Do Your ESG Initiatives Open the Door to Fraud?

Within a relatively short period, corporate environmental, social, and governance (ESG) initiatives evolved from a disjointed and confusing set of goals to a more unified business imperative. This is largely because investors, employees, customers and other stakeholders have demanded it. But as companies ramp up ESG spending and require executives to meet ESG objectives, the likelihood of fraud also increases.

Although the SEC has created a Climate and ESG Task Force, there's currently little regulatory guidance related to ESG and fraud. Therefore, your business needs to be proactive.

ESB - Environmental, Social & Governance Goals

Broad Range of Goals

When designed and managed strategically, ESG initiatives target a broad range of goals — for example, they reduce environmental impact, increase workforce diversity and require transparent accounting methods. Yet, despite your organization's best intentions, fraud can occur if you don't have adequate internal controls and proper oversight to ensure controls are followed.

In general, linking compensation with ESG goals and the use of carbon offsets represent the greatest risks. But there have also been cases of companies falsifying health and safety records, exaggerating the sustainability of products and burying embarrassing ethical mishaps. Even when actions aren't technically illegal, they have the potential to damage a company's reputation with investors and the public.

Role of a Risk Assessment

A fraud risk assessment that includes ESG initiatives is recommended. It can help you identify vulnerable functions, potential perpetrators and methods they might use, and can tell you whether current controls leave gaps fraudsters can squeeze through. If gaps exist, your business should address them as soon as possible.

Some people in your organization may not believe fraud to be a potential threat to your ESG program. Making ESG a normal part of your company's fraud risk assessment can help reduce resistance to adding a new budget item. Also, ensure your board of directors lends its support to efforts to contain ESG fraud.

Information You Need

Because ESG covers different areas, you'll need to gather input from many stakeholders for a risk assessment, including managers from accounting, human resources and media relations. You may also need to engage third-party advisors to evaluate your company's risk of specific forms of fraud. For example, experts can look for possible executive "greenwashing," which occurs when a company misrepresents its environmental record.

In some cases, a company's corporate strategy of maximizing shareholder value may run contrary to the goals of its ESG program (which could involve greater costs). So while conducting your fraud risk assessment, be sure to evaluate your corporate strategy and executive compensation practices relative to ESG.

What might happen, for instance, if your board ties executive compensation to environmental goals yet also requires executives to minimize costs? Executives might feel pressure to source materials from suppliers with better climate records — yet those supplies often cost more. To achieve their ESG goal and keep costs down, executives could falsify your business's use of products from existing, cheaper and less environmentally friendly vendors.

Positive Results

ESG initiatives can generate many positive results for companies, yet fraud is an ever-present threat that can reduce the impact of your organization's efforts. Regulators are working on catching up. In the meantime, your business needs to conduct risk assessments and possibly revisit compensation guidelines. Contact us for help.

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