In our previous article we addressed the topic of the principles of Environmental, Social and Governance (ESG).
Even though such principles indicate a better, more transparent and sustainable corporate world, there is also another side worth mentioning. The circumstances that created a ’’rise of demand“ for compliance with these principles were, actually, the unsound ones. We will mention most notable corporate scandals that led to public rising interest in ESG:
1. Volkswagen's Emissions Scandal - In 2015, Volkswagen was found to have installed software in its diesel vehicles that cheated emissions tests, violating environmental regulations and causing serious harm to air quality. This was the most notorious case that drew attention to the need for new work processes and organization of companies in order to improve environmental and work conditions;
2. Wells Fargo's Sales Practices Scandal - In 2016, it was revealed that Wells Fargo had created millions of unauthorized bank and credit card accounts in order to meet aggressive sales targets, resulting in significant harm to customers and a loss of trust in the bank.
3. Chocolate Industry Child Labor Scandal - Nestlé and Cargill, along with Mars, Hershey’s, Barry Callebaut, Olam and Mondelēz, were all sued for using child labor in their cocoa supply chain, violating human rights and failing to meet ESG principles for labor practices.
4. Dow Inc and the Singapore government Scandal - The most recent one might be the one from 2022 when the U.S. petrochemicals giant Dow Inc and the Singapore government said they were transforming old sneakers into playgrounds and running tracks. However, most of them end up being exported and sold in less developed Indonesia.
These cases put the ESG into a different perspective indicating that the current state of things is not enough.
ESG Principles – Trap for Misconduct
The ESG trends suffer from flaws like complexity of methodologies, lack of transparency and aggregated confusion, data quality, coverage and granularity, the principles being interlinked and too flexible etc. In such a setting these principles are suitable for abuse, and many companies do just that.
Let's take a look at ESG funds and their performance aimed at a better image. According to a study conducted by researchers from Columbia University and the London School of Economics, a comparison was made between the ESG performance of US companies in 147 ESG fund portfolios and that of US companies in 2.428 non-ESG portfolios. The results revealed that companies included in the ESG portfolios had worse compliance records for labor and environmental regulations. Additionally, the researchers found no evidence to suggest that companies added to ESG portfolios subsequently improved their compliance with labor or environmental regulations.
Many companies resort to so-called Greenwashing, a phenomenon that indicates a dishonest practice by adding to their business the labels like “green”, “sustainable”, “ESG” without changing anything in their business practices at all. The reason for this is a spiraling demand for sustainable and environment-friendly businesses. The public and the market itself put a severe pressure on businesses to be sustainable due to which the businesses take shortcuts that do not tackle this complex matter.
A study conducted by UK’s Quilter suggests that 44% of investors have concerns that ESG investments may not accurately reflect their intended goals. With growing concerns about climate change, some companies may overemphasize the environmental friendliness of their products and services to capitalize on the trend, potentially leading to false or unrealistic claims.
Biggest Issues Leading to Greenwashing
Since ESG has become a massive trend, both for investors and businesses alike, the ESG oriented companies become more desirable. However, the biggest issue is the lack of standardized common principles, definitions and roadmaps, so as a consequence every business is on a confusing and jumbled terrain.
The awareness of what the ESG principles represent must be placed at a higher level. We are witnessing that many companies install solar power plants in order to reduce their costs and make their business less grid energy dependent, thinking that in this way they also become an ESG oriented subject. However, if the rights of employees, further enhancement of data protection, conflicts of interest regarding the management of the company, and other, are not taken into account, such thinking is just not right.
Another issue is the lack of experts in this field. According to Prof. Dr. Kim Schumacher form Kyushu University in Japan, financial analysts are rapidly attending courses and obtaining certificates whereas the quality of such knowledge is questionable. To ensure effective integration of ESG principles into corporate decision-making processes, it is important to have ESG teams within companies that consist of both financial and non-financial experts. However, the current situation where the majority of team members (almost 80%) are purely financial experts suggests that the focus remains on traditional financial analysis. Additionally, clear criteria should be defined for becoming an ESG expert.
Finally, the issue with ESG is that it is not a mandatory, but a voluntarily accepted standard. The investment strategies in this field are mostly short-term without any regard to long-term challenges. Without the institutions to force the subjects to act accordingly, little progress can be made.
The before mentioned flaws should be seen as opportunities to grow, rather than setbacks. The ESG space has many open questions making it a fertile ground for not only a short-term gain, but also for a long-term plan to encompass all the issues and benefits in a thorough manner.
A combination of efforts from various stakeholders, including companies, investors, governments, and civil society organizations is necessary, leaving the topic in the court of an international fight-for-future-of-the-planet game.
Miloš Vučković, Senior & Managing Partner
Aleksandar Čermelj, Associate
*The information in this announcement does not represent legal advice and is provided for general informational purposes only.
**Partner, Senior Associate and Associate refers to Independent Attorney at Law in cooperation with IVVK Lawyers.