Investor-State Dispute Settlement (ISDS) Reform - Balancing Investor Protection And State Sovereignty

Author: LawSphereX

Category: General Law

Published: 2026-08-23T20:23:27.107012+00:00

Updated: 2026-08-26T17:11:00.522+00:00

INVESTOR-STATE DISPUTE SETTLEMENT (ISDS)

REFORM: BALANCING INVESTOR PROTECTION AND

STATE SOVEREIGNTY

Shshank Rai, University School of Law and Legal Studies

ABSTRACT

The following paper discusses current debates and reform efforts that circle the mechanism of Investor-State Dispute Settlement. Although ISDS provides a means for resolving disputes between foreign investors and host states, it has been criticized for its potential to undermine state sovereignty and regulatory autonomy. Among other things, this paper will focus on some of the key cases, pointing out transparency and partiality problems, high costs, and related issues with ISDS procedures. It considers some of the new generation initiatives executed to revamp the system in terms of betterment about fairness and balancing of interests between investors and host states.

In this context, it looks into the reforms being undertaken to outline the future path that ISDS may take, and to apprise the challenges involved in the endeavour of institutionalizing a fair and more transparent framework for dispute resolution.

1. Introduction

ISDS, or Investor-State Dispute Settlement, is a mechanism found in numerous trade and investment agreements designed to resolve disputes through arbitration instead of public courts. These agreements allow a company from one signatory country that invests in another signatory country to claim that new laws or regulations might adversely impact its expected profits or investment potential. The company can then seek compensation through a binding arbitration tribunal, often amounting to millions or even billions of US dollars. 1 Investor-State Dispute Settlement (ISDS) is a provision within free trade agreements (FTAs) or investment treaties that grants foreign investors, including Indian investors abroad, the ability to bring their investment disputes before an international tribunal for resolution. 2 How does it work?

The process begins with each party to the dispute namely, the investor making the accusation and the defendant state appointing one arbitrator each. Together, they agree on a third arbitrator. These three arbitrators then convene in an international arbitration tribunal to hold hearings. The specific tribunal to be used is typically outlined in the treaty. The hearings and their outcomes are generally kept confidential. 3 What is the purpose of ISDS and why is it needed? Without ISDS, many foreign investors would lack effective recourse against arbitrary, capricious, or otherwise unfair treatment by a host state. In the past, foreign investors had to resolve disputes with host states in the host state's local courts.

However, they often struggled to secure full—or any—compensation due to various obstacles, such as inadequate protections under local law, domestic sovereign or crown immunity rules, and a lack of judicial independence. Diplomatic intervention on behalf of the foreign investor was inconsistent and often inappropriate for resolving disputes. State-to-state dispute resolution mechanisms tended to politicize what were essentially private disputes.

1 The basics, isds.bilaterals.org, https://isds.bilaterals.org/the-basics.

2 Department of Foreign Affairs and Trade, Investor-state dispute settlement (ISDS) | DFAT, Dfat.gov.au (2018), https://www.dfat.gov.au/trade/investment/investor-state-dispute-settlement.

3 Supra note 1

ISDS was partly developed to depoliticize these disputes by taking them out of the realm of diplomacy and inter-state relations. 4 What protection and remedies it offers? Arguably, the most crucial procedural protection is the right to have disputes resolved in a neutral forum, before impartial adjudicators, and in accordance with transparent rules. Common substantive protections, the breach of which may lead to an ISDS claim, include fair and equitable treatment, full protection and security, national treatment, most favoured nation treatment, no expropriation without full (and prompt) compensation, and the free transfer of capital. Monetary compensation is the most typical remedy. However, in some cases, other remedies such as declaratory relief and restitution may also be available.

Interim relief during ongoing proceedings may be granted, including interlocutory measures to compel or restrain a party from certain actions (such as those that might aggravate the dispute or render it moot). 5 Purpose for the article The purpose of this article is to critically analyse the urgent need for reform within the Investor- State Dispute Settlement (ISDS) framework. This article will explore the intricate balance between protecting the rights of foreign investors and maintaining the sovereignty and regulatory autonomy of states. By examining current reform efforts, such as those led by UNCITRAL and the European Union, this paper will shed light on the benefits and criticisms of ISDS. Additionally, it will offer insights into how these reforms can be implemented to create a more fair and transparent system.

Through a detailed examination of key case studies and ongoing reform initiatives, this article aims to provide a comprehensive understanding of the challenges and potential solutions in achieving a balanced ISDS mechanism that serves the interests of all stakeholders.

2. Criticisms and controversies

ISDS has been under constant criticism and controversy for a long time now, since we are 4 Norton rose Fulbright, Frequently asked questions about investor-state dispute settlement | Global law firm | Norton Rose Fulbright, www.nortonrosefulbright.com, https://www.nortonrosefulbright.com/en/knowledge/publications/8014c6b7/frequently-asked-questions-aboutinvestor-state-dispute-settlement#section3 (last visited Jul 21, 2024).

5 Ibid.

aware of what ISDS is and how it functions, we can understand these points of criticism better. i) Regulatory confinement One of the biggest criticisms for the use of ISDS is the confinement it puts into practice on the regulatory capacity of the state in the matters of social welfare, public health, human rights, and environmental protection. In a study conducted by David R. Boyd, The United Nations special Rapporteur, in July 2023 has produced shocking results stating that ISDS has turned into a major obstacle in the way of implementing protective measures against environmental and human rights crisis. 6 Some critics argue that ISDS threatens democracy and the rule of law. ii) Transparency In the global trade and investment arena, confidential investor-state proceedings remain contentious.

Corporations, host states, and civil society organizations are increasingly concerned about the lack of transparency in dispute adjudication, which often occurs in private forums away from the scrutiny of interested and affected third parties. 7 This opaqueness in Investor-State Dispute Settlement (ISDS) procedures fuels mistrust and raises questions about accountability and fairness. Critics argue that without adequate transparency, the process can be manipulated to Favor powerful investors at the expense of public interest, undermining the legitimacy of the system as a whole. Consequently, there are growing calls for reforms to introduce more openness and ensure that all stakeholders have access to vital information about the proceedings and decisions.

iii) Bias and conflict of interest In global investment arbitration, allegations of bias and conflicts of interest threaten the trust in Investor-State Dispute Mechanisms (ISDMs). Arbitrator impartiality, crucial for fair dispute resolution, is often questioned, leading to scrutiny of potential entanglements. The frequent movement of individuals between roles as judges and advocates heightens scepticism, putting

6 David R. Boyd, A/78/168: Paying polluters: the Catastrophic Consequences of investor-State Dispute

Settlement for Climate and Environment Action and Human Rights, United Nations (2023), https://www.ohchr.org/en/documents/thematic-reports/a78168-paying-polluters-catastrophic-consequencesinvestor-state-dispute (last visited Jul 23, 2024). 7 Christina Wittmeier, Understanding Problems With Investor State Dispute Mechanisms, Transnational Matters (2023), https://www.transnationalmatters.com/understanding-problems-with-investor-state-disputemechanisms/.

the appointment procedures of arbitrators under close examination. These concerns drive debate and call for a thorough evaluation of how impartiality impacts the outcomes of investment disputes and the broader international investment landscape. 8 iv) Duration and Cost Arbitration was initially designed to be a relatively quick and low-cost method of resolving disputes. However, concerns have arisen regarding the increasing costs and lengthy proceedings associated with ISDS cases. These issues are partly due to the complexity of the cases, the fragmented nature of investor protection provisions, and the open-ended nature of many legal issues in dispute, which necessitate extensive examination of numerous prior arbitral awards and other legal sources. Certain respondent states may find it challenging to allocate the significant resources required to defend against an ISDS case.

States, in general, face criticism for the use of public funds in defending these cases, especially since arbitral tribunals have typically not required a losing claimant investor to cover the winning state's costs. 9

3. Reforms

Investor-State Dispute Settlement (ISDS) has faced significant scrutiny and criticism over the past decade, prompting various reform efforts aimed at addressing its perceived shortcomings. Key international bodies and regions have spearheaded these reforms to create a more balanced, transparent, and fair system. Notable among these efforts are the initiatives by the United Nations Commission on International Trade Law (UNCITRAL) Working Group III and the European Union's Investment Court System (ICS). i) UNCITRAL, Working Group III UNCITRAL Working Group III has been a central player in the push for ISDS reform since it was mandated in 2017 to explore possible improvements. The group's reform agenda targets three primary areas: the consistency and coherence of arbitral decisions, transparency and legitimacy, and the overall cost and duration of ISDS proceedings.

One significant criticism of

8 Ibid.

9 United Nations Commission on International Trade Law Working Group III (Investor-State Dispute Settlement Reform), (2017), https://documents.un.org/doc/undoc/ltd/v17/067/48/pdf/v1706748.pdf?token=vOAncaEDG2WYtqLv2L&fe=tru e (last visited Aug 3, 2024).

ISDS is the lack of consistency in arbitral awards, with different tribunals often interpreting similar clauses in divergent ways, leading to unpredictability. To address this, UNCITRAL Working Group III has proposed the establishment of an appellate mechanism that would review ISDS awards to ensure uniformity and coherence in legal interpretations. Transparency and legitimacy are also major concerns within ISDS. Critics argue that the opacity of ISDS proceedings undermines public trust and accountability. In response, the Working Group has advocated for increased transparency measures, such as public access to hearings and the publication of arbitral decisions. Additionally, proposals for a code of conduct for arbitrators are being considered to enhance the legitimacy and ethical standards of the process.

The high cost and lengthy duration of ISDS cases can be prohibitive for both investors and states. The Working Group is exploring various procedural reforms aimed at streamlining the arbitration process, reducing costs, and making it more accessible, especially for smaller investors and developing countries. 10 ii) European Union’s Investment Court System (ICS) The European Union has been particularly proactive in proposing an alternative to the traditional ISDS model through its Investment Court System (ICS). The ICS aims to address many of the criticisms levelled at ISDS by introducing a more structured and judicial approach to resolving investment disputes. The ICS features a permanent tribunal with a first instance tribunal and an appellate tribunal.

Judges, appointed by the contracting states, serve on a fixedterm basis, contrasting with the ad-hoc appointment of arbitrators in traditional ISDS. This structure is intended to enhance the independence and impartiality of the decision-makers. Similar to the UNCITRAL proposals, the ICS emphasizes transparency by mandating public hearings and the publication of documents and decisions. The system also includes provisions for third-party participation, allowing for greater public involvement and scrutiny. The appellate mechanism within the ICS ensures that decisions can be reviewed and corrected, promoting consistency and predictability in the interpretation of investment treaties. This appellate body addresses the criticism of inconsistent rulings that have plagued traditional

ISDS.11

10 Ibid.

11 Jus Mundi, Wiki Note: Investment Court System, jusmundi.com,

https://jusmundi.com/en/document/publication/en-investment-court-system.

4. Case Studies

i) Philip Moore v/s Australia The Philip Morris vs. Australia case arose when Philip Morris Asia challenged Australia's plain packaging laws for tobacco products, claiming they violated bilateral investment treaties. Australia argued that the laws were a public health measure. The tribunal dismissed the case in 2015, ruling that Philip Morris had restructured its investments to exploit treaty protections after the dispute had become foreseeable, which constituted an abuse of rights. 12 This case highlighted the potential for investors to manipulate treaties to their advantage, prompting calls for stricter definitions of investor and investment eligibility in ISDS agreements. It also underscored the need for clearer provisions that protect states' rights to implement public health measures without facing litigation.

The tribunal's dismissal based on procedural grounds rather than substantive issues raised concerns about the efficiency and focus of ISDS proceedings, fuelling the push for a more balanced and streamlined dispute resolution process. ii) B. Vattenfall vs. Germany

The Vattenfall vs. Germany case involved the Swedish energy company Vattenfall challenging Germany's decision to phase out nuclear power following the Fukushima disaster. Vattenfall claimed this decision breached the Energy Charter Treaty by reducing the value of its investments in German nuclear plants. The case was settled in 2021, with Germany agreeing to compensate Vattenfall approximately €1. 4 billion. 13 This case emphasized the tension between investor protections and state regulatory autonomy, particularly in environmental and energy policy. It highlighted the risk that ISDS could impede states' ability to make sovereign decisions in response to public concerns.

As a result, the case has fuelled arguments for ISDS reform to ensure that states can implement policy changes, especially those related to environmental protection and public health, without fear of costly 12 Philip Morris Asia Limited v. The Commonwealth of Australia, UNCITRAL, PCA Case No. 2012-12, (2015), https://www. italaw. com/cases/851. 13 Daniela Páez-Salgado, A Battle on Two Fronts: Vattenfall v. Federal Republic of Germany, Kluwer Arbitration Blog (2021), https://arbitrationblog. kluwerarbitration. com/2021/02/18/a-battle-on-two-fronts-vattenfall-vfederal-republic-of-germany/.

litigation. This has led to calls for clearer exceptions and safeguards in investment treaties to preserve regulatory space for public interest measures.

5. Conclusion

The need for reform to the Investor-State Dispute Settlement system is patently obvious from its criticisms, most especially in regard to state sovereignty and regulatory autonomy. Cases such as Philip Morris vs. Australia and Vattenfall vs. Germany have exemplified the struggles of states in putting in place public health and environmental policies where there is always the threat of very expensive arbitration. Issues of greater importance are transparency, possible bias and conflicts of interest of arbitrators, and the rising costs and duration. The wide-ranging reform efforts these have spawned concern, most importantly, the UNCITRAL Working Group III and the Investment Court System proposed by the European Union. While the proposed

UNCITRAL appellate mechanism tries to ensure greater consistency and predictability of arbitral decisions, the ICS enhances the independence and impartiality of the decision-makers under a more structured and judicial approach. Even so, reforming a more balanced ISDS requires great care. Reforms should protect the rights of investors but, at the same time, must respect the possibility for States to regulate in the public interest. It is of key importance that on one hand, the core purpose of ISDS as a neutral forum for dispute resolution be maintained, and on the other, the system made accessible to all, including small investors, and developing countries.

In other words, any reform to ISDS must be oriented to the establishment of a fair and transparent system that respects both investor protection and state sovereignty and is, therefore, in a position to offer a well-balanced approach to the resolution of investment disputes at an international level.