Debates around corporate purpose dominated headlines in the months leading up to the Covid-19 outbreak. Intensified scrutiny of corporate conduct, governance and investment behaviours during the pandemic only served to accelerate the conversation around environmental, social and governance (ESG) issues.
In 2021, ESG issues have remained at the top of the agenda for many governments, investors and businesses. A wave of new ESG regulation around the globe calls for more extensive and detailed corporate disclosures. In parts of Europe, mandatory ESG due diligence rules have been introduced to force a more active approach to ESG risk management.
In response to investor demand and increased regulatory and litigation risk, many corporates have significantly upgraded their own policies and risk management approaches, including to ensure that ESG risks are appropriately managed by third parties, in supply chains and in the context of other business relationships.
In this article we consider the impact of these developments on international arbitration and the potential for ESG-related disputes to become an increasingly prominent feature of the arbitration landscape.
What is ESG?
ESG as an acronym has been in use for more than a decade as a label for a range of factors that are relevant in assessing whether an economic activity is sustainable for the purposes of investment decision making. These factors were used, for example, by large investors and asset managers to decide on allocation of capital, with a view to ensuring sustainability and financial performance over the long term. Recently, the label has been applied more broadly to an ever-expanding universe of regulations, standards and expectations regarding the responsible management of a wide range of issues.
While ESG factors have not traditionally been seen as financial performance indicators, there is increasing acceptance of their potential to pose material financial risks. For this reason, governments and regulators are focusing on the need to promote effective ESG risk management, both to achieve sustainability goals and also to manage risks to investors, capital markets and the financial system more broadly.
In practice, effective ESG risk management involves:
assessing and understanding ESG risks in business operations, relationships and supply chains;
taking steps to avoid or mitigate those risks;
complying with reporting and disclosure requirements;
engaging effectively with stakeholders including regulators, investors, employees, consumers and communities; and
ensuring robust governance and accountability at board level and integration of material ESG factors into strategic decision making.
How might ESG-related disputes come before arbitral tribunals?
Disputes arising out of commercial contracts
One of the ways in which companies are managing ESG risks is by the use of ESG conditions in commercial contracts. In 2018, the American Bar Association (ABA) launched the first version of model contract clauses (MCCs) aimed at the protection of human rights of workers involved in international supply chains, mainly through imposing representations and warranties to suppliers. An updated version of the MCCs were released in 2021, expanding the scope of ESG obligations to require buyers to engage themselves more proactively in the protection of human rights.
Examples of ESG issues that may be covered by contractual provisions include:
The use of such terms in supply chain contracts is not an isolated phenomenon. Similar clauses are also increasingly common in loan facilities, joint-venture agreements and in M&A transactions. The inclusion of such conditions reflects the rising importance of ESG factors to companies. Equally, because these factors have become commercially important, they are more likely to be source of disputes if the relevant conditions are not complied with, or if ESG-related representations or warranties turn out to be false.
ESG-related conditions are also becoming more common in long-term investment contracts, including in the energy, mining and infrastructure sectors. These can include, for example, obligations on the investor to adhere to specified ESG standards. These contracts may also incorporate carve-outs to stabilisation clauses, allowing governments to introduce new regulations concerned with ESG issues (usually with a provision that any new regulations must be proportionate, non-discriminatory and consistent with relevant international standards). A well-known example is Paragraph 2(d) of the BTC Human Rights Undertaking from 2003, which provides that the Baku-Tbilisi-Ceyhan Pipeline Company's shall "not seek compensation under the 'economic equilibrium clause' or other similar provisions […] in such a manner as to preclude any action or inaction by the relevant Host Government that is reasonably required to fulfil the obligations of that Host Government under any international treaty or human rights […], labour or HSE in force in the relevant Project State from time to time to which such Project State is then a party"2.
Many such contracts will provide for international arbitration. Accordingly, where disputes arise in relation to these ESG provisions, arbitral tribunals will be called upon to settle those disputes.
Arguably, certain ESG-related contractual provisions may be intended to benefit third parties. For example, undertakings by a supplier to adhere to certain internationally recognised labour standards could be argued to be intended to benefit the supplier's employees, who will not be party to the contract. This raises the interesting question of whether a third party may be able to enforce these provisions and to invoke an arbitration agreement in order to do so. The answer to that will depend, among other things, on the terms of the contract itself and also the law(s) applicable to the contract and to the arbitration agreement.
Following the Rana Plaza tragedy, global fashion brands and trade unions entered into the 2013 Accord on Fire and Building Safety in Bangladesh which, among other things, involved agreement on fire and building safety standards necessary to protect workers in the local textile industry. The Bangladesh Accord contains an arbitration clause and there have been at least two cases initiated by trade unions (who are parties to the Accord) alleging breaches of the agreement by a number of fashion retailers.
Disputes arising under Investment Treaties
The renewable energy sector and other sectors targeted by ESG investors, such as technology, can be vulnerable to heightened levels of political and regulatory risk. Where an applicable investment treaty is in place between the home state of the investor and the host state and that political or regulatory risk materialises, this can result in investment treaty disputes. For example, the elimination or modification of subsidies in the renewables sector in various countries has generated dozens of investment treaty disputes over the last decade.
ESG themes and issues such as human rights, environmental protection, conflicts with indigenous or local communities, bribery and corruption and tax issues are also arising more frequently in investment treaty disputes.
Some examples of these themes include:
Model treaties and some recent investment treaties have also begun to incorporate provisions relating to sustainability objectives or investor conduct. How these provisions should be interpreted and applied may also give rise to disputes in future. These include:
Is arbitration well-suited to resolving ESG-related disputes?
International arbitration has many features that make it well-suited for the resolution of ESG-related disputes. Arbitration offers a neutral forum and flexible procedure. It also offers the parties the chance to appoint arbitrators with specialist expertise (for example in relation to human rights, climate change or other environmental matters). International arbitrators have also proved adept at resolving disputes involving a range of applicable laws and, in some cases, 'soft law' standards. The ability to enforce worldwide under the New York Convention may also offer considerable advantages. In 2019 a group of arbitration and human rights practitioners launched the Hague Rules on Business and Human Rights Arbitration aiming to retain these beneficial features, but also provide a set of rules with modifications needed to address issues likely to arise in the context of business and human rights disputes. These include a Code of Conduct, fostering good faith and collaboration, stressing the benefits of a diverse tribunal and encouraging the adoption of processes which are based on inclusion, participation, empowerment and transparency.
There has, however, been some criticism of the use of arbitration as a dispute resolution process in an ESG context. Some see it as inappropriate for the resolution of disputes between corporations and individuals due to the potential imbalance in resources between the parties and the likelihood that corporations will have an inherent advantage as "repeat players". Concerns such as these have led certain organisations to abandon the use of arbitration in certain contexts, including consumer or employment disputes, or allegations of sexual harassment or discrimination. Criticism has also been raised against some investment treaty tribunals for failing to take adequate account of environmental or human rights standards and also complaints about inadequate transparency in relation to proceedings which often implicate important public interest matters, including for example, tax, corruption and public health.
The rising importance of ESG in a commercial context is likely to lead to an increasing number and variety of ESG-related disputes. Given that arbitration remains the preferred dispute resolution mechanism of most major corporations in relation to cross-border commercial activity, it is likely that a significant number of these disputes will fall to be resolved through international arbitration. Rising community concern with ESG and related regulatory change may also mean that ESG issues arise more frequently in investment treaty arbitration. To date, some have questioned whether arbitration is the appropriate forum to resolve such disputes. Significant efforts have been, and are being made to meet those concerns head on. However, it remains essential that arbitrators and arbitration counsel become more familiar with ESG regulation and standards and respond proactively to adopt appropriate arbitration procedures for ESG-related disputes. This will help to ensure that arbitration remains an effective forum for resolving disputes in this fast-growing area.