ESG Fraud: Understanding the imminent risks for your organization

Considering the European Parliament's approval of the Corporate Sustainability Due Diligence Directive (CS3D) in June, subsequent clarifications of existing directives, such as those for the Sustainable Finance Disclosure Regulation (SFDR) and the Green Claims Directive set to protect consumers and businesses from harmful greenwashing practices¹, ESG regulations are becoming progressively demanding for companies.

Although regulations are becoming stricter, according to the “Global trends in climate change litigation: 2023 snapshot,” published by the London School of Economics, between June 2022 and May 2023, 2,341 litigations related to ESG matters were recorded and more than 50% of climate cases had direct judicial outcomes. Furthermore, when taking into account the 2000-2021 trends highlighted by the London School of Economics and the new regulatory requirements, it is possible to assume a significant increase in ESG litigation in the coming years.

Environmental, social, and governance (ESG) fraud can present itself in various forms. In recent years, an increasing amount of news articles have appeared in relation to greenwashing, bluewashing, pinkwashing, sportswashing, and other illicit practices that can deceive stakeholders for corporate or personal gain. The consequences of being untruthful or misleading in ESG efforts can be significant, including expensive litigation and irreparable reputational damage—and, potentially, the loss of a social license to operate. It's worth mentioning that in contrast to greenwashing, a new trend known as 'green housing' has arisen. This refers to companies purposefully refraining from discussing their sustainability goals, even if they are well-intentioned and achievable, out of fear of being accused of greenwashing.

To understand exactly how ESG practices that are intended to be "good" can go bad and, conversely, how the ideal conditions for internal/external fraud and misconduct may arise when the elements of the Fraud Diamond aligned in an ESG context, we summarize below the main factors that can contribute to ESG Fraud.

The Fraud Diamond², developed by David T. Wolfe and Dana R. Hermanson, and based on the Fraud Triangle developed by Donald R. Cressey, is a generally accepted framework that proposes fraud is more likely to occur when the following elements are present: motivation, opportunity, rationalization, and capability.

Motivation refers to the incentive behind engaging in fraud. This can be either personal or business related, such as an individual's financial debt or the pressure to meet performance targets. From an ESG perspective, there can be several potential motivations:

• Individuals may face pressure from management and other stakeholders to meet sustainability targets or their compensation may be tied directly to the achievement of ESG-related targets. Inappropriate behaviors may develop where individuals are trying to catch up with management's big claims, such as the numerous companies who claim they will be "carbon neutral" or will achieve significant emissions reductions by a certain year not too far in the future.
• Organizations may face pressure to meet certain production thresholds and requirements to avoid penalties or other costs as carbon pricing models are introduced (such as carbon taxes and greenhouse gas emissions limitations), and the regulatory landscape continues to evolve (i.e., where the correct path seems unclear, shortcuts are more likely to be taken).
• Investors and lenders increasingly incorporate ESG considerations into their investment and lending decision-making processes. Sound ESG performance and disclosure enhances companies' access to capital. This may incentivize companies to manipulate ESG data or provide unbalanced reporting.

Opportunity refers to the course of action presented to an individual or group that allows them to abuse their power to resolve the source of the motivation.

• For example, loose and self-defined ESG metrics may provide an opportunity for manipulation. A company facing pressure to be more socially responsible can use various forms of ESG washing (e.g., greenwashing) where they advertise their ESG efforts against vague metrics in a way that gives the company a favorable impression to stakeholders despite their efforts falling short of these claims.
• Even if there are clear metrics, an organization's ESG reporting processes, controls, policies, and systems may be immature. If there are no qualified individuals who internally review ESG reporting metrics for completeness, accuracy, and understandability against a consistent framework, or the company does not receive external assurance over its ESG reporting, there is opportunity for the qualitative and/or quantitative information made available to stakeholders to be manipulated.

Rationalization is essentially what a fraudster tells themselves to be able to sleep at night. It refers to a more cognitive stage of committing fraud where the individual or group justifies their actions in a way that is admissible to their moral compass. This is usually more specific to the individual and often based on external factors.

• In the ESG context, it may be common to rationalize based on an "appeal to ideals." For example, if an individual believes the overall purpose of an organization is to be a benevolent corporate citizen, they may rationalize that fudging the ESG reporting is negligible in relation to the greater good the company intends to achieve.
• Rationalization may also be based on denial of injury or denial of victims—i.e., the perception that no-one is harmed by fraudulent ESG practices or reporting.
• And of course, there is the popular "everyone is doing it" perspective (regardless of whether this is true or not).

Capability is a new factor that has been introduced in the Fraud Diamond approach, compared to the traditional Fraud Triangle theory. It refers to an individual's personal traits and specific abilities to pull off a fraud scheme.

• For instance, someone with a stronger understanding of the ESG regulatory environment, expertise in ESG reporting, and in a position of oversight would likely be in a better position to commit ESG fraud, as they would understand how regulators and other stakeholders scrutinize ESG reporting and practices and may be able to manipulate what is presented externally.
• Traits such as confidence, being able to persuade others, excellent stress management, and generally being a good liar also play into capability.

There are many factors that can contribute to potential instances of fraud in a company's ESG practices. The first preventative step is to understand the root causes, as described briefly above. In today's landscape, heightened ESG regulatory pressure presents a unique opportunity for third-party verification to not only enhance credibility but also act as a potent tool against fraudulent practices.

In our next post, we’ll discuss how organizations can manage ESG risks, including the risk of ESG fraud, and how ESG risks can be included in a (fraud) risk management program.

NGOs, consumers, investors, employees, and regulators are becoming ever more alert to false or exaggerated ESG claims. And where there’s greenwashing, there’ll be consequences such as: brand damage, ongoing scrutiny from regulators, and the risk of fines and litigation.

Investors, who are also facing increased scrutiny, are becoming more discerning about the ESG status of their investments and will be watching carefully and may be quick to divest where red flags or issues occur.

As experts in the fields of Forensics, ESG, Supply Chain, Compliance and Law, KPMG can support your organization to prevent, detect and respond to ESG fraud. In particular:

• ESG Fraud Investigation & Litigation Support: We support your organization in identifying any ESG Fraud through detailed inquiries and examinations, including the use of leading data analytics and eDiscovery techniques. Our professionals take an impartial approach to establish truths, evaluate implications, identify appropriate remedial actions, and communicate with regulators or external auditors.
• Corporate Intelligence Services: Our team of multilingual specialists come from a range of professional backgrounds including political risk, investigative journalism, public policy, and academia. Through investigation into the background, track record and connections of third parties and prospective partners, we assist you in identifying and mitigating reputational and regulatory risks, with a specific focus on financial crime and ESG issues.
• ESG Fraud Risk Assessment: Our approach is aimed at helping clients prevent, detect, and respond to ESG fraud and misconduct risks. We do this by working with our clients to design, implement, and evaluate ethics and compliance programs and related ESG antifraud programs and controls.
• Third Party Risk Management (TPRM): We support our clients to mitigate the third-party risk, also from an ESG point of view, and manage their third-party relationships whilst also providing an end-to-end TPRM solution.