A Pareto-Improving Compensation Rule for Investment Treaties

Abstract

Investment treaties currently address two conceptually distinct economic problems. The first is dynamic inconsistency of host state policy – i.e. the possibility that a host state will offer attractive conditions to new foreign investment and then renege on the bargain once the investment has been made. The second is a broader problem that the host state may undervalue foreign investors’ interests when responding to new information throughout the life cycle of the investment.

There are three reasons to distinguish problems of dynamic inconsistency from problems of new information. First, the original economic and political justifications offered for these treaties were grounded in their ability to solve problems of dynamic inconsistency. Second, as we show in this paper, solving problems of dynamic inconsistency generally increases both host and source country welfare. In contrast, redressing a broader tendency for the host state to undervalue foreign investors’ welfare when responding to new information does not necessarily increase host country welfare. In other words, a tendency to undervalue foreign investors’ welfare is not a “problem” at all from a host country perspective. Third, as an empirical matter, there are doubts about whether foreign investors’ welfare is consistently undervalued within host state decision-making.

We propose a solution which maintains protection for investors from opportunistic/predatory actions by host states, while allowing host states the flexibility to change rules and regulations in response to new information about the social costs and benefits of an investment. Our solution comes in the form of an integrated liability rule and compensation standard that defines both when a state should be required to compensate an investor for adverse government action and how much compensation should be required.

Keywords: investment treaties; expropriation; regulatory change; compensation; dynamic inconsistency; hold up problem; new information; law and economics

JEL Classification: D60; F21; F63; K11; K33