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CFA Level II Exam · Environmental, Social, and Governance (ESG) Considerations in Investment Analysis

ESG Overview and Key Terminology for CFA Level II

Updated 7 October 2026 · Fact-checked

ESG stands for environmental, social and governance factors: non-financial issues that can affect a company's risk, cash flows and value. Responsible investing is the broad umbrella for using them. To answer exam questions, classify each issue as E, S or G, judge its materiality for that industry and region, then match the approach.

Understand ESG Overview and Key Terminology

ESG means environmental, social and governance factors. Environmental factors cover things like climate change and carbon emissions, resource depletion, water use, waste and pollution, and biodiversity. Social factors cover employee relations and working conditions, health and safety, human rights, supply chain labour practices, product safety, data privacy and community impact. Governance factors cover board composition and independence, executive pay, shareholder rights, audit quality, ownership structure, bribery and corruption, and transparency.

The terms around ESG are used loosely in practice, so you must know the distinctions. Responsible investing is the broadest term: investing that considers ESG factors in some way. Sustainable investing usually refers to investing aimed at long-term sustainability, often through ESG integration and themes. Socially responsible investing (SRI) is an older term that usually means excluding sectors or companies that conflict with an investor's values or ethics. Impact investing targets measurable social or environmental outcomes alongside a financial return. ESG integration means including material ESG factors in traditional financial analysis and valuation. Always read the vignette to see which meaning the investor actually uses.

The key idea is materiality. An ESG issue matters for investment analysis when it can reasonably affect a company's financial performance, risk or valuation. The same issue can be material for one industry and trivial for another. Carbon emissions and regulation are central for utilities and cement makers. Data security and privacy are central for software and banks. Labour practices in the supply chain are central for apparel and electronics makers. Mining, oil and gas also carry heavy environmental and community risks.

Regions differ too. Regulation, disclosure rules, enforcement, cultural norms and investor expectations vary across countries. Some regions require detailed sustainability reporting, and others rely on voluntary disclosure. Governance norms such as board structure, shareholder rights and the role of controlling shareholders also differ, so a governance practice that is a red flag in one market may be normal in another. Analysts should judge ESG issues in local context, not apply one template everywhere.

Finally, ESG can enter analysis as a source of risk (for example fines, stranded assets, litigation, reputational damage) and as a source of opportunity (for example efficiency gains, new products, lower cost of capital). That link to cash flows, discount rates and credit risk is what turns ESG from a values topic into an analysis topic.

Key formulas to remember

Environmental factors
E = climate change, emissions, resource use, water, waste, pollution, biodiversity
Issues about a company's effect on, and exposure to, the natural environment.
Social factors
S = labour relations, health and safety, human rights, supply chain, product safety, privacy, community
Issues about how a company treats people inside and outside the firm.
Governance factors
G = board structure, pay, shareholder rights, audit, ownership, ethics and transparency
Issues about how the company is directed and controlled and how it treats shareholders.
Materiality test
Material if the issue can reasonably affect cash flows, risk or valuation for that industry and region
Not every ESG issue is material to every company.
Term distinctions
Responsible investing (broad) ⊃ SRI (exclusion/values), ESG integration (financial analysis), impact investing (measurable outcomes)
Definitions vary in practice, so follow the usage in the vignette.

How to solve ESG Overview and Key Terminology questions

Use this method on any item-set question about ESG definitions, factors or industry and regional differences.

  1. 1Read the vignette and underline each ESG issue mentioned, including those buried in exhibits.
  2. 2Classify each issue as environmental, social or governance. Some issues touch two categories, so choose the best fit for the question asked.
  3. 3Identify the industry and the region. Ask which issues are most likely to be material for that industry there.
  4. 4Decide how the issue affects the company: through cash flows, risk, cost of capital or reputation.
  5. 5Identify what the investor is doing: excluding, integrating, targeting outcomes or engaging. Match this to the right term.
  6. 6Check the question stem for a qualifier such as most likely, least likely or most material.
  7. 7Eliminate options that confuse terms, such as calling exclusion screening ESG integration, or that treat every issue as equally material.
  8. 8Choose the option that best fits the vignette facts, not general opinion.

Quickest way: Label, rank, match

When to use it: When time is short and the question asks you to classify an issue or pick the right term.

  1. Write E, S or G next to each issue in the vignette.
  2. Ask whether it plausibly hits the financial results of this industry; if not, it is low materiality.
  3. Match the investor's action to a term: avoid = SRI or exclusion, include in valuation = integration, measurable outcome = impact.
  4. Pick the option consistent with all three checks.

Common mistakes in ESG Overview and Key Terminology

  • Treating ESG, SRI and sustainable investing as exact synonyms.

    Practitioners and media use the terms interchangeably.

    Fix: Anchor on what the investor actually does. Exclusion on values points to SRI. Using ESG factors in valuation points to integration.

  • Assuming all ESG factors are equally material to every company.

    Candidates memorise lists without linking them to business models.

    Fix: Always tie the issue to the industry and its cash flows before judging materiality.

  • Misclassifying issues, for example putting executive pay under social.

    Pay affects people, so it feels social.

    Fix: Remember that board structure, pay, audit and shareholder rights are governance. Worker conditions and product safety are social.

  • Applying one region's norms to all regions.

    Candidates assume disclosure rules and governance practices are global.

    Fix: Note that regulation, disclosure and ownership structures differ, and judge practices in local context.

  • Viewing ESG only as a risk or cost.

    Exam examples often highlight scandals and fines.

    Fix: Remember ESG can also create opportunities, such as efficiency, new products and a lower cost of capital.

Worked examples

Example 1

Vignette: An analyst covers a regional cement producer and a large online lender. For the cement producer, she notes high carbon emissions per tonne and the risk of a future carbon price. For the lender, she notes a recent customer data breach and a board where the CEO is also chair. Q1: Classify the cement producer's carbon issue. Q2: Which issue is most clearly a governance concern at the lender? Q3: Which issue is likely more material to the cement producer than to the lender?

Show the solution
  1. Q1: Carbon emissions and carbon pricing relate to climate change and the natural environment, so this is environmental.
  2. Q2: The data breach concerns customer privacy and security, which is a social issue (with operational risk). The CEO also serving as chair concerns board structure and independence, which is governance.
  3. Q3: Carbon emissions and carbon pricing directly affect production costs and capital spending for a cement producer. For an online lender they are minor. So carbon emissions are more material to the cement producer.

Answer: Q1: Environmental. Q2: The CEO also being chair (board structure). Q3: Carbon emissions and carbon pricing.

Example 2

Vignette: Fund A refuses to hold tobacco and weapons companies because its clients object to them on moral grounds. Fund B keeps all sectors but adjusts its forecasts and discount rates for material ESG risks it identifies in each company. Fund C buys affordable-housing projects and reports the number of homes delivered, alongside its financial return. Q1: Which approach does Fund A follow? Q2: Which approach does Fund B follow? Q3: Which approach does Fund C follow?

Show the solution
  1. Q1: Fund A excludes sectors on values, which is the classic socially responsible investing or exclusionary approach.
  2. Q2: Fund B includes material ESG factors in traditional financial analysis and valuation, which is ESG integration.
  3. Q3: Fund C targets measurable social outcomes together with a financial return, which is impact investing.

Answer: Fund A: SRI (exclusionary screening). Fund B: ESG integration. Fund C: impact investing.

Exam tips

  • Expect vignettes that mix E, S and G issues and ask you to classify or rank them by materiality for the stated industry.
  • Match the investor's action to the term. The stem usually describes what the fund does rather than naming the approach.
  • Watch qualifiers such as most likely, least likely and primarily. They change which answer is best.
  • Use regional clues in the vignette, such as disclosure rules or ownership structure, to judge governance and reporting differences.
  • This topic is quick marks if you stay disciplined, so do not overthink and spend time better used on calculation-heavy sets.

ESG Overview and Key Terminology in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

ESG Overview and Key Terminology: frequently asked questions

What is ESG investing in CFA Level II?

It is the use of environmental, social and governance factors in investment analysis and decisions. At Level II you apply it inside item sets by classifying issues, judging materiality and linking them to risk and value.

What is the difference between ESG and socially responsible investing?

SRI usually means excluding companies or sectors that conflict with an investor's values. ESG integration means including material ESG factors in financial analysis to assess risk and return. The two can be combined, but they are not the same thing.

Can you give examples of environmental, social and governance factors?

Environmental: carbon emissions, water use and pollution. Social: worker safety, supply chain labour and data privacy. Governance: board independence, executive pay and audit quality.

Why do ESG issues differ across industries and regions?

Business models expose firms to different risks, so emissions matter for cement while data privacy matters for software. Regions also differ in regulation, disclosure requirements and governance norms.