Introduction to Financial Services: Environmental, Social, and Governance (ESG) Issues

Introduction to Financial Services: Environmental, Social, and Governance (ESG) Issues

Updated January 5, 2023
Introduction to Financial Services: Environmental, Social, and
Governance (ESG) Issues
ESG is a widely used acronym for environmental, social,
either physically relocate or seek alternative production
and governance issues. Corporate governance—concerns
inputs at a higher cost and diminished profits.
about how companies should be managed—has evolved
over time to include, arguably, a wider array of issues that
Social. Social factors encompass a firm’s effects on its
encompass ESG. Some consider ESG factors to be an
various stakeholders, such as consumers, employees,
integral part of discussions about sustainability. According
suppliers, contractors, and the local and broader
to one definition, sustainability at the firm level is “an
communities. Risks include potential infringement on the
approach that creates long-term shareholder value through
rights of others, gender- or ethnicity-based discrimination
managing opportunities and risks that derive from
when hiring or promoting employees, failure to monitor
economic, environmental and social developments.”
supplier and contractor pay, handling of customer data in a
nontransparent and nonsecure way, political spending, and
Over 7,000 signatories, with over $120 trillion in assets
investing in projects or sectors that could be considered
under management (i.e., client assets managed by the
objectionable to specific segments of society. Companies
signatories) support Principles for Responsible Investment
that handle these risks poorly might experience effects
(PRI), a nongovernmental organization (NGO) that
similar to environmental risks, such as the inability to
promotes sustainability through ESG. Although the United
attract quality employees and exposure to costly litigation.
Nations initiated PRI in 2005, the six principles of
responsible investment were launched at the New York
In addition, some stakeholders might consider certain
Stock Exchange in 2006 with 100 initial signatories. Over
business operations or funding of certain entities in various
the years, as more signatories have joined PRI, they have
areas to be unacceptable, including tobacco, gun
increasingly asked investment managers to incorporate ESG
manufacturing, private prison industries, abortion providers,
factors in their investment decisions. In addition, state
and gambling. On the other hand, other stakeholders might
regulators, NGOs, and some Securities and Exchange
consider an infringement of their rights any limitations
Commission (SEC) commissioners and advisory groups
placed on their right to operate or fund such lawful entities.
have increasingly taken interest in ESG concerns.
Congressional interest has centered on what types of ESG
Governance. A firm’s self-governance and integrity when
disclosures, if any, should be required.
conducting business may raise questions. The policies,
processes, and controls implemented by a firm help to
What Is ESG?
define its self-governance and impact on various
There is no universally agreed-upon definition of what
stakeholders. A firm’s integrity is measured by whether it
constitutes ESG. Investors and other stakeholders consider
avoids corruption and bribery and engages with individuals
a wide-ranging array of topics as part of ESG. The
and other firms that may pose a reputational risk to the firm.
discussion below on the characteristics and risks that can
accompany ESG is not definitive. It is meant to illustrate
If a corporation chooses not to address governance issues,
some of the perceived risks of either addressing or ignoring
the associated risks could include harm to its consumers
various ESG factors.
and an environment leading to criminal activity and
corporate reputational harm, potentially resulting in firm
Characteristics and Risks
failure. Firm failure negatively affects stakeholders—
Environmental. Investors and stakeholders may examine a
employees may lose their jobs, suppliers might not be paid,
firm’s impact on the environment. Some consider the
and local governments may receive less tax revenue. Some
interaction with the environment to be a form of capital—
examples are Enron (2001 bankruptcy), WorldCom (2002
the stock of natural resources. Environmental risks include
bankruptcy), and MF Global (2011 bankruptcy). Recently,
declining biodiversity; pollution; resource scarcity; and
the fake account scandal at Wells Fargo Bank harmed its
potential climate change impacts, including increasingly
clients, resulted in the removal of many key executives, and
frequent and severe floods, hurricanes, and forest fires.
prompted regulators to restrict the bank’s growth.
For individual firms, ignoring environmental risks could
Materiality and ESG
potentially harm their reputations, endanger employees, and
The disclosure of material information is an important
imperil physical operations, which could lead to costly
accounting principle. The notion of materiality is at the
litigation. For other firms and communities, addressing
center of SEC-regulated disclosure requirements.
environmental risks might cause economic harm, with
Materiality is deemed to be information that a reasonable
diminished access to natural resources and the need to
investor would deem important in determining whether to
purchase a security. In the ESG realm, there is an ongoing
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Introduction to Financial Services: Environmental, Social, and Governance (ESG) Issues
debate about what is material in determining which ESG
independent audit. Some studies have found that many
factors a firm should target and disclose to investors.
companies report on ESG issues, but the information
Discussion around what constitutes materiality is similar to
published by the companies is not standardized, and
discussion about what constitutes ESG—companies have
investors can suffer from “information overload.”
discretion over what to include in both. Some proponents of
Inconsistent disclosure standards make it harder for
ESG disclosure have stated that focusing on financial
investors to measure a firm’s performance on ESG issues.
materiality would be most helpful to investors.
Standardizing the disclosure requirements by industry could
help investors and firms compare peer groups. In this
Financial materiality issues, as defined by the
context, some have criticized the 2010 SEC climate
Sustainability Accounting Standards Board, “are the
guidance for resulting in inadequate and inconsistent
issues that are reasonably likely to impact the financial
climate-related disclosures.
condition or operating performance of a company and
therefore are most important to investors.”
SEC and ESG
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 the following:
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
fleet fuel efficiency at a company that transports goods
Task Force in the Division of Enforcement tasked with
proactively identifying ESG-related misconduct.
could improve its financial results while benefitting air
quality. Applying the same set of ESG factors to a data

warehouse might not make sense; in that instance, lowering
In March 2022, the SEC proposed rules aimed at
requiring publicly traded SEC-registered firms to
the cost of electricity (which could depend on the relative
provide more enhanced climate risk disclosure to
cost of fossil fuels versus renewable energy) would
investors.
probably be more relevant.
 In May 2022, the SEC proposed rules aimed at
Investors and other stakeholders might want to consider if a
company is following the existing minimum federal and
enhanced ESG-related disclosure by funds and
investment advisers who consider ESG factors in,
local statutory requirements. In addition, stakeholders might
respectively, their investment portfolios and the advice
want to consider if a company’s ESG issues can be
addressed through the existing regulatory regime—for
that they give to retail and institutional investors. Also,
the SEC proposed rules aimed at providing greater
example, all employers are subject to hiring and
clarity regarding ESG-related fund names.
employment practices based on Equal Employment
Opportunity Commission requirements and workplace
 In July 2022, the SEC adopted final rules rescinding
safety based on Occupational Safety and Health
Administration (OSHA) requirements.
earlier unimplemented rules related to proxy advisory
firms, which advise institutional investors on proxy
Policy Issues
voting. According to the SEC, “The final amendments
aim to avoid burdens on proxy voting advice businesses
Proponents of ESG disclosures in SEC filings argue that
investors might positively perceive a company that includes
that may impair the timeliness and independence of their
advice.”
additional ESG disclosures, which could result in positive
financial results for the company. ESG disclosures could

help address long-term risks. Increased disclosure could
In November 2022, the SEC adopted final rules aimed at
enhancing the information funds report on their proxy
also benefit firms if it results in lower cost of capital, with
comparable disclosures across peer groups.
voting, including ESG-related matters. According to the
SEC, “funds can influence the outcome of a wide
variety of matters that companies submit to a
Critics argue that existing regulations already address many
shareholder vote, including matters related to
ESG issues, and the status quo—required disclosure when
information is material; otherwise, voluntary disclosure at
governance, corporate actions, and shareholder
the firm’s discretion—
proposals.” The SEC intends for the reform to make
is appropriate. Critics further argue
funds’ proxy voting disclosures more usable and easier
that mandatory reporting of ESG factors based on an
inflexible standard could be time-intensive and costly for
to analyze, making it easier for investors to monitor
fund voting and comparing voting across funds.
companies and may be of minimal use if it is not material or
comparable with reporting by peer companies. Such critics
believe companies should focus on shareholder value, and
As discussed earlier, without a clear definition of what
some ESG proposals would distract from that goal.
constitutes ESG, some of the adopted rules might be
difficult to measure and enforce.
Consistency of disclosures is another area of concern.
Public companies discuss ESG-related issues in the
Raj Gnanarajah, Analyst in Financial Economics
Management Discussion and Analysis (MD&A) section of
Gary Shorter, Specialist in Financial Economics
their annual financial reports. Any ESG issues discussed in
IF11716
the MD&A section are generally not subject to an
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Introduction to Financial Services: Environmental, Social, and Governance (ESG) Issues

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