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01 February 2023

ESG-related arbitrations: A new kid on the block

Companies are no longer only assessed on their financial performance. Increasingly they are being asked to demonstrate that their business activities are socially responsible, environmentally sensitive and contributory to sustainable development.

This is because ESG (Environmental, Social and Governance) factors have substantially gained in importance. While ESG reporting and regulatory requirements are on the rise, rating agencies are factoring in ESG compliance when assessing creditworthiness. Incentives to showcase ESG compliance are also coming from investors, shareholders, suppliers, employees, customers, local communities and other stakeholders.

Companies are thus increasingly making ESG a part of their decision-making process. They keep looking for legal mechanisms that would allow them to secure ESG compliance. When they fail, their responsibility is often assessed in international arbitration.

Commercial contracts

One way of securing ESG compliance is by including ESG clauses in business agreements (e.g. commercial, sales and supply agreements, construction project agreements, loan facilities, even M&A contracts), usually as representations, indemnities or warranties. For example, buyers and suppliers often agree to conduct human rights due diligence, or a developer warrants to comply with environmental and health policies.

ESG clauses should be used as a driver for positive change. However, they may easily become a burden because they are still new and untested. Yet, they create binding contractual obligations, liability and exposure for the parties. In other words, ESG clauses should not be taken lightly.

To encompass a wide variety of often imprecise and complex standards and metrics, ESG clauses are typically drafted too broadly. While "catch all" terms and concepts in ESG clauses have their advantages, it is hard to expect that they are consistently applied across different industries and sectors. The main environmental concerns and responsibilities are likely to be perceived differently by, for example, an energy company and an investment fund. Likewise, labour standards in the supply chain of a large production facility inevitably differ from those applicable to an online service provider. Accordingly, misinterpretation or misapplication of ESG clauses may easily lead to a new type of dispute: ESG disputes.

Cross-border ESG disputes may be decided in commercial arbitrations if the underlying business agreements contain arbitration clauses. The advantages of arbitration over litigation – providing faster, more efficient and less expensive solutions – become especially notable in ESG disputes. Arbitration also ensures confidentiality and allows for the application of interim measures, which are often very important in ESG disputes. Moreover, parties can appoint arbitrators with ESG experience who do not have to be lawyers. They may also engage their own experts or allow third parties to join the arbitration proceedings, such as environmental or compliance specialists, human rights practitioners and the like. Commercial arbitration may thus easily become a preferred method for resolving the evolving ESG disputes between businesses.

International investment agreements

ESG factors are important in the international investment arena too. Although most existing international investment agreements do not contain provisions directly addressing ESG factors, unlike in commercial arbitration, ESG disputes are not entirely novel.

Indeed, the records show that investor-state arbitrations so far dealt with serious environmental concerns, exploitation of natural resources and energy development. Governments were sued because they allegedly breached their guarantees towards foreign investors when they intended to regulate environmental protection or to ensure their citizens' human rights. On the other hand, investors were either exempted from legal protection or the damages awarded to them were reduced because their actions were not ESG compliant (e.g. due to involvement in corruption or due to breaches of applicable environmental standards).

These claims were brought under traditional standards of protection, most notably under the fair and equitable treatment standard. Their broad and vague nature sparked the need for a more detailed legal framework for ESG disputes. The recent trend among governments is to expressly address ESG factors in trade and investment agreements. The Dutch Model Treaty (2019), Belgium-Luxembourg Economic Union Model BIT (2019) and Italian Model BIT (2022) are the most prominent examples of progressive model treaties that are likely to be followed by other states, a trend that will inevitably increase the number of ESG disputes going forward. Thus, companies should be aware of ESG requirements under international investment agreements when planning to invest abroad.

authors: Nataša Lalatović Đorđević, Dragana Nikolić