As has been written about at length, over the past decade there has been a gradual rise in legislation, regulation and policy surrounding businesses’ responsibility for environmental, social and governance issues, which fall under the umbrella term of ESG (“ESG”). This increase is evident from a local to a global scale: businesses themselves are taking steps to regulate responsibility and implement their own internal policies and governance mechanisms, reflecting the trend in national legislation towards more stringent regulatory frameworks. Internationally, there is also now a plethora of guidance for both corporates and investors (e.g. the OECD Guidelines for Multinational Enterprises, the Equator Principles, etc).
As a result, ESG wording is increasingly creeping into both commercial contracts and investment treaties, and businesses are investing vast sums in ensuring their compliance with the many obligations that they find themselves under. According to the 2022 Hogan Lovells Global Compliance Survey Steering the Course, 82% of compliance leaders consulted stated that identifying ESG risk is a current and future priority in their business strategy.
Given the relative recency of these developments, disputes relating specifically to ESG issues are still, relatively-speaking, in their infancy. To date, the ESG disputes that have emerged have been most prevalent before domestic courts, but there are signs that this is changing – and quickly.
Published at the start of International Bar Association (“IBA”) Week in Paris, a new report by the IBA Arbitration Committee analyses the results of two years of research and investigations into current trends in dispute resolution as it relates specifically to ESG. The timing was perhaps fitting, given France is home to one of the most comprehensive domestic ESG laws to date: the Loi de Vigilance requires companies to devise, publish and effectively implement measures to identify and prevent abuses to human rights, fundamental freedoms, the health and safety of individuals and the environment, including implementing plans to align with targets set by the 2015 Paris Agreement on Climate Change.
Composed of desk research, a survey of in-house counsel and compliance staff at large multinationals, and roundtable discussions with in-house counsel, the final report indicates that arbitration is likely to become the dispute resolution mechanism of choice for both commercial and investment disputes.
ESG obligations are becoming increasingly prevalent in commercial contracts
The proliferation of ESG regulation at all levels has led to a corresponding increase in the number of ESG-specific requirements that are set out in commercial contracts. Such clauses provide for standards of behaviour that are considered more “socially conscious”, and can range from environmental regulation (such as the use of specific products or packaging and shipping requirements) to labour rights (e.g. regulations prohibiting the engagement of child labour, or obligations to provide a safe work environment) and compliance with voluntary standards for ESG issues such as the UN Guiding Principles on Business and Human Rights.
ESG clauses now appear in a variety of contracts across the board, but the report’s analysis focuses mainly on supply contracts, share sale and purchase agreements (“SPAs”) and loan agreements, in which these requirements have become particularly prolific. These requirements can take the form of contractual warranties, due diligence clauses, and monitoring, reporting and compliance requirements, and contractual remedies for the breach of ESG clauses can range from indemnification to termination. SPAs, for example, often contain warranties by the target, such as that they have adopted adequate ESG policies. In supply contracts, it is not uncommon for there to be environmental and climate change warranties from suppliers as well as obligations to report and provide evidence of satisfying ESG performance metrics. A clear motivation for including such provisions is to comply with regulations and therefore to avoid potential penalties as, in some instances, parent companies have been found liable for the ESG-related actions of their subsidiaries (as notably held by the UK Supreme Court in the 2019 case of Lungowe v Vendata). There is also a reputational angle at play here and a desire to maintain positive relationships with investors and customers, who increasingly look for compliance with ESG standards. In fact, according to Hogan Lovells’ 2022 Steering the Course survey, 81% of compliance leaders stated that "integrated ESG programs will positively impact their organisation’s reputation".
To put this all into numbers, according to the IBA report:
- 28.9% of survey respondents noted that their organisations had entered into contracts which include specific clauses requiring the implementation of an ESG due diligence process;
- 34.8% of survey respondents confirmed that they have entered into contracts requiring compliance with environmental laws and regulations, and the same percentage had entered into contracts requiring compliance with human rights or labour rights laws;
- 40.6% of survey respondents confirmed that they have entered into contracts requiring compliance with anti-bribery and corruption laws; and
- 21.7% of respondents confirmed that they have entered into contracts which include clauses giving termination rights as a result of a breach of an ESG-related obligation.
Some of the disputes resulting from these contracts naturally take the form of more traditional breach of contract claims in respect of non-performance of ESG obligations, or breach of ESG-related representations and warranties. However, some of the contractual provisions are relatively new and innovative, and thus remain largely untested before courts or tribunals. These are therefore likely to result in disputes with complex questions of contractual interpretation, enforceability and compliance. These remain relatively rare for now, but the increased tendency to incorporate such clauses in contracts makes resulting disputes inevitable.
Amongst the participants in the surveys and roundtables, confidentiality was considered the single most important factor in the choice of dispute resolution mechanism for ESG-related disputes, with many respondents commenting that while litigation would be the usual mechanism they would adopt for contractual disputes, they would not want ESG disputes to be resolved by litigation. A recurring reason given for this was fear of reputational damage. This is consistent with the fact that the costs of the process ranked low as a factor influencing the choice of dispute resolution mechanism, suggesting that reputational costs are given more weight than financial costs. The ability to select decision-makers also ranked highly as a factor.
The report acknowledges that the inherent confidentiality integrated into the arbitral process makes it difficult to ascertain exactly how it is currently being used in the resolution of ESG disputes, but the clear preference for confidentiality and the ability to select decision-makers strongly suggests that arbitration, rather than litigation, will become the dispute resolution forum of choice for contractual ESG disputes as they inevitably begin to proliferate.
ESG obligations are also on the rise in investment treaties
The report also found that ESG-related wording is increasingly featuring in investment and trade treaties, particularly in newer model treaties, in four key ways:
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In the Preamble: the Preamble to a treaty usually sets out the purpose, motives and considerations underlying the conclusion of the treaty, and can assist with its interpretation. States are exhibiting an increased focus on investment as a means to further sustainable development, and to align their investment agendas with other international obligations, such as those under the 2015 Paris Agreement on Climate Change. The 2015 Norway Draft Model BIT is cited as an example. Jurisdictional clauses: while these don’t tend to directly address ESG issues, they often do so implicitly, for example by requiring that an investment must be made “in accordance with the law”, thereby barring investment protection to investments made outside the law (an example is the Morocco Model BIT). Tribunals have also implied this criteria to investments even when this clause is absent from the treaty (e.g. in Inceysa v. El Salvador).
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Substantive ESG clauses: these vary from voluntary action (e.g. that investors will “endeavour to voluntarily incorporate internationally recognised standards of corporate social responsibility in their practices and internal policies”, an example from the India Model BIT) to referencing specific international guidelines like the Equator Principles. Examples of express provisions include requirements that investors “maintain an environmental management system”, “uphold human rights in the host stage” and “act in accordance with core labour standards” (all from the Nigeria-Morocco BIT, not in force). There is also a trend in more recent treaties to include provisions reserving the right of the state to regulate on certain issues, including ESG matters, which recent tribunals have termed “safeguard clauses”. Indeed, even without these provisions, states have invoked the police powers doctrine to justify environmental or public health measures in the context of expropriation claims, with mixed results (e.g. Rockhopper Exploration v. Italy; Lone Pine v. Canada).
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Institutional provisions: still other treaties grant powers or duties to various bodies to monitor ESG standards and behaviours. For example, the Norway Draft Model BIT envisages a joint committee with the power to discuss certain issues including corporate social responsibility standards, environmental protection and human rights. The Comprehensive Economic and Trade Agreement between Canada and the EU (the “CETA”) envisages a committee that will review the impact of the treaty on sustainable development and address issues of environmental protection. Other treaties require that tribunals take into account an investor’s failure to comply with certain ESG standards in awarding compensation for the state’s breach of investment protection (e.g. the Netherlands Model BIT) thus making investors’ ESG failings relevant to any arbitration proceedings.
Lastly, the report notes that the wording of dispute resolution clauses and applicable law clauses may also be relevant to ESG issues. For example, in 2016 the Urbaser v. Argentina tribunal considered a counterclaim on the basis of an investor’s human rights obligations, finding that international law viewed corporate social responsibility as a relevant standard.
Although not mentioned in the IBA report, another notable example of an investment treaty which includes a broad range of ESG wording is the African Continental Free Trade Area (“AFCFTA”) Investment Protocol. This includes articles which require investors and their investments to comply with International Labour Organisation standards (Article 33) and to take active steps to "respect and protect the environment" (Article 34), including carrying out an environmental impact assessment and taking steps to mitigate any potential environmental harm caused. These provisions go further than most previous investment agreements and it will be interesting to see how these are applied and enforced going forward.
In part, the trend towards ESG-wording reflects broader trends in international policy and treaty making more generally, which increasingly features explicit ESG goals which impact the rights and obligations of investors in the territories of signatories (the 2015 Paris Agreement on Climate Change is a key example). Recent efforts to modernise the Energy Charter Treaty (“ECT”) likewise at least partially stem from a fear that investment protection may undermine efforts to fight climate change. This section of the report concludes that the way in which international efforts in this direction interact with investment protection will be a key “topic to watch” in coming years.
Conclusion
While the large attention given to ESG-related issues is still relatively recent, and there always tends to be a time-lag effect in terms of changes in policies and attitudes leading to disputes, there are already examples of concrete arbitration cases which are revealing of the way the wind is blowing. In Solvay Specialty Polymers Italy v. Edison, which arose from breach of a warranty that Edison and its subsidiaries were in “substantial compliance” with the applicable environmental laws, the Tribunal found in favour of the claimant, suggesting an increasingly positive attitude towards the enforcement of ESG obligations. Equally, following the Rana Plaza building collapse in Bangladesh, several global brands and trade unions entered into the 2013 Accord on Fire and Building Safety in Bangladesh, which contained a specific referral for any dispute to go to arbitration leading to two subsequent arbitrations.
As the tendency towards the inclusion of ESG obligations both in commercial contracts and investment treaties shows no signs of abating, it is inevitable that ESG-related disputes are going to increase over the next decade, both as the primary cause of disputes or as a secondary impact. The mix of reputational issues and relationship to international trade strongly suggest that referrals to arbitration for such disputes will be on the increase for the foreseeable future.
Authored by Kate Gardner and Thomas Kendra.
