Understanding key ESG concepts: a glossary

ESG. An acronym for Environmental, Social Responsibility and Corporate Governance-related factors used by investors to make decisions about investing in companies. While there are financial regulations related to each of these factors individually, note that “ESG” itself is not currently used in regulation or statute.

Sustainability. When used about investments, it is often used as a synonym for ESG with a focus on environmental factors.

Climate-related financial risk. Financial regulators are looking at how climate change could affect the safety and soundness of both individual banks and the financial system as a whole. There are two keys paths of climate-related financial risk: physical risk and transition risk. Meanwhile, the Financial Stability Oversight Council, led by the Department of the Treasury, is assessing the potential for climate-related financial risks to pose systemic risks.

Physical risk is the risk posed by climate change-driven weather events to property, operations or collateral—for example, the risk that rising sea levels may pose to coastal real estate.

Transition risk covers what happens to a bank’s loans should the economy continue its transition to less carbon-intensive sources of energy—for example, the risk that banks may have to write down loans to more carbon-intensive industries.

Climate disclosures. At press time, regulators are weighing how and when to require public companies and financial institutions to disclose climate risk factors and exposures to climate change. This is a complex enterprise, because climate models are to some degree speculative and there is often a wide band of potential climate effects. Translating these models to bank balance sheets is a novel exercise that adds additional complexity—and may require banks to balance competing environmental priorities. For example, a bank may reduce its carbon exposure by financing electric car manufacturing but offset this reduction by increasing its environmental exposure through lithium mining, which is necessary for electric car batteries. The Financial Stability Board created a Task Force on Climate-Related Financial Disclosures to attempt to standardize reporting. In 2020, a little under a quarter of large and regional banks worldwide were making climate disclosures. At press time, the SEC had proposed the first-ever climate-related disclosure requirements for public companies.

Community Reinvestment Act. This is the statutory requirement for banks to meet the credit needs of the communities—in particular, low-to-moderate-income communities—they serve, through mortgages and small business loans, community development investments, financial education, volunteering and philanthropy. Banks are unusual among U.S. businesses in having a statutory duty to meet social responsibility goals; banks’ CRA activities map neatly to the social responsibility factor of ESG.

Diversity, equity and inclusion. DEI initiatives at banks address both social responsibility and corporate governance factors. Through DEI initiatives, banks can embrace fair lending practices and responsibilities that ensure they meet (or exceed) their CRA goals. DEI initiatives also affect governance by prioritizing representation from different communities and backgrounds among corporate executives and board members.

Board diversity. There is currently no regulatory requirement for board diversity, but the Securities and Exchange Commission has blessed a private-sector requirement by the Nasdaq stock exchange on board diversity. Specifically, Nasdaq requires most of its listed companies to have at least two directors who do not self-identify as straight white men—at least one who self-identifies as a woman and at least one who self-identifies as a member of a racial or ethnic minority or as LGBTQ. If a company does not meet this requirement, it must explain why publicly. While this only applies to Nasdaq-listed banks, similar requirements may be implemented at other exchanges. Similar requirements are also being established by state law, and Acting Comptroller Michael Hsu said in 2021 that the OCC is considering ways to mandate board diversity for national banks and federal thrifts.

Fair access. Originated in a since-rescinded rulemaking by former Acting Comptroller of the Currency Brian Brooks, this concept refers to a requirement for banks to affirmatively serve legal businesses. The OCC’s former rule would have limited larger banks’ discretion not to serve industry sectors like oil and gas. While the OCC rule was rescinded, “fair access” proposals are in play in state legislatures that would remove banks’ discretion in providing credit or banking services to sectors like firearms manufacturers. It is in some ways the converse of Operation Choke Point, an Obama-era initiative by which examiners pressured banks not to lend to legal businesses and industries; under fair access, banks would be required to lend to legal industries.

Sustainable and responsible investing. This is the discipline practiced by bankers as wealth managers and investment advisers when their clients seek investments that score high on ESG factors. According to Gallup, 42 percent of U.S. investors in 2021 reported being somewhat or very interested in sustainable investing funds.