ESG Criteria and Their Application in International Commercial Contracts and Their Potential Application in Honduras

ESG Criteria and Their Application in International Commercial Contracts and Their Potential Application in Honduras

ESG Criteria and Their Application in International Commercial Contracts and Their Potential Application in Honduras

Currently, companies are no longer evaluated solely on their financial performance, as there is an increasing demand for them to demonstrate that their operations are socially responsible, environmentally respectful, and contribute to sustainable development. In this context, the components or ESG criteria (Environmental, Social, and Governance) play a fundamental role in international trade and the contracts arising from it. These elements are incorporated as clauses in modern contracts.

ESG criteria refer to environmental, social, and corporate governance factors considered when investing in a company. Although their origin dates back several decades, in recent years, they have become the reference for socially responsible investment (SRI).

ESG stands for “Environmental, Social, and Governance.” But what does each letter refer to?

• The “E” for Environmental encompasses the effect that a company’s activities have on the environment, both directly and indirectly. Its elements include:
  • Environment: Refers to how a company manages its impact on the natural environment and its commitment to sustainability. Environmental criteria can include natural resource management, reducing greenhouse gas emissions, biodiversity conservation, waste management, and energy efficiency.
  • Sustainability: Evaluates an organization’s approach to long-term sustainable practices. This can range from the use of renewable energy sources to promoting the circular economy and reducing the carbon footprint. Companies incorporate clauses related to eco-friendly technology/green buildings/renewable energy, as well as product design, life cycle management, and hazardous waste and substance management.
• The “S” for Social includes the impact a company has on its social environment and community. Its elements include:
  • Society: Examines how an organization impacts society as a whole and local communities. Social criteria address issues such as employee and customer health and safety, diversity and inclusion, human rights, gender equity, and commitment to local communities.
  • Labor Rights: Involves fair and ethical practices concerning employees, including safe working conditions, fair wages, and respect for labor rights.
• The “G” for Governance refers to a company’s corporate governance, such as the composition and diversity of its Board of Directors, transparency policies in public information, and codes of conduct.
  • Corporate Governance: Evaluates how an organization is managed and supervised, and whether it adheres to ethical and transparent practices. This includes the board structure, decision-making, accountability, and risk management. Including governance clauses or referring to performing due diligence on the company is a good practice for better understanding the company, minimizing risks, and defining operational strategies.
  • Business Ethics: Considers the integrity and ethics of the organization, as well as its commitment to corporate responsibility and anti-corruption measures.

These ESG concepts and criteria are essential for risk and opportunity assessment and management for companies and organizations, and they are becoming increasingly important for investors, regulators, and clients. The effective incorporation of these elements into business strategy can contribute to long-term sustainability and greater social responsibility.

Application of ESG Clauses in Commercial Contracts

ESG Clauses and Their Applicability

The term ESG encompasses a range of standards and regulations, both nationally and internationally, that may be relevant in the contractual context. According to the most recent doctrine, ESG clauses encompass a wide array of contractual provisions, which may include any new clause generated by the evolution of environmental, human rights, or governance regulations, as well as other emerging fields.

These clauses, in any case, imply the practical obligation to establish a specific procedure for assessing and weighing risks (risk assessment) in order to fully understand the inherent risks of the three ESG pillars in business relationships and supply chains, where these clauses have gained significant relevance.

Some of the ESG clauses incorporated in the latest contracts are those that fit into standard contractual models, known as Model Clauses or MCC (Model Clauses), designed to safeguard human rights, the environment, and governance. A notable example is the clauses aimed at protecting workers involved in international supply chains, proposed by the International Bar Association, which establish the need for representations and warranties from suppliers. In 2021, an updated version of these MCCs was released, expanding the ESG obligations to require a more active commitment from wholesale buyers in protecting human rights. Furthermore, there is growing interest from regulators in implementing ESG clauses, especially in the area of European Union environmental law.

We are not only increasingly seeing Environmental, Social, and Governance (“ESG”) ideals reflected in corporate policies of large companies, but they are also beginning to find their place in international commercial contracts, especially between these large companies. As a result, the focus of corporate policy seems to be shifting from value creation and monetary measures to a broader spectrum that includes positive social and community impact. These ESG ideals are also increasingly evident in legislation, regulation, and (inter)national jurisprudence.

As previously mentioned, there is a growing trend among companies, particularly large ones, to align their corporate policies with ESG objectives. Managing the risks associated with ESG becomes critical to ensure the effective implementation of these policies. A commonly adopted strategy by companies in this context is the inclusion of ESG clauses in their commercial contracts. These clauses may derive from the company’s own ESG objectives and policies, be inspired by non-binding guidelines from organizations like the OECD and the United Nations, or be required by applicable legislation. The latter category is expected to play a more significant role in the near future. For example, the European Commission recently proposed a directive on sustainability due diligence aimed at promoting sustainable corporate behavior and integrating human rights and environmental considerations into corporate governance. As a result of these trends, ESG clauses are becoming more common in a variety of commercial contracts, from supply chain agreements to mergers and acquisitions transactions.

It is important to note the relative novelty of ESG clauses and the challenges associated with their drafting, which allow us to identify some potential issues in the future, such as:

Interpretation

Since the application of ESG clauses is a relatively new phenomenon, disputes are likely to arise over how to interpret them and what specific actions are required to comply in a given case. This is especially true for clauses drafted in broad or imprecise language. Additionally, it remains to be seen what will be considered a material breach of an ESG clause, which would grant one party the right to terminate an agreement.

Regulatory Proliferation

In circumstances where ESG requirements may stem from the law applicable to the parties in their place of residence, the law at the place of contract performance, the law governing the contract, and others, identifying the applicable requirements can be challenging. Therefore, it is important to incorporate an effective arbitration clause to address the aforementioned issues.

Supply Chains

Ensuring ESG compliance across an entire supply chain is a potentially burdensome obligation for companies. While companies that have not yet adapted are increasingly getting used to understanding what is happening in their supply chain, the magnitude of the task will likely lead to disputes. It may also be unclear how far due diligence obligations extend. For example, the proposed EU Corporate Sustainability Due Diligence Directive imposes obligations when a relationship with a contractual partner “is expected to be durable, given its intensity or duration and does not represent a negligent or merely ancillary part of the value chain” (Article 3(f) proposed). Decision-makers will need to provide content to these standards in the circumstances of the specific case and according to applicable law.

To ensure the proper applicability of ESG criteria in commercial contracts, it is crucial to educate and raise awareness among legal professionals and negotiators about the importance of ESG principles, as well as to incorporate specific clauses into contracts that reflect environmental, social, and governance commitments. Additionally, ESG risk assessments should be conducted during the due diligence phase, monitoring and reporting mechanisms should be established to ensure compliance with agreed-upon commitments, and compliance should be incentivized with rewards and penalties. Having specialized legal advice on ESG issues is also critical to mitigate risks such as reputational and brand damage, financial loss, administrative penalties, and even criminal sanctions by regulatory bodies.

Application of ESG Elements in Honduras

The Dutch Model Treaty (2019), the Belgium-Luxembourg Economic Union BIT Model Treaty (2019), and the Italian BIT Model Treaty (2022) are the most prominent examples of progressive model treaties that are likely to be followed by other states, a trend that will inevitably increase the number of ESG disputes in the future. Therefore, companies must be aware of ESG requirements under international and national investment agreements when planning investments abroad. To date, Honduras has not established mandatory ESG regulations that apply to all companies universally. However, there are specific laws related to environmental, social, and governance issues, although they are not fully integrated into a global ESG regulatory framework per se.

In environmental matters, Honduras, although a signatory to the Paris Agreement, has internal environmental legislation that requires environmental licenses and covers areas from waste regulation and management to proper water management, but lacks specific regulations focused on the application of ESG elements. Similarly, in the social and governance aspects, Honduras only has internal legislation such as the Commercial Code, the Law for the Promotion and Protection of Competition, and the APNFD Law, which generally address issues such as business ethics, corporate governance, and proper regulation of monopolies.

Therefore, in pursuit of commercial progress, as part of global and changing trade, Honduras must move toward the correct incorporation of legislation that specifically regulates and incorporates ESG elements, promoting greater investment projection, environmental protection, corporate governance (such as transparency and business ethics), and community development.

In conclusion, the application of ESG criteria in international commercial contracts and their potential integration in Honduras reflects a paradigm shift in the evaluation and operation of companies, where environmental, social, and governance aspects are increasingly fundamental. Although Honduras lacks mandatory ESG regulations on a general scale, there are specific laws related to these issues. However, their integration into a global ESG regulatory framework is limited. To ensure effective implementation, measures such as education on these principles, the inclusion of specific clauses in contracts, ESG risk assessments during due diligence, and specialized legal advice are required. In the Honduran context, moving toward more specific ESG legislation would not only promote sustainable and responsible business practices but also drive economic development, environmental protection, corporate transparency, and community progress. In a globalized world, this legislative adaptation is essential for the country’s competitiveness and sustainable growth in the international arena.

I hope this helps resolve some questions and concerns about this topic. As professionals in Corporate, Regulatory, and Commercial Law, we are pleased to offer our services to assist with any needs you may have in these areas. If you need advice or wish to know more about our skills and experience, do not hesitate to contact us. You can find me on our website www.lexincorp.com or email us at lcruz@lexincorp.com and infohn@lexincorp.com. It will be a pleasure to work with you and help you achieve your goals. See you soon!

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Written by: Luis Cruz