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Will ESG Prevent The Next Enron?

Forbes Finance Council

Director of Responsible Investing at Federated Hermes, leading ESG integration and engagement across $645 billion in global assets.  

This summer marks the 20th anniversary of the demise of Enron. Once valued as America’s seventh-largest corporation, Enron completed a spectacular fall from atop the energy industry to bankruptcy, sending top executives to prison, putting Arthur Andersen out of business and wiping out billions of enterprise value. The collateral damage was immense. Employees suffered immeasurably, many not only losing their jobs and healthcare but also their retirement savings, which were largely invested in the company.

The three key players, founder Kenneth Lay, CEO Jeffrey Skilling and CFO Andrew Fastow, are among the most infamous in business ethics history. One can argue that the only good that came out of the scandal was the book The Smartest Guys in the Room and the reforms created in the Sarbanes-Oxley Act of 2002.

Enron had plenty of abhorrent practices, including playing with people’s well-being when it capitalized on the massive California energy crisis of 2000-01, driving prices sky-high and at times fabricating blackouts. But the scheme that enabled it all was much subtler: accounting fraud.

At the center was the deliberate manipulation of mark-to-market valuation and the accrual method. Accruals are the heart of the Generally Accepted Accounting Principles (GAAP). The method is considered more accurate than the cash method as it books expenses when they happen, not when payments are made. 

Enron accountants turned the method on its head. They would recognize revenue from the energy contracts they expected to receive (although they often just fabricated that number), rather than reporting what they actually got. They created astounding loopholes, including using special purpose entities to hide debt. But in the short term, it drove up earnings and the perception of impressive, albeit unsustainable, growth.

ESG Accruals

Clearly, Enron shows the importance of assessing governance — one of the three legs of environmental, social and governance (ESG) investing. Had more investors and stakeholders demanded transparency and oversight, the crimes might have been caught earlier and the damage limited. But the scandal can serve as a larger analogy.

As the push for assessing companies’ sustainability and contribution to the greater good continues to accelerate across sectors and countries, management should consider their approach to ESG like they do financial accounting. I like to call it “ESG accruals.” A business must weigh strategic actions that can help it grow and strengthen its position for the future versus short-lived and transitory benefits. Leaders can take the same approach to extra-financial concerns.

If they don’t acknowledge their industry is structurally changing and forgo investment in new practices, products and workforce training, they face falling behind peers. Sticking with energy as an example: If a traditional thermal coal company doesn’t consider transitioning to other types of power generation, its business model will likely become outdated and less valuable over time. This could hold back growth and potentially strand assets and obsolete infrastructure. A company that begins setting a long-term strategy to transition its revenue and workforce into greener pastures may experience uneven profitability in the short term. But that doesn’t impair the entity as a going concern; rather investors may award a premium valuation for above-market growth prospects well into the future. Just ask Tesla and Amazon. 

Profit Boomerang

Social issues are no less important than environmental ones, and thinking myopically about profits at the direct expense of people’s welfare can come back to hurt you. Take the pharmaceutical industry. Quadrupling the price of a drug will boost short-term revenue, but if done in a suspect manner, the negative societal effects not only hurt access for people in need, but also could lead to a customer revolt that plays out in the press and social media. If a profit-grab is egregious, look out. That one-time windfall may end up costing far more in terms of brand value, tighter regulations and the company’s overall cost of capital.

And then there is flirting with disaster in our new virtual reality. For instance, failing to invest in strong cybersecurity is an obvious target these days. Weak data governance can severely damage reputation and lead to customer exodus if personal information is compromised. Not addressing a structural issue, like a dam’s integrity, can hurt the top line as much as any financial scandal.

The Trade-Off

Kenneth Lay once said, “In the case of Enron, we balance our positions all the time.” Business decisions are always a trade-off between the short and long term. But that applies to far more than just the accounting books and income statements. Enron’s gaming its mark-to-market method made marks out of many creditors and stockholders. When they found out they were deceived, no past profits could save them from the blowback. Nearly 20 years after bankruptcy, the only value of an Enron stock certificate is in the form of memorabilia sold on eBay. Left unchecked, financially material ESG issues can follow a similar path, rendering a company uncompetitive and in secular decline as the best-case scenario.

Lessons from Enron and other poorly governed entities are clearer than ever: Transparency, prudence and the vision to navigate structural risk can accrue positives rather than lead to devastating problems down the line.


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