Putting the G in ESG Investment: Incorporating Anticorruption into Investment Decisions

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.

Guest Post: The 2017 World Development Report’s Embrace of Anticorruption Incrementalism

GAB is pleased to welcome back Finn Heinrich, from Transparency International’s research team, who contributes the following guest post:

In January, the World Bank published its latest World Development Report (WDR)– this time focused on “Governance and the Law” and their role in effective development policies. The annual World Development Reports typically receive significant attention from the wider development community, and indeed there have already been a number of events (see here, here, and here) and reviews (see here and here) dedicated to the 2017 WDR. The reviewers generally agree that the report’s key points—that governance matters a lot for many development outcomes, that what matters are governance functions rather than specific institutional forms, and that effective governance often depends more on underlying power dynamics than on institutional forms or capacities—are important insofar as the World Bank’s explicit acknowledgement of them represents a big step for the bank, but otherwise nothing new. After all, initiatives such as Thinking and Working Politically and Doing Development Differently have propagated these insights for a while.

None of the existing reviews, however, engages with the question of the 2017 WDR’s implications for the anticorruption community specifically. Yet the report repeatedly emphasizes three dysfunctionalities of a governance system—exclusion, capture, and clientelism—all of which are “negative manifestations of power asymmetries,” and all of which can be thought of as forms of corruption. While these terms (especially “capture,” which ends up being the one the WDR uses most frequently) is still conceptually underdeveloped, the term helpfully focuses on systemic forms of corruption in public institutions (broadly defined), rather than on corruption as an individual exchange between two actors (such as bribery). Thus, the WDR emphasizes that combatting the corruption of policies and governance processes (i.e. corruption in its political, grand, and systemic forms, rather than a focus on street-level bribery) is at the heart of making development policies work. That the World Bank is taking this position in its flagship publication is no small accomplishment, especially given that 25 years ago the Bank shied away from even using the word corruption.

Where the WDR falls short, however, is to put forward operationally relevant insights on how to address the problem of capture of public institutions by private interests. It starts off well with acknowledging the importance of expanding participation in governance (“contestability”) and of changing the relevant actors’ incentives and belief systems. Yet the WDR’s real-life examples of anti-capture interventions, scattered throughout the report, largely refer to cases where minor nudges or other incremental adjustments slightly shifted preferences and therefore behavior. To be clear, many of these examples of anticorruption interventions are not widely known to the anticorruption community, making the WDR a treasure trove of empirical nuggets on accountability, transparency, and participation interventions. Nonetheless, the report is frustratingly silent on the question of how to proceed when fundamental dysfunctional power asymmetries need to be changed.

Perhaps, though, that aspect of the report is a feature rather than a bug: Maybe it is a reflection of a new humility on the part of the World Bank and other external development actors in terms of what role they can be expected to play in governance and anticorruption. Mushtaq Khan, for example, embraced the WDR as “the incrementalist’s manifesto,” arguing that external development agencies should focus on fixing those problems where the interests of reformers and powerful actors within the society align (see also here). Could it be that this incremental approach to anticorruption will yield more results over time than the many grand and ambitious initiatives which unfortunately have often fallen short of their marks?