The environmental cost of corruption

Corruption as a phenomenon is as old as human society itself. It has existed from ancient Egypt to modern times. In some senses, it seems inevitable and will probably always exist in human societies on some level. According to estimations by The World Bank, the annual value of corruption around the globe runs to a staggering number of USD 1.5 trillion, or around 2% of the global GDP. Corruption can be found at every level of society and it ranges from small bribes to large scale corruption schemes in which high-level government leaders end up with millions or more worth of illicit proceeds.

Corruption is part of the Governance pillar of ESG and is often not as high profile as the more visible Environment and Social challenges a company might face. Being an illicit activity, when well executed, it is often very hard to detect and in most cases, the damage is not directly visible to the world. But is it less important than the risks stemming from E and S? Furthermore, what is it exactly?

Corruption, in its fundamental form, is an abuse of a trusted position to gain monetary or other advantages to oneself or to one's close associates or relatives. Corruption can happen in both the private or public sector and can take many different forms. The most usual forms of corruption are taking or paying bribes and favoritism in exchange for personal gains. However, corruption is also often related to other forms of illegal conduct, such as money laundering, tax evasion, embezzlement, fraud, theft, falsification of accounts, conflicts of interest and blackmail, or in some cases even the financing of terrorism. The core aspect setting corruption apart from the other ESG risks is, however, that it is always intentional. Corruption is not an accident, it requires intent. 

The illegal nature of corrupt conduct is already acknowledged in national and international legislation, and the fight against corruption is being enforced by national and international authorities. In addition to long-standing legislation, as the market demand for non-financial disclosures increases, anti-corruption and bribery information has been included in the EU Non-Financial Reporting Directive.

Climate change is at the heart of the EU Non-Financial Reporting Directive. Most of the obligatory information that companies are required to release is directly related to climate change.  However, even though social and governing disclosures are included in the obligatory reporting, they often take a backseat. However could corruption, even though on the backbench in the reporting disclosures,  have an effect on the environment?

Academic evidence implying a clear link between corruption and CO2 emissions, improper land use, environmental degradation and lax oversight is starting to emerge. It seems that the link between corruption and lower environment quality is most evident in developing countries and some evidence even indicates that corruption might be the main driver behind the environmental problems experienced in some parts of the developing world.

The effects of corruption on the environment are two-fold and complex. Research shows that corruption in society has both direct and indirect effects on the economy and the environment. Overall, corruption has a net-negative effect on GDP growth but at the same time, a high level of corruption causes energy consumption to go up due to the decrease of energy policy stringency. This in turn, leads to an increase  in CO2 emissions,  triggering a modest increase in GDP. Furthermore, corruption increases public spending since the budgets for projects need to be adjusted for this additional cost. At the same time, however, this illicit activity lowers the quality and efficiency of the project, thus delivering net-negative effect. There is also some evidence that bribes to people in positions of power have, in the past, led to economically unviable projects or even purposefully low-quality infrastructure that needs to be re-done in a short time. 

Research has shown that there is a link between corruption and the level of CO2 emissions. While the link exists in both the developed and developing world, it seems to be stronger in the developing world. It appears that the more corruption there is in society, the less likely it is that the environmental policies are strictly enforced leading to lower standards in energy production and environmental quality. As mentioned before, while corruption causes modest increases in the GDP via the increase of energy consumption and public budgets, the negative effects are higher. These come into play as lower growth, lower quality, lower efficiency and higher costs. It is estimated that a 1% increase in corruption can lower the growth rate of business by 3%. Thus the illicit activity is far more negative for business than an official tax.

In the world of science, there is compelling and strong evidence that natural forests contribute directly and positively to global biodiversity worldwide. In addition to biodiversity, as mentioned before, global forests and especially rainforests are operating as the lungs of the planet and the loss of forest is negatively affecting the planet’s capacity to absorb and neutralize GHGs created by human activity. Climate change, while lifting global temperatures, causes the climate in rainforest areas to dry out, increasing the risk of unintentional forest fires. This is especially noticeable in the Amazon region. Deforestation and warming climate are therefore creating a self-feeding negative loop where deforestation causes the climate to warm further and the warming climate potentially destroys more and more forest and biodiversity. Some projections even go as far as to imply that the Amazon is in serious danger of drying out during the 21st century. Corruption is contributing to this negative feedback loop in two ways. Firstly, by increasing energy consumption and therefore GHG emissions. Secondly, research confirms the link between corruption and decrease in ecological quality and wasteful use of natural resources such as forests.

Research indicates that a large part of the deforestation globally is taking place in a reasonably low number of developing countries, located in Latin America, Africa and Asia. More disturbing is that academic research suggests a strong positive relationship between the level of corruption in a country or region and deforestation. The link is very pronounced in the regions where most of the global deforestation is taking place. An important question would be, what is driving the deforestation in these locations? The case has often been, like in Indonesia and several other locations in the developing world, that the business interest has been to convert forest into agricultural land. This has led to an intentional burning of large swathes of the rainforest. The political elite have, after the intentional deforestation actions, protected business from justice in return for financial benefits. In 2001, the FAO stipulated for the first time that corruption was one of the main drivers behind deforestation in the developing world.

While corruption within the client company is rarely a direct reputational risk to the insurer, the corporate conduct is very relevant to the insured company and to the public image the client is projecting. Companies with a strong sustainability mindset and focus on environmental stewardship and contribution to society, also need to focus on good governance embedded with effective compliance systems. As outlined in this risk-briefing, the literature shows that corruption is viewed as a highly important topic and, in some cases, even the main driver behind negative environmental trends. Whether it is the negative effects of corruption on the level of GHG emissions or deforestation, a company engaging in this illicit activity is at a higher risk of receiving adverse attention or being liable for illegal conduct. Companies paying bribes often produce lower quality, therefore corrupt actions by a company might later lead to liability over the products produced by the company. Additionally, as the activity is illegal by nature, the corporate executives of the company might be liable for the governance failures of the company.

In order to achieve the goals set out in the Paris Agreement, which Allianz is also committed to, all contributing factors need to be considered in the risk management process. It is clear that corruption is viewed as one of the biggest hindrances of positive development in combatting deforestation and lowering of the GHG emissions. Additionally, as has been observed in the past, large scale corporate governance failures such as corruption or fraud can put whole companies in severe financial stress or even into insolvency, which underlines the high relevance of the topic in the world of ESG.

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