Stabilization Clauses: The hidden provisions that can hinder tax and investment policy reform

Stabilization clauses are provisions in investor–state contracts designed to protect the investor from changes in the host country's laws or regulations that could affect their operations.

The term might not immediately get your pulse going. But developing countries must get their approach to these increasingly contentious clauses in investment contracts right to protect and promote revenue collection and attract foreign investment that supports sustainable development, human rights, and a just energy transition.

Stabilization clauses will be on the agenda at next week's session of the International Institute for the Unification of Private Law and the International Chamber of Commerce Institute of World Business Law Working Group on International Investment Contracts.

Launched in 2023, the Working Group is looking to develop guiding Principles, model provisions, and commentary for investment contracts. While these address corporate social responsibility and sustainability, the Working Group's guidance is also set to include stabilization clauses. This means there's a risk that the Working Group could end up legitimizing these clauses as an automatic part of "modern" investment contracts.

Any new efforts to revisit stabilization clauses must instead reflect the latest norms and standards, most recently the Organization for Economic Co-operation and Development's (OECD's) Guiding Principles for Durable Extractive Contracts from 2020, seizing the opportunity to better align investment contracts with modern standards of sustainability, transparency, and fairness.

Stabilization clauses should no longer automatically be included in investment contracts. Laws and regulations on climate change, environmental protection, human rights, or labour rights should never be subject to legal guarantees of stabilization. If fiscal issues are subject to stabilization, the investor should demonstrate a legitimate commercial need—and if that’s the case, the time and scope should be limited, with the option for review. Governments should remain free to align regulations with internationally recognized rules to address tax avoidance—for example, the Global Minimum Tax.

What Are Stabilization Clauses?

Stabilization clauses are provisions that can be included in contracts between investors and states. These clauses typically lock in specific laws and regulations of the country where the investment takes place at the time the contract is signed and for a specific period (the stability period).

This shields investments from subsequent changes in those laws and regulations, including on issues such as taxation, climate mitigation, environmental protection, and human rights. In many investment contracts, the stability clauses cover all or large parts of domestic law, and the periods often extend over several decades.

Stabilization clauses are particularly common in developing countries' investment contracts, especially within the mining industry. They have been most prevalent in sub-Saharan Africa and essentially non-existent in OECD countries. They also tend to be the most generous in developing countries, both on substance and the time period they cover. This can be explained by the power imbalance between large companies and developing country governments, which isn't the case in developed countries, where stabilization is uncommon (and may even be considered unconstitutional).

These clauses are also sometimes enforced through international arbitration between investors and states. This means that when a country changes a law or regulation supposedly stabilized by these clauses, the investor can seek monetary compensation from the government by suing it in arbitration tribunals, so-called investor–state dispute settlement.

OECD Principles a Starting Point for Wider Reform

States looking to modernize their investment contracts should base their efforts on the OECD's 2020 Guiding Principles for Durable Extractive Contracts, which reflect the most recent normative understanding of stabilization clauses.

The Principles were developed over 5 years by an inclusive process that included industry, international organizations, civil society, academia, developed countries, and developing countries. They build on several earlier standards, beginning with John Ruggie's efforts in 2007–2011 as Special Representative of the UN Secretary General on Business and Human Rights.

They propose several fundamental changes in how to approach stabilization.

First, they distinguish between stabilization of fiscal issues and non-fiscal issues, underlining that non-fiscal stabilization is no longer acceptable. This means that laws and regulations on climate change, environmental protection, human rights, or labour rights should be clearly excluded from the scope of any such clauses.

Second, they are clear that fiscal stabilization clauses should be seen as a choice for governments and investors based on commercial and investment-related issues and not a presumptive legal requirement for governments.

Third, to the extent that they are required, the Principles point to reduced and narrower uses for fiscal stabilization clauses—such as reducing the scope to select fiscal terms, limiting the time period, and possibly applying a stability premium to the tax rates so the stabilization regime is in effect purchased from the state.

Finally, they introduced a concept of revenue certainty. Whereas stabilization has always been addressed from the investor's perspective, the Principles seek to untie governments' hands to address corporate tax avoidance or evasion and protect government revenues when a sharing-of-benefits agreement between the parties is in place.

An upcoming practice note by the Intergovernmental Forum on Mining, Minerals, Metals and Sustainable Development (IGF), whose Secretariat is hosted by IISD, will provide further guidance on the content and implementation of the OECD Principles, emphasizing their approach to more limited and narrow uses of stabilization clauses in mining and other investment contracts.

Freezing Clauses and Economic Equilibrium

While the OECD Principles don't discuss the different types of stabilization clauses, several reports have shown that a shift is taking place away from traditional freezing clauses toward so-called economic equilibrium clauses.

As the name suggests, freezing clauses freeze specific laws and regulations as of the time of signing the contract and for a specified period. Any attempt by the state to make subsequent changes in these laws and regulations will automatically lead to a breach of the clause. When investors decide to sue states in investment tribunals for breaching freezing clauses, states usually end up being ordered to pay monetary compensation to the investor.

Economic equilibrium clauses are another form of stabilization. These clauses aim to restore the economic balance between the parties as it existed when the contract was signed. If a change in law has had a demonstrably negative economic impact on the investor, this will trigger economic compensation from the state to the investor—for the expense of complying with the legal change—or at least efforts to negotiate.

The advantage of this approach is that governments retain the flexibility to change laws that cover existing investments. The risk is that if economic equilibrium isn't well-defined in the contract, arbitration tribunals can later interpret it as having the same effect as a freezing clause and order states to pay similar levels of monetary compensation to the investor.

Experience shows that no approach to fiscal stabilization is without risk for host governments, which is why the OECD Principles also propose an alternative to legal guarantees of stability. They suggest that a predictable fiscal regime for investors—one that adjusts how the financial benefits are shared between the parties when factors affecting the investment project's profitability change (such as prices and costs)—can contribute to contracts' long-term sustainability and reduce incentives for renegotiation.

Opportunity to Revisit Investment Contracts and Stabilization

Amid the growing focus on investment contracts, developing country policy-makers should take this opportunity to revisit their approach to stabilization clauses based on the path set out by the OECD's Principles and with the following guardrails:

• Laws and regulations on climate change, environmental protection, human rights, or labour rights should never be stabilized.
• Fiscal stabilization clauses should not automatically be included in investment contracts. They should only be used if the investor can demonstrate a legitimate commercial need.
• If they are included, fiscal stabilization clauses should be limited in scope and time and may include a premium.
• Fiscal stabilization should never limit governments' ability to align regulations with bona fide, internationally recognized rules to address tax avoidance. Nor should they limit governments' room to protect against investors shifting profits and eroding the country's tax base.
• Governments should consider designing their fiscal regime to be responsive to changes in profitability. A flexible regime is more likely to be sustainable over the longer term, making the investment environment more predictable and reducing the need for renegotiation.