How good governance can keep corporates clean from greenwashing

In the case of sustainability, pressure in the fraud triangle is intensifying as investors, activists, customers, consumers, employees, suppliers and regulators all have heightened expectations of a company’s strategy and reporting in this area. Companies are compelled to respond. But how?

Traditionally they’d look to either regulation or the competition, but neither currently offers clear guardrails when it comes to ESG outcomes. Promises are therefore quickly made, and internal practices along with current structures of systems, processes and controls that allow an organization to govern itself often don’t seem to be fit for the challenge.

Take net-zero targets. The plans of the so-called pioneers – now being picked over by activists, investor groups and non-governmental organizations (NGOs), among others – may well have been set in good faith but not backed by the necessary due diligence, data and processes.

The result? Greenwashing. The Cambridge Dictionary defines greenwashing as “behavior or activities that make people believe that a company is doing more to protect the environment than it really is.” Planet Tracker³, an NGO, has identified six main types of greenwashing that are “increasingly sophisticated” and are spreading far and fast as ESG becomes a defining characteristic of successful, sustainable and socially aware companies.⁴

Scrutiny of the numbers will only intensify as we move towards reasonable assurance, and missing carbon targets can have financial consequences too. Recent research across large global food and beverage companies showed gaps in shareholder return and EBITDA growth between top and bottom performers on ESG goals, and just 4% are confident of delivering the required reductions in their Scope 3 emissions.⁵

Much like climate and social impacts, greenwashing doesn’t stop within an organization’s four walls. Delivering against ESG targets means lifting the lid on supply chains and digging through the detail. However, accurate data on climate risk, greenhouse gas emissions, biodiversity impacts, employee treatment, human rights, tax transparency, anti-corruption and anti-bribery, board diversity and many more aspects of ESG isn’t often readily available and requires companies to collaborate and if necessary, investigate across the entire supply chain to source it.

Assets in global sustainable funds hit a high of US$2.97 trillion in 2021, according to Morningstar⁶ for example, and yet unsubstantiated or misleading claims continue to exist with green finance.

ESG data may be manipulated, with employees relying on the inherent weaknesses and ambiguity of sustainability reporting. Within a financial reporting system, typically a strong controls framework with management signoffs is in place. However, as ESG programs are cross-functional and less mature, that same controls framework may not be in place. People also matter: how the signoff is enabled illustrates the importance of governance in the avoidance of such greenwashing.

It’s no surprise, then, that 76% of investors accuse businesses of “cherry picking” on sustainability activity.⁷  The EY global survey of senior finance leaders and institutional investors, published in November 2022, found ESG metrics lacking.⁸  A resounding majority (88%) of investors said “unless there is a regulatory requirement to do so, most companies provide us with only limited decision-useful ESG disclosures.”⁹

Experts at MIT and the University of Zurich, who recently reported divergence of ESG ratings between major ratings agencies, have joined others in calling for “greater transparency” and harmonization of ESG disclosures.

The regulatory net is also tightening around green claims, including ones made in relation to ESG topics like net-zero, and those made in marketing materials. International authorities coordinated by the UK Competition and Markets Authority found 42% of green claims made online by companies were exaggerated, false or deceptive – and could by turn break consumer law¹⁰. Mandatory reporting structures are on their way, and these are in the interests of both inadvertent misreporting and fraudulent claims.

From top to bottom, The EY Global Integrity Report 2022 found ethical standards to be slipping in the aftermath of the pandemic.¹¹ 

The responses from those who categorized themselves as Board members were particularly insightful:

Base: Global Integrity Report 2022 Board members (442), and Global Integrity Report 2020 Board members (333)

Among a list of fraudulent activities, including falsifying financial records, taking or offering bribes, and misleading regulators or auditors, 43% of board members and 35% of senior managers would do at least one of these for personal gain. Thirty-nine percent of employees would be willing to perform an illegal or unethical activity for their own benefit or at the request of a manager.

Employees will justify their actions in committing ESG fraud the same way they do when committing financial fraud. “No one gets hurt;” “it’s not a big deal;” and “it’s for the greater good of the company” are common rationales. And with remuneration increasingly linked to ESG performance, personal hardship is a potential fraud risk factor at every level of an organization.

The tone and action from the top are crucial. And yet boards are too often failing to recognize where ESG risks and issues exist, particularly in challenging an organization’s ESG communications and reporting. Is lack of experience at the very top an issue for the evolving challenges and standards companies are facing? Research from New York University’s Stern Center for Sustainable Business demonstrates some of the gaps: The team dug into the ESG credentials of 1,188 Fortune 100 board directors.¹² Just 6% had relevant experience relating to each of the “E” or “G” in ESG; only three people (0.2%) had specific climate expertise. Is your board equipped to recognize where tough questions need to be targeted in their management teams?

Legal counsel is taking on more responsibility. Corporate social responsibility (CSR) and ESG teams are shifting their reporting to the General Counsel, for example: The 2022 Chief Legal Officers (CLO) survey by the Association of Corporate Counsel found that 24% of organizations’ CSR and ESG teams have such reporting lines, compared to only 15% in 2020.¹³ The 2023 report showed this had fallen slightly to 23%, but 69% of CLOs believe the focus on ESG will accelerate (versus 66% in 2022).¹⁴

The role of law departments in ESG is evolving rapidly, but the lack of a controlled regulatory environment makes policy-making problematic.

A record 97% of respondents to the EY Global Integrity Report 2022 agree that integrity is important.¹⁹ However, senior management is often overconfident in the effectiveness of corporate integrity programs, with a growing “say-do” gap emerging between rhetoric and reality. This has implications for an organization’s ESG aspirations and increases the opportunities to greenwash.

Greenwashing in this context can be seen as a disconnect between words (what an organization says) and actions (what it is actually doing).

Senior management and board members should make sure they can back up what they are saying and consider the potential commercial, reputational, legal and financial risk of making statements they cannot support. Otherwise, they can be held accountable for violating a basic principle of stewardship and corporate citizenship, namely corporate integrity.

Consider what has happened with the financial services sector, where there is a swath of regulations sweeping across the globe to ensure organizations are held accountable both for their investments and the products they sell.

“If you’re investing in a ‘green’ fund you now need substantial documentation that those funds are living up to their name,” says Sarkar. “You need to look at the metrics you are using, how up to date the information is and whether it is disseminated appropriately and compliantly.”

Climate reporting and crises

Corporate reputations and the careers of CEOs are quickly destroyed by public disclosures of a say-do gap, and those reputations will be even more closely scrutinized as rigorous disclosure obligations on a company’s ESG performance come into force. Any companies facing scrutiny on disclosures, deeper analysis between peers and more cross-border enforcement should understand how they can validate (through strategy, data, and reporting) public-facing statements. Without that grounding, the reputational risks may be tantamount to greenwashing, regardless of a statement’s intent. “With ESG, it’s much harder to see where the threat is going to come from and how to respond,” says David Higginson, Partner, Forensic & Integrity Services, Ernst & Young LLP. “The ability to manage a greenwashing issue quickly and effectively needs to be moved further up the Board agenda.” He cites EY research showing that 58% of board directors/members and 37% of other employees would be “fairly” or “very concerned” if their decisions came under public scrutiny.²⁰

Integrity can be a difficult concept to define, not least because organizations face different ethical dilemmas. It’s about making the intangible tangible, about committing to the interdependence of business and society by embedding integrity into the culture and behaviors of the organization. But fewer than half those EY surveyed for the 2022 Global Integrity Report are using the basics of integrity enhancing measures such as providing regular training on regulatory issues (43%) or ethics (38%), applying sanctions to address behaviors (32%) and conducting due diligence on suppliers (30%) or customers (28%).

Suppliers, it should be noted, are exposed to the same pressures, and can be enticed by equally favorable opportunities and will rationalize these decisions in similar ways to their clients and customers. In other words: The very same fraud triangle exists, so the very same risks of greenwashing are present and the impacts can be felt up the supply chain.

Organizations should take a “tell me, now show me” approach to ESG with facts to the fore. Board members need to be on top of this strategy, because regulators increasingly are. Some are already employing data science to ensure, for example, that the claims made in glossy CSR reports match official ESG accounts.

Harmonized and mandatory reporting will help reduce ambiguity and provide more confidence in reporting. And make no mistake: Organizations will increasingly need to communicate externally – often with external assurance – on key sustainability matters and metrics applicable to their activities, like greenhouse gas emissions, as pressure from all stakeholders increases. This communication is the foundation of an organization’s social contract with all stakeholders. Moreover, putting sustainability at the heart of company strategy pays financial dividends. In a recent survey of more than 500 companies committed to improving their environmental performance, 69% report that they capture higher financial value than expected from their climate initiatives.²¹

Recommendations and actions

Chandan Sarkar, Principal, Forensic & Integrity Services, Ernst & Young LLP, Zain Raheel, EY Canada Forensics & Integrity Services Leader, Rob Locke, EY Oceania Forensic & Integrity Services Managing Partner and David Higginson, Partner, Forensic & Integrity Services, Ernst & Young LLP contributed to this article.

Summary

ESG should be led from the top and integrated into the business culture and strategy. Organizations’ ESG objectives and credentials need to be visible and measurable so they can be held up to scrutiny and avoid any allegations of greenwashing.