Environmental, social, and governance (ESG) fraud can present itself in various forms. In our last post, we talked about greenwashing, bluewashing, social washing, 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 social license to operate.
In this post, we'll explore how ESG practices that are intended to be "good" can go bad—how the ideal conditions for fraud and misconduct may arise when the elements of the Fraud Diamond align in an ESG context.
The Fraud Diamond1 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 behaviours may be motivated by 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.
- 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 incite companies to manipulate ESG data or provide imbalanced 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, loosely 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 favourable impression to stakeholders even though in reality their efforts fall short of their 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 actually harmed by fraudulent ESG practices or reporting.
- And of course, there is the popular "everyone is doing it" (regardless of whether this is true or not).
Capability is the factor that most recently evolved the traditional Fraud Triangle into the Fraud Diamond. 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 more capable of committing fraud as they would understand how regulators and other stakeholders scrutinize ESG reporting and practices and may be in a position 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, and the first step to prevention is understanding the root causes, described above. In our next post, we'll discuss how organizations can implement fraud prevention and detection measures, including red flags to look out for and how data analytics can be integrated into a fraud risk management program.
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