To say that businesses are witnessing an ‘ESG revolution’ is not hyperbole. Active engagement with ESG issues is no longer a choice; ESG impacts are increasingly permeating public and private decision making across all sectors of the economy, as recent discussions around the COP26 climate change conference have shown.
As outlined in Corrs’ ESG Guide for General Counsel, “The message from corporate stakeholders is clear: companies must rise to meet demands for ESG accountability and transparency with proper risk management, due diligence and reporting, or risk shareholder and employee activism, investor divestment and exclusion.”
Those demands are producing new forms of risk (requiring allocation) that businesses need to grapple with in their operations and contractual relationships. In turn, these new forms of risk are and will continue to give rise to disputes. In that context, we ask: what role can arbitration play in resolving ESG-related disputes?
In this Insight, we explore this question from two perspectives. We first consider contractual disputes and the extent to which arbitration is suitable for resolving such disputes on projects overlaid with ESG requirements. Second, we discuss the evolving ESG considerations that businesses engaged in projects overseas should bear in mind to ensure that they are able to protect their interests through arbitration.
The role of commercial arbitration in resolving ESG-related contractual disputes
Contracts are the ultimate risk allocation device. ESG risk allocation too can be provided for by contract. Parties are increasingly asked to warrant that their activities will be responsible, that they will take steps to eliminate any modern slavery in their supply chains, and that they will conduct their operations in line with emissions reduction commitments. At the same time, some financiers are insisting on conditions precedent to finance requiring that the financier be satisfied with the borrower’s ESG compliance.
Just as the uptake of ESG requirements in commercial transactions increases, so does the risk of dispute involving those requirements. That risk is particularly pronounced because of the tension between certainty and breadth in drafting ESG clauses.
The concept of an ‘ESG risk’ is an umbrella term used to describe environmental, social or governance factors which may impact on (or present an opportunity for) the entity. What falls inside or outside of the umbrella is not clearly defined. As a result, any clause using the umbrella term is ripe for dispute.
On the flip side, as clauses become more particular, the risk that factors will be missed increases. One way drafters are managing this risk is to use a broad term and then give one party a contractual discretion. For example, one party may need to satisfy the other ‘acting reasonably’ about its ESG compliance. Risk lurks in these clauses too. A dissatisfied party may challenge the exercise of the contractual discretion, including by saying that, for example, the decision maker had regard to irrelevant material.
If the parties fall into dispute on these issues, those disputes can be dealt with through arbitration. Arbitration provides a private and confidential way to resolve disputes. Administered properly, it can be quicker and more efficient than other methods of dispute resolution, including by bringing proceedings in court. The parties can moreover appoint arbitrators who are specialists in the issues in dispute. For example, if the dispute is environmental or if it involves new technology solutions, an arbitrator with expertise in the technical issues can be appointed to hear the dispute and bring their specialist knowledge to its resolution. Moreover, arbitration can produce a final resolution faster than the time it ordinarily takes to litigate a complex technical dispute in court.
With the commitments flowing from COP26 fresh in mind, many expect to see States’ climate policies attempt to reshape the global energy industry. We may see an increase in disputes under ‘change in law’ clauses, as law and regulation change to meet new climate policies. Given the appreciation of different legal systems that comes with international arbitration practitioners, they are well suited to grappling with these disputes.
Arbitration is also well suited to dealing with disputes that result from high-tech and complex engineering issues on major projects because it allows parties to agree on procedures tailored to each individual dispute.
There are some risks involved in taking disputes involving ESG clauses to arbitration. The strategic imperative behind some ESG action is to attract attention or public scrutiny, and plaintiffs see open court as a better way to achieve that end. This has in turn driven some large entities to introduce arbitration clauses in their consumer contracts to preserve confidentiality. Recent US experience shows that this approach runs the risk of plaintiff law firms ‘book building’ (that is, signing up individual claimants) and commencing mass arbitrations, and it may also incite a public backlash against what some see as a business using the confidentiality of arbitration to hide its misdeeds.
That backlash may be warranted where public policy concerns are in play but it is unlikely to detract from the appeal of arbitration for resolving the majority of ESG related disputes. The qualities of confidentiality, party autonomy and efficiency of arbitration mean that it will continue to be the forum of choice for many contracts that include ESG clauses. There will be an accordant rise in expertise that arbitrators can bring to resolving ESG-related disputes and from which parties can draw when selecting arbitrators to hear their disputes.
ESG considerations relevant to cross-border projects
Contractors involved in cross-border projects should be mindful of how the increase in focus on ESG is changing their risk exposure when operating overseas, and how a failure to comply with ESG requirements may come to affect their rights, in particular rights afforded under international investment agreements.
By way of context, many Australian companies with assets overseas benefit from legal protections available under investment agreements between Australia and countries across Africa, South America, Europe and South-East Asia. These treaties protect individuals and companies from certain kinds of government-mandated measures, typically in the form of changes in laws or regulatory action, that may affect their assets - including contractual rights. Often these treaties allow companies to commence arbitration proceedings directly against the government of the state in which the asset is located (i.e. the ‘Host State’) to seek damages for unlawful government action.
The ability to invoke investment treaty protections can be a meaningful risk mitigation tool for Australian companies undertaking commercial activities overseas. Indeed, there have been hundreds of arbitrations commenced by individuals and corporations under various investment treaties worldwide and across a range of sectors – including resources and construction – in circumstances where their cross-border investments of capital and resources are adversely affected by action taken by the Host State.
These protections are increasingly being interpreted through the ESG lens and newly-negotiated investment treaties are re-allocating the risk of foreign business operations that are not conducted responsibly. We note here a few ways in which this shift manifests itself.
As an example, companies and individuals that otherwise meet the requirements to be afforded protection under investment treaties may lose the ability to rely on those protections if they fail to respect ESG requirements. One reason for this is that there is either an explicit or an implicit ‘legality requirement’ in investment treaties that conditions a party’s right to seek compensation on its compliance with the host state’s domestic legislation, which increasingly mandates compliance with components of ESG.
Further, on a number of recent occasions investment treaties have been interpreted to allow the Host State faced with a treaty claim by a foreign corporation to raise a counterclaim and seek compensation for ESG-related harm done by the corporation.
In one case involving an arbitration commenced by Spanish company Urbaser S.A. against Argentina, that arose out of Argentina’s termination of a concession for water and sewerage services, Spain was allowed to pursue a counterclaim against the claimant alleging that the claimant’s administration of the concession had breached international human rights obligations.
While the counterclaim was not ultimately successful, the case signals the willingness of tribunals to entertain ESG-related counterclaims.
Parties that fail in their ESG-related obligations can also face a reduction in damages to which they may otherwise be entitled – for example, if by failing to comply with social and human rights obligations their ability to generate future income on a project is seen as too uncertain, or even if their conduct is seen as having contributed to their losses.
In an arbitration between the Canadian mining company Bear Creek and Peru over a silver ore project that was unable to proceed to the exploration phase due to local community opposition, the tribunal awarded a significantly reduced quantum of damages because the manifest failure to obtain a social license to operate (among other things) made it impossible to assess expected profitability of the project.
Moreover, one of the arbitrators considered that the damages award should have been further reduced on account of the claimant’s contributory fault, concluding that the community opposition to the project was the result of the claimant’s failure to engage in public consultations.
Additionally, states increasingly see investment treaties as policy tools that can contribute to their ability to meet emissions reduction targets and promote responsible business conduct. Some newly negotiated and model investment treaties already require investors to comply with human rights due diligence obligations and conduct their business responsibly. For example, the Morocco-Nigeria Bilateral Investment Treaty (BIT) requires projects to be assessed for their environmental and social impacts and to comply with international environment protection standards. The Netherlands Model BIT requires that individuals and companies comply with the laws and regulations on human rights in force in the country in which they invest, and the Indian Model BIT expressly contemplates a reduction in damages payable where the foreign investor has caused harm to the local community or environment.
Australian companies operating overseas that rely on investment treaty protections to de-risk their cross-border operations and investments should follow these developments closely. We expect that international treaties will increasingly mandate that business is done responsibly before individuals and corporations can benefit from the protections they afford.