Greenwashing away value in Deals

COP26 highlighted the role of business in environmental issues and there is increasing stakeholder pressure to act in a sustainable manner. More than half of UK CEOs have been increasing investment in Environmental, Social and Governance (ESG) initiatives, and this number continues to rise^[1].

ESG is now a key driver of business value, and ESG related issues are now key value drivers in transactions. Yet there are a growing number of headlines concerning companies who may have misled stakeholders through a process called greenwashing, potentially resulting in a significant negative impact upon their market values, as well as their reputation and trust with their shareholders.

What is Greenwashing and how to avoid it?

Greenwashing is often a deliberate strategy. It’s an attempt to capitalise on the demand for environmentally conscious products and services but where more time and money is spent on marketing ‘environmental’ credentials than undertaking real sustainability measures. But greenwashing can also happen inadvertently, when not enough attention is given to the actions and compliance of a business or it’s third parties in supply chains. The negative impact upon value, however, is still the same.

The risk of greenwashing, or the perception of greenwashing, is particularly high due to the absence of consistent standards and taxonomies for ESG data, which makes measurement and comparability between companies more challenging.

This issue impacts all industries, with one estimate from 2019 reporting that over $500 billion has been wiped off market capitalisations of large US companies alone due to ‘ESG controversies’ in the past five years^[2].

It is essential that the risk of deliberate or inadvertent greenwashing is considered during the diligence stage of a transaction lifecycle; so that value risks can be managed and priced into the deal.

During this process, investors should consider the greenwashing risk both in the target company, and in the target company’s supply chain.

Evaluating greenwashing controls in the target company

To manage value risks arising from greenwashing, a robust corporate control framework is essential, covering compliance with applicable laws, regulations and reporting requirements. Any diligence process should evaluate the strengths of processes and controls designed to prevent greenwashing in the target, to assess how effectively they protect value. In order to do so, companies should consider the following key areas:

Compliance with existing laws, regulations and reporting requirements
Controls relating to voluntary disclosure
Controls relating to other ESG commitments
Horizon scanning
Culture and behaviours
Ability to respond to greenwashing allegations

Compliance with existing laws, regulations and reporting requirements

At a minimum, investors should expect targets to have a robust process to monitor compliance. Targets should be able to demonstrate a clear understanding of the relevant requirements and have a control framework that considers each of the following elements; control environment, risk assessment, information and communication, monitoring activities and existing control activities.

Controls relating to voluntary disclosure

In addition to mandatory requirements, an increasing number of companies make a range of voluntary disclosures. In many instances, these will not be subject to the same control and assurance process as mandatory requirements. Investors should consider the controls and processes in place to ensure the accuracy and validity of voluntary disclosures, which should be just as robust as those for mandatory reporting.

Controls relating to other ESG commitments

A significant proportion of companies will have publicly made a range of ESG commitments outside those required by laws and regulations. Our recent research based on a snapshot of the FTSE 350, found that 71% of companies made some sort of carbon commitment^[3]. Investors should consider the controls associated with disclosures related to these commitments, but should also make a wider assessment of the target’s progress to meeting these commitments.

Horizon scanning

With an ever changing compliance environment, investors should consider how well equipped the target is to identify upcoming changes to laws, regulations and reporting requirements. Value may be enhanced in targets that achieve compliance at an early date, and conversely, may be damaged in targets that miss deadlines.

Culture and behaviours

Even the strongest control environments can be undermined by a poor tone and culture. Culture can be particularly challenging to measure. However, as well as examining key data points such as staff surveys and customer feedback, investors should consider how behaviours are incentivised in the target. For example, with ESG linked remuneration on the rise, where management bonuses are predicated on meeting certain ‘green’ targets without providing the tools to achieve these, this may increase the likelihood of greenwashing.

Ability to respond to greenwashing allegations

In addition to proactive controls, investors should assess whether targets have robust and transparent processes in place for handling greenwashing issues and crises. This assessment should consider in-house risk identification, mitigation, investigation and crisis management capabilities, processes to communicate findings to stakeholders and whether there is a track record of conducting remediation activity to improve the control environment and prevent a recurrence.

Understanding greenwashing related risks in the supply chain

Target value can also be significantly impacted by the actions of third parties in supply chains. With increasingly complex global networks of suppliers, and a swathe of regulations that hold businesses responsible for not only their own actions, but those of third parties they deal with, it is essential that investors understand the risks associated with both their target and its supply chain.

In our recent Act Now research, when we asked UK businesses about their objectives for current change management and restructuring programmes, making their supply chain environmentally and socially responsible came bottom of the list of priorities – just 5% ranked these as their main objectives.

As a result, it’s even more critical that investors undertake third party due diligence to fully understand the greenwashing related risks posed by third parties and the wider supply chain. Detailed third party due diligence may uncover issues such as involvement in modern slavery, environmental breaches, health and safety breaches and human rights violations, all of which could pose significant reputational damage.

In evaluating the greenwashing risk in a target’s supply chain, investors should consider:

Do you understand the extended supply chain of the target, including, for example, any subcontractors used by the suppliers, and the companies that supply the target’s suppliers?
What greenwashing risks exist in the supply chain? Investors should consider ESG related risks.
How do contracts with suppliers address the risk of greenwashing?
What due diligence does the target undertake when contracting with new suppliers?Does this consider the risk of greenwashing?
What support is provided to suppliers to help them to identify and escalate greenwashing risks?
How does the target investigate allegations of greenwashing by its suppliers?

Strong ESG performance can drive value, but conversely, allegations of greenwashing can have a significant negative impact. It is essential that the risk of greenwashing is considered during the diligence phase to allow value risks to be managed and priced into the deal.