While there is little literature focusing on companies’ disclosure of their environmental, governance, and social (ESG) outcomes, there is a growing call for investors to consider ESG holistically in their investment strategies, so say academics from the Centre for Innovation Management Research (CIMR) at Birkbeck, University of London.
CIMR, one of the world’s most eminent sources on innovative practice, believes that though ESG data disclosure has increased dramatically in the last decade, the process is often unaudited. Furthermore, as not all ESG disclosure instruments are mandatory, companies can opt-out entirely or disclose their favorite data only. Consequently, companies may not convey their ESG performance to the relevant stakeholders fully and truthfully, which is clearly problematic. Furthermore, due to the variation of the quality and the content of ESG data in nonfinancial reports, it is challenging for investors to incorporate ESG information into their asset selection process.
Amid growing public interest regarding the matter and global spotlight amplified by COP26, a recent research project led by CIMR’s Dr. Ellen Yu, Lecturer in Accounting and Financial Management, extended the theory of greenwashing by investigating large-cap companies’ greenwashing behavior in all aspects of ESG.
What is Greenwashing?
While previous studies focused on evaluating the greenwashing issue for each dimension separately, Yu re-defined greenwashing as companies masking their less impressive overall ESG performance by disclosing large amounts of ESG data to manage stakeholder parties’ perceptions. In doing so, CIMR’s research focused on ESG data disclosure at the firm level, which is particularly interesting because by establishing a peer-relative greenwashing score, it’s possible to estimate the extent of a firm’s greenwashing behavior in ESG dimensions holistically.
“Our dataset is comprised of more than 1900 large-cap companies across 47 countries and territories,” says Yu. “Our empirical evidence shows that large-cap firms exposed to greater scrutiny are less likely to engage in ESG greenwashing,” she continues, suggesting that ownership and governance factors are essential in dissuading firms’ ESG greenwashing behavior.
CIMR defines “greenwashers” as companies that perform poorly in ESG aspects but reveal large quantities of ESG data, arguably obfuscating the public. Their research study uses Bloomberg’s ESG Disclosure Score to measure the amount of ESG data disclosed by firms, comprised of more than 900 key disclosure indicators, such as total energy consumption, hazardous waste, political donations, and board meeting attendance.
As an indicator of a firm’s performance in ESG issues, CIMR adopts the Asset4 ESG performance scores by Thomson Reuters, which evaluate more than 600 data points per firm, ranging from employment quality to emission reduction. Both ESG performance and disclosure scores range between 0 and 100. However, to generate a meaningful comparison between the disclosure score and performance scores, it is important to re-weight the performance scores using the weighting scheme for the disclosure scores.
“We estimate the peer-relative greenwashing score for each firm in two steps,” says Yu. Firstly, by normalizing them to the same scale by subtracting the average and dividing them by the standard deviation. Next, a firm’s peer-relative greenwashing score is calculated as the difference between its normalized ESG disclosure and its normalized ESG transparency score. “Finally, we identify a firm as greenwashing if it has a better relative position than its peers in its ESG disclosure score than its ESG performance score,” she continues.
Conversely, CIMR believes firms with negative greenwashing scores play down their environmental achievements. “The median peer-relative greenwashing score is 0.059, while the mean of our dataset is 0.04,” observes Yu, implying that many large-cap firms pursue a greenwashing strategy (by overstating their achievement in ESG issues).
These implications for leaders are paramount and reveal that the peer-relative greenwashing scores are very industry-dependent. For instance, the Materials (0.1522), Energy (0.1477), and Utilities sectors have the highest peer-relative greenwashing scores among the ten GICS sectors. In contrast, firms in the following three industries understate their ESG performance: Industrials (-0.0363), Consumer Staples (-0.0455), and Telecommunication services (-0.1202). CIMR findings imply that companies in the Materials sector are more likely to greenwash in ESG issues.
So, what can leaders do?
“We’ve considered the possible mechanisms which can mitigate large-cap firms’ greenwashing behavior,” comments Yu. “Our hypotheses are based on the notion that a company is less likely to greenwash in ESG dimensions because it encounters pressure and oversight from relevant stakeholders.”
CIMR’s empirical results indicate that the shares of independent directors and institutional investors matter, although the size of the board has no effect in deterring ESG greenwashing. Specifically, their research finds that a 1% rise in the percentages of independent directors can reduce ESG greenwashing by 0.85%. In comparison, a 1% growth in the rate of institutional ownership can cut ESG greenwashing behavior by 0.36%. In addition, they show that scrutiny from both firm-level factors, independent directors and institutional investors, significantly influences firms’ ESG greenwashing behavior. These results are consistent with Yu’s predictions that companies are less likely to engage in ESG greenwashing when relevant stakeholders scrutinize a company’s relation between actual ESG performance and ESG disclosure.
“We also investigate whether greater scrutiny and pressure from the public can result in more trustworthy corporate ESG disclosures,” says Yu. Given the evidence from the previous studies, she expects that companies will be less likely to engage in ESG greenwashing in countries with more political rights and less corruption. “We find empirical support for the hypothesis, which suggests that a less corrupted country is more likely to offer more opportunities for relevant stakeholders to lower the extent of greenwashing.” Her empirical results indicate a 1% increase in the “absence of corruption” variable (the country experiences less corruption) results in 0.60% less greenwashing in ESG issues.
Surprisingly, CIMR’s results for the “political rights” variable challenge the consensus that significant political rights enable stakeholders to discourage a firm’s ESG greenwashing behavior. This counterintuitive finding aligns with prior literature, which indicates that organizations can secure financial rewards and legitimacy by adopting symbolic actions without truly changing their practices. While countries with greater political rights allow their citizens to speak up about ESG concerns by using the various media, non-governmental organizations, or environmental organizations, large companies are also given more power to sway public opinion through political actions such as lobbying efforts or seeking the legitimacy of corporate green branding.
CIMR set out to explore the varied factors that impact large-cap firms’ greenwashing behavior. Their empirical results suggest the following mechanisms to be adopted to dissuade firms’ ESG greenwashing behavior: more independent directors, more institutional investors, and more compelling public interests through a less corrupted country system. Moreover, these findings offer support for the stewardship model of ownership because a company engages less in ESG greenwashing when its stakeholders scrutinize the linkage between disclosed ESG data and its actual ESG performance. Therefore, it would undoubtedly seem time that large-cap companies aim for responsible and effective active ownership by attracting more institutional investors and independent directors on the board.