The role of international arbitration in reconciling ESG standards with investor-state dispute settlement

Introduction

The emergence of Environmental, Social, and Governance (“ESG”) principles is slowly but undeniably reshaping the global legal and investment landscape. Although the current state of ESG standards is primarily reflected as soft laws, guidelines, and due diligence terms in international investment agreements, there is a growing trend towards their incorporation into international treaties and domestic legislation, thereby acquiring a binding status that strengthens their enforceability.

While investor-state disputes involving ESG principles have recently gained global attention, they are not novel occurrences, as they can be traced to earlier dispute settlements. Prior to the explicit incorporation of ESG standards into international investment agreements, disputes arising from earlier treaties, such as the Energy Charter Treaty (“ECT”) and bilateral investment treaties, have provided ground to adjudicate matters involving environmental and human rights concerns. Of particular note is Burlington Resources v. Ecuador, under which a counterclaim was filed on the grounds of ecological damages alleged against the investor. Of similar consequence, in Vattenfall v. Germany 1 (2009), claims of expropriation and violation of fair and equitable treatment were levied against Germany under the ECT for imposing strict environmental regulations.

Notwithstanding the historic tension between ESG standards and international investment protection, the two concepts are not inherently mutually exclusive, because the enforcement of investment protection does not inherently conflict with fundamental humanitarian and sustainable development objectives. Understandably, countries, especially developing states, may adopt a cautious stance on embedding ESG obligations in domestic laws and treaties due to potential liabilities under investor-state dispute settlement (“ISDS”) and costly arbitration investment claims. According to a United Nations report (2023), investors have claimed over 100 billion dollars in awards against states upholding environmental standards. This has resulted in a state of regulatory chill where States are hesitant to act in the interest of sustainable development and public interest.

Considering the rising trend of ESG-related investment disputes, particularly environmental permits and climate action, it is imperative to examine the role of international arbitration as a tool for reconciling ESG standards with investor-state dispute settlement without undermining global sustainability.

The Intersectional Relationship Between ESG Principles and Investor-State Disputes

Environmental, Social, and Governance (ESG) is a structure that outlines key principles companies and organisations adopt to evaluate non-financial risks and opportunities, including their environmental impact, ethical practices, and governance structures. It is a benchmark through which investors assess a company’s commitment to sustainability, risk management, and ethical business operations. ESG considerations increasingly influence responsible investment decisions by promoting corporate accountability for environmental and societal impacts.

Sustainability is a global responsibility, notably reflected by the adoption of the Paris Agreement (“Agreement”) in 2015, to which all countries and the European Union are signatories. To meet their obligations under the agreement, many States have strengthened their national environmental laws and implemented regulations to reduce carbon emissions and mitigate environmental risks.

Meanwhile, foreign investors seek protection mechanisms to safeguard their investments against risks such as expropriation, unfair treatment, and discrimination. Without such protections, investor confidence and, inadvertently, foreign direct investment would significantly decline. To build trust, bilateral and multilateral agreements, such as the Energy Charter Treaty (“ECT”), were negotiated and adopted to protect foreign energy investments from domestic regulatory changes that could adversely affect them.

However, conflicts have emerged as States enhance environmental regulations in pursuit of climate action goals. Many investment treaties, including those under the ECT, were drafted before ESG standards became prominent, resulting in potential financial losses and unpredictable regulatory governance. Therefore, these climate action policies may be perceived as a threat to foreign investment protection and a violation of investment treaties and agreements. This conflicting interest between ESG principles and investor rights requires international arbitration tribunals to establish a balance between investment protection and the sovereign right of States to regulate public interest.

Key Considerations in International Arbitral Processes For ESG and Investor-State Dispute Settlement

ESG and sustainability introduce new elements to investor-state dispute settlements that transcend traditional international investment protection principles. These international investment protection principles, including fair and equitable treatment (“FET”) protection against expropriation, full protection and security, national treatment and free transfer of funds, should be upheld without compromising the State’s sovereign right to environmental protection. In achieving this, the following must be considered:

● Legitimate Expectation: The doctrine of legitimate expectation, which is an expectation of fair and equitable treatment, was first referenced by an arbitral tribunal in Tecmed v. Mexico (2003). In interpreting legitimate expectation, arbitral tribunals should assess whether the investor could have foreseen the regulatory change, especially in sectors affected by environmental sustainability policies.

● Legality: There is an implicit requirement that only foreign investment in compliance with the domestic laws of the host state is entitled to treaty protection. The arbitral tribunal in Álvarez y Marín Corporation and others v. Panama (2018) in its final award held that the legality of such foreign investment is an inherent requirement of the notion of investment and the general principle of good faith and nemo auditur propriam turpitudinem allegans.

● Proportionality: In determining proportionality, arbitral tribunals should assess whether the State’s actions and policies are proportionate to the public interest objectives, considering the quantum of damages incurred by the investors. Tribunals may justify such a policy if found to be non-discriminatory and reasonable.

● Confidentiality and Accountability: Confidentiality is a fundamental principle of arbitration processes that preserves the integrity of the process and ensures parties’ confidence. Conversely, accountability and transparency are core pillars of ESG principles that require the accessibility of information to the public. It is, therefore, imperative to delicately balance the confidentiality of arbitral processes with the need for accountability and transparency.

● Capacity: Developing and least developed States face unique challenges in balancing investment attraction with climate action, which should be taken into consideration in ISDS. These States heavily rely on foreign investment to sustain their economic growth and can not afford the luxury of nitpicking foreign investment. They often lack the capacity to bear the burden of exorbitant liability awards, which could threaten their economic stability. Failure to accommodate these realities could trigger regulatory chill and perpetuate economic colonialism.

Case Studies of Climate Action Related ISDS

● Rockhopper v. Italy (2017): This dispute arose from energy investment and environmental regulation. The arbitration process was initiated under the Energy Charter Treaty (ECT) and the ICSID Convention on the grounds of FET and protection from expropriation after the Italian government reintroduced a ban on oil drilling and gas exploration within 12 nautical miles of its shorelines. The tribunal decided in favour of Rockhopper with a final award of 290 million USD, and found the Italian government in breach of Article 13(1) ECT in 2022.

● Korea National Oil Corporation v. Nigeria (2023): This is an ongoing dispute arising from the Nigerian government’s revocation of an oil prospecting license, which was subsequently upheld by the Supreme Court on procedural grounds. The revoked licences allegedly constitute a breach of the Nigeria-Republic of Korea Bilateral Investment Treaty (BIT) of 1997.

Strategic Recommendations for Reconciling ESG Standards with ISDS in Arbitration Proceedings

In an attempt to resolve the longstanding feud between ESG standards and international investment protection, international investment agreements should expressly incorporate ESG clauses that emphasise environmental obligations. Similarly, older investment treaties should undergo modernisation to reflect sustainability goals. To balance confidentiality with transparency, ISDS procedural rules should permit the publication of case materials and award, subject to the parties’ consent. Also, arbitral tribunals should accept amicus curiae briefs from interest groups as they are important stakeholders in environmental sustainability.

Conclusion

ESG principles are inextricably linked to investor-state dispute settlement due to their growing relevance in shaping international investments. Therefore, strategic measures must be adopted, including treaties and legislative review, contractual sensitivity, and judicial reform to achieve a proactive framework for sustainable international investment protection.