Insight

Joining the dots between ESG and corruption

Written by inCOMPLIANCE® on Monday December 12, 2022


Dr Ingrida Kerusauskaite and Rory Donaldson explain why business integrity and anti-corruption are core components of ESG

In July 2022, The Economist provided a scathing diagnosis of the problems1 with many of the current approaches to, and applications of, environmental, social and governance (ESG) criteria to investing. It proposed doing away with the ‘S’ and ‘G’ t o focus on the ‘E’, and to further reduce the ‘E’ to emissions rather than the environment more broadly.

This, however, would be an overly extreme approach to take, and one that would not solve the core issues. The current ESG criteria are far from perfect, but the solution is to invest in understanding the complexities of the political, social and broader environments, and devise appropriate mitigations alongside a transparent reporting framework for ESG risks.

A large part of what makes ESG the ‘unholy mess’ that The Economist describes is the interconnected nature of each of its three elements. Indeed, corruption and poor governance often result in negative environmental impacts, for example, through falsification of environmental progress measures or driving communities to environmentally damaging practices to make ends meet.

Transparency International (TI) UK’s recent report on impact investing, Investing with Integrity,2 set out the case for why business integrity and corruption issues should be considered as core issues in the context of impact investing. In other words, business integrity considerations, and, with them, anti-corruption, should be seen as the organic fertiliser investors use to ensure that their ESG and financial impact grows.

Terminology and impact washing

There is a lot of debate surrounding the terminology used in the context of ESG, impact, sustainable and responsible investment. Ultimately, we can distinguish two types of investor: those mostly focusing on risk management and those actively seeking to make positive impacts beyond financial returns through their investing.

The ESG investors that are in the first category (risk management) are focused on making sure that no environmental, social or governance-related harm is done as a result of their investment activity. This requires investors to fully understand the impact that the businesses they support have on their communities and ecosystems, and put in place mitigations where required, engaging in remedial action such as carbon off-setting or refraining from financing some types of businesses.

Impact investors are focused on development impact, seeking to go beyond ‘doing no harm’ and actively working to improve ESG measures alongside generating a financial return. This can include improved labour standards, improved diversity and inclusion in business or biodiversity preservation.

Business integrity considerations are relevant to both types of investors. Business integrity and anti-corruption are particularly salient in light of the green-washing3 and broader impact-washing concerns that the public and the regulators are raising.

In October 2022, the UK’s Advertising Standards Authority reprimanded4 HSBC for misleading consumers with its ‘green posters’, asking it to ensure that “future marketing communications featuring environmental claims were adequately qualified and didn’t omit material information about its contribution to carbon dioxide and greenhouse-gas emissions”. HSBC’s posters, released ahead of COP26 in 2021, had stated that HSBC will “provide up to $1 trillion in financing and investment globally to help our clients transition to net zero,” and that the bank is “helping to plant two million trees, which will lock in 1.25 million tons of carbon over their lifetime”. The campaign failed to acknowledge the significant financing of fossil-fuel companies and other carbon-intensive

industries by the bank.

Recent regulatory action comes as a warning to businesses that the regulators have started focusing on this topic. In 2021, the US Securities and Exchange Commission (SEC) launched a dedicated taskforce focusing on Climate and ESG issues5, initially focusing on identifying material gaps or misstatements in issuers’ disclosure of climate risks. Consequently, the SEC charged several businesses. For example, in May 2022, the SEC issued a $1.5 million fine to BNY Mellon6 for allegedly misstating and omitting information about its mutual funds’ ESG investment considerations. Specifically, BNY Mellon had stated that all investments in the funds had undergone an ESG quality review when nearly a quarter of investments in one mutual fund lacked an ESG quality review score at the time of the investment.

Why business integrity matters

Corruption can undermine both the development impact and financial goals that investors are attempting to achieve. TI UK’s partners have shared various examples that demonstrate how corruption and lack of business integrity can affect the labour, human rights and environment footprints of businesses. In one example, a company was aiming to ensure that jobs in a factory were distributed fairly among the local population, engaging the services of a local man to carry out recruitment. Over time, however, it became clear that he had been requesting monetary bribes from men and in-kind payments from women in return for a job at the factory.

In another case, a company’s headquarters noticed a spike in the number of health and safety incidents in a factory and went to investigate. It soon emerged that a large portion of the workforce was illiterate. The health and safety training and notices, however, had been designed with the assumption that the workforce could read. And this had been a reasonable assumption, given that all workers were required to present an education certificate upon being hired. As such, corruption within the hiring processes and/or the educational system had led to real consequences for workers at these factories.

One investor shared with us their experience of having invested in a hospital. In addition to a financial return, they were aiming to bring about improved health outcomes. Post-investment, they had discovered that doctors were receiving kickbacks from pharmaceutical companies. This can have serious consequences for patients, such as not receiving the right medication for their conditions. The investor in question had taken a pro-active approach to business integrity which helped to identify the issue, and they subsequently worked to change the corrupt practices at the hospital. This ultimately led to the hospital providing better care to underserved populations. In other words, better management of business integrity led to better development impact.

The serious impact of corruption in relation to ESG issues is also evident from the regulators’ cases. The SEC charged a Brazilian mining company, Vale S.A., for misleading investors about the safety of its dams prior to the collapse of its Brumadinho dam, which killed 270 people.7 The SEC noted that Vale “manipulated multiple dam 10 safety audits; obtained numerous fraudulent stability certificates; and regularly misled local governments, communities, and investors about the safety of the Brumadinho dam through its … [ESG] disclosures”.

The state of play

Impact investors are often first movers in markets that others deem too risky, including markets with high corruption risk. However, there are improvements to be made as to how business integrity and corruption are considered and incorporated within impact investing. Our report8 found that there is no common anti-corruption framework or standards, or even guidance, that impact investors can follow. There is, therefore, a very inconsistent and patchy approach across the impact investing sector. Investors consider business integrity in different ways and ask for different action and reporting of their investees. This leads to inconsistency and poses an administrative burden on investees, as they try to manage various differing requests.

Anti-corruption efforts typically lack energy or enthusiasm. Anti-corruption is often seen as a chore, with sometimes only minimal compliance being undertaken before investment and as any material events occur. A proactive approach to the identification and management of risks, on the other hand, would help reduce corruption and contribute to business resilience through more effective ESG and financial risk management. For example, a pro-active business integrity approach would include a thorough political landscape assessment, including the likelihood of demands for bribes, arbitrary enforcement of regulations as well as the introduction of sanctions.

Impact investors generally do not count improvements in business integrity as development impact. Therefore, if a company has a significant effect on reducing systemic bribery within a sector, it is unlikely that impact investors are even picking up on this improvement.

What’s next?

The ESG world is moving fast, and both interest in ESG and sustainability, as well as critiques of it, on the increase. On the impact investing and business integrity side, TI UK and other impact investors, including British International Investment (BII), are starting to work on common framework or guidance that addresses business integrity for impact investors or development finance Institutions. TI UK will provide guidance on what proactive steps businesses should take to identify, assess and manage business integrity risks in the context of ESG risk management within different aspects of their operations. Alongside this, TI UK will devise a framework for ESG and impact investors to monitor business integrity risks and performance of their portfolios, and bring together impact investors in a bi-annual forum to discuss business integrity and impact investing challenges, approaches, measurement and innovations.

More broadly, investor and anti-corruption communities should collaborate more. The anti-corruption community can help investors achieve their development as well as financial goals, as set out above. The investor community can help to amplify the impact of integrity work, as companies pay attention to what their investors say. What investors ask of their investee companies can have a real effect on how the companies behave.


About the authors

Dr Ingrida Kerusauskaite is former Head of Business Integrity, Transparency International UK and Rory Donaldson is Programme Manager, Business Integrity, Transparency International UK.

This article was published in inCOMPLIANCE, ICA’s member publication. For more, visit the ICA member hub.


References:

  1. https://www.economist.com/leaders/2022/07/21/esg-should-be-boiled-down-to-one-simple-measure-emissions
  2. https://www.transparency.org.uk/investing-with-integrity-impact-investors-anti-corruption
  3. https://www.bloomberg.com/news/articles/2021-09-01/regulatory-scrutiny-of-esg-greenwashing-is-intensifying#xj4y7vzkg; greenwashing is where companies make false or misleading claims about the extent of their environmental footprint and sustainability record.
  4. https://www.bloomberg.com/news/articles/2022-10-18/hsbc-breached-advertising-code-with-green-posters-watchdog-says?leadSource=uverify%20wall
  5. https://www.sec.gov/news/press-release/2021-42
  6. https://www.ft.com/content/ff0097c4-3f1c-49d8-8189-153fc56aeeb3
  7. https://www.sec.gov/news/press-release/2022-72
  8. https://www.transparency.org.uk/investing-with-integrity-impact-investors-anti-corruption

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