An optimal investor state dispute settlement mechanism Frank St¨ ahler University of T¨ ubingen, University of Adelaide and CESifo Norwegian School of Economics May 19, 2016 St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 1 / 20
Background and motivation I Trade and Investment Partnership (TTIP) and the Trans-Pacific Partnership Agreement (TPP): investor protection through an ISDS provision. ISDS: compensate foreign investors if host country government policies are causing “unjustified” harm. If there is a case for (special) foreign investor protection: existence of a holdup problem; the investor is “locked in” after the investment has been made. Two conditions: (i) incomplete contracts; (ii) relation-specific investment. OECD (2012): ISDS provisions to be present in as many as 93%, or some 3.000 agreements. Explanation: developing countries compete for FDI with ISDS provisions. Literature: BITs increase FDI, but ISDS provisions do not. St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 2 / 20
Background and motivation II Kohler and St¨ ahler (2016): compare an ISDS provision with a national treatment provision. Here: ISDS provision not given. Q: How should it be designed? In particular: Q: Does an optimal ISDS mechanism exist that does not rely on third party verification? A: Yes! Q: Does this mechanism need an arbitrator? A: Yes! Q: Has this mechanism much in common with recent ISDS designs? A: No! Implication: an active role of supranational institutions is needed for efficient investor protection. St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 3 / 20
The model I Prior to the game played here, there has been an investment stage that we do not consider in detail. For now, we assume that the investment has been made. Maximized investor profit depends negatively on the activity level a : π ( a ) : π ′ ( a ) < 0, π ′′ ( a ) ≤ 0, ∃ ¯ a > 0 : π ( ¯ a ) = ¯ π ≥ 0. Implication: investor leaves the country if a > ¯ a . Marginal domestic welfare depends positively on the realization of a stochastic variable θ that measures the degree of intervention necessity. Both the government and the investor anticipate that θ ∈ [ θ , θ ] , 0 < θ < θ < ∞ and is distributed according to the c.d.f. G ( θ ) . St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 4 / 20
The model II Importantly, this realization becomes known at least to the government and the investor, but cannot be verified by the arbitrator or any other third party. Domestic welfare: � 0 if π ( a ) < ¯ π , W = v ( θ , a ) > 0 if π ( a ) ≥ ¯ π , where v ( θ , a ) : v a ( θ , 0 ) > 0, v aa ( · ) < 0, v θ a ( · ) > 0, ∃ ˜ a ( θ ) > 0 : v a ( θ , ˜ a ( θ )) = 0. Holdup problem: Without any investor protection, the government and the investor play a two-stage game: in the first stage, the government sets a , and in the second stage, the investor decides whether to leave or to stay. Implication: If ¯ a < ˜ a ( θ ) , the government will set a = ¯ a , and if a ≥ ˜ a ( θ ) , the government will set a = ˜ a ( θ ) . ¯ St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 5 / 20
The model III The investor, anticipating this outcome, may not make any investment to begin with. What if contracts were complete and enforceable? Both parties maximize aggregate welfare such that v a ( θ , a ∗ ( θ )) + π ′ ( a ∗ ( θ )) = 0, ∀ θ ∈ [ θ , θ ] holds. Note that a ∗′ ( θ ) > 0. If the optimal policy could be implemented, the entry decision would also be optimal at the investment stage. St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 6 / 20
An optimal ISDS mechanism I The proposed mechanism is an extension and modification of a mechanism suggested by the implementation literature (see Moore and Repullo, 1988, and Maskin and Tirole, 1989). Basic idea: the government will announce an intervention necessity ˆ θ . The true θ can be observed at least by the government and the investor, but ˆ θ cannot be proven true or false by any third party. However, the investor, being familiar with the implications of her investment, can challenge this announcement, and any challenge will have implications for both the investor and the government that will be managed by the arbitrator. Here are the details ( ISDS mechanism I ): Stage 1: The government and the investor agree on the optimal action plan a ∗ ( ˆ θ ) , on alternative action plans a 2 ( ˆ θ ) and a 1 ( ˆ θ ) and transfer schemes F 1 , F 2 , T ( ˆ θ ) . The alternative action plans fulfil the following requirements. ∀ ˆ θ ∈ [ θ , θ ] : St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 7 / 20
An optimal ISDS mechanism II a ∗ ( ˆ θ ) ≥ a 2 ( ˆ θ ) > a 1 ( ˆ θ ) , and a ′ 2 ( ˆ θ ) , a ′ 1 ( ˆ θ ) > 0. Stage 2: The government announces ˆ θ . Stage 3: The investor may challenge the announcement ˆ θ . If she does not, action plan a ∗ ( ˆ θ ) is implemented, no transfers are paid and the game is over. If she does, the government has to make an upfront payment of size F 1 to the arbitrator. Stage 4: If ˆ θ has been challenged, the government is offered to continue with action plan a 1 ( ˆ θ ) for which it will receive a transfer T ( ˆ θ ) from the arbitrator. Otherwise action plan a 2 ( ˆ θ ) is implemented. If the government accepts, action plan a 1 ( ˆ θ ) is implemented, the government receives T ( ˆ θ ) from the arbitrator and the investor receives F 1 − T ( ˆ θ ) from the arbitrator. If the government rejects, a 2 ( ˆ θ ) is implemented and the investor has to pay F 2 to the arbitrator. St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 8 / 20
An optimal ISDS mechanism III Suppose that the transfer in Stage 4 to the government when accepting a 1 ( ˆ θ ) is given by T ( ˆ θ ) = v ( ˆ θ , a 2 ( ˆ θ )) − v ( ˆ θ , a 1 ( ˆ θ )) > 0. (1) T ( ˆ θ ) depends only on the announcement, and since v a ( · ) > 0 and a 2 ( ˆ θ ) > a 1 ( ˆ θ ) , T ( ˆ θ ) is unambiguously positive. Proposition If T ( ˆ θ ) is set according to (1) and both F 1 and F 2 are sufficiently large, ISDS mechanism I will imply the optimal action plan a ∗ ( θ ) as a subgame-perfect equilibrium. Go to details Obvious: the government has no incentive to under-report θ . St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 9 / 20
An optimal ISDS mechanism IV Hence, the government should only be challenged if ˆ θ > θ (appropriate challenge) and should not be challenged in all other cases (inappropriate challenge). The transfer scheme T ( ˆ θ ) is designed such that only appropriate challenges will be accepted: The government will accept the offer to continue with action plan a 1 ( ˆ θ ) only if v ( θ , a 1 ( ˆ θ )) + T ( ˆ v ( θ , a 2 ( ˆ θ ) θ )) ⇔ > v ( ˆ θ , a 2 ( ˆ θ )) − v ( ˆ θ , a 1 ( ˆ v ( θ , a 2 ( ˆ θ )) − v ( θ , a 1 ( ˆ θ )) θ )) ⇔ > ˆ θ , θ > where the last line follows from v θ a ( · ) > 0: let φ ( x ) = v ( x , a 2 ( ˆ θ )) − v ( x , a 1 ( ˆ θ )) . Then, St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 10 / 20
An optimal ISDS mechanism V φ ′ ( x ) = v x ( x , a 2 ( ˆ θ )) − v x ( x , a 1 ( ˆ θ )) > 0 because v xa ( · ) > 0 and a 2 ( ˆ θ ) > a 1 ( ˆ θ ) . Thus, φ ( x ) increases with x and φ ( x ) > φ ( θ ) for all x > θ . Consequently, an inappropriate challenge will never imply the alternative action plan a 1 ( ˆ θ ) but a 2 ( ˆ θ ) . Let us check now the conditions: Appropriate challenge condition: The investor will challenge the government if π ( a 1 ( ˆ θ )) + F 1 − T ( ˆ θ ) ≥ π ( a ∗ ( ˆ θ )) . (always fulfilled since F 1 ≥ T ( ˆ θ ) and π ( a 1 ( ˆ θ )) > π ( a ∗ ( ˆ θ )) ). Inappropriate challenge condition: The investor will not challenge the government if π ( a 2 ( ˆ θ )) − F 2 ≤ π ( a ∗ ( ˆ θ )) , St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 11 / 20
An optimal ISDS mechanism VI Truth-telling condition: The government will not over-report if v ( θ , a ∗ ( θ )) ≥ v ( θ , a 1 ( ˆ θ )) + T ( ˆ θ ) − F 1 A sufficiently large F 1 and F 2 do the job. Go to details Here: transfer is paid for a less ambitious action plan a 1 . Q: Is it possible that the government, after being challenged, will be offered to return to the more ambitious action a 2 by paying instead of receiving a transfer? St¨ ahler (T¨ ubingen, Adelaide, CESifo) An optimal ISDS mechanism NHH, May 19, 2016 12 / 20
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