Banks Have Been Caught Red-Handed Committing ESG Fraud – or Have They?
Environmental, social, and corporate governance (ESG) greenwashing has soared by 70%, with many of the ‘guilty’ firms based in the EU. Yet all may not be as it seems.
Image: Unsplash
First things first - what is ESG?
Short for Environmental, Social, and Governance, ESG represents a holistic approach to evaluating a company's impact on society and the planet. This multi-dimensional framework has swiftly evolved from a buzzword to a crucial determinant of long-term success for businesses across the globe.
Environmental:
The "E" in ESG pertains to a company's environmental impact. It encompasses the strategies and practices related to sustainability, such as reducing carbon emissions, conserving natural resources, and adopting eco-friendly technologies. As the world grapples with climate change, businesses are under increasing scrutiny to limit their carbon footprint and protect the environment.
Incorporating environmental considerations into business strategy can lead to cost savings, improved efficiency, and a positive public image. Sustainable practices not only help preserve the planet but also attract environmentally conscious consumers and investors.
Social:
The "S" focuses on a company's social responsibilities. It encompasses issues like diversity and inclusion, labor practices, community engagement, and product safety. Modern consumers are not only interested in what a business produces but also how it treats its employees, engages with local communities, and ensures product safety.
A strong commitment to social responsibility can enhance a company's reputation, bolster employee morale, and cultivate customer loyalty. Moreover, it can be a critical factor in attracting and retaining top talent in a competitive job market.
Governance:
The "G" underscores the importance of effective governance within a company. This entails aspects such as board diversity, executive compensation, transparency, and anti-corruption policies. A well-structured governance framework is fundamental in ensuring ethical behavior, accountability, and long-term stability.
Robust governance practices not only protect a company from potential legal and financial risks but also inspire trust among investors. When stakeholders believe a company is managed responsibly, they are more likely to invest their capital and support its growth.
Integrating ESG principles into business operations is no longer a choice; it's a strategic imperative, also for banks. A growing body of evidence suggests that companies that embrace ESG outperform their peers in the long run. Investors are increasingly factoring ESG performance into their decision-making processes, and consumers are favoring businesses that align with their values.
For businesses, ESG represents an opportunity for differentiation and innovation. It encourages companies to rethink traditional practices and develop sustainable solutions that benefit not only their bottom line but also society and the environment. Moreover, it mitigates the risks associated with a rapidly changing world, from climate-related disruptions to social unrest.
ESG in banking and finance
The peer pressure and the upcoming regulations push banks in one direction – ESG compliance. Are all strategic motives neat and innocent, though?
Instances of greenwashing by banks and financial services companies rose 70% in the year to end of September 2023, according to a recent report by RepRisk. The total was 148, compared with 86 during the previous 12 months, says the ESG data firm. Of those 148 worldwide cases, 106 were instances of greenwashing by European institutions.
Greenwashing is broadly defined as statements, marketing or PR material that misleads customers into believing that a company’s product or service – or the company as a whole – has a positive or minimally harmful impact on the environment. It relates to the ‘E’ in ESG (Environmental, Social and Governance).
A cabal of rule-breakers or something simpler?
So what's going on here? Is Europe a hotbed of ESG greenwashing by devious banks and financial services institutions, all cynically trying to make themselves look greener-than-green when the reality is significantly grubbier? That's certainly how it appears, but there's more to this situation than meets the eye.
As the European Banking Federation has been quick to point out, these are allegations of greenwashing, not legally proven cases of fraud. That’s hardly surprising, because there is no legal definition of greenwashing, at least not in the EU. Without that, the legality of non-compliance with ESG expectations remains a grey area.
However, ESG is not just a nice little earner for firms that manage to tick the requisite boxes: for many it's effectively become a regulatory requirement, even though it’s not usually legally binding (yet). That's because some of the largest investment portfolios in the world, such as pension funds, have chosen not to invest in companies that do not meet certain ESG criteria.
The pressure to appear ESG-compliant is therefore immense. Banks and financial services firms that do not make the ESG grade are likely to end up with fewer institutional investors, a lower share price, less available capital, and may potentially even go bankrupt if they’re operating in a highly competitive market.
Cigarettes beat EVs under ESG
Yet ESG ratings are a tricky prospect at the best of times. The weightings and requirements can lead to some unlikely-sounding outcomes. As Elon Musk recently pointed out, Tesla (leading the world in terms of zero-emissions vehicles and high-capacity batteries capable of being powered by renewable energy) has a much lower ESG rating than some tobacco companies (whose products have been linked to millions of cancer deaths globally).
Love or loathe the man, he has a point. If ESG is supposed to make the world a better place, electric vehicle companies are surely a more ethical investment proposition than tobacco manufacturers?
The reasons for this anomaly are complex: a company with a good score for the diversity and gender equality of its board might be able to offset some of the negative aspects of its environmental impact, for example, giving a higher overall ESG rating. And maybe the tobacco plants are farmed in a sustainable manner.
Measuring environmental impact is like counting smoke
It's greenwashing in particular that's the focus of the RepRisk report. How can any regulator accurately measure environmental impact, whether of an entire corporation or a subset of its products and services? This is a problem for every industry, not just banking and financial services. For example:
• How much CO2 does a boutique tech start-up produce, taking into account issues as varied as its eco-friendly working-from-home employment policy, its reusable ethically-sourced bamboo coffee cups, and the massive energy consumption of its vast datacenter located in arctic tundra?
• How many trees must an airline plant to offset the carbon emissions of its flights? And the purchase, maintenance and repair of its planes? And the construction of the airports from which those planes operate? And the road networks that feed those airports?
• Is it better to scrap a 5-year-old diesel car and replace it with an EV, once the respective environmental costs of manufacture, delivery, maintenance and fuel/electricity supply have been taken into account? How about a 10-year-old diesel car? Or a 3-year-old one? How does the equation change if the EV's battery pack is depleted in 5 years? Or 7 years?
These are not spurious or rhetorical questions. Researchers have been trying, and are continuing to try, to place real numbers on all of these factors and many others, but often it's like nailing jelly to a wall. The outcome is usually a matrix with so many variables that it becomes meaningless.
Add a sprinkle of opaque bureaucracy
To make the situation even more complicated, the EU definition of “sustainable” when relating to environmental issues is actually two separate definitions, as explained by this article translated here from the original German using the DeepL online translator:
“This green spectrum is roughly defined by two taxonomy terms. Article 8 of the Regulation stipulates that capital market products classified in this way must only take into account and disclose environmental and/or social aspects as investment selection criteria. No statement is made here about the extent to which environmental and social goals are to be measurably achieved. Most of these light green products, commonly referred to as ESG funds, carry this classification. Article 9 classified products, on the other hand, must explicitly define sustainability goals and continuously report the extent to which they contribute to a better world. There are very few of these dark green, impact-oriented capital market instruments to date.”
A consumer might reasonably think that a product or service marketed as “sustainable” would meet the criteria of Article 9, when actually it is likely to only be compliant with Article 8, if at all. Furthermore, although the EU has drafted rules to combat greenwashing, they are not as strong as they could be thanks to pushback from potentially affected industries, especially in Germany and Italy.
So how can any firm honestly measure and declare the real environmental impact of any of its activities? With great difficulty, is the simple answer. The commercial pressure to exaggerate some of the figures is therefore overwhelming.
No laws broken (probably) but better compliance needed
It seems likely that banks and financial services firms have engaged in deliberate greenwashing to make their ESG scores look better than they should be. ESG itself is deeply flawed, so it's hard to entirely blame them. If they had done anything else they would have been severely punished by the market.
This is not to let anyone off the hook, however. Best practices should always apply. There's a big difference between accidentally overstating the ecological scope of a reforestation project and intentionally underplaying the environmental impact of fossil fuel consumption, for example. Banks and financial services firms currently enjoy a reasonably high level of trust amongst their customers, especially in Nordic countries, but that trust could quickly evaporate if ESG non-compliance were proven to be wilful ESG fraud.
For now, without clearer, legally-binding metrics to gauge how a company's activities really impact the environment, charges of greenwashing in this industry make for catchy headlines and little else.
