The calculation of compensation and damages constitutes the pinnacle of international investment awards.  It quantifies the damage suffered by an investor and indicates what amount of taxpayers’ money a breaching state must allocate to repair the harm it has done to an investor.  Yet, despite its crucial practical importance for policymakers, market actors, states, and their citizens,1See, e.g., Kyla Tienhaara, Regulatory Chill in a Warming World:  The Threat to Climate Policy Posed by Investor-State Dispute Settlement,7(2) Transnational Env. L. 229, 237 (Dec. 22, 2017) (noting how ISDS was framed in public campaigns as a threat to taxpayers due to the potential for costly litigation).X1 the issue of damages valuation remains “one of the least understood and most unpredictable areas of international investment law.”2Noah Rubins et al., International Investment, Political Risk, and Dispute Resolution: A Practitioner’s Guide, at 292 (Oxford Academic 2d. ed. April 2, 2020). X2 Often seen as “dangerous territory” and a sophisticated exercise beyond the expertise of the legal profession,3RosInvest Co. U.K. Ltd. v. Russian Federation, SCC Case No. 075/2009, Final Award (Sept. 12, 2010), ¶ 669 (“[T]he tribunal might steer into dangerous territory by attempting to enter its own economic valuation into the findings of the respective economic experts’ opinions . . . .”).X3 inconsistent and imprecise valuations have led to increasingly large amounts of compensation granted to investors in Fossil Fuel Phase-Out (“FFPO”) disputes.4Jonathan Bonnitcha & Sarah Brewin, Compensation under Investment Treaties: What Are the Problems and What Can Be Done?, INT’L INST. FOR SUSTAINABLE DEV., at 4 (December 16, 2020), https://www.iisd.org /system/files/2020-12/compensation-investment-treaties-en.pdf. X4 

The failure to render sound valuation decisions constitutes an additional attack on the legitimacy of the ISDS system,5Susan D. Franck, The Legitimacy Crisis in Investment Treaty Arbitration: Privatizing Public International Law through Inconsistent Decisions, 73 FORDHAM L. REV. 1521, 1584 (2005).X5 which is already receiving intense criticism for “obstructing a just energy transition.”6Kyla Tienhaara et al., Investor-State Dispute Settlement: Obstructing a Just Energy Transition, 23(9) CLIMATE POL’Y 1197, 1197 (Nov. 18, 2022).X6  Indeed, as of today, over 100 countries have committed to carbon net neutrality targets via various multilateral agreements and legally binding commitments to reduce carbon emissions,7United Nations Env. Programme, Emissions Gap Report 2023: Broken Record — Temperatures hit new highs, yet world fails to cut emissions (again), 56 (Nov. 20, 2023), https://www.unep.org/emissions-gap-report-2023.X7 the most notable one to date being the Paris Agreement.  While the Paris Agreement does not preclude investors from filing ISDS claims, the growing number and magnitude of such claims may deter states from adopting ambitious climate policies.  At least fifty-seven known ISDS cases post-Paris Agreement have emerged based on critical mineral investments, with claimants collectively seeking more than US$200 billion in damages.8Elizabeth Meager, Clean Energy Boom Is Fuelling Mineral-Related Investor-State Disputes, SUSTAINABLEVIEWS (July 8, 2024), https://www.sustainableviews.com/clean-energy-boom-is-fuelling-mineral-related-investor-state-disputes-ad98954b/.X8 

Scholarly work regarding the calculation of damages in arbitration has developed quickly in recent years.  Most of this “new compensation” literature9Oliver Hailes, Unjust Enrichment in Investor–State Arbitration: A Principled Limit on Compensation for Future Income from Fossil Fuels, 32(2) REV. OF EUR., COMP. & INT’L ENV. L. 358, 359 (Dec. 10, 2022); see also Toni Marzal, Quantum (In)Justice: Rethinking the Calculation of Compensation and Damages in ISDS, 22(2) J. OF WORLD INV.T & TRADE 249, 252 (Apr. 22, 2021).X9 has been aimed at rethinking valuation techniques to avoid “crippling” compensation10See Martins Paparinskis, A Case Against Crippling Compensation in International Law of State Responsibility, 83(6) MOD. L. REV. 1246, 1249 (July 15, 2020); see also Kyla Tienhaara et al., Valuing Fossil Fuel Assets in an Era of Climate Disruption, INT’L INST. FOR SUSTAINABLE DEV. (June 20, 2020), https://www.iisd.org /itn/2020/06/20/valuing-fossil-fuel-assets-in-an-era-of-climate-disruption/ [hereinafter Valuing Fossil Fuel Assets in an Era of Climate Disruption] (discussing the introduction of a social cost of carbon which would be subtracted from the damages awarded to investor depending on their greenhouse gas emissions and incorporated into the discount rate).X10 that yields more accurate and predictable results, as doing so would increase the legitimacy of the ISDS system.11On the legitimacy crisis, see Thomas Dietz et al., The Legitimacy Crisis of Investor-State Arbitration and the New EU Investment Court System, 26(4) Rev. of Int’l Pol. Econ. 749, 750 (July 2, 2019).X11  As a result, it has become a common perception that compensation issues in investment arbitration lack a coherent approach12SERGEY RIPINSKY & KEVIN WILLIAMS, DAMAGES IN INTERNATIONAL INVESTMENT LAW, xxxv (Brit. Inst. of Int’l and Comp. L. 2008).X12 and that innovative approaches to valuation resulting in more precise damages awards “should certainly be encouraged.”13Noah Rubins et al., Approaches to Valuation in Investment Treaty Arbitration, in CONTEMPORARY AND EMERGING ISSUES ON THE LAW OF DAMAGES AND VALUATION IN INTERNATIONAL INVESTMENT ARBITRATION 171, 200 (Christina L. Beharry ed. 2018) [hereinafter Rubins, Approaches to Valuation].X13

Based on the premise that tribunals in FFPO disputes will apply the DCF method,14While the DCF method is not always appropriate, it remains “the most widely used and generally accepted method in the oil and gas industry.” See Report of the International Law Commission to the General Assembly, 56 U.N. GAOR Supp. No. 10, at 103-04, UN Doc. A/56/10 (2001); Occidental v. Ecuador (II), ICSID Case No. ARB/06/11, Award (Oct. 5, 2012), ¶ 779.X14 this article argues that incorporating transition risks into DCF at the valuation stage of arbitral proceedings constitutes the right step towards achieving and reinforcing the legitimacy of the ISDS system.  The capacity of transition risks to reduce crippling compensation has already been examined by previous literature.15Anatole Boute, Investor Compensation for Oil and Gas Phase out Decisions: Aligning Valuation Methods to Decarbonization, 23(9) CLIMATE POL’Y 1087, 1088 (Aug. 1, 2023).X15  However, no one has yet examined how the recognition of transition risks in investment arbitration could contribute to increasing the legitimacy of the ISDS system.  Motivated by the lack of close examination of transition risks in international investment arbitration, this article aims to bridge the gap by presenting the case for such incorporation.

To make the case for incorporating transition risks into DCF valuation, this article will rely on three different sources, namely, legal scholarship on compensation, arbitral case law on the incorporation of various types of risks in the DCF method, and financial literature on climate transition risk; to demonstrate that a consistent recognition of transition risks within the DCF method increases the legitimacy of the ISDS system by addressing inaccuracy issues in the valuation of fossil fuel assets, preventing investors from receiving windfalls and ultimately, reducing the “crippling” compensation commonly awarded to investors in FFPO disputes.

This article will be structured as follows:  

Part 2 situates transition risks within financial literature.  It clarifies key concepts and terminology, providing an analysis of the measurement of transition risks and explaining its relevance in international arbitration.  It finds that most financial institutions fail to value transition risks, leading to overprized fossil fuel assets.  

Part 3 explores how transition risks can tackle the challenges posed to the legitimacy of the ISDS system by preventing the windfall of claimants and accurately reflecting the fair market value (“FMV”) of fossil fuel assets, reducing “crippling” compensation.  

Part 4 focuses on the practical incorporation of transition risks into the DCF method.  In doing so, it finds that introducing transition risks at the cash flow stage is more practical and less onerous than accounting for such risks within the discount rate.  It then recognises that inconsistencies in arbitral practice in incorporating risks can be duplicated when accounting for transition risks, thus further increasing the costs of arbitration.  

Lastly, this article concludes that the recognition of transition risks in FFPO disputes is a worthwhile and promising approach to reducing compensation amounts and addressing the legitimacy crisis of the ISDS system.  However, absent treaty reform on compensation—which is expected to happen in the next generation of investment treaties16See, e.g., Agreement between the Slovak Republic and the Islamic Republic of Iran for the Promotion and Reciprocal Protection of Investments, Aug. 30, 2017, art. 21 (providing method for and limitations on calculating compensation).X16— this technique is likely to face implementation challenges.  It suggests that this solution will reach its optimum once respondent counsel instructs quantum experts to make use of transition risks.

The literature on climate finance distinguishes between two categories of climate-related and environmental risks, namely physical risks and transition risks.  While the former refers to the risks related to the physical impacts of climate change, the latter refers to risks emerging from climate policy and regulatory actions taken to help countries transition to a lower-carbon economy in line with the Paris Agreement goals.1Climate Risks and Opportunities Defined, U.S. EPA (March 3, 2025), https://www.epa.gov/climateleadership/climate-risks-and-opportunities-defined. X1  Transition risks are themselves composed of various sub-categories of risks, ranging from policy and legal to reputation, technology, and market risks.2Transition Risk Framework Managing the Impacts of the Low Carbon Transition on Infrastructure Investments Public Report, U. of Cambridge Inst. for Sustainability Leadership, at 6 (Feb. 2019), https://www.cisl.cam.ac.uk/system/files/documents/cisl-climate-wise-transition-risk-framework-report.pdf.X2  This article is specifically interested in market risks.  Market risks refer to how markets are affected by the shifts in supply and demand for certain commodities, including fossil fuels, given the energy transition.3Id. at 7.X3  These market risks include, most notably, the re-pricing of assets (e.g. fossil fuel reserves).

A. Measurement of Transition Risks: A Challenging Set of Risks to Capture

Transition risks posed by the climate transition can be quantified through various methods, one of which involves using scores that consider two primary variables:  a country’s exposure to economic changes from the global climate transition and its capacity to mitigate these impacts by reducing greenhouse gas emissions.4Matteo Ferrazzi et al., What’s your climate change risk?, EUR. INV. BANK (April 26, 2021), https://www.eib.org/en/stories/climate-change-risks-developing-countries.X4  The calculation of the first variable is based on multiple factors, including revenues stemming from the fossil fuel business—which are expected to decline given the energy transition5Id. (noting that “revenues stemming from fossil fuel business … are expected to decline in the future due to stricter climate policies and changing consumer preferences”).X5—and current greenhouse gas emissions performance.  The second variable can be calculated based on a country’s performance in deploying renewable energy sources, implementing energy efficiency improvements, and its commitment to tackling climate change based on the “nationally determined contributions” each country has set under the Paris Agreement.6Id.X6 

Transition risks can also be measured via the Transition-Exposure Coefficient (“TEC”).  This coefficient measures how much different sectors must change due to climate risks.  TECs range from 0% to 100%—0% means the sector will not change at all, and 100% means that the sector’s activities will need to be stopped entirely.  For instance, fossil fuel companies have a TEC of 100% because they will eventually need to stop their activities entirely.7Lucia Alessi & Stefano Battiston, Two Sides of the Same Coin: Green Taxonomy Alignment versus Transition Risk in Financial Portfolios, 84 INT’L REV. OF FIN. ANALYSIS (July 30, 2022), at 6.X7 

1. Effect of Transition Risks Measurements on Fossil Fuel Assets

As seen above, both techniques used to measure transition risks demonstrate that climate policies are the main drivers of transition risks.  But how exactly are these climate policies affecting the value of an investor’s assets in fossil fuel industries?

First, climate policies driving transition risks “affect the cost of doing business and the returns on domestic assets.”8Ferrazzi et al., supra note 21.X8  Financial literature in this regard is well-developed, with climate-related risks being frequently discussed and modelled by financial regulators, central banks, and academics.

Climate policies also create another risk, namely the risk of stranded assets.9Id. (noting that “these climate policies affect the cost of doing business and the returns on domestic assets, increasing the likelihood of carbon intensive assets becoming stranded”). X9  In FFPO disputes, stranded assets are fossil fuel resources that cannot be burned and fossil fuel infrastructures that are no longer used.  These assets may thus end up as liabilities before the end of their anticipated economic lifetime.10Sini Matikainen & Eléonore Soubeyran, What Are Stranded Assets?, GRANTHAM RSCH. INST. ON CLIMATE CHANGE AND THE ENV. (July 27, 2022), https://www.lse.ac.uk/granthaminstitute/explainers/what-are-stranded-assets/.X10  It is now well-established at the macro-economic level that stranded fossil fuel assets translate to significant losses for both fossil fuel investors in advanced economies and OECD countries.11Gregor Semieniuk et al., Stranded Fossil-Fuel Assets Translate to Major Losses for Investors in Advanced Economies, 12 NATURE CLIMATE CHANGE 532, at 534 (May 26, 2022).X11  Assets that are heavily affected by transition risks end up becoming stranded assets.  As such, the risk of stranded assets is particularly high for companies extracting oil, gas, and coal because of the low-carbon transition.  It is expected that an estimated 60% of oil and gas reserves and 90% of known coal reserves should remain unused in order to limit global warming to 1.5°C,12Dan Welsby et al., Unextractable Fossil Fuels in a 1.5 °C World, 597 NATURE 230, 231 (Sept. 8, 2021).X12 to comply with the Paris Agreement target.

B. Pricing of Transition Risks: A Failure on Behalf of Financial Institutions?

There is, to this day, only patchy evidence on the pricing of transition risks,13Patrick Bolton & Marcin T. Kacperczyk, Global Pricing of Carbon-Transition Risk, 78(6) J. OF FIN. 3677, 3678 (Aug. 12, 2023).X13 and the effect of transition risks on market risk losses is severely understated, as an economic downturn has yet to be reported.14European Central Bank (“ECB”), Good Practices for Climate-Related and Environmental Risk Management: Observations from the 2022 Thematic Review (Nov. 2022), https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.thematicreviewcercompendiumgoodpractices112022~b474fb8ed0.en.pdf. X14 

Indeed, while the impact of transition risks on the valuation of fossil fuel assets is recognised, the same cannot be said for the pricing of transition risks.  Recent financial literature highlights how little transition risks have actually been incorporated into fossil fuel company valuations.  It appears that cash flow scenarios used by financial analysts themselves exclude transition risks references and possible future repricing of assets.15Drew Riedl, Why Market Actors Fuel the Carbon Bubble. The Agency, Governance, and Incentive Problems That Distort Corporate Climate Risk Management, 12 J. OF SUSTAINABLE FIN. & INV. 407, 413 (June 1, 2020) [hereinafter Riedl, Why Market Actors Fuel the Carbon Bubble].X15  Overall, it is reported that only about 40% of all survey respondents incorporate climate change information, including stranded asset risks, into the investment process.16Matt Orsagh, Climate Change Analysis in the Investment Process, CFA INSTITUTE (Sept. 21, 2020), at 18. X16  Further research shows that markets using the DCF method continue to price these assets under a “business as usual” scenario, as opposed to a scenario where an adequate climate policy response that would limit warming to 1.5°C has been enacted.17Drew Riedl, The Magnitude of Energy Transition Risk Embedded in Fossil Fuel Company Valuations, 7(11) Heliyon (Nov. 2021), at 9.X17  This failure to price transition risks has also been highlighted in the Respondent’s Expert Report filed in RWE v. Netherlands,18RWE AG v. Netherlands, ICSID Case No. ARB/21/4, Expert Report by Pablo T. Spiller and Alan G. Rozenberg, ¶ 49 (Sept. 5, 2022) [hereinafter RWE Expert Report].X18 whereby quantum experts highlighted that investors tend to ignore the forward-looking transition risks faced by their heavy fossil fuel-reliant industries.

Why do investors fail to price transition risks?  Economic research suggests that financial players (e.g., banks) fail to appropriately consider and price transition risks deriving from fossil fuels when making investment and lending decisions.19Matikainen & Soubeyran, supra note 27.X19  Even more, banks fail to be sufficiently transparent when disclosing transition risks.20Press Release, ECB, Banks Must Get Better at Disclosing Climate Risks, ECB Assessment Shows (Mar. 14, 2022), https://www.bankingsupervision.europa.eu/press/pr/date/2022/html/ssm.pr220314~37303fd463.en.html. X20   This is despite the non-negligible impact of transition risks on bank income.21ECB, Climate Transition Risk in the Banking Sector: What Can Prudential Regulation Do?, at Sections 2, 3.6 and 4, (ECB Working Paper Series No 2910), https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2910~c4d2c82f8c.en.pdf. X21 

But why is the failure to meaningfully price in transition risks relevant in international investment arbitration?  It is relevant because failure to do so results in strong overvaluations, which are reported to be the largest among oil firms.22Orsagh, supra note 33, at 10.X22   Indeed, failure to meaningfully factor in transition risks leads to fossil fuel producers being “significantly overvalued” due to an underinflated discount rate.23See Riedl, Why Market Actors Fuel the Carbon Bubble, supra note 32, at 1.X23  This holds particularly true where the most significant proportion of an investment's value is spread in the medium to long term.24For an account of the reasons behind the failure to price such risks, see id. at 408.X24  This was precisely the issue in ConocoPhillips v. Venezuela,25ConocoPhillips v. Venezuela, ICSID Case No. ARB/07/30, Award (March 8, 2019).X25 where, according to scholars, the project was overvalued as a result of the tribunal continuing to base future oil prices on existing market conditions26Boute, supra note 16, at 1093.X26 and refusing to acknowledge that oil firm prices should be substantially lower as a result of the uncertain climate policy resulting from the Paris Agreement.27Matikainen & Soubeyran, supra note 27.X27

Similarly, it has been found that investors also fail to price stranded asset risks, and the risk of these assets might not be fully reflected in the value of companies that extract, distribute, or rely heavily on fossil fuels.  Research has shown that “if this risk were priced in, a sudden drop in value could result, presenting a risk to investors and shareholders.”28Id.X28  This failure to price transition risks, including stranded asset risks, may also “lead to credit allocation that is not aligned with sustainable development.”29Winta Beyene et al., Financial Institutions’ Exposures to Fossil Fuel Assets: An Assessment of Financial Stability Concerns in the Short Term and in the Long Run, and Possible Solutions, ECON. GOVERNANCE SUPPORT UNIT OF THE EUR. PARLIAMENT, at 10 (June 2022), https://www.europarl.europa.eu/RegData/etudes/STUD/2022/699532/IPOL_STU(2022)699532_EN.pdf (reasoning that one reason why big banks do not create appropriate economic incentives to facilitate the transition to a greener economic is that they are considered too big-to-fail (“TBTF”), meaning that they may expect to be protected from the negative consequences of transition risks and, therefore, have a greater incentive to take on transition risks compared to smaller financial institutions).X29 

Failure to price transition risks is all the more problematic given the liquidity of fossil fuels.30See Rubins, Approaches to Valuation, supra note 14, at 227.X30  Indeed, the more illiquid an asset, the lower its price.  Yet, this liquidity is not reflected in the cash flow projections of fossil fuel assets.  This is particularly important for coal stocks, as they enjoy much weaker liquidity due to the fragmentation of their market compared to publicly listed oil and gas equities.31Atif Ansar et al., Stranded Assets and the Fossil Fuel Divestment Campaign: What Does Divestment Mean for the Valuation of Fossil Fuel Assets?, SMITH SCH. OF ENTER. AND ENV., at 12 (October 2013), https://www.smithschool.ox.ac.uk/sites/default/files/2022-03/SAP-divestment-report-final.pdf. X31 

However, significant efforts have been made in the past couple of years to encourage investors to price such risks.  These efforts have been reflected on a macroeconomic level, where an increased discounting of transition risks has recently been noted.32Michael Barnett, A Run on Oil: Climate Policy, Stranded Assets, and Asset Prices (June 27, 2019) (Ph.D. thesis, U. of Chicago), https://www.frbsf.org/wp-content/uploads/Paper-7-2019-11-8-Barnett-240PM-1st-paper.pdf. X32 

C. Varying Levels of Exposure to Transition Risks

For states, the European Central Bank (“ECB”) findings suggest that high-income countries face the greatest transition risks as they tend to consume a large share of world resources, generating higher risks from transitioning to low-carbon economies.33ECB, Who’s More at Risk? A Global Index of Climate Risk for Countries, at 15 (June 2025), https://www.eib.org/attachments/lucalli/20250135-120625-economics-working-paper-2025-06-en.pdf. X33  However, low- and middle-income countries are also exposed to high transition risks due to their significant dependence on fossil fuel revenue and lower mitigation capacities.

As for investors, they are impacted by transition risks to varying levels, depending on their portfolios.  First, it has been found that investors relying on fossil fuel assets face large shifts in asset values or higher costs of doing business.34Matteo Ferrazzi et al., Assessing Climate Change Risks at the Country Level: The EIB Scoring Model (European Investment Bank Working Paper 2021/03, 2021), https://www.eib.org/files/efs/economics_working_paper_2021_03_en.pdf.X34   As such, they are notably more exposed to transition risks as the economy adjusts to a renewable energy base.35Bolton & Kacperczyk, supra note 30, at 3752; see also Matthijs Leegstra, The Influence of Climate-Related and Environmental Risks on Bank Loan Credit Migration, at 4 (July 10, 2023) (Master’s thesis in Quantitative Finance, Erasmus Sch. of Econ.).X35  These higher costs should be reflected in their risk premiums but are not, as explained above.

Additionally, the most comprehensive study to date on transition risks suggests that a firm's exposure to carbon transition risks is proportional to the level of its emissions.36Bolton & Kacperczyk, supra note 30, at 3679.X36  For these firms, there seems to be a strong case that “fossil fuel assets, far from being a source of profit in the future, risk becoming liabilities.”37Helionor de Anzizu et al., Overcoming International Investment Agreements as a Barrier to Climate Action: A Toolkit to Safeguard Fossil Fuel Measures from Investment Treaty Claims, at 23 , CTR. FOR INT’L ENV’T L. (January 2024), https://www.ciel.org/wp-content/uploads/2024/02/Overcoming-International-Investment-Agreements-as-a-Barrier-to-Climate-Action.pdf.X37  Investors are also more or less impacted depending on the radicality of the relevant environmental policy.  It is well-admitted that the less stringent the carbon policy, the lower transition risks.38ECB, 2022 Climate Risk Stress Test, at 13 (July 2022), https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.climate_stress_test_report.20220708~2e3cc0999f.en.pdf.X38 

Given the overvaluation of fossil fuels caused by the failure to price in transition risks, we will now turn to examine how states can and should question valuation assessments used by claimants in light of climate change considerations and the value of fossil fuel resources.39Valuing Fossil Fuel Assets in an Era of Climate Disruption, supra note 11.X39  The following Part will continue to build on the argument that when responding to damages claims from investors, states should argue that tribunals “cannot assume constant or growing demand for fossil fuel products or fossil fuel-backed energy/feed-stocks.”40Id.X40 

A. The Failure of Arbitral Tribunals to Consider Transition Risks

Despite empirical evidence of the impact of transition risks on the valuation of fossil fuel assets (Part 2), it seems that no arbitral tribunal has applied transition risks at the valuation stage of FFPO disputes.  This is particularly problematic given that, to satisfy the standard of compensation required under international law and international investment agreements, arbitral tribunals are invited to look at the nature and circumstances under which an investment operates, parameters that are greatly affected by transition risks.

1. Standards of Compensation and Methods of Valuation in International Investment Law

Upon finding a breach, arbitrators undertake a two-stage quantum analysis, which involves determining the standard of compensation before selecting the appropriate method of valuation to satisfy that standard.1Oliver Hailes, Valuation of Compensation in Fossil Fuel Phase-Out Disputes (LSE Legal Stud. Working Paper No. 23/2023, December 8, 2023), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4658851 [hereinafter Hailes’ Working Paper].X1   Regarding the standard of compensation, arbitral tribunals have “broadly converged on some reference to [FMV].”2Id. at 4.X2   

The internationally recognised definition of FMV is “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”3International Glossary of Business Valuation Terms, American Society of Appraisers, https://www.appraisers.org/docs/default-source/discipline_bv/glossary-of-terms.pdf (defining “Fair Market Value”).X3 

We now turn to the appropriate method of valuation to satisfy the applicable standard.  In the absence of textual guidance, arbitrators have been given substantial discretion to calculate the FMV of an investment.  Because the FMV is “often not observed directly,”4See Rubins, Approaches to Valuation, supra note 14, at 316.X4 it can be calculated under various methods, ranging from asset- to market- and income-based approaches.  This article is interested solely in income-based approaches such as the DCF method,5Julie M. Carey et al., Demystifying the Damages Assessment in International Arbitration, in THE GUIDE TO DAMAGES IN INTERNATIONAL ARBITRATION - SIXTH EDITION (Glob. Arb. Rev., June 21, 2024), https://globalarbitrationreview.com/guide/the-guide-damages-in-international-arbitration/6th-edition/article/demystifying-the-damages-assessment-in-international-arbitration.X5 given that the DCF method is the preferred choice for claimants6Hailes’ Working Paper, supra note 58, at 4.X6 as it tends to lead to a higher valuation of an investment, and it has been “widely accepted as the appropriate method to assess the [fair market value] of going concerns.”7Quiborax SA v. Plurinational State of Bolivia, ICSID Case No. ARB/06/2, Award (September 16, 2015), ¶ 344.X7 

The DCF method is categorised as a forward-looking method because it aims to calculate the present value of an asset by forecasting its future expected cash flows and applying a discounting rate.8Tiago Duarte-Silva, Country Risk, in THE GUIDE TO DAMAGES IN INTERNATIONAL ARBITRATION - SIXTH EDITION (Glob. Arb. Rev., June 21, 2024), https://globalarbitrationreview.com/guide/the-guide-damages-in-international-arbitration/6th-edition/article/country-risk.X8  The discount rate helps account for two things.  First, it accounts for the time value of money, according to which money now is worth more than the same amount of money in the future because one can invest and earn interest (risk-free rate).  Second, the discount rate accounts for risk, under which a safe future cash flow is worth more than an uncertain future cash flow (risk premium).  Here, the riskier the investment, the higher the premium.  The appropriate rate to apply to future cash flows is thus the sum of a rate reflecting the risk-free rate and the risk premium.9IRMGARD MARBOE, CALCULATION OF COMPENSATION AND DAMAGES IN INTERNATIONAL INVESTMENT LAW, at 196 (Oxford U. Press 2d ed., Mar. 30, 2017).X9

 Transition risks can be reflected either via downward adjustments to cash flow forecasts or via the discount rate to reflect the increased risks of generating a carbon-intensive cash flow in a specific country.  In the latter scenario, it would be called a “transition risk premium.”  Typically, arbitral tribunals translate risks via the discount rate.10Duarte-Silva, supra note 65 (noting that practitioners prefer adjusting the discount rate as it is simpler than explicitly setting up various situations and their probabilities).X10  However, this is not always the case given that certain risks can also be reflected in the forecast.11CALCULATION OF COMPENSATION AND DAMAGES IN INTERNATIONAL INVESTMENT LAW, supra note 66, at 197.X11  This issue is discussed further in Part 4 upon examination of whether transition risks should be incorporated into the cash flow or discount rate.

For our present purposes, it is precisely the manner in which the FMV is determined via the DCF method that will inform the need to account for transition risks.  Indeed, FMV is determined by looking at various factors that are affected by transition risks, including the “nature of the investment, the circumstances in which it would operate in the future and its specific characteristics.”12WBG, Guidelines on the Treatment of Foreign Direct Investment, II LEGAL FRAMEWORK FOR THE TREATMENT OF FOREIGN INV. 33, 41-42 (1992) (providing a guideline for the determination fair market value if no method is agreed to by the State and the foreign investor, the tribunal, or another designated body).X12  So, do arbitral tribunals account for transition risks in practice?

2. Transition Risks in Arbitral Practice

Arbitral practice shows that tribunals have, to this day, failed to incorporate transition risks at the valuation stage.  Indeed, as part of their quest to determine the FMV of a fossil fuel investment, tribunals have to determine the forecasted fossil fuel price from the date of the breach to the date when the investment was expected to end.  In doing so, it seems that tribunals applying the DCF method have accepted the use of data that does not price transition risks to estimate the future revenues of a carbon-intensive investment.  For instance, the 2019 award in ConocoPhillips used projected oil prices from mid-2007 to the planned end of production in 2036.13ConocoPhillips v. Venezuela, ICSID Case No. ARB/07/30, Award (March 8, 2019), ¶ 710.X13  Similarly, the arbitrators in Rockhopper referred to the DCF model that the investor used when deciding to invest in the Ombrina Mare oil field and which failed to price transition risks.14Rockhopper Exploration Plc v. Italian Republic, ICSID Case No. ARB/17/14, Final Award (August 23, 2002), ¶ 284.X14 

The most advanced mention of transition risks in arbitral practice can be seen in the Respondent’s Expert Report in RWE v. Netherlands, which states that “the negative impact that [the energy transition] risk has on the value of assets can be incorporated through the cash flows or via the discount rate.”15RWE Expert Report, supra note 35, ¶ 22.X15  However, put in its context, the significance of this statement in the recognition of transition risks in investment arbitration is minimal:  the Respondent’s experts were simply responding to the Claimant’s Expert Report by pinpointing that they have not accounted for such energy transition risks when they should have, but did not develop this idea in greater depth.

The failure to account for transition risks can be explained in various ways.  First, it is observed that an increasing amount of FFPO disputes do not make it to the merits stage as they are dismissed at the jurisdiction stage.16James Searby, Measuring Country Risk in International Arbitration, in CONTEMPORARY AND EMERGING ISSUES ON THE LAW OF DAMAGES AND VALUATION IN INTERNATIONAL INVESTMENT ARBITRATION, supra note 14, at 256.X16  It could also be that parties simply do not raise that issue.  In that case, the solution is simple:  it is for the respondent’s counsel to mention the importance of accounting for transition risks to reflect the FMV of a fossil fuel investment.  However, because respondent expert reports are rarely disclosed, it would be difficult to assess whether transition risks are increasingly being accounted for.

Second, this failure could also be explained by the fact that many FFPO disputes, especially involving Venezuela, have concerned lawful expropriation.  In those instances, it is not necessary to forecast the price of oil given that the date of valuation is set before the expropriation.17Boute, supra note 16, at 1094.X17 

It could also be that arbitrators have doubts as to their own capacity to integrate transition risks into valuation methods, especially given that financial experts themselves encounter difficulties in doing so.18See RosInvest Co. U.K. Ltd. v. Russian Federation, SCC Case No. 075/2009, Final Award (Sept. 12, 2010), ¶ 669 (recognizing that “[t]he tribunal might steer into dangerous territory by attempting to enter its own economic valuation into the findings of the respective economic experts’ opinions.”).X18  Indeed, arbitrators can be reluctant to undertake financial and economic analysis of the “detailed formulas and spreadsheets submitted by the parties” given their lack of background in these sectors.19Joshua B. Simmons, Valuation in Investor-State Arbitration: Toward a More Exact Science, in INTERNATIONAL ARBITRATION: CONTEMPORARY ISSUES AND INNOVATIONS 53, 69 (John Norton Moore ed., Mar. 15, 2013).X19  This reluctance is particularly understandable given that, as explained in Part 2, transition risks in financial practice are not always reflected in the price of fossil fuel assets. The risk of error is high, as it will be highlighted in Part 4.

The fact remains that absent mention of transition risks by the respondent’s quantum experts, tribunals have a tendency to follow the flawed valuation brought by claimants that do not price in transition risks.  For instance, the investors in RWE v. Netherlands calculated the beta, i.e. the parameter used to account for the systematic risks of a project or asset at the discount rate stage, by referring to a sample of historical betas of companies operating within a similar industry.20Id.X20  This is problematic, as have rightfully pinpointed experts, because historical betas are only suitable for stable environments, and industries relying on fossil fuel energies are far from stable (see Part 2).  As such, tribunals should recognise that using a historical beta parameter is no longer appropriate for FFPO disputes.  In addition, the claimant’s quantum experts in RWE also relied solely on past returns, as opposed to relying on additional information such as industry characteristics.  Had they relied on these latter, the tribunal would have had no choice but to consider the negative adverse effects of the energy transition on the valuation of the relevant energy market.

Thus, it appears that arbitral tribunals in FFPO disputes have yet to incorporate transition risks into the DCF method.  But what would be the benefit of doing so?

B. Transition Risks as a Way to Prevent the Investor’s Windfall

It is argued here that arbitrators should consider transition risks when valuing fossil fuel assets because failure to do so would result in the unjust enrichment of the claimant, which is prohibited as a general principle of law.21Hailes, supra note 10, at 359.X21 

This is because failure by arbitral tribunals to incorporate net-zero prices can lead to the windfall of the claimant.  To illustrate the extent of the windfall received by a claimant in FFPO disputes, some authors has considered the alternative scenario whereby the tribunal in ConocoPhillips applied Paris-aligned prices of fossil fuels to evaluate the future cash flows of the Hamaca project.22Boute, supra note 16, at 1995.X22  The results first show that using net-zero prices does lead to results that are more aligned with the reality of the energy transition, with a total income adjusted to a net-zero pricing scenario being approximately 48% lower than the total income accepted by the arbitral tribunal without the net-zero price-adjust.  

These results also show that accounting for transition risks in arbitral practice can help radically reduce the quantum of the compensation given to an investor, thus constituting a possible technique for reducing crippling compensation.  

Lastly, the findings suggest that absent price adjustment, the claimant receives a windfall of about USD 3.7 bn.  Some scholars have suggested that one way to prevent such windfall would be to apply a higher risk premium to the discount rate within a DCF method, treating the risk of asset stranding as an incident of country risks.23Id.X23  But this method would result in increased arbitration costs given that the determination of the appropriate premium for climate-related regulatory risk would be highly contested by expert evidence, which would “hardly mitiga[te] the widespread concern that the ISDS system is raising the cost of climate action.”24Id.X24 

As demonstrated above, accounting for transition risks in FFPO disputes can reduce an investor's compensation, and while it is unsure whether the money that was not prevented from falling into the hands of investors could have been used for public purposes,25Soh Young In et al., Pricing Climate-Related Risks of Energy Investments, 154 RENEWABLE AND SUSTAINABLE ENERGY REVIEWS (Feb. 2022), https://www.sciencedirect.com/science/article/abs/pii/S1364032121011485; see also Boute, supra note 16, at 1988.X25 the incorporation of transition risks within the DCF method can at least prevent the claimant from being unjustly enriched.

C. Transition Risks as a Reflection of the Fair Market Value of an Investment – The Need to Reflect Economic and Environmental Realities

As seen in Part 2, despite the fact that current economic literature on climate change is “still in its infancy,”26Bolton & Kacperczyk, supra note 30, at 3.X26  it is now well-established that transition risks exist at the macroeconomic level.27Jean-Francois Mercure et al., Macroeconomic Impact of Stranded Fossil-Fuel Assets, 7 NATURE CLIMATE CHANGE 588, 592 (June 4, 2018), https://www.nature.com/articles/s41558-018-0182-1.X27  As such, despite financial actors failing to price such risks and despite the fact that determining damages is not an “exact science,”28Compañía de Aguas del Aconquija S.A. v. Republic of Argentina, ICSID Case No. ARB/97/3), Award (August 20, 2007), ¶ 8.3.16.X28 arbitrators can strive to make this science a bit more exact and closer to economic reality by applying transition risks at the DCF stage to accurately determine the FMV of a fossil fuel asset.  But aside from materially reducing the valuation of an investment, what other benefits can the application of net-zero price adjustments to the forecasted cash flows of a carbon-intensive investment bring?

Accounting for transition risks could, most importantly, assist the economy by tackling the issue of the “carbon bubble.”29Mercure et al., supra note 84 at 588.X29  According to this theory, the failure to account for uncertain climate policy in oil firm value can lead to the creation of a carbon bubble”30Id.X30 whereby oil firm values are overpriced “because the price does not incorporate the risk of oil reserves becoming stranded and the run on oil production that stranded assets risk causes.”31Barnett, supra note 49, at 54.X31  Indeed, the higher the uncertainty regarding climate policy, the more likely the run on oil, the lower the price of oil, the higher the likelihood of stranded assets (liabilities), and the lower the value of the oil firm.  However, because financial institutions fail to price the risk of stranded assets (Part 2), the value of oil firms remains the same.32Id.X32  The failure to properly price oil is creating a carbon bubble, which is causing expectations of higher prices because it is assumed that all the oil reserves held by these firms will eventually be used.  This lack of pricing transparency leads to reinvestment in assets that may become stranded, and if this bubble were to burst, it could potentially lead to a financial crisis.  Tienhaara would have warned us:  “an investment law regime that insulates investors from transition risks perpetuates the over-investment problem.”33Valuing Fossil Fuel Assets in an Era of Climate Disruption, supra note 11.X33  Yet, it seems that because stock market reactions to the existence of the carbon bubble are limited.34Paul A. Griffin et al., Science and the Stock Market: Investors’ Recognition of Unburnable Carbon, 52(A) Energy Econ. 1, 4 (Dec. 2015), https://www.sciencedirect.com/science/article/abs/pii/S0140988315002546.X34 

D. Result: Overall Increased Legitimacy of the ISDS System

Transition risks as part of the DCF method is an efficient tool to increase the legitimacy of the ISDS system because it reflects circumstances that can be mathematically assessed.  This holds particularly true for mining and oil and gas companies given that they are subject to disclosure requirements in many jurisdictions.35Richard Caldwell et al., Valuing Natural Resources Investments, in CONTEMPORARY AND EMERGING ISSUES ON THE LAW OF DAMAGES AND VALUATION IN INTERNATIONAL INVESTMENT ARBITRATION, supra note 14, at 321.X35  The overall efficiency of transition risks incorporated within the DCF method is due to the more objective nature of the expectations that arbitrators look at when determining the FMV.  Indeed, in the context of transition risks, arbitrators undertake a transaction-focused approach36See supra III.A.1 (discussing WBG definition of FMV).X36 (e.g. global economic changes such as the disruption of the price of oil) as opposed to government-focused.  These include global economic changes such as the disruption of the price of oil.  

The symmetry between expectations as part of transition risks and legitimate expectations is worth noting.37Note that legitimate expectations as a part of transition risks are different from those considered in assessing a potential breach of a treaty standard because the target of the expectations is different. X37  Legitimate expectations typically refer to specific assurances made by a host state to an investor about the future of its investment, which the investor relied upon in making its investment.38Plama Consortium Limited v. Republic of Bulgaria, ICSID Case No. ARB/03/24, Award (August 27, 2008), ¶ 176. X38  These expectations are assessed at the merits stage and concern future governmental conduct. By contrast, expectations relevant to transition risks are broader and more objective.  They account not only for governmental climate measures but also for wider global economic changes (such as the disruption in oil prices) that could affect the FMV of an investment.  This added objectivity is particularly desirable given that the incorporation of transition risks into valuation is not always straightforward.

Risks in general can be incorporated under various approaches, including asset- and market-based approaches.  However, as explained in the introduction, this Part will only examine how transition risks can be incorporated into the DCF method.

A. The Cash Flow vs. Discount Rate Debate

While there is growing consensus to account for transition risks in financial literature, there is still dissent as to where to account for such risks within the DCF method.  As seen in Part 2, one can incorporate risks within the DCF method by increasing the discount rate or decreasing the cash flow.  The question then arises as to whether energy transition risks would be more accurately reflected if considered when estimating the value drivers of the carbon-intensive asset (i.e. at the forecasted cash flow stage) or whether it should be added at the end as a risk premium (i.e. at the discount rate stage).

Arbitral practice does not give a definite answer.  For instance, arbitral tribunals have incorporated country risks both in the forecasted cash flow1CME Czech Republic BV v. Czech Republic, 9 ICSID Reports 246 (2006), Final Award on Damages (March 14, 2003), ¶ 117. X1 and in the discount rate,2Gold Reserve Inc. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/09/1, Award (September 22, 2014), ¶ 844; Sempra Energy International v. Argentina, ICSID Case No. ARB/02/16, Award (September 28, 2007), ¶ 431; Saint-Gobain Performance v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/12/13, Decision on Liability and the Principles of Quantum (December 30, 2016), ¶ 670; Mobil Cerro Negro Holding, Ltd. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/07/27, Award (October 9, 2014), ¶ 365; ConocoPhillips v. Venezuela, ICSID Case No. ARB/07/30, Award (March 8, 2019), ¶ 868. X2 although there is a stronger tendency to incorporate them within the discount rate.  However, risks can also be considered at the cash flow level.3Carey et al., supra note 62.X3  For instance, in a hypothetical, one author incorporated transition risks in ConocoPhillips at the forecasted cash flow level because, for him, “significant downward adjustments to the components that make up an oil and gas asset’s cash flows can be achieved by setting DCF in consistency with net-zero pathways.”4Boute, supra note 16, at 1092.X4  Similarly, reputable financial institutions such as Morgan Stanley also incorporate transition risks downstream.5Navigating the Transition: Managing Climate Risks and Opportunities—Morgan Stanley’s Task Force on Climate-related Financial Disclosures Report, 2020, Morgan Stanley (Oct. 2020), https://www.morganstanley.com/assets/pdfs/Morgan_Stanley_TCFD_Report_2020.pdf.X5  Legal literature also supports the introduction of risks at the cash flow level, arguing that doing so would reduce the level of arbitrariness in valuation.6See Simmons, supra note 76, at 100 (arguing that arbitrators should account for certain risks “by adjusting the forecasted cash flows instead of arbitrarily increasing the discount rate”).X6 

In theory, either approach—or both, given the possibility of introducing transition risks under both variables, provided that the same risk is not being accounted for twice—if properly implemented, is acceptable.  For instance, in RWE v. Netherlands, many investment banking analysts covering RWE assigned no value beyond 2030 for coal-intensive operations, directly chopping off cash flows or assuming profit margins of zero for 2030 onwards.7RWE Expert Report, supra note 35, ¶ 23.X7  In the alternative, they could have projected positive cash flows for 2030 and then discounted them extremely heavily to reflect expectations of coal phase-out, which would essentially yield a value of zero beyond 2030

Some academics argue, however, that transition risks are best accounted for in the discount rate as they could then be incorporated into the industry rate.8CALCULATION OF COMPENSATION AND DAMAGES IN INTERNATIONAL INVESTMENT LAW, supra note 66, at 261.X8  This approach is not desirable as highlighting how the appropriate premium for climate-related regulatory risks can be highly contested by expert evidence and transition risks within the discount rate would just result in inflating already-high costs of arbitration.9Hailes, supra note 10, at 369.X9  For instance, in Tethyan Copper v. Pakistan, the claimant spent US$4.5 million on financial experts and US$17.5 million on legal fees for the compensation phase of proceedings alone; Pakistan spent almost US$10 million defending the compensation phase, including both financial experts and legal fees.10Tethyan Copper v. Pakistan, ICSID Case No. ARB/12/1, Award (July 12, 2019), ¶¶ 1824, 1831.X10  As already seen in Part 3, arbitral experience with country risks shows that quantum experts tend to give significantly different numbers to account for risks.  This is mainly because various diverging approaches have been taken to measure country risks, and the same can be said for transition risks (Part 1).  For cost-efficiency reasons, it would then be preferable to account for transition risks at the cash flow stage.

Advocates of incorporating transition risks in the forecasting of cash flows first invoke practical reasons.  As examined in Part 1, transition risks affect the value drivers of carbon-intensive investments in various ways.  More specifically, transition risks, just like country risks, most often call for a reduction in the value of the relevant asset.  In practice, this would be done by projecting multiple cash flow situations into the future and calculating the average of these values, taking into account their respective probabilities of occurring, to obtain the value of the asset.11Duarte-Silva, supra note 65 (explaining that arbitrators may use probability-weighted scenarios to estimate asset value under certain future conditions).X11 

There is also more data available, notably regarding the future price of a certain fossil fuel given the energy transition.  For instance, the International Energy Agency has already published reports stating that for the world energy system to meet the Paris Agreement targets, the future price of oil is likely to be within the US$36 per barrel range in 2035.12International Energy Agency (”IEA”), Net Zero Roadmap: A Global Pathway to Keep the 1.5 °c Goal in Reach – Analysis (September 2023), https://www.iea.org/reports/net-zero-roadmap-a-global-pathway-to-keep-the-15-0c-goal-in-reach (average calculated between the 2030 and 2040 price projection). Note the far cry from the oil forecast used by the claimants and accepted by the tribunal in ConocoPhillips of US$77.22 per barrel in 2036. See ConocoPhillips v. Venezuela, ICSID Case No. ARB/07/30, Award (March 8, 2019), ¶ 708.X12  As such, it appears conceptually “more straightforward [for arbitrators] to directly adjust the cash flow forecasts to arrive at the expected future cash flows”13Duarte-Silva, supra note 65 (suggesting that economic literature prefers adjusting projected cash flows directly to account for country risks rather than altering discount rates).X13 by plugging these numbers into established models.  Avoiding risk premium calculations also has the benefit of preventing the handling of authority from the lawyers to the accountants, which may find greater support amongst the arbitration community.

Additionally, cash flow level incorporation is preferred because not every asset is equally exposed to transition risks (see Part 2).  Indeed, “an asset’s risk does not necessarily equate to the transition premium risk”; for instance, an asset that does not rely on energy is less exposed to environmental regulatory change than one that does.14Id.X14  Although this article is only focused on fossil fuel assets, the fact remains that certain fossil fuel assets are more or less exposed to regulatory change on climate change.  One can easily imagine how adjusting the rate of transition risk premiums to the asset in every individual case can be a demanding and cost-ineffective exercise, as opposed to the simple incorporation of the net-zero price of the asset.

As such, even if the literature on incorporating transition risks in the DCF method is underdeveloped, it seems that accounting for transition risks downstream is preferable as it is less burdensome in terms of evidence and, therefore, more cost-effective.

B. Inconsistency in Arbitral Practice Regarding Risk Assessment

When incorporating risks into valuation calculations, arbitral tribunals tend to disagree on two main issues.  This could be a bad omen for transition risks.

1. Disagreement Over the Nature and Measure of the Risks to Be Accounted for in the DCF Method…

Arbitral tribunals disagree over what risks to account for when using the DCF method.15Bonnitcha & Brewin, supra note 5, at 4.X15  This is notably the case for country risks, which quantify the “general risks, including political risks, of doing business in a particular country.”16Tidewater Investment SRL v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/10/5, Award (March 13, 2015), ¶¶ 184, 186 (holding that the treaty was not insurance against such risks).X16  For instance, for four different investments made in the same country, arbitral tribunals have taken “radically divergent views” about country risk premiums associated with an investment in Venezuela, ranging it from 4% to 14.75%.17See Gold Reserve Inc. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/09/1, Award (September 22, 2014), ¶ 842 (country risk premium of 4%); OI European Group B.V. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/11/25, Award (March 10, 2015), ¶ 773 (6%); Flughafen Zürich A.G. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/10/19, Award (November 18, 2014), ¶ 900 (7,9%); Saint-Gobain Performance v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/12/13, Decision on Liability and the Principles of Quantum (December 30, 2016), ¶ 753 (10.26%); Tidewater, ¶ 190 (14.75%). X17  These inconsistencies were caused, in large part, by disagreement between parties and arbitrators on whether to incorporate certain elements—such as “all political risks”18Saint-Gobain, ¶ 718.X18 associated with investing in a specific country, including expropriation risks—as part of country risk premiums.  However, despite this inconsistency, the fact remains that country risks are nonetheless consistently recognised by arbitral practice.19Duarte-Silva, supra note 65 (noting that despite different methodological approach in valuation, arbitral tribunals consistently incorporate country risks at the valuation stage).X19 

The second inconsistency concerns the way in which tribunals run DCF calculations to incorporate risks.20See Searby, supra note 73, at 251.X20  This inconsistency is significant as it can lead to discrepancies between country risk premiums used by respondents and claimants amounting to hundreds of millions of dollars.21See Gold Reserve Inc. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/09/1, Award (September 22, 2014), ¶ 842 (citing to Duarte-Silva, supra note 65, to illustrate that a higher assumption concerning country risk by the respondent’s expert implied a discrepancy between the damages calculated by the claimant’s expert and the respondent’s expert of more than US$550 million, or almost 70 percent of the claimant’s expert’s figure).X21  Some tribunals examine various DCF calculations submitted by the parties to assess how sensitive the investment's implied valuation is to potential changes in future cash flows and discount rates.22Tethyan Copper v. Pakistan, ICSID Case No. ARB/12/1, Award (July 12, 2019), ¶ 887.X22  Others, however, tend to accept the investor's expert valuations with only minor adjustments.23Searby, supra note 73, at 249.X23  In both cases, tribunals heavily rely on the evidence presented by the parties when calculating compensation using the DCF method.

2. . . . Which Could Be Replicated Regarding Transition Risks

There is no telling whether the aforementioned inconsistencies are doomed to be replicated if transition risks were to be incorporated into the DCF method.  This is because arbitrators have historically always been quite opaque when approaching valuation questions, having addressed it at varying levels of transparency, detail and depth.24Id.X24  This failure to explain calculations can be explained by the high threshold set for the “failure to state reasons” annulment standard in ICSID arbitration.25See ICSID Convention (2006), art. 52(1)(e) (noting that one ground of annulment is “that the award has failed to state the reasons on which it is based”).X25  It transpires that aside from the exceptional annulment in MINE v. Guinea,26MINE v. Republic of Guinea (II), ICSID Case No. ARB/84/4, Decision for Partial Annulment of the Arbitral Award (December 22, 1989), ¶ 5.13.X26 the “failure to state reasons” standard has not yet been used in any other case to overturn a decision based on an inadequate explanation of valuation.  This opacity and failure to provide reasoned judgments contribute to the legitimacy crisis of the ISDS system as it “stifles the legitimacy-building effect of greater transparency.”27See Simmons, supra note 76, at 217.X27  But most importantly for our purposes, it prevents us from assessing and forecasting whether transition risks can be consistently applied and measured by arbitral tribunals.

C. Other Limitations

One implication of the proposal to integrate transition risks in quantum valuation is that measuring transition risks could create additional difficulties and, thus, additional costs.

Additional costs would be first incurred if the host state is suspected of having willingly disguised its expropriation intentions behind the enactment of environmental regulations pre-breach.  Generally, when approaching risk premiums, arbitral tribunals are wary not to reward the conduct of a state acting in bad faith.  As examined in Part 2, uncertain climate policies will increase transition risks, thus reducing the value of an asset and damages.  It may thus be tempting for states to willingly start decreasing the value of an asset by increasing transition risks via environmental regulation, even before the cause of harm (e.g. expropriation).28Duarte-Silva, supra note 65 (explaining that a state’s actions—even prior expropriation—can increase “country risk” and thereby diminish asset value by increasing regulatory or political uncertainty).X28  For example, a state might start introducing environmental regulations that do not directly expropriate the investment but that create an increasingly risky environment for the investment.  In such an instance, the question before a tribunal would be whether all risks should be incorporated prior to the valuation date, including risks protected by investment treaties.  

Tribunals have taken diverging approaches regarding these disputes.29Id. X29  The case of American International, cited in Occidental,30Occidental v. Ecuador (II), ICSID Case No. ARB/06/11, Award (Oct. 5, 2012), ¶ 542.X30 is particularly enlightening.  Paragraph 60 of the American International award states that “[i]n ascertaining the going concern value of an enterprise at a previous point in time for purposes of establishing the appropriate quantum of compensation for nationalization, it is . . . necessary to exclude the effects of actions taken by the nationalizing State in relation to the enterprise which actions may have depressed its value.”31American International Group, Inc. and American Life Insurance Company v. The Islamic Republic of Iran, IUSCT Case No.2, Award (December 19, 1983), ¶ 60.X31  Applied to FFPO disputes, it could be that the actions referred to are regulatory changes enacted to attain the Paris Agreement objectives.  It then becomes

necessary to distinguish the negative consequences on the value which were caused by the actions of the State from those negative consequences on the value caused by changes of the general political, social, and economic conditions.  The former must be excluded from the valuation because otherwise, the State would benefit from its own acts.  The latter, however, falls under the business risk.32Occidental v. Ecuador (II), ICSID Case No. ARB/06/11, Award (Oct. 5, 2012) ¶ 545 (citing to CALCULATION OF COMPENSATION AND DAMAGES IN INTERNATIONAL INVESTMENT LAW, supra note 66, to justify excluding the impact of “Law 42,” a windfall profits tax on oil revenues which the tribunal found to be an unlawful expropriation, from the DCF calculation).X32  

One can quickly see how differentiating between negative consequences caused by the actions of the State from those caused by external actions in the context of transition risks would require additional expert evidence and witnesses, thus occasioning additional costs.

An additional significant limitation to the incorporation of net-zero price expectations is that there is no industry consensus as to the appropriate energy forecasting model regarding the exact asset-level cash flow to use.  There are three main types of organisations publishing energy outlook reports:  oil companies, international energy agencies and international consulting firms.  However, all these organisations use different energy forecasting models, leading to different results.33In, supra note 82, at 4.X33  This is because “the spectrum of cash flow projections varies widely depending on asset profile, regional circumstances, market awareness, and financial contract, all of which need to be considered while the availability of the data required to do so is limited.”34Id. at 154.X34  

It is undeniable that there is great uncertainty about the future value of fossil fuels.  This is true, especially as commitments to decarbonise have shown signs of slowing in certain industries35Malcolm Moore, BP to Drill New Gulf of Mexico Field as Profits Beat Forecasts, FINANCIAL TIMES (July 30, 2024), https://www.ft.com/content/19f50a05-5e50-4e33-b585-f1d1ff090cbc.X35 and wars continue to break out.  However, the value of fossil fuels is far from being incalculable36Jay Cullen, After “HLEG”: EU Banks, Climate Change Abatement and the Precautionary Principle, 20 CAMBRIDGE Y.B. OF EUR. LEGAL STUD. 61, 80 (Aug. 30, 2018).X36 and an estimated average can be calculated from the various forecasting models.  At this stage, what is more important is not to arrive at a perfect measurement of transition risks but rather at a situation where transition risks are at least accounted for  However, doing so could once again drive up litigation costs.37Bonnitcha & Brewin, supra note 5, at 29.X37  As seen in Part 2, transition risks are difficult to quantify, and there is disagreement amongst experts on how to quantify them.  Additionally, just like country risks, the choice of an appropriate measure of country risks is a matter of judgment that depends on the available data, date of valuation and overall circumstances in which the valuation is being made.38Searby, supra note 73, at 246.X38  Relying on expert witnesses is already expensive as it is,39See, e.g., Tethyan Copper v. Pakistan, ICSID Case No. ARB/12/1, Award (July 12, 2019), ¶¶ 1824, 1831.X39 and it is believed that adding another complexity into the process, namely arguing that transition risks should be considered, only risks increasing litigation costs further.  This is particularly the case if transition risks are to be incorporated into the discount rate, as seen at the beginning of Part 4.

However, the benefits flowing from the recognition of transition risks in arbitral practice (Part 3) far outweigh the negatives.  Ultimately, the aforementioned limitations can be curtailed if the incorporation of transition risks within the DCF method is done in conjunction with other measures.  Other effective methods could include treaty reform introducing valuation provisions in BITs.  These provisions would establish the criteria and methods for valuing investments.40De Anzizu et al., supra note 54, at 16.X40  They could first impose an obligation on investors to consider transition risks when using any valuation method or, again, an obligation imposing that compensation reflects a balance between a range of competing facts.  These provisions could also require tribunals to determine the amount of compensation in accordance with the laws of the host state.41Bonnitcha & Brewin, supra note 5, at 35.X41

Arbitral practice, as well as legal and financial literature, demonstrates that incorporating transition risks into the DCF method can enhance the legitimacy of the ISDS system.  This is achieved by reducing excessive compensation, preventing investor windfalls, and aligning valuation methods in international investment arbitration with decarbonisation and economic realities.  The research found that transition risks are ready to be integrated at the cash flow stage, as reliable data on net-zero price adjustments have already been forecasted.  This data now requires practical application.  As discussed in Part 2, while this task also falls onto financial institutions, which have yet to accurately price transition risks, respondent's counsel can already begin instructing valuation experts to consider transition risks.

Overall, transition risks represent a sincere effort to align the arbitration community with economic and environmental realities.  However, in the absence of treaty reform on compensation, the implementation of this approach may continue to face obstacles.  Governments participating in the UNCITRAL Working Group III on ISDS reform can advocate for further work on damages related to fossil fuel investments.  Ultimately, as the arbitral and financial industries become more familiar with transition risks, they can establish guiding principles on valuation in the energy transition recognising the importance of accounting for transition risks.  But change needs to happen fast: as the climate crisis intensifies, parties to the ISDS system and financial institutions need to be swifter in incorporating transition risks into arbitral practices and start pricing these risks appropriately.