Updated January 13, 2022
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 4,000 signatories with over $120 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
In addition, some stakeholders might consider certain
United Nations initiated PRI in 2005, the six principles of
business operations or funding of certain entities in various
responsible investment were launched at the New York
areas to be unacceptable, including tobacco, gun
Stock Exchange in 2006 with 100 initial signatories. Over
manufacturing, private prison industries, abortion providers,
the years, as more signatories have joined PRI, they have
and gambling. On the other hand, other stakeholders might
increasingly asked investment managers to incorporate ESG
consider an infringement of their rights any limitations
factors in their investment decisions. In addition, state
placed on their right to operate or fund such lawful entities.
regulators, NGOs, and some Securities and Exchange
Commission (SEC) commissioners and advisory groups
Governance. A firm’s self-governance and integrity when
have increasingly taken interest in ESG concerns.
conducting business may raise questions. The policies,
Congressional interest has centered on what types of ESG
processes, and controls implemented by a firm help to
disclosures, if any, should 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. The notion of materiality is at the
potentially harm their reputations, endanger employees, and
center of SEC-regulated disclosure requirements.
imperil physical operations, which could lead to costly
Materiality is deemed to be information that a reasonable
litigation. For other firms and communities, addressing
investor would deem important in determining whether to
environmental risks might cause economic harm, with
purchase a security. In the ESG realm, there is an ongoing
diminished access to natural resources and the need to
debate about what is material in determining which ESG
either physically relocate or seek alternative production
factors a firm should target and disclose to investors.
inputs at a higher cost and diminished profits.
Discussion around what constitutes materiality is similar to
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Introduction to Financial Services: Environmental, Social, and Governance (ESG) Issues
discussion about what constitutes ESG—companies have
Inconsistent disclosure standards make it harder for
discretion over what to include in both. Some proponents of
investors to measure a firm’s performance on ESG issues.
ESG disclosure have stated that focusing on financial
Standardizing the disclosure requirements by industry could
materiality would be most helpful to investors.
help investors and firms compare peer groups. In this
context, some have criticized the 2010 SEC climate
Financial materiality issues, as defined by the
guidance for resulting in inadequate and inconsistent
Sustainability Accounting Standards Board, “are the
climate-related disclosures.
issues that are reasonably likely to impact the financial
condition or operating performance of a company and
SEC and ESG
therefore are most important to investors.”
Since the beginning of 2021, the SEC has expanded its
focus on climate- and ESG-related risks and disclosures.
Financial materiality and ESG outcomes vary by firm.
Agency actions in this context include:
Focusing on specific ESG factors at one firm or industry
may lead to different outcomes than focusing on the same
In March 2021, the agency created a Climate and ESG
factors at another firm or industry. For example, improving
Task Force in the Division of Enforcement tasked with
fleet fuel efficiency at a company that transports goods
proactively identifying ESG-related misconduct.
could improve its financial results while benefitting air
quality. Applying the same set of ESG factors to a data
In July 2021, SEC Chair Gary Gensler noted that
warehouse might not make sense; in that instance, lowering
investors are demanding more information on climate
the cost of electricity (which could depend on the relative
change and said that he asked SEC staff to develop a
cost of fossil fuels versus renewable energy) would
rule proposal for mandatory disclosure of climate risks.
probably be more relevant.
In August 2021, Gensler said that he has asked his staff
Investors and other stakeholders might want to consider if a
to recommend new human-resource-based corporate
disclosures that could range from “workforce turnover,
company is following the existing minimum federal and
local statutory requirements. In addition, stakeholders might
skills and development training, compensation, benefits,
want to consider if a company’s ESG issues can be
workforce demographics including diversity, and health
and safety.”
addressed through the existing regulatory regime—for
example, all employers are subject to hiring and
employment practices based on Equal Employment
In September 2021, Gensler reported that he had asked
Opportunity Commission requirements and workplace
his staff to review current practices and consider
safety based on Occupational Safety and Health
recommendations about whether fund managers should
disclose criteria underlying when their funds call
Administration (OSHA) requirements.
themselves “green” and “sustainable” and the like.
Policy Issues
Proponents of ESG disclosures in SEC filings argue that
In October 2021, Gensler announced that the SEC
investors might positively perceive a company that includes
would be requiring public companies to provide
investors with “consistent, comparable, and decision
additional ESG disclosures, which could result in positive
-
financial results for the company. ESG disclosures could
useful ESG-related disclosures.” In this context, the
SEC’s 2
help address long-term risks. Increased disclosure could
021 RegFlex agenda describes potential future
also benefit firms if it results in lower cost of capital, with
SEC rulemakings.
comparable disclosures across peer groups.
Congress and ESG
Critics argue that existing regulations already address many
Congressional interest in ESG matters is reflected in
ESG issues, and the status quo—required disclosure when
various bills introduced in the 117th Congress. For example,
information is material; otherwise, voluntary disclosure at
the House passed H.R. 1187, which would, among other
the firm’s discretion—is appropriate. Critics further argue
things, require publicly traded companies to periodically
that mandatory reporting of ESG factors based on an
disclose information concerning ESG performance metrics.
inflexible standard could be time-intensive and costly for
H.R. 2570 and S. 1217 would require the disclosure of a
firm’s
companies and may be of minimal use if it is not material or
risk management strategies related to the physical
comparable with reporting by peer companies. Such critics
risks and transition risks posed by climate change, among
believe companies should focus on shareholder value, and
other things.
some ESG proposals would distract from that goal.
CRS Resources
Consistency of disclosures is another area of concern.
CRS In Focus IF11221, Introduction to Financial Services:
Public companies discuss ESG-related issues in the
Corporate Governance, by Raj Gnanarajah and Gary
Management Discussion and Analysis (MD&A) section of
Shorter
their annual financial reports. Any ESG issues discussed in
the MD&A section are generally 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
investors can suffer from “information overload.”
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Introduction to Financial Services: Environmental, Social, and Governance (ESG) Issues
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