ESG investing needs standards to prevent fraud and greenwashing

The rise of ESG-focused investing should be defined by accountability. It should be easy for investors to discern a company’s ESG policies, reporting structures, and results.

Yet, it can be difficult to verify ESG claims and detect potential fraud. The business world needs to move quickly to ensure trust and good governance by creating clear standards and universal practices for ESG reporting. We can’t afford to ignore this challenge.

History has taught us that people don’t typically fudge numbers unless there are compelling reasons–and there are plenty of compelling reasons to misstate ESG efforts. ESG-driven investment is estimated at greater than $35 trillion in assets under management and is on track to exceed $53 trillion by 2025. Nearly nine out of 10 millennials report that they want their money in sustainable investments. In 2020, Goldman Sachs pledged to take public only companies with diverse boards, while NASDAQ required member companies to have at least two directors from underrepresented groups. Harvard’s endowment, the University of California, and Cornell are divesting from fossil fuel companies, while Stanford eliminated coal from its portfolio in 2014.

Regulators clearly see the fraud potential. The Security and Exchange Commission (SEC) has created a Climate and ESG Task Force to help identify misconduct and analyze data to identify potential violations. It also created a website to receive ESG-related tips, referrals, and whistleblower complaints.

Further, the SEC’s Division of Examinations issued a risk alert in April detailing observations of ESG-related deficiencies and internal control weaknesses, plus those related to investment advisers and funds making ESG claims.

ESG elements have been a part of corporate action for decades, and there have been several prominent incidents of unmet promises. Volkswagen’s diesel engine scandal, for example, remains one of the most notable incidents of fraud in business history. In another example, a massive Ponzi scheme was based on the fraudulent claim that biochar (waste from tires and household garbage) would be a future source of green energy. And a vast carbon credit fraud perpetrated on people in the UK led to the arrest and extradition of perpetrators.

These high-profile incidents, while dispiriting, make it clear that ESG is becoming a key corporate outcome. They also reveal a simple truth: When stakes are high, people are willing to lie. ESG is no exception.

How to Avoid fraud

Despite the temptation, ESG fraud is not inevitable. The key is to maintain guardrails, ask hard questions and invest in better reporting, controls, and approaches. Such tasks may prove a more powerful deterrent than regulatory action and litigation.

Meanwhile, we need a greater understanding of what constitutes material information, standardized frameworks, and reporting definitions for issues like climate impact, human rights, and income inequality. For companies focused exclusively on maximizing shareholder value, ESG reporting metrics are a challenge.

It’s critical that the SEC, accounting standards boards, and others sharpen their focus on materiality assessments and standardized disclosures. Companies also play a role and should apply a consistent process to determine materiality and refine when necessary.

Creating an ESG Culture

Leaders must ask some hard questions:

Are my company’s ESG disclosures subject to the same rigor as our financial disclosures?
What are our management assertions about ESG, and are controls in place to make faithful assertions?
What is the plan to disclose and correct ESG reporting problems?

ESG can’t be left to a single department or reporting chain. It’s central to all parts of the business, part of the culture to drive better outcomes and create more procedural controls and cross-enterprise discipline.

If we treat ESG with the same attention and importance as financial reporting, results will improve with a natural focus on accuracy.

ESG fraud prevention experts can help ensure accuracy in disclosures. We also need to build an ecosystem consisting of academic departments, mid-career training, ongoing professional certification and standards, and case studies that shape future judgment.

These issues are never settled for good. Like accounting standards, ESG goals evolve, and companies will test new ideas about valuation and performance.

That process is manageable, doable, and most importantly, necessary. People care about ESG. They want results and they decide where to invest, where to work, and what to buy based on those outcomes. ESG is worth the investment and making it trustworthy is essential to a company’s overall success.

Brad Preber is the CEO of accounting and advisory firm Grant Thornton LLP.