January 4, 2021
Introduction to Financial Services: Environmental, Social, and
Governance (ESG) Issues
ESG is a widely used acronym for environmental, social,
Social. Social factors encompass a firm’s effects on its
and governance issues. Corporate governance—concerns
various stakeholders, such as consumers, employees,
about how companies should be managed—has evolved
suppliers, contractors, and the local and broader
over time to include, arguably, a wider array of issues that
communities. Risks include potential infringement on the
encompass ESG. Some consider ESG factors to be an
rights of others; gender- or ethnicity-based discrimination
integral part of discussions about sustainability. According
when hiring or promoting employees; failure to monitor
to one definition, sustainability at the firm level is “an
supplier and contractor pay; handling of customer data in a
approach that creates long-term shareholder value through
nontransparent and nonsecure way; political spending; and
managing opportunities and risks that derive from
investing in projects or sectors that could be considered
economic, environmental and social developments.”
objectionable to specific segments of society. Companies
that handle these risks poorly might experience effects
Over 3,000 signatories with over $103 trillion in assets
similar to environmental risks, such as the inability to
under management support Principles for Responsible
attract quality employees and exposure to costly litigation.
Investment (PRI), a nongovernmental organization (NGO)
that promotes sustainability through ESG. Although the UN
In addition, some stakeholders might consider certain
initiated PRI in 2005, the six principles of responsible
business operations or funding of certain entities in various
investment were launched at the New York Stock Exchange
areas to be unacceptable, including tobacco, gun
in 2006 with 100 initial signatories. Over the years, as more
manufacturing, private prison industries, abortion providers,
signatories have joined PRI, they have increasingly asked
and gambling. On the other hand, other stakeholders might
investment managers to incorporate ESG factors in their
consider an infringement of their rights any limitations
investment decisions. In addition, state regulators, NGOs,
placed on their right to operate or fund such lawful entities.
and some Securities and Exchange Commission (SEC)
commissioners and advisory groups have increasingly taken
Governance. A firm’s self-governance and integrity when
interest in ESG concerns. Congressional interest has
conducting business may raise questions. The policies,
centered on what types of ESG disclosures, if any, should
processes, and controls implemented by a firm help to
be required.
define its self-governance and impact on various
stakeholders. A firm’s integrity is measured by whether it
What Is ESG?
avoids corruption and bribery and engages with individuals
There is no universally agreed-upon definition of what
and other firms that may pose a reputational risk to the firm.
constitutes ESG. Investors and other stakeholders consider
a wide-ranging array of topics as part of ESG. The
If a corporation chooses not to address governance issues,
discussion below on the characteristics and risks that can
the associated risks could include harm to its consumers
accompany ESG is not definitive. It is meant to illustrate
and an environment leading to criminal activity and
some of the perceived risks of either addressing or ignoring
corporate reputational harm, potentially resulting in firm
various ESG factors .
failure. Firm failure negatively affects stakeholders—
employees may lose their jobs, suppliers might not be paid,
Characteristics and Risks
and local governments may receive less tax revenue. Some
Environmental. Investors and stakeholders may examine a
examples are Enron (2001 bankruptcy), WorldCom (2002
firm’s impact on the environment. Some consider the
bankruptcy), and MF Global (2011 bankruptcy). Recently,
interaction with the environment to be a form of capital—
the fake account scandal at Wells Fargo Bank harmed its
the stock of natural resources. Environmental risks include
clients, resulted in the removal of many key executives, and
declining biodiversity; pollution; resource scarcity; and
prompted regulators to restrict the bank’s growth.
potential climate change impacts, including increasingly
frequent and severe floods, hurricanes, and forest fires.
Materiality and ESG
The disclosure of material information is an important
For individual firms, ignoring environmental risks could
accounting principle. There is ongoing debate about what is
potentially harm their reputations, endanger employees, and
material in determining which ESG factors a firm should
imperil physical operations, which could lead to costly
target and disclose to investors. Discussion around what
litigation. For other firms and communities , addressing
constitutes materiality is similar to discussion about what
environmental risks might cause economic harm, with
constitutes ESG—companies have discretion over what to
diminished access to natural resources and the need to
include in both. Some proponents of ESG disclosure have
either physically relocate or seek alternative production
stated that focusing on financial materiality would be most
inputs at a higher cost and diminished profits.
helpful to investors.
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Introduction to Financial Services: Environmental, Social, and Governance (ESG) Issues
Financial materiality issues, as defined by the
investors can suffer from “information overload.”
Sustainability Accounting Standards Board, “are the
Inconsistent disclosure standards make it harder for
issues that are reasonably likely to impact the financial
investors to measure a firm’s performance on ESG issues;
condition or operating performance of a company and
standardizing the disclosure requirements by industry could
therefore are most important to investors.”
help investors and firms compare peer groups.
SEC and ESG
Financial materiality and ESG outcomes vary by firm.
Focusing on specific ESG factors at one firm or industry
The aforementioned MD&A disclosures are part of
may lead to different outcomes than focusing on the same
Regulation S-K of the Securities Act of 1933 (P.L. 73-22)
and subsequent updates. In August 2020, the SEC updated
factors at another firm or industry. For example, improving
Regulation S-K to include risk factors. The update does not
fleet fuel efficiency at a company that transports goods
could improve its financial results while benefitting air
specifically require ESG disclosures, but it lets companies
quality. Applying the same set of ESG factors to a data
determine what material risks factors to disclose.
warehouse might not make sense; in that instance, lowering
In December 2020, the SEC’s Asset Management Advisory
the cost of electricity (which could depend on the relative
cost of fossil fuels versus renewable energy) probably
Committee made the following recommendations about
would be more relevant for the warehouse’s financial
ESG disclosures:
outcomes.
The SEC should require the adoption of standards
Investors and other stakeholders might want to consider if a
by which corporate issuers disclose material ESG
company is following the existing minimum federal and
risks.
local statutory requirements. In addition, stakeholders might
The SEC
should utilize
standard setters’
want to consider if a company’s ESG issues can be
frameworks to require disclosure of material ESG
addressed through the existing regulatory regime—for
risks.
example, all employers are subject to hiring and
employment practices based on Equal Employment
The SEC should require that material ESG risks be
Opportunity Commission requirements and workplace
disclosed in a manner consistent with the
safety based on Occupational Safety and Health
presentation of other financial disclosures.
Administration (OSHA) requirements.
To date, the SEC has not adopted these recommendations.
Policy Issues
Other committees within the SEC have made similar
Much of the policy debate related to ESG involves
recommendations. If Congress were to determine that the
questions over ESG disclosure requirements for companies.
SEC should act on these recommendations, it could require
Proponents of requiring ESG disclosures in SEC filings
the SEC to adopt them.
argue that investors might positively perceive a company
Congress and ESG
that includes additional ESG disclosures, which could result
in increased revenues and profits for the company. Such
Congress has a number of options with respect to the SEC
disclosures also might help address long-term risks.
and ESG disclosures. Congress could consider requiring the
Increased disclosure also could benefit firms if it results in
SEC to mandate specific ESG-related issuer disclosure
increased access to lower cost of capital, especially when
requirements. For example, Congress could require the SEC
ESG disclosures are comparable across peer groups.
to amend federal securities laws to require issuers to
disclose diversity information regarding their boards of
Critics argue that existing regulations already address many
directors, nominees for the boards, and executive officers.
ESG issues, and the status quo—required disclosure when
Alternatively, it could opt to defer to the SEC; some
information is material; otherwise, voluntary disclosure at
officials, but not all, have argued that mandating discrete
the firm’s discretion—is appropriate. Critics further argue
ESG-related disclosures is unnecessary because they must
that mandatory reporting of ESG factors based on an
be disclosed anyway if they are material.
inflexible standard could be time-intensive and costly for
CRS Resources
companies and may be of minimal use if it is not material or
comparable with reporting by peer companies. Such critics
CRS In Focus IF11221, Introduction to Financial Services:
believe companies should focus on shareholder value, and
Corporate Governance, by Raj Gnanarajah and Gary
some ESG proposals would distract from that goal. They
Shorter
believe government, not boardrooms, should set social
policy.
CRS In Focus IF11222, Corporate Governance: Board
Diversity, by Gary Shorter
Consistency in disclosure is another area of concern. In
general, firms discuss ESG-related issues in the
CRS In Focus IF11307, Climate-Related Risk Disclosure
Management Discussion and Analysis (MD&A) section of
Under U.S. Securities Laws, by Eva Su and Nicole Vanatko
their annual financial reports. Any ESG issues discussed in
the MD&A section generally are not subject to an
Raj Gnanarajah, Analyst in Financial Economics
independent audit. Some studies have found that many
Gary Shorter, Specialist in Financial Economics
companies report on ESG issues, but the information
IF11716
published by the companies is not standardized, and
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Introduction to Financial Services: Environmental, Social, and Governance (ESG) Issues


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https://crsreports.congress.gov | IF11716 · VERSION 1 · NEW

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