With increasing pressure to improve performance, could ESG become the next big corporate fraud? Tristan analyses how it fits into the classic fraud triangle and explains what boards need to look for.
If 2020 was the wake-up call that thrust the environmental, social and governance (ESG) movement into mainstream consciousness, then 2021 was the year in which it came to dominate the corporate and regulatory agenda in the UK and much of Europe.
This has significantly increased pressures on ESG targets and results, which will inevitably lead to a greater risk of fraud. Here, we review how ESG has accelerated up the board agenda in the past two years and why the conditions are perfect for ESG reporting to become the next big fraud.
How ESG became a defining business issue
Although it had been gaining momentum for a number of years, until recently, the ESG movement was more the preserve of activists or niche investors. However, the COVID-19 pandemic and an increasing number of extreme weather events have highlighted how acutely global crises can impact economies, businesses, and societies at large. This awakening has extended beyond the climate crisis to social issues, embodied by movements such as Black Lives Matter and MeToo.
As a result, a company’s ethical values, environmental footprint and standards of governance have become defining issues for investors, consumers and regulators alike. In response, ESG issues were top of mind for boards and managers in 2021 as they grapple with the rapidly evolving needs and expectations of stakeholders. This was reflected in our recent Business Outlook Tracker, which surveyed 601 UK businesses, and found that more than 90% of respondents considered a strong ESG strategy to be a significant factor in their company’s:
overall value creation (92%)
ability to obtain funding (91%)
attractiveness to investors (90%)
It's right that businesses should be rewarded for doing the right thing and making a positive contribution to society. But the rapidly evolving ESG landscape has also created an environment that satisfies all three elements of the classic 'fraud triangle': pressure, opportunity and rationale.
1 Pressure to meet ESG expectations
It is readily apparent that companies are coming under increasing pressure to meet the ESG expectations of both their internal and external stakeholders. This means that boards and CEOs have to consider the welfare of the planet, their customers and their employees in ways considered unimaginable just a few years ago. Failure to do so will be met with a wave of negative publicity, such as that which has dogged online fast-fashion retailer Boohoo Group Plc for much of the past 12 months, in the wake of revelations about the working conditions in its supply chain.
NGOs and activist investors are increasingly challenging companies and holding them to account for what they consider to be sub-standard behaviour, resorting to litigation if necessary.
This led to a groundbreaking judgement in May 2021, in which the Hague District Court ordered Royal Dutch Shell Plc to reduce its worldwide CO2 emissions by 45% by 2030. More recently, in October 2021, miner BHP Plc suffered a shareholder rebellion against its “climate transition action plan”, based on concerns regarding its scope and the alignment of its target with the latest climate science.
Boards and CEOs are clearly under pressure to respond to the changing demands of their stakeholders. Doing this in practice may prove to be difficult, however. This is particularly true for those businesses and industries whose operating models are not intrinsically 'ESG friendly' but who are still facing calls from shareholders to improve ESG performance while maintaining profitability.
2 Opportunity for 'greenwashing' and manipulating ESG data
Faced with the pressure to improve their ESG performance, boards and CEOs may be tempted to artificially enhance their ESG credentials. They could either do this through a concerted PR campaign ('greenwashing') or by manipulating their underlying ESG data. Two key factors create ample opportunity to do this.
Firstly, although 2021 saw both the FCA and the Department for Business, Energy & Industrial Strategy launch consultations on mandatory climate-related financial disclosures, as yet there are no common ESG and sustainability reporting frameworks in place. This makes it difficult for investors, consumers and other stakeholders to assess an organisation’s true sustainability and ESG performance. It also means that any ESG control environment will, by definition, be immature and vulnerable to threats.
Secondly, within whatever ESG reporting framework is chosen, there are no natural checks on the integrity of the underlying ESG data. This contrasts with the financial side of the business, for which one fundamental principle will always apply: double-entry bookkeeping ensures that financial crimes and manipulation will always leave a trace that can be detected and remedied. This is because, with double-entry book-keeping, every debit must have an equal and corresponding credit. This balancing mechanism is an effective fraud-detection tool, which can be used to identify and mitigate threats.
By contrast, ESG reporting and monitoring rely on a single-entry recording system (if it is properly recorded at all). As this is not a self-balancing system, numbers can be easily manipulated, presenting plenty of opportunities for fraud.
3 Rationale – because it's easier!
Rationale is often the most personal aspect of the fraud triangle. The majority of people commit financial frauds on the basis of wrong treatment in the workplace, personal hardship, or because senior management is also committing fraud. But while all of these are applicable to ESG fraud – particularly if remuneration is linked to ESG performance – additional factors may also apply.
In situations where companies are facing pressure to improve their ESG performance while maintaining profitability, individuals may feel that they have no choice but to resort to fraud. Rather than invest in making fundamental changes to their organisation’s infrastructure and operating models (which would affect profit), they can simply manipulate ESG data, relying on the inherent weaknesses of sustainability reporting to do so.
Likewise, we now live in a world where consumers are more than happy to hold corporate decision-makers to account. Doing whatever it takes to ensure that newly made net-zero commitments (47 of the FTSE 100 had signed up to net-zero goals by the start of COP26) are achieved provides further motivation for committing ESG fraud.
ESG fraud on the rise?
Climate change and sustainability dominated the news for much of 2021. This culminated in the highly anticipated COP26 climate summit in Glasgow last Autumn, where ambitious emission reduction plans were presented and agreed to. While this will be critical for bridging the ‘Emissions Gap’ by 2030, it will also place even more pressure on companies to improve their ESG performance.
Looking forward to 2022 and beyond, this could well lead to an increase in ESG frauds. Senior management will need to understand this vulnerability in order to navigate the evolving ESG landscape. To do this, we recommend that boards conduct ESG risk assessments on their existing operations to identify areas of vulnerability. This may require the use of outside experts to assist, for example, an ESG corporate intelligence specialist to conduct due diligence on business partners and supply chains.
A robust ESG compliance framework should also be put in place. This should include a suitable ESG monitoring system that is linked to a red-flag identification system. Any red flags should be investigated immediately. ESG breaches present unique risks, so an internal investigation will be important to establish the facts in a way that best protects the organisation and the board, while providing comfort to stakeholders that the organisation has appropriately dealt with any wrongdoing.
For more insight and guidance on ESG and the corporate fraud triangle, get in touch with Tristan Yelland.