As shown during COP26—the UN Climate Change Conference—in Glasgow this past fall, the role financial markets can play in ending dependence on fossil fuels engenders heated discussion and debate. UBS recently estimated that $140 trillion will be spent to realize the Paris Agreement’s target of carbon neutrality by 2020, a “once-in-a-generation” investment. Putting aside exact figures, the sheer scale of investment required to decarbonize the world’s energy supply—what climate analysts call “shifting the trillions”—will require mobilizing private capital on a potentially unprecedented scale.
Whether the private sector has the appropriate framework and the incentives to redeploy capital away from carbon-intensive activities towards macro-scale green investments remains an open question. The growth and strong performance of Environmental, Social, and Governance, or ESG, funds, climate innovation funds, and climate transition funds shows the increasing consumer demand for environmentally-responsible investing. Even so, it is far from clear that the financial sector as a whole intends to wean itself off fossil fuels. According to one recent report, the 60 largest banks have financed $3.8 trillion in fossil fuel extraction and infrastructure in the five years since the Paris Agreement. Beyond these direct investments in carbon-intensive industries, watchdogs have voiced strong concerns about “greenwashing” in ESG investments—that is, making exaggerated or even false claims that an investment is climate friendly.
Given these uncertainties, it is not surprising regulators have intervened or are considering intervening to bring clarity and transparency to sustainable investment market segment. In June 2020, the European Union enacted a “green taxonomy” establishing a shared language and uniform criteria for investors to determine which activities can be considered environmentally sustainable. US regulators are now reportedly actively engaged in the development of a green taxonomy of their own. In May, the Securities and Exchange Commission, now chaired by Biden-appointee Gary Gensler, requested public input on climate change disclosures. Such efforts may presage even more ambitious climate-related financial regulation, such as capitalization requirements tied to climate risk and even outright bans on financing of fossil fuels.
As with other forms of mandated disclosure, effective regulation of climate financial standards will depend not just on public servants, but on private-sector service providers. An August 2021 piece in The Financial Times noted that the Big Four accounting firms were eager to capitalize on the shifting ESG regulatory environment as an opportunity “to rebrand a scandal-plagued profession as experts on climate change.” In other words, auditors are now seeking to position themselves as experts in evaluating firms’ “nonfinancial metrics” such as their carbon footprint, potentially applying a framework by a proposed International Sustainability Standards Board.
But if the past is any guide, investors should rely on more than just the assurance of auditing firms when making investments on the basis of sustainability. There is no question that independent auditing is a vital tool in capital allocation; however investors should also recognize the limits of that tool. As recent scandals involving now-bankrupt German payments processing firm Wirecard and Chinese retail company Luckin Coffee illustrate, the methodology applied by audit firms does not reliably detect and arguably does not actively seek to unearth sophisticated forms of fraud on corporate balance sheets. This is especially the case where the fraud involves forgery or fabricated revenue streams in foreign jurisdictions: conventional audit procedures may be unable to recognize spurious information supplied by a client.
If audit is an imperfect tool for detecting fraud in financial statements, it is even less reliable in assessing claims of environmental sustainability. Consider the following: for years, Wirecard’s management fraudulently attributed assets and revenue streams to foreign partners and subsidiaries in a way that repeatedly evaded the scrutiny of its statutory auditor, Ernst & Young. Now imagine an equally unscrupulous set of managers were to make false claims about an overseas supplier’s, or subsidiary’s, greenhouse gas emissions, or waste disposal practices, or commitment to sustainable forestry. How likely is it that such falsehoods would be detected through conventional auditing techniques such as employee interviews and spot checks of invoices and other relevant documents?
It is neither feasible nor practical for auditors to conduct these sorts of inspections on a routine basis. And while some organizations specialize in non-financial audits relevant to ESG matters—for example, in assessing sustainability in seafood supply chains—these service providers are relatively few in number and do not cover the broad range of environmental considerations addressed the EU green taxonomy and other environmental standards and regulations. In addition, such specialized firms are not always adept at working in closed or authoritarian political systems, where it can be challenging to speak to knowledgeable witnesses and obtain relevant documentation.
Rather than risk reputational embarrassment and possibly fines and other sanctions for falsely certifying claims of environmental sustainability, auditing firms or the boards of directors that are already engaging this subterfuge would be well-advised to employ investigative professionals to complement the work of auditors.
Unlike auditors, investigators are experts at determining the veracity of a client’s statements by consulting sources other than those provided by the client. They are often invaluable in comparing a company’s environmental performance claims to reality, relying on tools beyond the balance sheet. In jurisdictions with an open public domain, research in corporate registries or in records maintained by government offices or courts can reveal inaccuracies in what has been touted while also potentially identifying evidence of regulatory action taken against environmentally improper practices. Investigators who make site visits can speak to those responsible for company operations and clearly understand the true extent of a business’s footprint. Through such research, in combination with source enquiries—with former employees, regulators, government and oversight bodies, unions, and others familiar with a company’s operations—investigators can determine whether corporate divisions and employees adhere to policies and procedures allegedly established to protect the environment. Relying solely on auditors will develop an incomplete picture. Investigators can provide a synoptic view of whether a business is true to its claims of environmental accountability.
Financing the transition to a decarbonized economy may be a once-in-a-lifetime investment opportunity, but discerning which investments will contribute to a greener future—and which are merely greenwashing—will require looking beyond the conventional instruments of financial audit. With the growth of climate finance comes the risk of climate fraud, and corporate directors will need to employ new tools if they want to avoid falling victim to the latter.