Global Green Guide: ESG Colourwashing – why leadership with integrity is necessary to combat corporate hypocrisy

The Legal 500 Deutschland and Global Green Guide editor Anna Bauböck talks to widely respected The Legal 500 Germany GC Powerlist alumnus and internationally acclaimed head of legal Timo Matthias Spitzer, LL.M. (Wellington) about the introduction of ESG principles in business strategies and a resulting potential proliferation of so-called “ESG colourwashing”.

In his soon to be published article, ‘ESG Colourwashing: Combating Modern-day Corporate Hypocrisy’, which Timo co-authored in conjunction with his colleague and former student Klemen Kreča, he describes how consumers and investors are increasingly demanding the introduction of sustainable practices and, in turn, even though they may not be “born-believers” as regards the creation of sustainable value, corporations are introducing Environmental, Social and Governance (ESG) factors into corporate decision-making. As ESG has become the new benchmark of corporate sustainability, this has meant, unfortunately, that corporate hypocrisy is rife. Some companies may try to avoid ESG implementation costs by simply sugar-coating the status quo or wilfully creating false impressions about their underlying business models and their actual efforts to integrate sustainable practices.

Anna Bauböck (AB): How can implementing ESG criteria create value for companies, and is it beneficial for all industries and business models?

Timo Spitzer (TS): The implementation of ESG criteria, ie economic, social and governance policies, creates both direct as well as indirect benefits for the company. Direct benefits include a boost in employee morale (improvement in both efficiency and productivity), attraction of better talent, enhanced returns, decreased costs (mostly due to better energy consumption) and easier access to government funding.

Furthermore, due to changing consumer and investor preferences, the implementation of ESG criteria can also lead to indirect benefits such as, among others, increased consumer loyalty, higher revenue, better equity and debt financing opportunities as well as reduced market volatility.

Nevertheless, not all industries and business models are alike. Certain industries such as coal mining are simply inherently unsustainable, while other industries may see only small benefits compared to the still considerable costs of implementing ESG criteria into day-to-day business operations.

AB: Why is the appearance of ESG compliance potentially more lucrative for companies than actually implementing ESG principles?

TS: The implementation of ESG principles comes with significant costs. For most companies, such costs may already be outweighed by the direct benefits, and even further enhanced by the indirect benefits, such as gaining favour from sustainability orientated investors and consumers. However, this may also create a moral hazard when for some companies, the direct benefits of ESG implementation may not outweigh the costs of implementation, or at least not right away. For such companies it may be more beneficial to simply create false impressions about having incorporated ESG metrics into the business model, thereby still gaining indirect benefits, whilst not having to bear any of the associated costs. This is called “ESG colourwashing”, when companies claim to promote sustainability goals, eg social progress, equality, environmental awareness, and diversity, while in reality they are merely sugar-coating the status quo in order to win over consumers and investors who want to support ESG principles.

AB: Why are ESG disclosure rules not enough to prevent companies from colourwashing their ESG credentials?

TS: Disclosure obligations are based on the idea that under full market transparency consumers and investors will be able to ensure companies are ESG compliant. However, ESG colourwashing is not a case of informational asymmetry, where better informed market players could easily penalise non-conforming companies, but rather a case of intentional deceitful action. Companies are wilfully trying to misrepresent their business model to obtain financial gain from consumers and investors.

It is naïve to think that a company that is actively trying to deceive consumers will be stopped just because it has to disclose information. Disclosure laws cannot prescribe for all scenarios, and companies will still be able to find ways to circumvent such laws. Moreover, disclosure obligations are hindered by various drawbacks: i) only certain market participants are bound by disclosure obligations; ii) obligations are triggered only in limited situations; iii) disclosure is often accompanied by enormous bureaucratic burdens; iv) the actual reporting requirements may be shrouded in uncertainty; v) companies often need to hire expert consulting firms, which further drives up their costs; and vi) disclosure standards are not universal means, creating an uneven playing field in a globalised market.

AB: What are some of the problems with existing regulatory actions and enforcement systems?

TS: The European Union is currently leading the charge in combatting ESG colourwashing, and not only through mandatory disclosure obligations. The existing consumer protection legislation and even ex ante labelling mechanisms provide for a system well equipped to combat ESG colourwashing, at least in theory. The issue the EU is facing is not a lack of relevant disclosure regulation, but even more so weak enforcement and poor coordination and harmonisation among its Member States.

The Unfair Commercial Practices Directive (UCPD) and the Comparative Advertising Directive (CAD) form the foundation of the EU’s consumer protection legislation. The UCPD is a fall-back for instances where more specific laws do not exist. It applies to implicit green claims (images, colours, types of package or even smells or sounds used for promoting products and suggesting environmental characteristics), as well as other sustainability claims. Even retail investment services are subjected to the UCPD, insofar as they are not more specifically regulated by the Distance Marketing of Consumer Financial Services Directive and of course the very comprehensive Markets in Financial Instruments Directive (MiFID II) and the Markets in Financial Instruments Regulation (MiFIR).

Nevertheless, in practice the existing system faces a severe lack of harmonisation and coordination. The ex-post enforcement mechanisms under the UCPD are sluggish, poorly organised and unrecognised on an EU-wide level, and it often lacks the required technical expertise.

That being said, with appropriate amendments to these laws, most of the aforementioned issues could be mitigated. Harmonising or, better yet, unifying enforcement measures on an EU level could ensure effective ex-post control. Complementary efforts could also be considered, eg supplementing the UCPD with such mechanisms as coordinated pre-approval systems of green claims and an accreditation system of green labels. These measures could help establish appropriate ex-ante control and technical/scientific expertise.

AB: In your opinion, what are some possible solutions to prevent ESG colourwashing and penalise companies and persons who indulge in it?

TS: One possibility is to improve or expand on the existing regulation with a lesser focus on disclosure obligations and an increased focus on consumer protection laws, competition laws, general fraud doctrines, ex ante screening mechanisms and even private enforcement actions under securities laws.

Alternatively, we could alter the premise entirely and pursue a top-down approach. The CEO must set the corporate standard by creating a culture of corporate sustainability, whilst the in-house counsel must ensure both legality and legitimacy of the business model, acting as part of the moral compass.

AB: You suggest that a company-based top-down approach could be beneficial or even more effective than external regulatory measures. Could you please tell us more?

TS: There is no such thing as a perfect regulatory system which prevents any and all problems from arising. Moreover, any law or regulation is most effective when the subjects adopt it as their own. That is to say, they abide by it not because they have to, but because they genuinely want to. Colourwashing is inherently linked to the question of integrity, or, to be frank, the lack thereof of those who practice it.

A culture of sustainability, ie can best be shaped by the Chief Executive Officer (CEO) acting as corporate role model for employees. To facilitate this, companies could and should, with governmental support, adopt corporate codices to underline the importance of sustainability-led governance and set the overall values of the company. In this respect all relevant stakeholders should be taken into account, as well as the overarching societal impacts of the business model. Such internal policies could be further bolstered by a corporate leadership model, whereby all relevant stakeholders are included within a special governance board established within the company to promote sustainable corporate governance. This entity, led by the CEO, could prove to be the key to preventing the company from indulging in illegal and/or illegitimate practices, such as colourwashing. In fact, this internal mechanism may prove to be significantly more effective than external regulatory measures.

AB: What do you see as the role of the legal department in the prevention of ESG colourwashing?

TS: Companies could provide for an expanded role of the legal department when publicly supported by the CEO. The legal function could serve as part of the company’s moral compass, supporting the CEO in ensuring that corporate hypocrisy is not tolerated anywhere within the company. In-house lawyers can, in this manner, demonstrate, support and facilitate accountable leadership within the company and safeguard compliance with both laws and uniform global ethics, even when no one is watching.

In its expanded role, the legal department should fully assess corporate behaviour not only within the remit of applicable law, including consumer protection, competition, and anti-fraud laws, but also against a uniform code of global ethics and traditional moral values such as honesty, fairness, and commitment to inclusion, thus limiting the potential exposure of the company. In practice, the corporate framework and especially the CEO must provide the legal department with the necessary autonomy to raise concerns vis-à-vis commercial decisions that might constitute ESG colourwashing and corporate hypocrisy. At the same time, the CEO should expand the mission of the legal department to also assess other matters of importance, such as strategic, HR and budgetary matters.

AB: The European Commission is currently drafting a potential Directive on Sustainable Corporate Governance. What can be expected from this?

TS: The potential Directive on Sustainable Corporate Governance represents an extension of the European Green Deal and aims to further stimulate the integration of sustainability considerations into companies’ strategies and decision-making processes. The drafting phase has given a glimpse into what can be expected. The European Commission is exploring the possibility of expanding the directors’ duties of care to require directors to consider the environmental and social ramifications of the business model. Furthermore, the proposal could include a so-called due diligence duty, whereby corporates would be obliged to implement adequate processes for preventing, mitigating, and accounting for human rights and environmental impacts in both companies’ operations as well as supply chains. The European Commission is also considering introducing appropriate measures to align directors’ remunerations with long-term objectives of the corporation. For example, their remuneration may be linked to the company’s sustainability metrics or vary depending on achieving various non-financial targets. Lastly, the European Commission aims to alter the composition of boards of directors, making it necessary to involve environmental and human rights experts.

It remains to be seen how this initiative will develop in practice. In any case, regulation can never replace the need for corporate leaders acting with integrity and making sustainable business decisions.


Author

Timo Spitzer, Head of Legal, Adjunct Professor, Chairman of The Legal 500 Advisory Board Germany

Anna Baubock is The Legal 500 Deutschland and Global Green Guide Editor