A growing number of investors now consider environmental, social, and governance (ESG) issues when making investment decisions. While ESG investment methods vary, typically ESG investment involves evaluating potential investments not only based on traditional financial indicators, like annual cash flows and debt levels, but also on a number of observable ESG criteria, such board diversity or use of renewable energy. Given the difficulty of establishing investment parameters that incorporate a wide range of sometimes competing objectives, however, ESG investors usually end up prioritizing certain ESG considerations over others. In particular, governance issues—including corruption-related concerns—have often fallen by the wayside (see here, here, here, and here), so much so that a joke in the field has it that the “G” in ESG is silent.
This is unfortunate. Investments tainted with corruption not only indicate a failure in corporate governance—which can reduce the investment’s expected profitability—but also can contribute to a plethora of grave social and environmental ills (see here, here, here, here, and here). Given the fact that an investment’s corruption risk is relevant to a range of social and financial objectives, why hasn’t corruption risk played a more prominent role in ESG investing?
The cynical explanation would be that ESG investing is nothing more than a marketing ploy, and that ESG investors are therefore more likely to tout PR-friendly topics, such as CO2 emissions, and neglect less flashy issues like corporate governance. But that cynical explanation is unpersuasive in light of the fact that ESG investors are spending heavily on efforts to obtain more comprehensive ESG data—behavior that is hard to square with the view that this is all for PR. More plausibly, the insufficient attention to corruption is not from a lack of concern, but rather from a lack in ability to properly assess corruption risk. Reasons for this shortcoming are twofold:
- First, companies’ reporting on corruption varies significantly in terms of both the quantity and quality of information provided to investors. Without certain standardized disclosures, it is difficult to compare corruption risk across investments. Reliance on voluntary disclosures can allow for the corruption equivalent of greenwashing, where positive information is exaggerated and negative information is buried or completely excluded.
- Second, even if companies report robust internal control policies, it is difficult for external parties to assess whether these practices are effective or actually utilized. Proper assessment of corruption risk requires internal information that is hard for investors to obtain on their own.
There are several possible things that government regulators, and the ESG investors themselves, might do to address these problems, thereby making it more feasible for ESG investors to take corruption issues more seriously.
With respect to regulation, financial regulators should require certain corruption-related disclosures, so that ESG investors could better engage in relative comparison between investments’ corruption risk. The required disclosures might include:
- Detailed information on the company’s internal controls and chain of command, including the size and scope of the compliance department, the names the officers and board members responsible for oversight of the compliance program, and whether the company as an “ombudsperson” or independent reporting channel;
- The number of alleged compliance infringements and the number of resulting disciplinary measures;
- The company’s assessment (perhaps in the annual report) of the corruption risks it faces, including general risks associated with its line of business and, more specifically, the level of interaction it has with governments and public officials.
The ESG investors themselves can also do more to demand greater corruption-related information from companies and insist that this information be accurate and independently verified. Independent assessments by third-party organizations could ensure that impressive anticorruption reporting and compliance programs are not merely “lip service.” NGOs and consultants already engage in similar analysis of private sector corruption, and would be well-placed to perform such “corruption audits.” For example, Transparency International’s Defense and Security program assesses corruption risk for individual companies in the opaque private military and security industry. With sufficient demand from the growing ESG market—which has already large capital outflows from investments that fail to meet certain socially responsible investment parameters—this type of corruption audit could become an industry norm.
ESG investors have been able to exert meaningful financial pressure on companies, making them increasingly influential over corporate behavior (see here, here, and here). These investors could become a powerful force in combating corruption—if, but only if, they are equipped with the necessary information.