ESG euphoria and the threat of the fraud triangle

The Environment, Social, and Governance (ESG) standard has become a hot topic widely discussed by the public, in company board meetings, audit committees, investor forums, and other forums all around the world. The pandemic, which taught important lessons about the importance of sustainable ecosystems, was one of the catalysts that made this standard widely adopted by companies and turned it into an important corporate strategy.

Essentially, ESG principles seek to align business with environmental and social sustainability. The concepts which are then adopted have become the industry norm, resulting in a very high investment turnover.

ESG-related investments, for example, totaled $22.8 trillion in 2016, $30.6 trillion in 2018, and $35 trillion in 2020. It is expected that investment in these schemes would exceed $50 trillion by 2025.

The threat of fraud

Unfortunately, despite its noble intentions, this concept is not without the risk of fraud. Improperly implemented ESG increases the likelihood of these risks.

According to the National Association of State Auditors, Comptrollers, and Treasurers (NASACT), most individuals can be persuaded to commit fraud under the right circumstances.

The precise circumstances here refer to the occurrence of three elements from the fraud triangle theory: motive or pressure, opportunity, and justification. Grant Thornton outlines how the “fraud triangle” theory applies to ESG in his study “ESG and the Risks of Having Good Intentions.”

The ESG revolutionizing global business is urging companies to align their strategies. These changes impact how executives are motivated or pressured to reach ESG performance targets, which is what stakeholders—particularly investors—demand.

At the same time, while the trend of ESG adoption is relatively rapid, relevant authorities have yet to create a standardized regulatory and reporting framework. Without standards, opportunities for fraud remain in nonfinancial ESG reports.

Companies, for example, may purposefully omit, misrepresent, or construct false information in their reports in order to fulfill the expectations of investors. However, since there are no reporting standards, it is difficult for investors to detect fraud.

The pressure to meet expectations and the opportunities to commit fraud are sufficient to motivate someone to justify wrongdoing.

One example is the Hino case. Rather than spending the time to enhance the quality of their products, the manufacturer believed that manipulating the results of emission testing was the best approach to fulfill deadlines and meet standards for environmentally friendly vehicles.

Mitigation, robust internal control

Mitigating ESG-related fraud is challenging homework for businesses. Beginning with a risk assessment based on the fraud triangle hypothesis is conceivable.

Based on this assessment, companies may take actions to manage risks, such as preventing, detecting, and correcting them.

One of these measures, according to the COSO/ACFE’s “Fraud Risk Management Guide,” is to increase internal control.

Robust internal control is critical in the prevention and detection of fraud. According to ACFE’s Report to the Nations 2022, a rampant cause that underpins the prevalence of fraud in organizations is a lack of internal control, which accounts for roughly 29% of the cases.

Concretely strengthening internal controls, including the implementation of a whistleblowing system, vendor screening, employee background screening, and other compliance instruments, is essential. Companies can manage internal control measures independently.

These internal control measures, however, can also be carried out via collaboration with third parties that offer compliance services. As independence is critical in managing internal control, working with other parties that do not have an interest in the company may be the best option.

Integrity Indonesia has been trusted as a compliance service provider by clients from diverse business backgrounds for over two decades. Contact us for more information about compliance services.

Putri
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