diff --git a/src/spec-common/variableSubstitution.ts b/src/spec-common/variableSubstitution.ts
index c1dd969f9..f7d2c67ad 100644
--- a/src/spec-common/variableSubstitution.ts
+++ b/src/spec-common/variableSubstitution.ts
@@ -37,7 +37,7 @@ export function containerSubstitute<T extends object>(platform: NodeJS.Platform,
 	return substitute0(replaceContainerEnv.bind(undefined, isWindows, configFile, normalizeEnv(isWindows, containerEnv)), value);
 }
 
-type Replace = (match: string, variable: string, argument: string | undefined) => string;
+type Replace = (match: string, variable: string, args: string[]) => string;
 
 function substitute0(replace: Replace, value: any): any {
 	if (typeof value === 'string') {
@@ -75,21 +75,21 @@ function resolveString(replace: Replace, value: string): string {
 function evaluateSingleVariable(replace: Replace, match: string, variable: string): string {
 
 	// try to separate variable arguments from variable name
-	let argument: string | undefined;
+	let args: string[] = [];
 	const parts = variable.split(':');
 	if (parts.length > 1) {
 		variable = parts[0];
-		argument = parts[1];
+		args = parts.slice(1);
 	}
 
-	return replace(match, variable, argument);
+	return replace(match, variable, args);
 }
 
-function replaceWithContext(isWindows: boolean, context: SubstitutionContext, match: string, variable: string, argument: string | undefined) {
+function replaceWithContext(isWindows: boolean, context: SubstitutionContext, match: string, variable: string, args: string[]) {
 	switch (variable) {
 		case 'env':
 		case 'localEnv':
-			return lookupValue(isWindows, context.env, argument, match, context.configFile);
+			return lookupValue(isWindows, context.env, args, match, context.configFile);
 
 		case 'localWorkspaceFolder':
 			return context.localWorkspaceFolder !== undefined ? context.localWorkspaceFolder : match;
@@ -108,25 +108,32 @@ function replaceWithContext(isWindows: boolean, context: SubstitutionContext, ma
 	}
 }
 
-function replaceContainerEnv(isWindows: boolean, configFile: URI | undefined, containerEnvObj: NodeJS.ProcessEnv, match: string, variable: string, argument: string | undefined) {
+function replaceContainerEnv(isWindows: boolean, configFile: URI | undefined, containerEnvObj: NodeJS.ProcessEnv, match: string, variable: string, args: string[]) {
 	switch (variable) {
 		case 'containerEnv':
-			return lookupValue(isWindows, containerEnvObj, argument, match, configFile);
+			return lookupValue(isWindows, containerEnvObj, args, match, configFile);
 
 		default:
 			return match;
 	}
 }
 
-function lookupValue(isWindows: boolean, envObj: NodeJS.ProcessEnv, argument: string | undefined, match: string, configFile: URI | undefined) {
-	if (argument) {
+function lookupValue(isWindows: boolean, envObj: NodeJS.ProcessEnv, args: string[], match: string, configFile: URI | undefined) {
+	if (args.length > 0) {
+		let envVariableName = args[0];
 		if (isWindows) {
-			argument = argument.toLowerCase();
+			envVariableName = envVariableName.toLowerCase();
 		}
-		const env = envObj[argument];
+		const env = envObj[envVariableName];
 		if (typeof env === 'string') {
 			return env;
 		}
+
+		if (args.length > 1) {
+			const defaultValue = args[1];
+			return defaultValue;
+		}
+
 		// For `env` we should do the same as a normal shell does - evaluates missing envs to an empty string #46436
 		return '';
 	}
diff --git a/src/test/variableSubstitution.test.ts b/src/test/variableSubstitution.test.ts
new file mode 100644
index 000000000..218bcc4d0
--- /dev/null
+++ b/src/test/variableSubstitution.test.ts
@@ -0,0 +1,136 @@
+/*---------------------------------------------------------------------------------------------
+ *  Copyright (c) Microsoft Corporation. All rights reserved.
+ *--------------------------------------------------------------------------------------------*/
+
+import * as assert from 'assert';
+
+import { substitute } from '../spec-common/variableSubstitution';
+import { URI } from 'vscode-uri';
+
+describe('Variable substitution', function () {
+
+	it(`environment variables`, async () => {
+		const raw = {
+			foo: 'bar${env:baz}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/bar',
+			containerWorkspaceFolder: '/baz/blue',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+				baz: 'somevalue'
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'barsomevaluebar');
+	});
+
+	it(`localWorkspaceFolder`, async () => {
+		const raw = {
+			foo: 'bar${localWorkspaceFolder}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/bar',
+			containerWorkspaceFolder: '/baz/blue',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+				baz: 'somevalue'
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'bar/foo/barbar');
+	});
+
+	it(`containerWorkspaceFolder`, async () => {
+		const raw = {
+			foo: 'bar${containerWorkspaceFolder}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/bar',
+			containerWorkspaceFolder: '/baz/blue',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+				baz: 'somevalue'
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'bar/baz/bluebar');
+	});
+
+	it(`localWorkspaceFolderBasename and containerWorkspaceFolder`, async () => {
+		const raw = {
+			foo: 'bar${containerWorkspaceFolder}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/red',
+			containerWorkspaceFolder: '/baz/${localWorkspaceFolderBasename}',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+				baz: 'somevalue'
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'bar/baz/redbar');
+	});
+
+	it(`environment variables with default value if they do not exist`, async () => {
+		const raw = {
+			foo: 'bar${localEnv:baz:default}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/bar',
+			containerWorkspaceFolder: '/baz/blue',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'bardefaultbar');
+	});
+
+	it(`environment variables without default value if they do not exist`, async () => {
+		const raw = {
+			foo: 'bar${localEnv:baz}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/bar',
+			containerWorkspaceFolder: '/baz/blue',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'barbar');
+	});
+
+	it(`environment variables with default value if they do not exist`, async () => {
+		const raw = {
+			foo: 'bar${localEnv:baz:default}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/bar',
+			containerWorkspaceFolder: '/baz/blue',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+				baz: 'somevalue'
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'barsomevaluebar');
+	});
+
+	it(`environment variables without default value if they do not exist`, async () => {
+		const raw = {
+			foo: 'bar${localEnv:baz:default:a:b:c}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/bar',
+			containerWorkspaceFolder: '/baz/blue',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'bardefaultbar');
+	});
+});