Navigating ESG challenges with ADR: Forging a sustainable future - Part I

By Ajla Serdarevic

Student

Geneva LL.M. in International Dispute Settlement (MIDS)

A. Serdarevic - Navigating ESG Challenges with ADR Forging a Sustainable Future 1.pdf

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Abstract: This article examines the importance of Environmental, Social, and Governance (ESG) principles in the context of arbitration and sustainable development. It consists of two parts that explore the rise of ESG, highlighting its evolution from soft law instruments to binding obligations. Topics covered include the challenges of implementing ESG practices, with a focus on the adoption of ESG standards and emphasizing their role in fostering long-term stability and global sustainability.

Keywords: ESG (Environmental, Social, and Governance), Arbitration, Sustainability, Corporate Responsibility

Arbitration has become an increasingly common dispute mechanism in which parties choose to resolve their disputes. Within the framework of commercial and investment arbitration, many changes and improvements have been made, and many new changes will follow in the future. Disputes in relation to crypto, corruption, pharma, and even future disputes such as Metaverse are some examples of how fast the world is developing, and arbitration is following the changes. One such change is the increase of ESG-related claims, and the importance it holds for laying a foundation for arbitrators to resolve novel disputes. Promoting and ensuring sustainability has become a widespread goal of governments around the world. Moreover, the 17 Sustainability Development Goals (hereinafter SDG) were adopted by all UN Member States in 2015 as part of the 2030 Agenda for Sustainable Development, which set out a 15-year plan to achieve the Goals.[1] Environmental Social Governance (hereinafter ESG) represents numerous aspects connected with sustainability and the responsibilities investors and companies have to uphold. Over the years, and especially in recent years, ESG has grown into much more than ethical responsibilities for a sustainable future. Both states and investors are aiming to have sustainable markets with a range of ESG practices.

Sustainable finance plays an important role in solving ESG-related issues and ensuring its proper application. With sustainable finance, investments are made with the goal of achieving a sustainable outcome in line with ESG practices. In Europe, recent industry standards require issuers or sellers of sustainable financing products to disclose information and metrics (both at issuance and on an ongoing basis) regarding the relevant ESG projects or initiatives to which the products relate, including quantification of ESG impact.[2] The COVID-19 pandemic has increased the concerns regarding corporate responsibility, investments and ESG due diligence. The concerns of investors have not only been with regard to corporate behavior but also with achieving long-term and stable economic goals. Against this backdrop, the term ESG is constantly developing and encompassing new rules, norms, practices, and expectations for the future. As a further consequence, claims that are ESG-related are steadily increasing around the world, with expectations of further growth. In 2021, the Securities and Exchange Commission (hereinafter SEC) formed a Task Force and solicited input on ESG disclosures.[3] Later in 2022 SEC proposed ESG disclosure rules for funds and investment advisers as well as placing a focus on climate change disclosure. The work of the SEC, as well as other actors such as the EU Banking Authority, ensures that ESG compliance is being closely followed.

Among other things, these claims arise from a company’s poor governance, failure to comply with ESG standards, or business activity that has a negative impact, causing public concerns and class activity. Considering its flexibility and other benefits, arbitration could be the mechanism for resolving ESG-related disputes. Reporting and upholding ESG standards are the way to have ESG obligations established apart from upholding it under soft law obligations. Recent trends suggest that states are moving towards using non-financial reporting on ESG, such as “the polluter pays principle” and “producer responsibility”. In order to promote sustainable growth, social equality, and transparent governance, both state and investors should turn to well-applied ESG practices that encompass environmental, social, and governance principles, and shortfalls in this regard are expected to cause disputes.  However, when disputes arise, arbitration is a more favorable dispute mechanism. One of the driving factors for the suitability of arbitration for ESG disputes is that arbitration provides the needed flexibility that companies, investors, and states can use for resolving a specific ESG-related issue. Even in arbitration, where changes and improvements are welcomed and encouraged, the first step has to be to establish the governance factor. Only then can the factors, which are environmental and social aspects within the ESG umbrella term, be properly established, applied, and resolved within a dispute.

The rise of ESG and its three pillars

ESG is an umbrella term that presents both great risk and opportunity to businesses and states in the future. The term ESG was first coined in 2005 in a landmark UN report titled ‘Who Cares Wins’, which stated that the incorporation of ESG factors in capital markets would ultimately lead to more sustainable business practices. [4] Since ESG has become a widely discussed topic its definition is still in the process of developing. ESG is recognized as the driving force behind many corporate policies, finance and investment decisions. The focus on ESG is continuously growing not only at the business level for financial gains but also for making a positive social impact. Even though ESG disputes are increasingly emerging as a significant concern, there is not yet a definitive approach to handling such disputes. In the past, ESG obligations existed through soft law instruments. An example of a soft law instrument used is Corporate Social Responsibility (hereinafter CSR), which states had preferred so far as a way of promoting dedication to sustainability. This growth in the number of enacted hard law instruments and the increasing frequency of including ESG-related representations and warranties in contracts will inevitably lead to a rise in ESG and HR disputes.[5] A broad range of ESG-related claims are already being brought, including arbitration, especially in regard to international trade disputes and investor-against-state disputes. Since ESG-related claims are connected to sustainable finance, ESG reporting is of vital importance. This is achieved through initiatives such as the Sustainable Finance Disclosure Regulation, which applies from 2022 to financial market participants. It requires all financial market participants and financial advisers to provide information on their financial products, sustainability risks, and negative sustainability impacts in their investment process.[6] This is an example of how ESG, as the backbone for sustainable markets, is achieved through efficient legislative initiatives. The ESG rating industry has been expanding rapidly, with household names including Bloomberg, Dow Jones or Refinitiv all providing ESG reports and support to their clients.[7] Managing risks, as well as upholding the principles, can only be achieved through effective decision-making dedicated to the underlying nature of ESG.

In order to get a complete understanding of ESG, all three pillars have to be analyzed separately, apart from establishing the common points. To begin with, the E, which is the environmental nature of ESG, includes climate change commitments such as net zero goals. Since the E is well defined, at present it is arguably more developed than the S and G aspects. Considering that ESG is still novel, this is not the right approach since, with proper governance, both E and S can achieve their proper formalization as well as distinguish what it entails. Consequentially, among other things, this would also allow ESG disputes to be resolved better.  The G stands for governance, which is the decision-making that includes governance practices, policy making, management, transparency, disclosure and creating models, etc., that are applied in accordance with E and S standards. Governance is a key element of overall corporate strategy and performance because it directly affects the way resources (including capital and talent), markets (the boardroom has an important role to play in markets), the regulatory and legal environment (i.e. compliance with laws and regulations) can be used in the pursuit of company objectives.[8] The need to expand the scope and clearly define ESG is pushed by states, investors, companies, consumers, and the public, including advocacy groups. Looking at the G20 OECD’s Principles of Corporate Governance have gained worldwide recognition and are well-designed corporate governance policies that can play an important role in contributing to the achievement of broader economic objectives and three major public policy benefits. [9] The three benefits include companies having financing access, promoting innovation and productivity, and overall fostering economic dynamism. Since the principles are non-binding, it is up to each individual state to implement them within their own domestic laws and regulations. This is just an example of how one governance-establishing approach can begin from the domestic level within one state, and then it can even be established on a regional level. Once it reaches a regional level, discussion over best practices can lead to development of international approaches which may be more efficient.

Importance of governance can be seen from the Enron scandal back in 2001, Volkswagens (hereinafter VW) diesel emission tests scandal in 2019 as well as the Facebook-Cambridge Analytica data scandal in 2018. All the scandals share one common point, which is that, at the time, there was a lack of proper governance that could have prevented poor corporate activities. Enron, which was a powerful business, came to a sudden drop and ultimately declared bankruptcy. The group manipulated records and concealed major debts from investors to create an illusion of higher current profits. This led to the enactment of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act of 2002 is a law the U.S. Congress passed on July 30 of that year to help protect investors from fraudulent financial reporting by corporations.[10] The Bush Administration passed it as "the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt."[11] This is an example of a step towards a high degree of corporate responsibility. This aligns with what ESG should nowadays preserve and develop even further, considering the changes in markets and business practices. The Volkswagen’s diesel scandal revolved around companies cheating on emission tests and the carbon dioxide levels of a large number of producer cars being understated. VW is one of the biggest car companies with a large management and influential position in the market. The scandal that broke out placed the company under pressure, but still, they kept their high position in the market. In this regard, VW has prepared to spend up to $25 billion in the US to take care of the emission problem. This includes legal fees, buyback of cars, repairs, etc.[12] Involvement of a considerable sum like that shows how companies are taking several steps to avoid such losses and possible damage to companies’ reputations. Moreover, the fact that their measures align with certain ESG principles demonstrates how ESG-based good governance can prevent such risks. After the scandal, VW took several steps, such as improving its management board and strategies within its business activity. However, the question remains for smaller companies that do not have an option to risk their position as to what could be the best alternative for avoiding such risks.

The answer can currently be seen in the sphere of ESG, despite a certain backlash against its presence in industries. Such backlash can be seen from the Republican lawmakers in the US who have argued that ESG imposes unnecessary constraints on corporations and undermines financial returns. [13] The emphasis is on governance, which is effective and clear goals of states and subsequently companies, investors, etc. to follow clearly defined ESG standards. Researchers led by Shivaram Rajgopal at Columbia Business School recently concluded that the effect of three Texan public pension plans withdrawing from ESG funds was neither statistically nor economically significant, according to the research: “The legislation appears to be political posturing and may serve no other purpose”.[14] This presents itself more as an issue of bad governance, which serves political goals that are not focused on achieving proper ESG application. Moreover, where ESG currently stands there are not yet any uniform applications of ESG nor governance approaches supporting the same.

Contrary to the US, the EU supports ESG, as can be seen with the Corporate Sustainability Reporting Directive that came into force in January 2023. This new directive modernizes and strengthens the rules concerning the social and environmental information that companies have to report.[15] A broader set of large companies, as well as listed small-to-medium enterprises, will now be required to report on sustainability. Another milestone coming from the EU is the finalization of the required internal procedures for the entry into force of the Sustainable Investment Facilitation Agreement concluded between the European Union and the Republic of Angola (SIFA).[16] SIFA contains an entire chapter dedicated to ESG provisions with the stated objective of integrating sustainable development in the Parties’ relationship and contributing to the achievement of the Sustainable Development Goals of the UN 2030 Agenda (Article 28(2)).[17] The importance of SIFA is that it shows a step towards sustainable investment and greater cooperation between countries to safeguard ESG. The VW scandal serves as an example of how, within a company, the adoption of good governance can prevent risks and keep the company from violating ESG standards. Another example of a vital governance scandal was in 2018, the Facebook - Cambridge Analytica scandal. The Guardian and The New York Times simultaneously published articles, in collaboration with a whistleblower, revealing Facebook users’ personal data was acquired without individual consent by Cambridge Analytica.[18] The issue was that Cambridge Analytica targeted people during the 2016 presidential elections in the USA with the use of Facebook users’ data. For mishandling users’ data, Facebook was ultimately fined $5 billion by the Federal Trade Commission. [19] The data breach also led to FTC imposing harsher regulations regarding data protection to Facebook which led to Facebook implementing new privacy strategies. Effectively, Facebook also took steps towards good governance, which can be implemented in their areas of operation, which was the EU’s General Data Protection Regulation (hereinafter GDPR). As such, EU GDPR is an example of an effective governance that is used even outside the EU. The same has to be achieved for ESG in the future. There is a need to work towards defining ESG disputes even with novel ESG claims since only then can the interpretation of ESG be achieved. ESG-related claims can take various forms, such as climate change-related claims, transitions in the energy sector, claims of foreign investors against states, etc. According to findings from a survey conducted by Queen Mary University of London, a number of in-house counsels operating in the energy sector confirmed that supply chain scrutiny, detailed contract reviews, and compliance with ESG obligations and objectives are mitigation tools that have shifted into greater focus.[20] SIFA also serves as an example of increasing the due diligence requirements.

Governance steps are taken in international trade and investment treaties. This opens the door to new claims that can be brought under the ESG, especially now against investors who have breached their ESG obligations. The forum for states to resolve the dispute would then be investment treaty arbitration, most probably under ICSID or ad hoc arbitration administered by the UNCITRAL Rules. States have now reached a point where they have greater freedom to regulate ESG-related obligations for investors. In the survey above mentioned by Queen Mary University of London the question, how are you adapting your activities to mitigate risks and challenges arising from climate change and environmental considerations was imposed for end users of arbitration which led to more than 40% answering that to mitigate such risks and challenges they would review corporate governance/ESG compliance.[21] Arbitration according to this survey was not the sole favorable option as a dispute mechanism, coming close to negotiation and even litigation. When questioned on why arbitration was seen as less favorable for climate change / environmental disputes, many respondents noted that the public interest element of holding corporates to account for so-called ‘greenwashing’ made them more suitable for resolution by high-level negotiation and litigation.[22] Notwithstanding these observations, arbitration allows parties to appoint arbitrators who, in the future, may be specialists in ESG-related issues relevant to other disputes. Another benefit is that ESG disputes resolved through arbitration can involve experts or allow for third-party participation, for example, environmental specialists or human rights practitioners. An example of such regulatory change that will put existing investments is seen with states increasing the regulation in energy transition and climate change commitments. As presented in the survey by Queen Mary University of London, this is especially relevant for public companies that need to make their ESG reports public to demonstrate that they are ‘good corporate citizens’ and stewards of the environment.[23] These disputes will not arise overnight, but the risk is already present and will gradually materialize. Even though it is expected that these disputes will reach the state courts, arbitration could present itself as an alternative option. This is also connected with governance since ESG could have its international character, and as such, disputes could be resolved using arbitration the same way arbitration is used for international commercial disputes or investor-state disputes. The ESG disputes are novel and complex, making it still possible to see the bigger picture and have parties opt for arbitration if an ESG-related claim is made.

[1] Martin (2023). The Sustainable Development Agenda - United Nations Sustainable Development. [online] United Nations Sustainable Development. Available at: https://www.un.org/sustainabledevelopment/development-agenda/ [Accessed 3 May 2023].‌

[2] Harvard Law School Center on the Legal Profession. (2023). Critical Topics in ESG - Harvard Law School Center on the Legal Profession. [online] Available at: https://clp.law.harvard.edu/knowledge-hub/magazine/issues/esg-and-lawyers/critical-topics-in-esg/ [Accessed 3 Jul. 2023].

[3] Clyde (2023). ESG claims under D&O policies will increase significantly in 2023. [online] Clydeco.com. Available at: https://www.clydeco.com/en/insights/2023/01/esg-claims-under-d-o-policies-will-increase [Accessed 27 Jul. 2023].

[4] Financier Worldwide. Financier Worldwide. Available at: https://www.financierworldwide.com/the-rise-of-esg-disputes-and-the-role-of-arbitration-in-resolving-them#.ZGSSWbJBw2w [Accessed 17 Jul. 2023].

[5] Gauthier Vannieuwenhuyse, 'Exploring the Suitability of Arbitration for Settling ESG and Human Rights Disputes', in Maxi Scherer (ed), Journal of International Arbitration, (© Kluwer Law International; Kluwer Law  International 2023, Volume 40 Issue 1).

[6] Peeters, L. and Joost Van Genechten (2023). ESG: From soft law to hard law. [online] Lexology. Available at: https://www.lexology.com/library/detail.aspx?g=81027c66-7561-4d12-894d-a2346193449a [Accessed 27 Jul. 2023].

[7] Lucia Bíziková, 'On Route to Climate Justice: The Greta Effect on International Commercial Arbitration', in Maxi Scherer (ed), Journal of International Arbitration, (© Kluwer Law International; Kluwer Law International 2022, Volume 39 Issue 1).

[8] Dean Emerick, The G in ESG. | The Report. Available at: https://www.esgthereport.com/what-is-esg/the-g-in-esg/ [Accessed 17 Jul. 2023].‌

[9] Oecd.org. (2023). OECD Legal Instruments. [online] Available at: https://legalinstruments.oecd.org/en/instruments/OECD-LEGAL-0413 [Accessed 17 Jul. 2023].‌

[10] Congress.gov. (2023). Text - H.R.3763 - 107th Congress (2001-2002): Sarbanes-Oxley Act of 2002. [online] Available at: https://www.congress.gov/bill/107th-congress/house-bill/3763/text [Accessed 17 Jul. 2023].‌

[11] Elisabeth Bumiller, Bush Signs Bill Aimed at Fraud in Corporations, N.Y. TIMES, July 31, 2002, at Al.

[12] An, Qi & Christensen, Morten & Ramachandran, Annith & Mukkamala, Raghava Rao & Vatrapu, Ravi. (2018). Volkswagen’s Diesel Emission Scandal: Analysis of Facebook Engagement and Financial Outcomes. 10.1007/978-3-319-94301-5_20.

[13] Bansal, P. and Diane-Laure Arjaliès (2023). ESG backlash in the US: what implications for corporations and investors? [online] @FinancialTimes. Available at: https://www.ft.com/content/3f064321-138c-4c65-bbb9-6abcc92adead [Accessed 17 Jul. 2023].

[14] Ibid.‌

[15] Finance. (2023). Corporate sustainability reporting. [online] Available at: https://finance.ec.europa.eu/capital-markets-union-and-financial-markets/company-reporting-and-auditing/company-reporting/corporate-sustainability-reporting_en [Accessed 17 Jul. 2023].

[16] “The Sustainable Investment Facilitation Agreement between the EU and Angola: A New Model for Investment Agreements? - Kluwer Arbitration Blog.” Kluwer Arbitration Blog, 23 Sept. 2024, arbitrationblog.kluwerarbitration.com/2024/09/23/the-sustainable-investment-facilitation-agreement-between-the-eu-and-angola-a-new-model-for-investment-agreements/.

[17] Ibid.

[18] Nossadata.com. (2020). 8 controversies that led to the rise of ESG - ESG Simplified. [online] Available at: https://www.nossadata.com/blog/8-controversies-that-led-to-the-rise-of-esg [Accessed 17 Jul. 2023].

[19] Gilbert, B. (2019). Facebook hit with major restrictions as part of $5 billion FTC fine. [online] Business Insider. Available at: https://www.businessinsider.com/facebook-hit-with-regulations-in-ftc-settlement-full-list-2019-7?r=US&IR=T [Accessed 17 Jul. 2023].

[20] Future of International Energy Arbitration, Survey Report, 2022, Queen Mary University of London.

[21] Ibid.

[22] Future of International Energy Arbitration, Survey Report, 2022, Queen Mary University of London.

[23] Ibid.