ESG Regulation, Reporting, and Impact Assessment

Sostenible development occurs where social, environmental and economic aspects come together.³

Non-Financial ESG Reports

For several years now, different entities, both in the European Community and in the United States, have begun to evaluate the need to inform interested parties how companies act in terms of sustainability.

The CRSD⁴ (Corporate Sustainability Reporting Directive), in Europe, and the IFRS⁵ (International Financial Reporting Standards) through the ISSB⁶ (International Sustainability Standards Board) have established standards for companies to report, together with their Financial Reports, their actions in the field of Environmental, Social and Corporate Governance (ESG).

This information is intended to share with all stakeholders its actions in terms of sustainable impacts.

ESG Strategies

When a company adopts a sustainability strategy, it is establishing a value strategy. This entails making decisions related to investment, financing, mergers and acquisitions, tax planning, legal aspects and production processes. For example, a company may modify its supply chain to align with its sustainability strategy and reduce greenhouse gas (GHG) emissions.

Today, with the inclusion in financial statements of information that was previously considered non-financial, sustainability issues have become highly relevant on the agenda of CFOs, boards of directors, investors, regulators and other actors in the global business ecosystem.

This implies that companies must develop sustainability strategies if they want to generate long-term value. However, they will face challenges such as adopting a new organizational culture, collecting, and protecting the non-financial information needed for their sustainability reporting.

Implementation of ESG Non-Financial Reporting

Objectives

In recent years, the information that sustainability reports must contain has been more precisely defined.

The ESG information that companies disclose is often included in sustainability reports and integrated reports, which cover both financial and non-financial aspects, presentations to investors, and external communications aimed at the general public.⁷

Companies are preparing and submitting ESG or sustainability reports that go beyond simple external communication campaigns on environmental or social responsibility actions. According to PwC Global’s Global Investor Survey 2023, 87% of investors believe that corporate reports contain unsubstantiated claims about a company’s sustainable performance.⁸

Sustainability reports have existed since 1997 and gradually various international organizations have collaborated to add value to the information, coherence and ensure that this information is audited.

In this way, ESG reports have gained credibility and have favored the transparency of companies.

Some of the standards that establish frameworks for reporting are:

1. Global Reporting Initiative (GRI)
2. International Integrated Reporting Framework (IIR).
3. IFRS (International Financial Reporting Standards) through the IASB (International Accounting Standards Board) & ISSB (International Sustainability Standards Board).
4. Climate Disclosure Standards Council (CDSB)

Likewise, the way to gain credibility and uniformity in the reports will be for companies to appoint an auditor specialized in the matter, in order to ensure the value of the company and reduce risks in terms of conflicts with third parties.

ESG Arbitration

The United Nations in its 2030 Agenda determined the Sustainable Development Goals (SDGs), which seek to establish strategies and guidelines to ensure a balance between economic, social and environmental development.⁹

The SDGs are fundamental to understanding ESG criteria and how they are influencing the decisions of companies, investors, and government policies, among other actors.

It is important to note that the European Union has been a pioneer in the implementation of these objectives through various strategies and plans, and, most importantly, through Regulations and Directives, such as:

1. The European Green Deal¹⁰: a set of policy initiatives whose ultimate goal is to achieve climate neutrality by 2050.
2. The Taxonomy Regulation: which seeks to inform investors about the environmental sustainability of an economic activity.
3. The Corporate Sustainability Directive (Directive 2022/2464)¹¹: whose purpose is to improve sustainability reporting by companies, establishing common criteria for the entire European Union (EU).

These Regulations and Directives, along with those mentioned in the previous points, indicate that International Organizations are actively addressing these issues with the aim of fulfilling the 2030 Agenda. However, it is also foreseeable that these objectives may result in a rise in disputes related to potential regulatory breaches.

Legal experts recognize the numerous advantages of arbitration in resolving ESG-related disputes, such as procedural flexibility, the high level of specialization of arbitrators, and the possibility of obtaining injunctive relief, which is especially crucial in cases of environmental risks or human rights violations. However, they also point out several aspects that can represent significant barriers to the resolution of ESG disputes in arbitration, such as the potential imbalance of resources between the parties and the difficulties in establishing the submission of ESG clauses to arbitration.

ESG Damages

Regardless of whether disputes are resolved in arbitration or in courts, a relevant issue will be the impact of ESG criteria and policies on the eventual valuation of ESG damages.

ESG cases can first be related to:

1. Claims in which ESG factors are relevant to determining damages, even if the subject matter of the dispute is not directly related to ESG considerations. For example, ESG damages due to misreported information or concealment of environmental risks, which can cause losses to shareholders, investors or third parties (typical case of greenwashing)
2. Cases involving claims not directly involved with environmental issues, but where, however, environmental aspects may be material in the determination of damages. For example, a case where an investor-government dispute occurs over the expropriation of coal mines. In itself, the case does not involve environmental damage, but the value of the assets may be relevant when determining the quantum of the damage.

ESG Valuation

The determination of damages usually involves a valuation process, for which there are different methods, which can be categorized as follows:

1. Cash Flow Method: under this method, future revenue flows are projected for a certain period of time, duly justified, and adjusted under certain parameters into the future. These cash flows are discounted at a certain discount rate (e.g. WACC), in order to value these future flows at the present time, this is the so-called Net Present Value (NPV). In other words, this method is composed of two elements: Cash Flows and Discount Rate. Each of these components may reflect certain ESG impacts.
2. Market Value Method: Typically applied to comparable companies, either if they are publicly traded, or comparable transactions between private companies that do not have a market listing. Normally, these valuations will be affected by ESG impacts that can be valued by “multiple” or comparable values with companies that regularly report socio-environmental impacts. In relation to the determination of the “multiples”, these will also be influenced by the ESG impacts caused by the company.
3. Cost or Assets Less Liabilities Method: Finally, when this method is applied, the values are taken at cost minus accumulated depreciation. This methodology is strongly influenced by ESG considerations, as the original costs may have, as of the valuation date, changed considerably. This is the case in mining or extractive industries, where environmental impact and considerations have a significant influence on their valuation.

Conclusion

Although ESG-related topics are broad and diverse, we already have methodologies for reporting, valuing, and calculating damages that can be applied to environmental and social aspects.

In terms of Corporate Governance, international institutions such as IFRS, through its ISSB and IASB areas, have developed and continue to work on the issuance of recommendations to achieve greater clarity, homogeneity, and transparency in the information reported by companies, with the aim of reducing the so-called greenwashing effect.

Given the growing importance of ESG concepts, legal experts anticipate an increase in sustainability-related disputes in the short to medium term.

Arbitration offers significant comparative advantages for resolving these disputes. Flexibility in the rules, which allows the parties to agree on certain guidelines for resolving their differences, together with the preparation of arbitrators and the support of expert experts in the field, ensures faster processes and satisfactory results for the parties involved.

EconOne’s International Arbitration team has extensive experience handling complex ESG  matters before International Arbitration Tribunals. Our expertise encompasses disputes related to environmental compliance, socio-economic responsibilities, corporate governance, and sustainability initiatives, wherein we provide strategic guidance and strong representation in international disputes.