Klauberg Baltics - Business in good hands.

Free and Equitable Treatment vs the State’s right to regulate

Rebane, Kristiina: Free and Equitable Treatment vs the State’s right to regulate, in: Äripäev, 26.07.2019

A professional investor must consider all the circumstances before making an investment, including the possibility that the legal environment may change, writes Kristiina Rebane, a lawyer at Klauberg Baltics, analyzing a recent World Bank arbitral award in ICSID case ARB/14/24 in favor of the Estonian state.

Tallinn City water company AS Tallinna Vesi (ASTV) was privatized in 2001 by the British foreign investor United Utilities. The City of Tallinn retained its shareholding in the company and was a regulator of water prices until 2010. Until the fall of 2010, the company and the city regulated the price of water by a service agreement. In November 2010, an amendment to the water and sewage act was passed to transfer the regulator’s powers from the city to an independent regulator, the Estonian Competition Authority (ECA). In 2011, the ECA did not approve the ASTV application for a price increase and issued a precept to lower the water price of water. ASTV challenged the decisions in the national court system and in 2014 filed an application with the World Bank Arbitration to initiate arbitration proceedings against the Republic of Estonia under the Bilateral Investment Treaty (BIT). ASTV was of the opinion that the state and the ECA should regulate the price of water on the basis of the service agreement concluded between the city of Tallinn and the ASTV. The State and the ECA were of the opinion that the service agreement concluded between the City of Tallinn and the ASTV is not binding on the state and that the ECA has the right to apply its own methodology and to regulate the price of water according to its own methodology. The service agreement used a different methodology for regulating the water price, a methodology close to the one used by the British water regulator Ofwat.

What is the formula for the price of water?

On June 21, 2019, the World Bank Arbitration tribunal ruled that the Republic of Estonia did not violate the principles of fair and equitable treatment, of due process and did not discriminate the investor under the Bilateral Investment Treaty (BIT) and international law and clearly stated that the company had no legitimate expectation that the law would not change. The privatization agreements already concluded in 2001 clearly state that the company must always comply with the applicable law in addition to the provisions of the agreement. In addition, the privatization agreements provided for the possibility of a change
of the water regulator in the future. It is important to note in this connection that the part of the privatization services agreement concerning the pricing of the water (formula) is not an ordinary private contract, but an administrative contract concluded instead of issuing an administrative act. The interesting part here is that this administrative agreement is still in force up to today, but it is impossible to enforce the agreement due to a change in law.
The main issue in the dispute was what formula should be used to regulate the water price and whether the law or the privatization agreement should be the primary basis for determining the formula. The arbitral Tribunal’s ruling consistently focused its analysis on the principle of fair and equitable treatment of investors (the so-called FET test). The sovereign right of the State to establish and change the rules must be balanced by the legitimate expectation of the investor to earn a reasonable return on the investment made. Finding the right balance can be difficult and can lead to long and costly disputes. Just as public procurement law does not allow for arbitrary requirements, the change in laws must be handled in a balanced and fair way. The right of a State to amend an existing law should be consistent with a wider public interest. Transparency of the whole procedure as well as substantive stakeholder involvement and consultation is also very important. At the same time, it is important to note that the legitimate expectation of an investor is not a subjective category but an objective category based on the circumstances and taking into account the rights of the consumers. (World Bank Arbitration in El Paso Energy International Company v. Argentine Republic, ICSID Case No. ARB / 03/15). A professional investor must consider all the circumstances before making an investment, including the possibility that the legal environment may change.

There was no breach of the principle of fair and equitable treatment

The principle of fair and equitable treatment would have been violated if the investor had been able to demonstrate convincingly that changes to the regulatory environment were arbitrary, grossly unfair, one-sided in harming the company and contrary to the principle of due process. None of these circumstances were established. Back in 2001 the legal framework, namely the Public Water Supply and Sewerage Act was new and there was no implementation practice, so both the investor and the city of Tallinn lacked a clear idea of how to precisely define the terms „justified profitability“. It was clear that the law required that the water price should be cost-based, ie to take into account production costs, ensure safety, hygiene and environmental compliance, and allow the company to earn „justified profitability“. Amendments to the law passed by the parliament in 2010 (the so-called anti monopoly bill) added the phrase „from invested capital“ to justified profitability. The purpose of the amendment was to exclude the privatization price from being included in the assets of the company as it would have significantly changed the permissible water price. The Arbitration Tribunal acknowledged that the public discussion prior to the amendment of the Act, including the political discussion, focused to a significant extent on the water price in the service area of ASTV. The arbitral tribunal also accepted, in the light of the evidence, that the
additional phrase „invested capital“ was included in the Act mainly because of ASTV, as it would not have been relevant to any other water company operating in Estonia at that time.

There was no discrimination

However, the arbitral tribunal found that while such public and political debate may be questionable, it was not a violation of the principle of fair and equitable treatment because the investor had no legitimate expectation of a particular formula for calculating the water price. When creating and modifying a regulation, a state may choose between different solutions as long as the chosen solution is non-discriminatory and uniformly implemented. The arbitral tribunal added that an unreasonably high rate of return could be one of the legitimate motives for changing the legal framework. This is understandable, since the object of regulation is not only the interest of the investor to make a profit, but also the interest of the consumers to obtain a quality service at the lowest possible price.
The Arbitral Tribunal used in questions of interpretation of the Estonian law the rulings of the Supreme Court of Estonia in the national dispute between ASTV and the ECA. The arbitral award is also noteworthy in the international context, as arbitration as a tool to dispute resolution is criticized for concerns of transparency and high costs. Within the European Union, the direction has been taken to terminate bilateral investment treaties between Member States, and one of the main arguments against arbitration is the fact that arbitral tribunals are not bound by jurisprudence of the national courts of the member states nor by the jurisprudence of the European Court of Justice. In the case of ASTV vs Estonia, the Arbitral Tribunal has very well demonstrated that this is not the case and that national jurisprudence can elegantly and harmoniously work together with international law.