In the shadow of nationalisation in the UK: Implications for investors

In its manifesto for the 2017 general election, the UK Labour Party stated that it would "bring key utilities back into public ownership". The Party has since then developed this policy further, with the publication in May 2019 of "Bringing Energy Home: Labour's proposal for publicly owned energy networks"¹ - the Labour Party's nationalisation blueprint.

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Although the Labour Party is not currently in government, the possibility of a change of government cannot be ignored given the prevailing political situation in the UK. The fragility of the current Government means this could happen long before the next scheduled general election due in 2022. The possibility of nationalisation can therefore no longer be ignored and investors in the relevant sectors must be prepared.

Foreign investors may be able to seek redress in the event their assets are nationalised, pursuant to bilateral and multilateral investment treaties which preclude nationalisation in the absence of prompt, adequate and effective compensation. It will be key for foreign investors in potentially affected sectors to give early thought to the extent to which treaty protection is presently available, and if it is not, whether steps can now be taken to ensure such protection. Detailed advice should be sought from lawyers experienced in the field - while restructuring might be possible to ensure treaty coverage where it does not currently exist, this is an inherently risky area, and claims following a restructuring may be subject to challenge as an abuse of process.²

What has Labour proposed?

The Labour Party's May 2019 paper outlines its plans for nationalising both transmission and distribution networks, putting in their place a National Energy Agency (NEA), Regional Energy Agencies (REA), and, in some cases, Municipal Energy Agencies (MEA) and Local Energy Communities.

If the plans are implemented, Distribution Network Operators (DNOs) will be owned, maintained and run by REAs, which will effectively be public authorities. There will be consolidation of companies into one REA where more than one private company currently exists. In certain cases, distribution networks may be run at the country, metropolitan or borough level, with REAs being obliged to devolve ownership and operation of the network to the local authority led MEA.

Nationalisation will be effected through an Act of Parliament which will transfer ownership to the REAs. Compensation to existing shareholders would be paid in the form of Government bonds, with the level of compensation being decided by Parliament.

However, the paper states that compensation may be subject to deductions to account for pension fund deficits, asset stripping, stranded assets, the state of repair of assets, and state subsidies received by the relevant energy company since privatisation.

What about the UK's obligations under public international law?

It therefore appears that a Labour Government would pay only book value compensation. Indeed, it has been reported that Labour Party sources have said that payments would be pegged to book value (or alternatively regulated capital value - an estimate of a regulated business's value which is used to determine appropriate rates of return).³ This does not accord with the UK's obligations under public international law and, in particular, pursuant to bilateral investment treaties (BITs) and the Energy Charter Treaty (ECT) to which it is party.

Public international law is the body of law that binds states in their interaction with each other and with companies and natural persons having the nationality of the other contracting State. Its primary sources are treaties and customary law. It sits outside any national court system and the EU legal system. Rights granted or existing under public international law will therefore not be affected by Brexit or any domestic legislation passed by any future government.

Public international law may also provide foreign investors with a means of seeking redress in circumstances where they may have no contractual basis for pursuing remedies —for example, because the agreements underpinning their investments include provision for unilateral termination (where a likely area of dispute will be the amount of compensation due).

BITs are international agreements between two states, whereby each state grants reciprocal guarantees and protection for incoming investments made by investors from the other state. The ECT is a multilateral investment treaty (MIT) (a BIT signed by more than two State parties) which also contains provisions on investment protection applicable specifically to investments in the energy sector.

The UK is a signatory to 110 BITs (93 of which are in force) and the ECT (both as an EU Member State but also in its own right). The ECT has been signed or acceded to by 52 others, including the EU and Euratom.⁴ The ECT and UK's BITs contain provisions that permit nationalisation of investments made by foreign investors only in limited circumstances and upon payment of "prompt, adequate and effective" or "fair and equitable" compensation. Such provisions are likely to be of interest to foreign investors in the UK energy sector who will likely be affected by the Labour Party's plans to nationalise energy sector assets against only "book value" compensation. In order to take advantage of such protection, investors must satisfy the treaty definitions of "investor" and an "investment".

Scope of application

The ECT and UK's BITs only extend protection to "investments" by "investors". Additionally, as noted above, the ECT is limited in scope to the energy sector.

Who is an investor?

The majority of the UK's BITs define "investor" sufficiently widely to encompass most forms of corporate entity. The UK's Model BIT, upon which most of the UK's BITs are based, provides that "investor" includes both nationals under UK law (in the case of individuals) and businesses and companies registered under UK law. Also, the fact that the Model BIT does not contain a "denial of benefit clause" means that for any investors seeking relief pursuant to BITs which adopt the Model BIT form, an investor not having "substantial business activities" in the UK (i.e. "brass plate" or "mailbox" companies) will qualify for protection. However, a number of the UK's individually negotiated BITs (such as those with Colombia and the Philippines) do contain such a clause. There is significant investment into the UK energy sector from investors based in (or routing their investments through corporate vehicles based in) jurisdictions with which the UK has concluded a BIT (such as China, India, Singapore and Hong Kong).

The definition of an "investor" under the ECT is also broad, covering both natural persons with the citizenship or nationality of or permanent residence in an ECT Contracting State, and entities "organised in accordance with the law applicable in [an ECT Contracting State]". However, the ECT does have a separate "denial of benefits clause", which provides that Contracting Parties (including the UK) can deny the benefits of part III of the ECT (which includes the provisions relating to nationalisation) to any legal entities that do not have "substantial business activities in the Area of the Contracting Party in which it is organised".⁵

There is, therefore, potentially a higher hurdle to be met by foreign investors in the UK energy sector looking to rely on the provisions of the ECT (although, as noted above, while the UK's Model BIT does not have a denial of benefits clause, many of the UK's concluded BITs do contain such a provision). Given the number of states that have ratified the ECT, and the inclusion of many of the developed economies from which investments in the UK energy sector have been made, the ECT is likely to be of particular significance.

What is an "investment"?

BIT definition

The UK Model BIT defines an "investment" as "every kind of asset, owned or controlled directly or indirectly, and in particular, though not exclusively, includes:

• movable and immovable property and any other property rights such as mortgages, liens or pledges; shares in and stock and debentures of a company and any other form of participation in a company;
• claims to money or to any performance under contract having a financial value;
• intellectual property rights, goodwill, technical processes and know-how; and
• business concessions conferred by law or under contract, including concessions to search for, cultivate, extract or exploit natural resources."

This means that even foreign investors who indirectly own an investment in the UK may be entitled to protection.

ECT definition

The definition of an "investor" under the ECT is similarly broad in scope and covers a multitude of energy sector assets. In particular, the ECT expressly makes clear that, in addition to physical assets, company shares, stock, and other forms of equity participation in a business, "investment" includes "any right conferred by law or contract or by virtue of any licences and permits granted pursuant to law to undertake any Economic Activity in the Energy Sector".⁶

"Economic Activity in the Energy Sector" is defined as "economic activity concerning the exploration, extraction, refining, production, storage, land transport, transmission, distribution, trade, marketing, or sale of Energy Materials and Products except those included in Annex NI, or concerning the distribution of heat to multiple premises".⁷ "Energy Materials and Products" is a similarly broad term, encompassing a range of nuclear, coal, natural gas, petroleum, petroleum products, electrical energy and fuel wood products.

Restrictions on nationalisation

While no two BITs are identical, each being a product of negotiation between the UK and the counterparty state, there are common themes in terms of how
different BITs deal with expropriation or nationalisation. In general, the UK's BITs:

• set out the circumstances in which an expropriation will be lawful, usually where it is for a public purpose and conducted in a non-discriminatory manner; and
• require that prompt, adequate and effective compensation is paid to any affected investors.

A good example is the UK's Model BIT, which provides as follows:

"Investments of nationals or companies of either Contracting Party shall not be nationalised, expropriated or subjected to measures having effect equivalent to nationalisation or expropriation (hereinafter referred to as "expropriation") in the territory of the other Contracting Party except for a public purpose related to the internal needs of that Party on a non-discriminatory basis and against prompt, adequate and effective compensation".⁸

Helpfully, the Model BIT refers expressly to "nationalisation". It also makes clear that measures falling short of full nationalisation, but having effect equivalent to nationalisation or expropriation, may also be within the scope of the clause, and therefore compensable.

Any government seeking to effect nationalisation would have to justify its nationalisation attempts by reference to the public purpose exception and the requirement for prompt, adequate and effective compensation. These legal obligations could be put to use in lobbying against nationalisation.

The ECT provides similar standards of investment protection as the UK Model BIT. Like the UK Model BIT, the ECT contains an express prohibition on nationalisation without compensation.

Article 13 provides that:

"Investments of Investors of a Contracting Party in the Area of any other Contracting Party shall not be nationalised, expropriated or subjected to a measure or measures having effect equivalent to nationalisation or expropriation [...] except where such Expropriation is:

• for a purpose which is in the public interest;
• not discriminatory;
• carried out under due process of law; and
• accompanied by the payment of prompt, adequate and effective compensation."

"Adequate" compensation

The reference to "adequate" compensation in the UK Model BIT and the ECT is likely to be interpreted by an arbitral tribunal as fair market value (FMV), which is also the standard under customary international law.

The ECT expressly provides for investors to be paid "the fair market value of the Investment expropriated at the time immediately before the Expropriation or impending Expropriation became known in such a way as to affect the value of the Investment"; including "interest at a commercial rate established on a market basis from the date of Expropriation until the date of payment".

By contrast, Article 5(1) of the UK Model BIT states (consistently with many of the BITs signed by other states) that the amount of compensation to be paid upon nationalisation should amount to "the genuine value of the investment expropriated immediately before the expropriation or before the impending expropriation became public knowledge, whichever is the earlier",⁹ with provision also being made for the payment of interest on such compensatory sums.

The World Bank Guidelines on the Treatment of Foreign Direct Investment provide that, in the absence of an agreed method, the FMV will be acceptable if determined by the State according to reasonable criteria related to the market value of the investment. The test is typically what a willing buyer would normally pay to a willing seller after taking into account the nature of the investment, the circumstances in which it would operate in the future, and its specific characteristics (including the period in which it has been in existence, the proportion of tangible assets in the total investment and other relevant factors pertinent to the specific circumstances of each case).

The World Bank guidelines provide that a determination of the FMV of a going concern with a proven record of profitability would be deemed reasonable if it is based on the discounted cash flow (DCF) value - that is, a valuation based on the cash receipts realistically expected from the entity in each future year of its economic life as reasonably projected minus that year's expected cash expenditure, and after discounting the net cash flow for each year by a factor reflecting the time value of money, expected inflation and the risk associated with such cash flow under reasonable circumstances.

The guidelines and the DCF method are frequently applied by arbitral tribunals in assessing claims for compensation for nationalisation and expropriation under BITs. One example is the award in Guaracachi America, Inc. and Rurelec PLC - v- Bolivia (PCA 2011-17), which involved claims for compensation for nationalisation of a power company under the UK-Bolivia BIT. The arbitral tribunal applied the DCF method and awarded the claimant nearly USD 29 million. In that case, the tribunal also noted in passing that a valuation based on book value is of "limited value".

Redress for investors

A failure to pay adequate compensation upon nationalisation would clearly infringe the protections guaranteed by the ECT and certain of the UK's BITs.

Even if compensation is to be paid, the difficulties of ascertaining the "genuine value" of energy sector investments prior to nationalisation, particularly in circumstances where Brexit may have impacted their value prior to any nationalisation or threats of such action, may mean that there is still scope to pursue the state for a breach of its obligations.

The protection against nationalisation provided for in the UK's BITs and the ECT is effective because those treaties also afford to investors a direct cause of action against the State. All of the UK's BITs grant foreign investors the right to commence arbitration proceedings (known as an investor-state dispute settlement, or ISDS provision).

The ISDS provision in the UK's Model BIT provide for arbitration under the rules of either the International Centre for Settlement of Investment Disputes (ICSID), the International Chamber of Commerce in Paris (ICC), or on an ad hoc basis subject to the rules of the United Nations Commission on International Trade Law (UNCITRAL).The forms of arbitration permitted under the ECT differ slightly to those provided for under the UK Model BIT. In addition to ICSID and UNCITRAL arbitration, arbitration under the rules of the Stockholm Chamber of Commerce (SCC) is possible, as is arbitration under the ICSID Additional Facility (the ICSID Additional Facility provides investors with a means of commencing arbitration proceedings against States that have not signed the ICSID Convention).¹⁰

The potential use of such arbitration mechanisms can cause States concern. ICSID is a World Bank institution, and so proceedings commenced under its arbitral rules carry with them reputational issues. ICSID arbitration is more "public" than arbitration under other institutional rules —the ICSID arbitration rules contain no general presumption that the proceedings will be confidential, and the Centre publishes online details of all requests for arbitration filed, including the names of the parties involved. Proceedings subject to the UNCITRAL Rules are also likely to give rise to publicity and reputational concerns. That is because the UNCITRAL arbitration rules were updated in 2013 to incorporate the UNCITRAL Rules on Transparency in Treaty-based Investor-State Arbitration (the Transparency Rules), a set of rules which provide guidelines aimed at making investor-state arbitration proceedings more transparent and accessible to the public. (The rules can be applied in any arbitration (e.g. ICC and ICSID arbitrations) with the consent of the parties.) The fact that the Transparency Rules are already incorporated into the UNCITRAL arbitration rules means that any UNCITRAL arbitration commenced under a UK BIT upon nationalisation of energy sector assets would be fully transparent. In other words, any written submissions and documents used in the proceedings, and the award and hearing transcripts, would be made public. Hearings would also be open for the public to attend. Parties can seek to disapply the Transparency Rules, but the fact that they apply by default makes the prospect of UNCITRAL proceedings unattractive for those who would prefer not to "wash their dirty linen in public".

The risk of a very public dispute (whether under the UNCITRAL Rules or otherwise), and one likely to be of interest to other energy sector investors considering similar action, is something that the UK may prefer to avoid. Awareness of the ability to take such action may provide leverage to influence the UK Government's nationalisation policy. It would even be open to an investor to commence proceedings with the primary goal of bringing relevant government documents into the public domain.

Conclusion

If a future Labour government offers compensation for shareholders in nationalised companies calculated by reference to book value, it may face claims from shareholders who enjoy investment treaty protection on the basis that they are entitled to fair market value for their assets.
The rights of foreign investors to pursue claims directly against the UK Government in the event of nationalisation without adequate compensation puts those investors in a powerful position. Those responsible for advising boards of companies holding investments in the UK, and particularly the energy sector - including those who may hold them indirectly - will want to take full account of an area of law they may never have thought relevant to their activities in a developed European economy. While the idea of exercising the "nuclear option" of commencing an arbitration claim against the UK might seem far-fetched, the importance of understanding the legal rights and obligations that would underpin any such claim cannot be underestimated.

1. Bringing Energy Home; Labour's proposal for publicly owned energy networks (May 2019).
2. For more on the topic of restructuring investments, see our earlier article "Investment protection: managing investment risk in an uncertain world".
3. Investors attack Labour’s renationalisation plans, The Financial Times, 29 May 2019.
4. All but three signatory states (Australia, Russia and Norway) have ratified the ECT. In more recent years, Russia and Italy have withdrawn from it.
5. ECT, Article 17(1).
6 ECT, Article 1(6).
7 ECT, Article 1(5).
8. UK Model BIT, Article 5(1).
9. Ibid.
10. The EU, Euratom, Liechtenstein, Poland and Tajikistan have signed the ECT but not the ICSID Convention.