Special economic zones (SEZs) are geographically defined areas that are subject to economic and legal regulations that differ from those of the rest of the country. SEZs are promoted as an investment tool for developing states to enhance industry competitiveness and attract FDI. They come in various shapes and sizes and offer special treatment to investors through reduced taxes, streamlined customs processes, and other regulatory benefits.

While SEZs are seen as tools to foster industrialization, boost exports, and create employment, their impact has been mixed. Thomas Farole, drawing from the World Bank’s operations and research, discusses SEZs’ potential to “catalyze structural change through economic and political reform.”^[1] However, many SEZs prioritize investor needs over social and environmental concerns, resulting in “negative spillovers.”^[2] The challenge lies in ensuring that SEZs deliver on their economic promise without undermining sustainable development goals or host states’ policy space. This article focuses on a critical regulatory feature of SEZs—the inclusion of ESG standards—and their interactions with international investment law (IIL).

SEZs’ Economic Promise and Challenges to Sustainable Development

Developing nations establish SEZs to attract foreign capital, expecting long-term economic growth and local spillovers from the incentives offered. SEZs have been instrumental in the success of economies like China’s, where Shenzhen transformed itself from a small fishing village into a global manufacturing hub. The province-sized SEZ was the first to adopt measures in line with sustainable objectives and provide a “sound legal regulatory framework and effective institutions with strong and long-term government commitment.”^[3]

However, not all SEZs achieve their economic, environmental, or social objectives. Negative spillovers^[4] manifest themselves through the deterioration of labour standards, environmental protections, reduction in tax revenue, the creation of enclaves with minimal linkages to the local economy, a dependency on tax incentives, and the sacrifice of integral parts of the host states’ policy space—effects linked to a “race to the bottom” as developing countries compete to offer the most favourable conditions to attract foreign capital. A 2021 UNCTAD report highlights that, apart from a few exceptions, African SEZs have failed to deliver widespread economic benefits to the rest of the country.

The success of SEZs depends on the establishment of clear objectives, a defined framework, and an institutional approach.^[5] SEZs’ policies must be integrated within a “coordinated, whole of government approach to investment promotion.” Moreover, SEZs must not operate in isolation without linkage with and integration into the state’s broader growth strategies, local economic development, and regional integration efforts. Lastly, incorporating ESG standards is crucial to ensure SEZs contribute to innovation, knowledge diffusion, and long-term national development.^[6]

Indeed, to counter negative spillovers and achieve sustainable development, SEZs increasingly aim to align with the UN’s Sustainable Development Goals (SDGs), ensuring high ESG standards and promoting inclusive growth through local linkages and spillovers. SDG model zones are described as being able to “effectively transform the race to the bottom into a race to the top.”^[7]

By embedding ESG considerations, SEZs can mitigate negative spillovers, enhance local economic linkages, and promote inclusive growth while maintaining investor confidence. The article will also present how IIL and investor protections—especially ISDS mechanisms—can limit a state’s ability to regulate in the public interest, potentially undermining ESG goals. Broad interpretation of investor standards in BITs and the potential of ISDS claims can pressure states to prioritize investor rights over ESG measures and reforms. Consequently, this article will now examine the strategies used to integrate ESG standards into SEZ frameworks.

Legal Complexities: SEZs and IIAs

The legal relationship between SEZs and IIL introduces an additional layer of complexity. Indeed, while SEZs are typically established through national policies, investors in these zones are also protected by IIAs, which provide common standards of treatment and safeguards such as FET and protection from expropriation. The presence of ISDS mechanisms in IIAs allows investors to bypass national courts and directly pursue claims against host states. This means that whether SEZs are run by a public or private entity, they are subject to IIAs, rendering the state accountable for any breach or action by companies within these zones.^[8] This arrangement, while ensuring investor protections, has been criticized for reducing regulatory flexibility.

Various ISDS cases highlight this tension. Ampal-American v. Egypt, for instance, explored whether legal arrangements aimed specifically at a certain investor could lead to expectations of fixed regulatory exemptions (paras 177-187). In this case, under Egypt’s SEZ framework, the revocation of the investor’s tax exemption amounted to indirect expropriation because the tax-free zone system formed a fundamental part of the economic structure of the investment, and the investor had reasonably relied on its continuation. The tribunal ruled that without adequate compensation, the removal of these benefits amounted to an expropriation. Moreover, in the wake of the Arab Spring, the arbitral tribunal found that Egypt breached its “full protection and security” obligation by failing to protect a gas pipeline from terrorist attacks in the volatile region.^[9] Arbitrators considered whether the host state did enough to protect investors amid insurgent violence or whether a terrorist attack could have been avoided had the state taken different measures. This case puts additional pressure on developing nations to “protect foreign investors at the expense of human rights, and to prioritize the security needs of foreign corporations over those of vulnerable populations caught up in the conflict.”^[10]

In contrast, other cases demonstrate that, in principle, SEZs alone cannot create legitimate expectations of an unchanging regulatory framework. In Yuri Bogdanov & Yulia Bogdanova v Moldova, the arbitrator upheld environmental protection as a valid defence against an investor’s claim of an FET breach. This dispute concerned whether environmental “charges” and policy modifications could override a stabilization clause promising fixed conditions in the Free Zone, a stabilization clause that the claimants argued amounted to assurance and legitimate expectations (paras 60, 184–5, 192–3). The arbitrator found that protecting the environment is a legitimate aim, justifying policy changes and not violating the FET.

Moreover, in Unión Fenosa v Egypt, the claim related to the alleged suspension of gas supply that should have been exported. Egypt argued that it prioritized this supply during the Arab Spring to support its national need to maintain national security and public order (paras 8.13, 8.24). Egypt claimed that it did so to safeguard its essential interests and sustained its basic services when confronted with “grave and imminent peril” (ILC Articles on State Responsibility for Internationally Wrongful Acts, Art 25) as riots constituted a “threat to the basic functioning of society and the maintenance of internal stability” (para 8.10). The tribunal concluded that Egypt failed to demonstrate its defence of necessity. These cases underscore the challenges to following ESG factors, as actions taken by the state in the public interest or environmental protection can be constrained by investor rights under investment treaties. It also showcases the immense power arbitral tribunals have in limiting a state’s regulatory autonomy, especially when ESG goals conflict with investors’ interests.

In principle, SEZs alone do not create legitimate expectations that their regulatory framework will remain unchanged. While tribunals generally rule that SEZs do not lock states into regulatory stasis, the potential for litigation highlights the tension between investor protections and a host state’s sovereign right to regulate, particularly regarding ESG standards. Investors who base their expectations on regulatory assurances within SEZs may view policy changes as breaches, deterring states from making necessary adjustments in the public interest.

A notable example is Honduras Próspera v Honduras, in which an American company, Próspera, is suing Honduras for what consists of two-thirds of its annual budget^[11] after it allegedly breached its obligations by repealing a law allowing foreign investors to establish Zonas de Empleo y Desarrollo Económico (ZEDEs, or Economic Development and Employment Zones). First found unconstitutional by the Honduran Supreme Court, the ZEDE legislation was approved following the dismissal of justices of the Court in what many saw as a legislative coup d’état.^[12] These ZEDEs allowed the company to establish “charter” cities in SEZs with their own civil and administrative laws. Many describe Próspera’s claim as “neo-colonial” as it allows foreign companies to circumvent national laws.

ESG Standards in Practice: Chinese and South African examples

In response to this tension, several developing states attempted to develop new critical takes on IIL. These developments are particularly important as emerging economies in regions, such as in East and Southeast Asia, are increasingly shaping global investment law, with many of these nations transitioning into capital-exporting countries. These developments are crucial since many developing states, historically at a disadvantage in negotiations, hesitate to adopt investment provisions focused on sustainable development for fear of deterring foreign investment.^[13]

China’s SEZs, particularly in Shenzhen and the Guangzhou Development District (GDD), integrate ESG principles through a combination of regulatory frameworks that encourage sustainable development, social responsibility, and good governance. China takes a decentralized approach that relies on local governance to effectively enforce ESG frameworks within SEZs. Environmentally, investors must comply with national laws, such as the Environmental Protection Law promoting a green economy and sustainable development, as well as regional and specific SEZ legislation with specific provisions emphasizing energy conservation, eco-environment protection, and public safety (Shenzhen Regulations Articles 12, 33 and Municipal Guangzhou Regulations Article 67). Socially, China’s Foreign Investment Law (FIL) mandates labour protections, including the establishment of labour unions and adherence to national labour laws, with the GDD further promoting community development and social services, such as housing, education, and elderly care (FIL Articles 8, 32 and GDD Regulation Articles 59–60,66,63). However, it does allow foreign investors to retain some control over certain aspects, such as wage standards (GDD Regulation Article 17). Regarding good governance, the regulations provide mechanisms for local participation in decision making and ensure public awareness through complaint channels, though they lack explicit anti-corruption provisions (Municipal Guangzhou Regulations Article 32, 76, and FIL Article 18, and Shenzhen Regulation Articles 5, 26–27).

Additionally, the SEZs aim to foster inclusive growth by encouraging technology transfers, knowledge sharing, and participation in China’s modernization initiatives, ensuring foreign investors contribute to the broader development goals of the host region (FIL Articles 3,12, 22). Article 23 of the Shenzhen Regulation declares that investors “shall ensure equal participation of foreign-invested enterprises” in the formulation and amendments of local standards. This is supported by Article 11 of the Ganzhou Regulations, which encourages investors to establish scientific and technological institutions in the SEZ.

By contrast, South Africa’s SEZ framework incorporates ESG principles by relying more heavily on the national level and the regional integration level. Environmentally, the 2014 SEZ Act mandates coordination with the Ministry for the Environment to ensure compliance with national laws on sustainability, with a focus on resource conservation and environmental impact assessments for investments (Sections 12(1)(g), 4(1)(e)). SEZs must also abide by national environmental legislation (Protection of Investment Act, Section 7(1)). Socially, the SEZ framework promotes skill development and regional economic participation (SEZ Act, Section 4(2)(h)), with the government committed to addressing historical inequalities and advancing the rights of disadvantaged groups (Protection of Investment Act, Section 8(4)(d)). While the SEZ Act lacks detailed labour protections, it encourages economic participation, including support for small and medium-sized enterprises, and states that the government would provide training to develop SEZ-relevant skills (SEZ Act, Section 4(2)(h)). Regarding governance, the Investment Act ensures compliance with national laws, although it lacks specific provisions on anti-corruption or transparency mechanisms. South Africa’s Investment Act includes a broadly formulated right to regulate in which the state may take any measure that would uphold its national legislation, “redress historical, social and economic inequalities and injustices,” promote and preserve cultural heritage, biological resources, foster economic development and the “progressive realization of socio-economic rights,” and protect the environment and the sustainable use of resources (Protection of Investment Act, Section 12).

Additionally, the SEZs aim to foster regional development and inclusive growth (SEZ Act, Section 4) by promoting technology and knowledge transfers, although these objectives are only framed as best efforts (SEZ Act, Section 4(2)(h)). Section 4 of the SEZ Act adds that the objective of these zones is the promotion of skills and technology transfers.

The African Continental Free Trade Area (AfCFTA) plays an important role in assessing South African (and Africa’s) SEZs in their quest to contribute to long-term sustainable development. The AfCTA’s goal of creating a single, liberalized market for goods and services across Africa—while harmonizing trade policies and regulations—has implications for SEZs’ national legal frameworks. It could enhance the appeal of African SEZs by enabling investors to access a larger, unified market with lower trade barriers. This could incentivize investments in regional supply chains within SEZs, thus creating economic linkages beyond national or local boundaries. Another key benefit of the AfCTA is its Protocol on Investment. The AfCFTA’s goal of harmonizing standards could help African states avoid the “race to the bottom” by establishing continent-wide minimum labour, environmental, and regulatory standards, thus making SEZs more sustainable and equitable across Africa. This is also seen through the inclusion of exceptions and carve-outs in each standard of protection and treatment of investors (Articles 12–23). This ensures that “reasonable investment protection is given and not absolute protection.”^[14]

Moreover, sustainable development is at the heart of the AfCTA as a “significant contribution to the host state’s sustainable development” (Protocol on Investment, Articles 1(e) & 2) is an intrinsic characteristic and objective of its definition of investment. It also includes a commitment not to lower environmental, labour and consumer protections (Protocol on Investment, Article 22). The inclusion of a chapter on investors’ obligations that includes respect for human rights, environmental rights, labour rights, and the rights of Indigenous Peoples and local communities showcases the adoption of ESG standards. This is also seen through investors’ obligations against corruption (Protocol on Investment, Chapter 4).

Conclusion

While SEZs can drive economic growth, integrating robust ESG standards into international investment frameworks is crucial for ensuring sustainable, inclusive development without undermining host states’ regulatory sovereignty. China’s decentralized model and South Africa’s experience, alongside the AfCFTA, show the effectiveness of complementary legal systems in enforcing ESG standards. This also underscores the growing influence of developing nations in IIL, particularly in response to arbitral tribunals’ broad interpretations of standards of treatment.

Author

Nathalie Zeeni recently obtained a master’s degree in international trade and investment law (LLM) and currently works as a paralegal at Avizor Advocaten & Arbiters in Amsterdam.

^[1] Farole, T. (2011). Special economic zones: What have we learned? World Bank Poverty Reduction and Economic Management Network, no. 64. https://documents.worldbank.org/en/publication/documents-reports/documentdetail/275691468204537118/special-economic-zones-what-have-we-learned

^[2] Zheng, L. (2021). Job creation or job relocation: Identifying the impact of China’s special economic zones on local employment and industrial agglomeration. China Economic Review, 69. https://doi.org/10.1016/j.chieco.2021.101651

^[3] Zeng, D. Z. (2015). Global experiences with special economic zones: Focus on China and Africa (Policy research working paper 7240). World Bank Trade and Competitiveness Global Practice Group. https://documents1.worldbank.org/curated/en/810281468186872492/pdf/WPS7240.pdf

^[4] Zheng (2021), supra note 4.

^[5] Ndubai-Ngigi, J. W., Readhead, A., & Nikièma, S. H. (2024). The Global Minimum Tax and special economic zones. International Institute for Sustainable Development. https://www.IISD.org/publications/brief/global-minimum-tax-special-economic-zones

^[6] United Nations Conference on Trade and Development. (2021). Handbook on special economic zones in Africa: Towards economic diversification across the continent. XIX. https://unctad.org/system/files/official-document/diaeia2021d3-overview_en.pdf

^[7] Wessendorp, P., Kamiya, M., Bonilla-Feret, S., & Bonera, B. (2020). Special economic zones and urbanization (Discussion paper), at 6. UN-Habitat. https://unhabitat.org/sites/default/files/2020/06/joint_un-habitat-unctad_discussion_paper.pdf

^[8] Chaisse, J. (2021). Dangerous liaisons: The story of special economic zones, international investment agreements and investor-state dispute settlement. Journal of International Economic Law, 24(2), 443–471, at 461. https://doi.org/10.1093/jiel/jgab015

^[9] Howse, R., & Yacoub, A. R. (2022). Litigating terror in the Sinai after the Egyptian Spring Revolution: Should states be liable for foreign investors for failure to prevent terrorist attacks? Michigan Journal of International Law, 43(3) 598. https://doi.org/10.36642/mjil.43.3.litigating

^[10] Ibid at 629.

^[11] Pròspera. (2022). $10.775 billion claim filed against government of Honduras. https://www.prospera.co/news/10-775-billion-claim-filed-against-government-of-honduras, accessed November 22, 2024.

^[12] Aguillar, L. (2021). Supreme Court ruling allowing Honduran president’s reelection was based on a lie. Contra Corriente. https://contracorriente.red/en/2021/08/20/supreme-court-ruling-allowing-honduran-presidents-reelection-was-based-on-a-lie/

^[13] Turrini, P. (2023). International investment law: The anarchical society where development sustainability are frenemies and participation plays gooseberry. In B. Peters & E. J. Lohse (Eds.), Sustainability through participation? Perspectives from national, European and international law. Brill, at 466.

^[14] Danish, El-Kady, H., Mbengue, M. M., Nikièma, S., & Uribe, D. (2023). The Protocol on Investment to the Agreement Establishing the African Continental Free Trade Area: What’s in it and what’s next for the continent? Investment Treaty News. https://www.IISD.org/ITN/en/2023/07/01/the-protocol-on-investment-to-the-agreement-establishing-the-african-continental-free-trade-area-whats-in-it-and-whats-next-for-the-continent/