ESG contract clauses — drafting tips to reduce your exposure to disputes and complaints

Designing contracts to manage your ESG risk 6 min read

Interest in environmental, social and governance (ESG) is continuing to grow at a rapid pace, including ESG-related goods and services. According to the Australian Securities and Investments Commission (ASIC), the number of listed companies referencing ‘net zero’ or ‘carbon neutral’ in price sensitive ASX announcements has increased by 840% over the past three years.¹ As would be expected, there has also been a significant uptick in ESG-related disputes and complaints.

One way for companies to manage their ESG risk is through contracts. However, care must be taken when drafting clauses, so that they do not become an additional source of disputes.

Key takeaways

• ESG-related disputes and complaints are on the rise. Strategic litigants are taking action against companies in relation to various issues and regulators are adopting a more stringent enforcement approach.
• Care should be taken in drafting ESG-related clauses, eg by tailoring clauses to the nature of the transaction and the counterparties; ensuring flexibility to account for the shifting expectations or requirements of stakeholders including investors and regulators; and making sure remedies for breach of contract are appropriate in the circumstances.
• Some organisations have published model clauses on ESG topics such as climate change and human rights – these are helpful but by no means a complete solution for addressing the unique risks of any commercial arrangement.
• Companies are encouraged to create, review and continually uplift ESG clauses that can be used for, and tailored to, different transactions or arrangements.

The role of contractual clauses in managing risk

Companies are increasingly turning to contractual clauses as a means of implementing and embedding their ESG commitments, increasing visibility and control of ESG-related risks, managing exposure in the event a complaint is made, shifting responsibility within supply chains, and managing a counterparty's ESG risk profile.  

The use of ESG-related clauses is also recommended by certain international frameworks (eg the United Nations Guiding Principles and the Organisation for Economic Co-operation and Development Guidelines for Multinational Enterprises and proposed domestic laws (eg the European Union (EU) Corporate Sustainability Due Diligence Directive, which – if passed – would also capture non-EU companies). Further, companies may already be leveraging the model clauses published by certain civil society organisations – eg the human rights clauses developed by the American Bar Association² and the climate clauses developed by the Chancery Lane Project.³

The rise in ESG-related disputes and complaints

There are a number of reasons why ESG-related disputes and complaints are on the rise in Australia and overseas. These include:

• Society directly taking action against companies, with a particular emphasis on eg climate change, biodiversity, modern slavery and cultural heritage;
• regulators adopting an increasingly stringent enforcement approach towards ESG-related misconduct – eg since 1 July 2022 ASIC's intervention in this space has resulted in 12 infringement notices and three civil penalty proceedings;⁴ and
• several jurisdictions having introduced (or, in Australia's case, proposing to introduce) mandatory disclosure regimes in relation to certain ESG matters. This serves to increase the amount of information available to the public, and raises the level of scrutiny and the risk of misleading statements being made.

The rise in ESG-related disputes and complaints has also highlighted a number of trends in the way that actions are being brought against companies. Notable ones include:

• closer interrogation of ESG commitments: eg in relation to whether there is a reasonable basis for forward-looking statements. This has played out in enforcement actions taken by ASIC (as reported in our previous Insight), and strategic litigation in the UK and the Netherlands, as well as consumer class actions in the United States;
• novel causes of action being asserted, including that companies owe duties of care to individuals impacted by other entities in the supply chain, as well as in relation to certifiers and social auditors on whom companies have relied to conduct ESG risk assessments;⁵ and
• private actors submitting complaints to regulators for further investigation (examples are the Environmental Defenders Office submitting a complaint to the Australian Competition and Consumer Commission (the ACCC) in relation to alleged greenwashing by an international airline;⁶ and in 2022 a group of organisations requesting that ASIC, the ACCC and the UK Financial Conduct Authority investigate an Australian mining company for allegedly misleading net zero claims).⁷

What to consider when drafting ESG clauses

Be clear on what is required to satisfy a contractual obligation

Just as public ESG commitments may be criticised as vague or aspirational, so too can contractual clauses. Organisations should try to include specific and measurable obligations, eg through targets or metrics that can be monitored and verified objectively. External industry standards or frameworks may also be helpful in this regard.

Tailor clauses to specific risks or concerns

Ensure that the clauses are tailored to concerns or risks relating to the transaction, taking into account the nature of the transaction itself, each party's supply chain (including industry- or geography-related risks), and the broader regulatory landscape applicable to the transaction and the parties involved.

ESG-related targets or requirements should be achievable

Companies may be tempted to set ambitious targets or requirements of their counterparties in view of their own ESG commitments. However, this approach may not only fail to deliver meaningful results but undermine a long-term relationship when targets aren't met. Instead, consider a gradated approach, in which clauses range from 'encouraging' through to 'obligating'– or even 'rewarding'– counterparties to meet, or exceed, certain standards. In this way, clauses can serve as a way of incentivising stronger ESG performance, rather than just being a tool for enforcing compliance. Further, companies that are better resourced or have more expertise in relation to particular ESG matters (as compared with their counterparties) may consider including an option to assist counterparties to meet ESG targets or remedy issues. These approaches are more likely to minimise the risk of a dispute and nurture the parties' ongoing commercial relationship.

Allow flexibility to account for shifting stakeholder expectations and regulatory requirements

With the ESG landscape evolving, it is important that clauses are drafted with enough flexibility to account for changing stakeholder expectations and regulatory requirements. In certain contexts, it may be appropriate for obligations to be tied to legal standards, and for one party to be responsible for the cost of uplifting its processes to meet those standards. At the same time, ensure that obligations do not become outdated through reference to specific laws or frameworks. Companies may consider including mechanisms that allow for new laws or frameworks to be nominated in relation to performance standards, or allow performance standards to be phased in.

Consider how compliance will be monitored effectively, including through transparent and accessible data

The proliferation of ESG around the globe has left companies contending with different standards and frameworks, and facing a potential lack of consistency in metrics and data when monitoring performance and contract compliance. To address this, consider including standardised reporting requirements (such as a common set of metrics and an agreed reporting format) throughout your supply chain, so accessible and transparent data can be obtained.

Companies are increasingly considering using AI tools in their data gathering and contract management processes. While AI can be of great benefit in analysing dense ESG information in a tailored fashion, its use brings countervailing ESG legal and ethical concerns that should be carefully considered. As noted in the CSIRO's recent report, Implementing Australia’s AI Ethics Principles, irresponsible applications of AI may breach legal standards, including in relation to privacy and the protection of personal or sensitive data. Please see our AI Governance Toolkit, which hashelpful tips on how to apply appropriate guardrails while leveraging AI internally.

Consider how you will manage supply chain risks

Some ESG risks may materialise beyond a counterparty's direct sphere of control and further along its supply chain – modern slavery is one example. Mechanisms that may assist in managing risks relating to tier 3 suppliers include:

• requirements on a counterparty to conduct regular due diligence on its own supply chain;
• 'cascading' clauses, to require counterparties to pass on contractual obligations to suppliers; and
• external ESG ratings providers and auditors, to identify risks associated with a counterparty, supply chain, industry or jurisdiction. However, external ratings providers and auditors should be approached with caution – concerns around the veracity of their findings have been raised in an ongoing human rights complaint, and in June the EU published a draft ESG ratings regulation.

Ensure that contractual remedies are appropriate

Terminating a contract in response to the breach of a clause may not always be appropriate. For example, terminating due to a counterparty's connection to modern slavery or environmental damage may not address the underlying harm that has occurred, and cause further harm by incentivising counterparties not to disclose issues that may otherwise amount to a breach; and, from a reputational standpoint, stakeholders may consider termination a form of walking away from an ESG issue.

Alternative remedies could include requiring a counterparty to:

• contribute to rehabilitation efforts that go towards resolving the underlying ESG issue;
• pay service credits in the event of failure to achieve predetermined key performance measures relating to ESG matters;
• implement new measures and evidence continuous improvement; and
• source an alternative supplier with a lower risk profile.

Actions you can take now

Companies should be considering the extent to which they need to create, amend and uplift contractual clauses that do, or could, relate to ESG matters.

If you require assistance, or would like to discuss the issues raised in this Insight, please contact any of the people below.