Manufacturers, service providers and investment asset managers are rushing to burnish their sustainability credentials amid a boom in the assessment of supply chains against environment, social and governance (ESG) standards. In this context, In-House Perspective assesses the threat from ‘greenwash’ – where an organisation’s credentials are marketed as being more sustainable than they really are – and what in-house teams need to know in this area.

As consumer, policymaker and investor concerns over sustainability have grown, accelerated by efforts to tackle climate breakdown and the Covid-19 pandemic, there has been a sharp increase in companies and investment asset managers seeking to differentiate themselves based on high environmental, social and governance (ESG) performance criteria. These pressures have led to efforts to tackle confusing or inaccurate claims on ESG performance – known as ‘greenwash’ – but data on social and governance criteria lag well behind those on environment.

So why does this matter? The emerging market is already large so any serious lack of integrity represents systemic as well as legal risks. In April 2021 the Climate Bonds Initiative reported an explosion in social bonds, reaching $249bn in 2020 alone. This represented more than a tenfold increase year-on-year, with pandemic bonds accounting for 34 per cent. Issuance for green, social and sustainability bonds combined, meanwhile, reached $700bn.

But widespread greenwashing corrodes trust and market integrity, risking a bubble. The UK’s Competition and Markets Authority found that some 40 per cent of online green claims fall apart once examined in depth. A lack of full supply chain information is exacerbated by a lack of standardised criteria, which hampers benchmarking and comparability, and this is particularly acute for social and governance criteria. This deficit is important too where there are transitional risks to workers in traditional high carbon economic sectors such as coal, oil and gas in the absence of a just transition to a net zero economy.

‘Social washing’, also known as ‘blue washing’, is common in sectors such as tourism, for example where nominal sums are paid to a social charity as a tick box exercise rather than local community engagement programmes being created, accompanied by deeper transformation of the business.

For corporate lawyers, there’s also inevitably overlap here between newer ESG due diligence and more traditional due diligence, for example ahead of mergers and acquisitions, on internal corporate or investment portfolio social criteria. Such due diligence covers a range of areas, such as screening out child labour, the management of harassment complaints, human rights, social diversity, staff training, wellbeing and a positive working atmosphere for employees.

On governance, screening needs to assess board level engagement downwards, active monitoring and reporting programmes covering the social and environmental aspects of operations, exposing corruption and ensuring reality matches rhetoric.

Overlapping pillars

Modern integrated definitions of sustainable development used to assess organisational performance but now usually include both environmental and social governance criteria, which are albeit very different but overlapping, connected systems, which are often linked to the 17 UN sustainable development goals (SDGs). The most common definition is that from the UN Brundtland Report (of 1987), which reads ‘Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs’.

Consequently, sustainability professionals warn against the dangers of assessing the three ESG pillars of sustainability in isolation. For example, the destruction of a biodiverse ecosystem by deforestation is often also damaging to local communities in terms of health, way of life and human rights.

Poor governance, a traditional red flag for investors, can mean good company or asset manager policy and leadership at board level is lacking or not followed through in practice, either deliberately or due to managerial failures, which then has an impact on the environment, communities or employees – or on any combination of these.

Social greenwashing, with a dearth of adequate monitoring and verification, can not only damage individual companies and funds, it can also lead to systemic risk across whole sectors. In 2013, appalling working conditions and safety violations in the low-cost and fast fashion clothing supply chain for at least 29 brands were exposed after the Rana Plaza building in Dhaka, Bangladesh collapsed. The disaster claimed at least 1,132 lives and injured more than 2,500 people, despite years of supposed corporate social responsibility being in place.

The collapse of Rana Plaza led to a binding Accord on Fire and Building Safety in Bangladesh being established, while the Rana Plaza Arrangement involving all major stakeholders was set up to compensate the survivors and the families of the deceased. In 2015 the Clean Clothes Campaign’s Rana Plaza Donors Trust Fund reached its target of $30m, including donations from the brands whose supply chains included the building, to provide financial awards such as medical costs.

From ESG to sustainable taxonomy

ESG screening has become increasingly widespread due to consumer and investor pressure, with mass screening now aided by the crude but useful tool of artificial intelligence (AI). One global movement that has brought a degree of systematic ESG assessment is the BCorp private certification movement, adopted by 1,700 B Corporations in 50 countries since 2007. The movement aims to ensure corporations go beyond shared value, for example by increasing capacity in local communities as long as it benefits the corporation’s shareholders, to generate wider, non-shareholder benefits for community, employees and environment.

The Cambridge Institute for Sustainability Leadership goes further, calling for the rewiring of businesses to align their organisational purpose, strategy and business models with sustainable development principles, based on clear evidence-based targets, metrics and transparency, embedding of sustainability in all practice and decisions, engagement, collaboration and advocacy for wider change.

But many different voluntary reporting methodologies have appeared and these vary substantially, frustrating the comprehensive benchmarking and comparability necessary for market transparency and the elimination of greenwash. This has led to various attempts to standardise corporate sustainability reporting and accounting globally, culminating in the Non-Financial Reporting Directive (NFRD) in the EU and broad international consensus through the Task Force on Climate-Related Financial Disclosures (TCFD), established by former Bank of England Governor Mark Carney.

At EU level, TCFD principles were adopted enthusiastically as part of creating the net zero European Green Deal in 2019 and the associated Action Plan on Sustainable Finance, which seeks to clear up confusion and tackle greenwashing. They were given added urgency as part of the EU’s pandemic recovery strategy.

A crucial part of ensuring investments are channelled into sustainable activities and not misallocated by greenwash is the EU’s Sustainable Finance Disclosure Regulation (SFDR) and its Taxonomy Regulation. Together with parallel work in the UK post-Brexit, these have been seen as potential models for the world, though the inclusion of fossil gas and nuclear in the taxonomy has divided opinion. Large companies had to report their taxonomical classification by 1 January 2022, while all other companies must do so once the Corporate Sustainability Reporting Directive comes into force in late 2022. This latter Directive replaces the more limited NFRD. In return, sustainable companies access bank lending at preferential rates.

The EU’s early taxonomy takes a somewhat reductionist approach to sustainability compared to many ESG analysts, focusing primarily on environment, with social and governance considerations implied but marginalised. To qualify fully for green taxonomy, companies must contribute substantially to at least one out of five environmental objectives while doing no significant harm to others, but need only comply with the minimum social safeguards based on the UN Guiding Principles on Business and Human Rights and the Organisation for Economic Cooperation and Development’s Guidelines for Multinational Enterprises. The emphasis here is on science-based evidence, largely quantitative, easy to use metrics, which leverage existing work.

In contrast, social objectives, guides and tools have all lagged behind environmental taxonomy so far, not least as quantitative metrics are harder to define, with there being more reliance on qualitative aspects and the need to highlight additional social benefits – and drawbacks – of projects beyond inherent business-as-usual ones such as job creation.

The case for social taxonomy is certainly strong. There is surging demand turbocharged by the pandemic, while corporate human rights abuses are still common. Meanwhile there’s a growing wariness of hidden social, reputational and legal risks, a lack of a just transition to net zero, and yet no standardised assessment and classification system, which frustrates transparency, comparability and benchmarking.

The new corporate social landscape

Mindful of these unmet needs, the EU Platform on Sustainable Finance, an advisory body, within the European Commission, is currently developing a social taxonomy, having consulted on a draft in July 2021 with the delayed follow-up report now expected by spring 2022. There’s much still to decide, but traditional human rights issues familiar to practitioners in mergers and acquisitions (M&A), along with delivering on social aspects of the SDGs and the Paris Agreement on climate, will all be core issues. The offsetting of poor corporate human rights practices in a company’s own operations by investment elsewhere will not be permitted. Another important principle will be that the ‘do no significant harm’ and minimum safeguards requirement should be comparably stringent between the environmental and social taxonomies.

Launching the social draft in July 2021, Antje Schneeweiß, Rapporteur of the Subgroup on Social Taxonomy, suggested there will not be a corporate governance taxonomy as such, but that the implications of the EU Corporate Governance Directive will be assessed for potential inclusion, notably its provisions on bribery, lobbying and tax compliance.

Roberto Randazzo is Newsletter Officer on the IBA Business Human Rights Committee and a partner with Legance Avvocati Associati in Milan, with a particular interest in ESG, impact and sustainability. He is the outgoing President of esela – the legal network for social impact – which is now to become the Global Alliance of Impact Lawyers (GAIL).

Randazzo notes that the EU’s shift from voluntary approaches to one based on a mandatory sustainable investment framework in 27 Member States might be expected to be fully completed by 2023/2024. It’s set to cover financial regulations, key performance indicators (KPIs), remedies such as class action, provisions on human rights, consumer rules and principles to counter greenwash, as well as third party data verification. With the Sustainable Financial Disclosure Regulation and the Taxonomy Regulation already in effect, the regulatory framework will soon be integrated with the expected Sustainable Corporate Governance Directive and the Corporate Sustainable Reporting Directive, with the former also envisioning ESG due diligence obligations.

‘More and more we will link ESG approaches to the UN declaration of human rights,’ says Randazzo. All this, he says, ‘is now crystallising into the mainstream and driving legal obligations, changing the market’, offering the prospect of a global, common system.

But on the reporting of social impacts, Randazzo says ‘it’s not easy to approach the “S” side of ESG in that social needs are linked to firstly looking at communities’ with specific needs, not only to ‘general rules like anti-slavery approaches to be shared at global level’. KPIs should be based on social returns to communities, differing according to local circumstances such as emerging markets, so they need ‘to be flexible but at the same time clear’.

But here impact investors have to go further than ESG screening by stating whether the investment considers ESG risks or aims at a positive impact outcome such as social entrepreneurship, and they must then comply or explain.

A challenge for metrics

Caroline Phillips is Treasurer for the IBA Banking Law Committee and a partner at Slaughter and May in London, working on public debt capital market issuances, loan financings and structured finance and sustainable finance advisory.

Clients ‘have found it much easier to focus their KPIs on science-based targets which are externally verifiable and the banks take comfort from this because they think it’s properly tested and rigorous with data behind it,’ she says.

‘I’ve found it much harder on the softer side of things and to negotiate KPIs which address progression in the workplace such as diversity [is] much more challenging,’ she says. Compared to the monitoring of parameters such as CO2 emissions, ‘the human issues are more challenging and I think investors are more nervous about the rigour of those’, says Phillips.

The credit rating agency S&P too has concerns over how corporate social impact can be effectively gauged, explored in its 2021 greenwash research report. ‘Because there are few standardized measures of social impact, many of the so-called “impact” indicators reported by issuers are actually measures of input, such as dollars spent, loans issued, number of participants, or hospital beds added as opposed to measures of improvement in social outcomes.’

This, it says, ‘had led to a level of vagueness and a lack of transparency in issuer disclosures, increasing investor skepticism that issuers are using proceeds for projects without additional social benefits’.

In addition, S&P stresses that ‘with the acceleration of social bond issuance over the past year, largely catapulted by the COVID-19 pandemic, speed to market became the most important factor, with many issuers foregoing development of a social bond framework or external verification and review, as recommended by the International Capital Market Association’s (ICMA) Social Bond Principles (SBP). Therefore, improvements in tracking and disclosure have experienced a significant lag compared to the more mature green bond market’. 

Restoring the social dimension

Elise Groulx Diggs is an international human rights lawyer and mediator and a Member of the IBA Business Human Rights Committee Advisory Board, and also Door Tenant at 9 Bedford Row Chambers in London.

Groulx Diggs’ approach to sustainability and human rights issues accepts a formal role for ESG reporting, but emphasises constructive stakeholder engagement and challenge, promoting community consultation and inclusive governance. ‘I don’t function well in a world of tick-the-box exercises,’ she says. ‘You could have all these audits, all these exercises and think you’re doing great, you go on the ground and you find a different story.’

It’s a story where consultation is often lacking, and where ‘People, unions, workers, civil society all need to come together […] otherwise we’re not making progress,’ she says. ‘You can design fantastic data systems, amazing frameworks, but it’s all theoretical’.

‘I’d rather ask the questions than name and shame […] forcing them to go further,’ adds Groulx Diggs.

Many of these problems come from ‘siloed vision’, which has been cruelly exposed in broken supply chains during the pandemic, in which the social and governance elements of corporate ESG are treated separately from environmental considerations and are all too often sidelined. ‘Covid shows how you have to approach it all as a whole,’ says Groulx Diggs. A key reason for neglect is that human factors are more complex to gauge.

Environmental justice and human rights are vital for communities, but also for corporate reputation and for reducing the risk of legal challenge. Groulx Diggs points out that new laws across Europe were passed in the wake of the Rana Plaza disaster, such as the 2017 Law on the Duty of Vigilance for Parent and Subcontracting Companies in France. This required companies, subsidiaries and sub-contractors to practise due diligence on human rights and environmental impacts, by assessing risks throughout the supply chain, mitigating these risks and avoiding serious violations, and also set up alert, reporting and monitoring mechanisms and to assess the efficacy of measures.    

New reporting obligations, though far from perfect, are having an impact, with increased exposure to investor pressure and liabilities. Moving to net zero and wider sustainability ‘must be done in the right way’, based on a just transition protecting rights and jobs. Groulx Diggs notes that the UN’s recent recognition of a human right to a healthy environment should also help raise the profile of environmental justice.

Meanwhile, another potentially very influential development has been launch of the independent World Benchmarking Alliance, which is based on ‘seven systems transformations that need to take place to put our society, planet and economy on a path to achieve the [UN] SDGs’.

Environmental clash

In Milieudefensie et al v Royal Dutch Shell in the Netherlands in May 2021, ‘soft law’ in the form of the UN’s Universal Declaration of Human Rights and duty of care played a key role in the outcome of a case. The Hague District Court found that ‘the serious threats and risks to the human rights of Dutch residents and the inhabitants of the Wadden region’ from dangerous climate change outweighed the sacrifices the Shell group would need to make in dropping plans for higher production and new fields, ordering Shell to make a 45 per cent reduction in global carbon emissions by 2030.

Shell lodged an appeal in March, which is ongoing. A Shell spokesperson told In-House Perspective that ‘We have an important role to play in the energy transition, which we take seriously. But even with an ambitious strategy and industry-leading climate targets in place, there are aspects of the court’s judgment that are just not feasible – or even reasonable – to expect Shell, or any single company, to achieve.’

‘The court’s ruling effectively holds Shell accountable for a wider global issue – reducing consumer demand for carbon-based fuels – something we cannot do alone and that requires action from all quarters. Regardless of the appeal, Shell will continue playing a leading role, amongst its peers, in the global energy transition,’ continued the spokesperson.

In Mexico, Leopoldo Burguete-Stanek is Programme Officer on the IBA Environment, Health and Safety Law Committee and a partner at Gonzalez Calvillo, heading up the Environment, Agrarian and Social Impact practice area. He is coordinator of the ethical committee of the Mexican Bar Association, where a working group has been formed to deal with compliance. Burguete-Stanek stresses however that while compliance deals with certain regulations in a specific place, the acknowledgement and promotion of wider ESG principles, particularly social and the new UN recognition of right to a healthy, safe environment, is just as important for Latin America. 

Conclusion

The ESG market has seen rapid growth in investment and, during the pandemic, a staggering increase in those focusing on social and governance aspects that is outstripping the limited capacity for robust assessment. These trends are coming up against a lack of standardised methodology, which presents difficulties in finding straightforward metrics. This raises major greenwash concerns. EU work on the social and governance aspects of its green taxonomy should provide some answers over the next two years, but meanwhile, and probably after, lawyers are likely to continue playing a key role in promoting good practice.