The rise of ESG disputes and the role of arbitration in resolving them

December 2022 | SPOTLIGHT | LITIGATION & DISPUTE RESOLUTION

Financier Worldwide Magazine

December 2022 Issue

The term environmental, social and governance (ESG) was first coined in 2005 in a landmark UN report entitled ‘Who Cares Wins’, which stated that the incorporation of ESG factors in capital markets would ultimately lead to more sustainable business practices. Today, almost 20 years later, ESG has become one of the main features of every company’s business landscape. ESG-related financial assets were estimated to exceed $35 trillion in value in 2020, up from $30.6 trillion in 2018 and $22.8 trillion in 2016, to become a third of the total global assets under management.

Today, ESG has matured to the point where it is commonly accepted that good corporate sustainability performance is associated with good financial results. It is no longer enough to produce a good product or provide a good service: consumers, regulators and other stakeholders also demand that the product or service meets certain environmental, social and governance standards. Ultimately, investor organisations that incorporate these values into their supply chain and corporate practices can improve returns.

Defining ESG is problematic. Determining which risks fall under the ESG umbrella and which do not is one of the main sources of commercial disputes in this area. Breaking ‘ESG’ down into its constituent components, ‘environmental’ factors might be said to include a company’s or government’s contribution to environmental degradation and to climate change. ‘Social’ factors often include human rights, labour standards in the supply chain, any exposure to illegal child labour, and more routine issues such as adherence to workplace health and safety. And ‘governance’ factors refer to the rules or principles that define the rights, responsibilities and expectations of the different stakeholders in corporate governance.

What sorts of ESG disputes may arise?

As expected, the growing interest of governments, regulators, non-governmental organisations (NGOs) and private companies in ESG has led to a corresponding increase in the number of disputes with ESG components. A recent report concludes that globally, the cumulative number of climate change-related cases has more than doubled since 2015, bringing the total number of cases to over 2000. Around a quarter of these were filed between 2020 and 2022.

ESG obligations are industry-specific and therefore have the potential to generate a wide range of disputes. Similarly, the actors promoting these actions can be individuals, groups of individuals, NGOs and sovereign states or their agencies and instrumentalities. Nonetheless, we have summarised below trends that have arisen in two specific areas: climate change and supply chain issues.

Climate-change disputes. While the climate-change issue has been on the business agenda for many years, it has gained significant momentum in recent years, including following the last UN Climate Change Conference (COP26) held in November 2021, where both public and private sector actors made progress in achieving the objectives of the Paris Agreement, by proposing to implement plans to reduce CO2 emissions to limit the increase in global temperature to pre-industrial levels.

In this context, it is not surprising that one of the main sources of ESG disputes is climate change. Climate change-related disputes have often been initiated by NGOs, with the aim of pressuring governments and corporations to increase their efforts to reduce greenhouse gas emissions. Plaintiffs in such disputes have cited various sources of potential climate change-related obligations, including international treaties, as well as national or local constitutions, laws or regulations. Other types of climate change disputes include so-called claims for ‘greenwashing’ of climate change statements or commitments, in which plaintiffs accuse a business of making false statements about its ESG practices to appeal to consumer interest in environmentally friendly and sustainable practices.

Supply chain ESG disputes. ESG disputes have also arisen in connection with supply chain issues, which may implicate concerns regarding forced labour, human rights and greenhouse gas emissions. While it was already common for international corporations to adopt voluntary international reporting and due diligence standards, this issue has now gained prominence on the legislative agenda. Several jurisdictions have enacted legislation requiring, to a greater or lesser extent, that companies conduct due diligence with respect to the human rights and environmental impacts of their business activities, as well as those of their business partners within their supply chain.

An example of this new regulatory trend is Germany, whose parliament on 11 June 2021 passed the German Supply Chain Due Diligence Act (GSCA). The law, which comes into force in 2023, imposes an obligation on German companies to identify, document and report potential human rights and environmental violations committed by their direct and indirect suppliers.

The role of arbitration in ESG dispute resolution

The increasing growth of ESG obligations has translated, in practice, into more frequent ESG risk allocation clauses in the commercial contracts that companies enter into in their operations. A clear example of this trend can be seen in M&A transactions, which often address ESG issues, including in representations and warranties. Similarly, it is common for companies to seek to mitigate and manage ESG risk in the contracts they enter with their suppliers across their entire production line. These clauses have generated and will likely continue to generate commercial disputes.

ESG disputes relating to such contractual clauses are frequently resolved through arbitration, just like many other contractual disputes. Indeed, the 2019 report of the International Chamber of Commerce (ICC) task force on ‘Resolving Climate Change Related Disputes through Arbitration and ADR’ noted the increasing trend of ESG disputes being resolved through arbitration and argued that arbitration is particularly well positioned to serve this end, for at least three fundamental reasons.

First, arbitration allows for the selection of specific adjudicators with relevant expertise and for the tailoring of the proceeding to the needs of each case. This is particularly relevant in ESG disputes, where the issues at stake, such as climate change, are often legally and technically complex. Thus, in ESG arbitration the parties can choose arbitrators with a high degree of expertise in the ESG issues to be debated and who will therefore understand highly specialised and technically complex arguments and evidence.

Second, it is common for ESG cases to contain a strong international component. A clear example of these are cases in which companies have supply chains operating across different countries, requiring analysis of international law as well as the laws of different nations and localities issues. Arbitration is often regarded as the best method of resolving these sorts of cross-border cases, thanks to, among other factors, the New York Convention, which allows an award to be enforced in virtually any jurisdiction more easily than a court judgment.

Third, another feature of arbitration that positions it as a potentially good method for resolving ESG disputes is the possibility of obtaining injunctive relief in an expeditious and efficient manner. ESG disputes often require an initial adjudication that cannot wait. For instance, there may be a serious and imminent risk of irreversible environmental damage resulting from a business practice. At the stage prior to the constitution of the arbitral tribunal, most arbitration rules have developed emergency arbitration procedures, under which parties can secure the appointment of an ‘emergency arbitrator’ to decide on requests for urgent provisional relief prior to the constitution of the arbitral tribunal that will afterwards hear the merits of the dispute. In some jurisdictions, these emergency arbitrator proceedings are more expeditious than similar preliminary injunction proceedings before the local courts.

From another perspective, ESG topics, such as environmental protections, human rights, conflicts with indigenous communities and corruption issues, are also arising more frequently in investment treaty arbitrations. New generation international investment agreements (IIAs) and revisions to existing investment treaties are now beginning to include provisions relating to sustainability objectives or investor conduct, such as human rights due diligence or combatting abusive practices in supply chains. Historically, arbitration has been the principal method for adjudicating international disputes arising under investment treaties.

Conclusions

ESG obligations are gaining increasing importance. Companies that manage to adapt to these expectations are likely to enjoy significant benefits. Arbitration may offer a good method for resolving ESG disputes. The possibility of choosing a neutral forum with expert adjudicators places arbitration in a privileged position to resolve ESG disputes. Accordingly, the growing importance of ESG in the life of companies, coupled with the advantages offered by arbitration to handle ESG disputes, will likely mean that the number of arbitrations on this issue will continue to increase.

Ari D. MacKinnon is a partner and Martin Vainstein is an international lawyer at Cleary Gottlieb Steen & Hamilton LLP. Mr MacKinnon can be contacted on +1 (212) 225 2243 or by email: amackinnon@cgsh.com. Mr Vainstein can be contacted on +1 (212) 225 2156 or by email: mvainstein@cgsh.com.

Ari D. MacKinnon and Martin Vainstein

Cleary Gottlieb Steen & Hamilton LLP