ESG considerations reshape investment arbitration landscape for Chinese investors

The traditional model of ISDS, in which a foreign investor brings a claim against a host state, no longer captures the full picture of modern investment arbitration. ESG obligations, host-state counterclaims and increasing procedural complexity have also become central features.

The shift has been particularly evident following the expansion of Chinese outbound investment under the Belt and Road Initiative. Since 2013, Chinese investors have significantly expanded their overseas presence in sectors including energy, mining and infrastructure, while China and many other Asian states increasingly occupy dual roles as both capital exporters and capital importers.

This is reshaping the traditional perception of investment arbitration as disputes between Western investors and Asian host states. The investment arbitration brought by Hong Kong-based Panama Ports Company, a subsidiary of CK Hutchison, against Panama is one example of the changing landscape. The ICC claim, reportedly worth approximately US$2 billion, followed a decision by Panama's Supreme Court declaring unconstitutional the legislation underpinning the company's right to operate the country's ports.

The dispute is expected to raise issues including expropriation, fair and equitable treatment, legitimate expectations and allegations of arbitrary regulatory action. Although not a conventional ESG dispute, it raises governance-related questions about transparency and the management of strategic public infrastructure. Such issues are increasingly relevant to how tribunals balance investor protections against a state's right to regulate.

Treaty reforms increasingly prioritise the right to regulate

The growing importance of ESG considerations is also reflected in investment treaties.

Investment treaties were originally designed primarily to protect investors. However, as environmental protection, national security and broader social governance concerns have gained prominence, tensions have emerged between investor protections and a state's right to regulate in the public interest.

States have responded by revising treaty models and introducing provisions designed to preserve regulatory autonomy. Investment treaty reform has been underway for some time, with UNCTAD reporting that at least 45 countries and four regional integration organisations were revising or had recently revised their model investment agreements, often to include safeguards protecting the right to regulate.

Recent agreements increasingly contain public policy exceptions relating to environmental protection, health and labour. Examples include the Chile-EU Advanced Framework Agreement and the Sri Lanka-Thailand free trade agreement.

In Europe, sustainability considerations have become particularly prominent. The Corporate Sustainability Due Diligence Directive, as amended, will require very large companies to identify, prevent and address adverse human rights and environmental impacts across their value chains. The EU's 2023 Model Bilateral Investment Treaty Clauses incorporate sustainable development principles, including climate-related provisions and exceptions to indirect expropriation claims.

However, sustainability considerations remain unevenly reflected in investment treaties. A UNCTAD review of 347 international investment agreements concluded between 2010 and 2021 found that only 5% contained provisions promoting sustainable investment and only 5% addressed the implementation of international environmental obligations.

Counterclaims create new risks for investors

One practical consequence of this changing treaty landscape is the growing use of host-state counterclaims.

Where an investor is alleged to have breached ESG-related obligations, a host state may, in certain circumstances, seek compensation within the same arbitration proceedings. This is a significant departure from the traditional ISDS model, in which claims were predominantly brought by investors.

Tribunals generally require three conditions before a counterclaim can proceed: the treaty or arbitration agreement must permit claims by both parties; the counterclaim must be closely connected to the investment or underlying dispute; and there must be a legal basis for the alleged obligation, whether arising under domestic law, contract or, in some circumstances, international law.

Case law demonstrates how tribunal approaches have evolved. In Saluka v Czech Republic, the tribunal’s 2004 decision declined jurisdiction over the state's counterclaim under the applicable bilateral investment treaty. However, in Urbaser v Argentina (2016), the tribunal accepted jurisdiction over a counterclaim based on alleged breaches of human rights obligations relating to access to water while ultimately rejecting the counterclaim on the merits. The award remains significant for its consideration of whether corporations may, in principle, be subject to obligations under international law.

Subsequent decisions reinforced the trend. In Burlington v Ecuador (2017), the tribunal awarded substantial environmental damages to Ecuador, while Perenco v Ecuador in 2019 resulted in significant compensation for environmental remediation and confirmed tribunals' willingness to apply domestic environmental law in ways that can create substantial liability for investors.

Taken together, these decisions illustrate a broader shift towards a system in which both investors and states may face liability, driven in large part by ESG concerns including environmental harm, human rights and corporate accountability.

Chinese investors face growing challenges

Counterclaims involving Asian parties have historically been relatively uncommon, partly because many first-generation investment treaties involving Asian states do not expressly address counterclaims. However, this is expected to change, particularly in sectors such as mining, energy, infrastructure and port concessions, where ESG-related allegations are becoming more common.

Awareness of investment treaty arbitration among Chinese investors is growing, albeit cautiously. Many still view ISDS as a measure of last resort, reflecting both cultural and practical considerations.

There is often a preference for preserving commercial relationships through negotiation, while litigation against a host state can be viewed as potentially damaging to long-term market access. Many Chinese enterprises, particularly state-owned entities, also have limited experience of investment treaty disputes and international arbitral institutions. Investment arbitration is often perceived as costly and time-consuming, and internal governance processes frequently favour exhausting domestic remedies or diplomatic channels before pursuing international proceedings. However, this approach can create significant risks.

Pursuing domestic remedies first may result in parallel proceedings and can inadvertently trigger so-called fork-in-the-road clauses or give rise to res judicata challenges based on earlier judgments once investment arbitration is commenced. The risk is particularly acute where parties initiate local court proceedings before obtaining specialist treaty advice, potentially undermining later treaty claims.

For that reason, specialist treaty advice on forum selection should be obtained before taking steps in domestic courts or contractual dispute mechanisms. Res judicata, lis pendens and fork-in-the-road clauses may limit or prevent parallel proceedings, and decisions taken at the outset of a dispute can ultimately restrict access to treaty protections.

ESG compliance now a legal issue

For investors, particularly those operating in Belt and Road sectors across the Asia-Pacific region, ESG compliance should no longer be regarded solely as a reputational concern.

Modern investment treaties increasingly permit broader counterclaims by states, while newer treaty models are more likely to impose express obligations on investors relating to compliance with local laws, environmental standards, anti-corruption requirements and human rights norms.

ESG-related legal frameworks are likely to continue evolving in ways that improve regulatory clarity and predictability. Those developments are expected to influence both treaty negotiations and arbitration strategy, while continued growth in cross-border investment across the Asia-Pacific region is likely to increase the importance of regional arbitration centres in resolving investment disputes.