Foreign direct investment (FDI) is the most important source of external finance in developing countries because it is more stable than portfolio investments and bank lending, and far more available than Official Development Assistance. In order to attract FDI, countries have increasingly offered certain forms of legal protection to foreign investors, including recourse to international arbitration mechanisms in the event of a dispute. These protections can be found in national laws and bilateral investment treaties (BITs) (now numbered at over 2300), as well as in numerous regional treaties and many state contracts. Recent years have witnessed an explosion of investor-state arbitration. Concerns have been raised, particularly in the wake of several controversial investor-state disputes, that in some instances the protection offered to investors may limit the ability of governments to regulate investment for the protection of the environment, natural resources and other social goods, and to ensure that foreign investment contributes to overall national development goals. Some authors have also suggested that the threat of an investor-state dispute could have a chilling effect on government policy, though they note that there is little evidence to substantiate such a claim. This article is structured in the following manner: first, the particular difficulties that developing countries face as respondents in investor-state disputes will be discussed; second, the relationship between investment protection and environmental protection will be explained, with a focus on the issues of expropriation, stabilization, and compensation; third, the potential chilling effect of investor-state disputes will be assessed; and finally a case study from Indonesia will be presented. The main argument is that the lack of transparency in arbitration, and the lack of consistency of tribunal decisions, creates uncertainty for regulators. This uncertainty, when combined with the financial risk involved in proceeding to arbitration, may create situations in which the threat of an investment dispute is sufficient to convince a developing country government to reverse, amend or fail to enforce an environmental regulation. The article concludes that in the absence of a complete overhaul of the investment arbitration system, efforts should be focused on procedural reform as well as targeted capacity building and financial assistance for developing countries
