not comply with the European Court of Justice. It’s worth noting that ISDS and intra-EU disputes are not even included in the list of 25 items to modernize, because Japan refused to revise the ISDS mechanism.
Then there is the time issue. The Modernization discussions started in 2009, and it took almost ten years to reach the negotiation stage. Then it took two years to prepare for negotiation in 2018 and 2019, and finally negotiation began in 2020, and the 4th round of negotiation just ended last week. How long are member states willing to negotiate to modernize the old Treaty? The next 20 years? Importantly, there is no end date for the modernization.
If the negotiation fails and ECT cannot be aligned with the EU's Climate Law and other internal rules, and the Paris agreement, then ECT will remain as it is. Then the EU has likely no choice but withdraw collectively. France urged the EU to be ready for a coordinated withdrawal from the ECT by issuing a joint letter of four ministers to the European Commission in December 2020, ahead of the 3rd round of negotiations. The Spanish Minister for Ecological Transition, together with two other Spanish ministers, sent a letter to the European Commission, asking it to draw up plans to withdraw from the treaty.
Why should the EU withdrawal be coordinated? " Because even after the withdrawal, the provisions of the Treaty continue to apply to existing investments for 20 years from the date of withdrawal, it's called a sunset clause. In fact, after Italy withdrew from the ECT, Italy continues to receive ISDS lawsuits. The solution to this sunset clause is to withdraw together and develop an EU agreement to end the clause between EU countries. This removes the risk of intra-EU ISDS claims. Currently, 66 percent of all ISDS under ECT are intra-EU.
ECT seems to be at a crossroads. Isn't it time for Japan to reconsider the significance of membership?
As I said earlier, the ECT is very much EU-centric. If you know ECT's history, you understand why. If the EU thinks the Modernization has failed, meaning the ECT stays incompatible with EU laws and system, then the EU will leave the ECT. For the EU, the choice is between a modernized ECT as they want or a collective withdrawal. Japan's membership is not an issue to them.
Japan's idea of "Modernization" initially was the "Expansion" of the Treaty. When the first roadmap of ECT Modernization was created in 2010 and expansion policy was adopted in 2012, Japan hoped that ECT would expand with more countries, especially countries where Japan was investing in energy like Southeast Asia. However, no Asian country except Mongolia has been added to ECT. Expansion efforts have been made mainly in African countries because of funding by the EU as it is in the EU's interest in Africa. The Secretariat should've analyzed possible Asian expansion based on Japan's energy investment situation/interest, but they didn't. Besides, expansion has been paused until modernization is done.
That's why Japan needs to re-visit the relevancy of ECT to Japan's energy investment separately from the EU's situation. General discussions about energy investment are not very useful; the discussions must be ECT specific. Investment in sustainable energy sources is needed. Protection of sustainable energy investment is needed. Of course, but would ECT play a role? More connectivity, international energy trade, and grid connections across different jurisdictions are important. Sure, but does ECT have a role in it for Japan?
If ECT stays unchanged as Japan wishes and the EU leaves, then will the ECT still be attractive to Japan? If ECT is modernized as the EU wants and fossil fuel investment is removed from ECT, ISDS is reformed, etc., is ECT still useful for Japan? The EU proposal mentioned above also includes an addition of low-carbon and renewable hydrogen to energy sources protected by ECT, but can hydrogen be an important reason for Japan to stay with ECT? About 90% of ECT member states and signatories are members of WTO. Almost all European ECT member states are under the EU legal system, as Eastern European countries have also signed energy community agreements with the EU. Japan has bilateral trade agreements with most of the ECT constituencies. Other key trade partners for Japan are not in the ECT, China, US, Indonesia, etc.
After Japan's pledge for 2050 Net Zero, does Japan need an obsolete treaty that requires endless negotiation to make it in line with Japan's (and global) decarbonization policy? Does Japan need ECT to cost Japan an infamous reputation that Japan sabotages EU's decarbonization by blocking ECT modernization?
Even if Japan leaves the ECT now, Japan's existing energy investments in ECT constituencies will be protected for the next 20 years due to a sunset clause. Maybe because I'm not a legal expert, I don't see any critical consequences even if Japan leaves the ECT unless Japan is convinced that ECT has a crucial role now and in the future in Japan's Sustainable Energy Investment. If this is the case, the government should provide evidence to support its claim.
From January 2017 to July 2019, Dr. Masami Nakata was involved in the operation of ECT as the Assistant Secretary General, who holds the number 2 position in the secretariat.
Editing by Naoya Abe
Former Bloomberg News reporter and editor
Capitol Intelligence Group (Washington D.C.) Tokyo bureau chief
Currently working as Editor-in-chief at MIRUPLUS