City Uni law grad Sammar Masood explores the viability of ESG clauses in commercial contracts

Our planet’s environmental state is at an all-time high level of concern. With the recent approval of the EU Corporate Sustainability Due Diligence Directive (CSDDD) in May 2024, it is clear that our most powerful institutions are beginning to take corporate entities’ impact on the environment seriously.

 The CSDDD, Corporate Sustainability Reporting Directive (CSRD), and emerging national counterparts are encouraging regulatory frameworks that impose binding obligations upon businesses to conduct due diligence on environmental, social, and ethical risks in their activities and supply chains.

These businesses will be large with high global turnovers and therefore multiple, complex, and multi-jurisdictional supply chain agreements. Along with this, it is known that the majority of a business’s emissions are produced in its supply chains. Therefore, it is widely acknowledged that the most powerful tool to enforce ESG due diligence requirements is the use of ESG clauses in commercial contracts. However, the reality of turning a contract ‘green’ to include such binding obligations, is easier said than done.

What exactly are ESG clauses?

Long and short, ESG clauses guarantee that suppliers adhere to ESG standards, whether these standards are derived from internal net-zero company policies or, as is most likely the case moving forward, from regulatory obligations included in the CSDDD. For the latter, the EU Commission is due to publish further guidance on what may be seen in such clauses. Moreover, the Commission has confirmed that it will introduce voluntary model contractual clauses for businesses. These clauses can take the form of conducting due diligence, compliance, monitoring, or disclosure. Depending on the sectors, industry, and variety of products or services involved, these actions can be required in areas including greenhouse gas emissions, modern slavery, waste disposal methods, and enforcing net zero standards for suppliers.

For smaller companies that may not fall under the jurisdictional or monetary scope of the CSDDD or any other corporate sustainability regulations, the Chancery Lane Project provides contractual clauses under English law which are ready to implement into a potential agreement. These clauses are tailored to the type of contract and certain climate-related aims.

Additionally, ESG warranties have been common practice in mergers and acquisitions. Warranties are contractual promises which, if breached, can result in damages. For example, a seller in a merger or acquisition may warrant that it has not fallen foul of any environmental legislation or does not have any ongoing investigations into its environmental conduct. If these claims are found to be untrue, damages and indemnity clauses can trigger action. The latter can establish which contracting party can hold the other responsible for breaching ESG clauses.

So, there is plenty of regulatory development and social awareness that permits the drafting and incorporation of ESG clauses into commercial and corporate contracts. However, when these clauses are attempted to be enforced, several problems start to appear.

Disputes, disputes, and more disputes?

There is no doubt that ESG clauses are relatively novel. They are also particularly complex because they will need to be increasingly based on multi-jurisdictional, legally binding obligations rather than flexible internal business ESG charters and commitments. Supply chain contracts will be particularly challenging to overhaul as they often span multiple developing jurisdictions, many of which do not prioritise or even have any processes in place for environmental protection or sustainability. For companies to delve into their supply chains and make each supplier aware of new ESG clauses or regulations, will be time-consuming and not easy.

As a result, it makes sense that lawyers and academics alike agree that the sheer size of this task will inevitably lead to more disputes relating to the enforceability and interpretation of ESG clauses in commercial contracts.

Firstly, this is because ESG is dependent on many factors beyond the commercial world. A new government after an election can have a vastly stricter or relaxed approach to environmental policies compared to its predecessor. One supplier may be based in an unstable country with many geopolitical tensions. Generally, the state of the global economy may be fragile, causing businesses to care more about profits rather than maintaining expensive sustainability obligations. This, paired with the fact that ESG clauses are relatively new and that companies may not want to damage relationships with some of their longest suppliers by imposing specific environmental obligations upon them, can result in broadly drafted ESG clauses which do not contain precise, measurable obligations via numerical metrics that can be objectively verified. Examples of a broad approach include general indemnity clauses or unilateral termination clauses. While some may argue flexibility is necessary when dealing with such a fast-evolving regulatory landscape when it comes to the interpretation of ESG clauses, increased flexibility can likely lead to interpretational ESG disputes.

Secondly, businesses have intricate, expansive supply chains, and suppliers frequently have independent subcontracts with third parties. So how far would due diligence obligations extend in these circumstances? Would these third parties be subject to rigorous due diligence requirements? Under the CSDDD, supply chain obligations are imposed on “lasting” and “not ancillary” relationships with business partners. Official examples of how far down the supply chain this provision can cover have not yet been introduced. Moreover, if a third party were to commit environmental abuse, this raises questions if the contracting parties decide to escalate the matter to arbitration proceedings. Arbitration proceedings tend to be more popular as they can be conducted behind closed doors as opposed to open litigation. Typically, arbitration proceedings possess a lack of jurisdiction when it comes to non-parties to the original agreement. The third-party deciding to initiate simultaneous proceedings can also complicate matters. Considering the current rise in litigation regarding claims that companies possess a duty of care to those who are affected by a third party’s actions in the supply chain, this issue will remain important.

Are contract law principles making ESG clauses harder to implement?

Conventional contract law principles should also be questioned, even though the new and evolving nature of ESG clauses and the introduction of corporate sustainability regulations are undoubtedly factors that are making it harder to practically enforce necessary ESG clauses without numerous roadblocks.

To begin with, English common law has been criticised for having a formalistic approach to contract law. This approach maintains the idea that contracts should be drafted and interpreted based on the plain structure of the words. Social and economic, or in this case environmental context, should not be embedded into the contract or its interpretation. So, while contemporary ESG clauses are being drafted to suit the needs of private regulation, English contract law is arguably not suited to interpret these clauses in the accommodating context that is required.

Additionally, contractual remedies may rely on proving loss. Therefore, if the breach of an ESG clause leads to harmful environmental impact, a company may be required to prove whether activities by a supplier caused the specific harm alluded to in a claim. Environmental damage or human rights abuses are not simple matters to prove. Chemical testing, soil samples, and even blood testing may be needed to verify a supplier’s activities were the direct cause of any abuses. Potential solutions might be to include a lump-sum indemnity payable if there is breach of an ESG clause or requiring the breaching supplier to perform a certain obligation in kind or make a donation to a recognised climate change organisation, though this, in turn, raises issues regarding the enforceability of a specific performance obligation.

A company may try to prove damage to its reputation as a result of breaches or abuses conducted by its suppliers. In the current economic climate containing increased awareness of ESG, investors are more cautious about investing in companies associated with ESG abuses. Therefore, a company must prove financial loss and damage to reputation as a result of their supplier’s actions or breaches, if it wishes to obtain damages in this manner. However, with larger, multinational companies, financial loss as a direct cause of a supplier’s actions will be hard to prove considering the multiple revenue streams companies are involved in at once.

Final outlook…

Overall, ESG clauses have the potential to completely transform the way commercial supply chains operate. Mandatory due diligence and monitoring with quantifiable commitments as essential contract clauses attached to robust remedies are the way forward if ESG clauses are to have their intended effect. However, fear of the new, the desire not to disturb long-lasting supplier relationships, and the added pressure and contractual processes for a company by potentially bringing claims against its supplier for breach of the newest type of contract clause, all make ESG clauses seem less attractive to parties. With the dawn of the CSDDD in December 2024, it will be interesting to see whether the EU will be able to truly turn contracts green. But for now, it seems as if the commercial world and contract law norms will be in a constant state of gradual adjustment and adaptation to ensure the right balance is met between commercial interests and ESG.

Sammar Masood is a recent LLB graduate from City, University of London. She has a keen interest in the intersection of environmental and commercial law, along with commercial dispute resolution.