The Advisors' Blog

Under the EU’s existing “green taxonomy,” economic activities that meet certain conditions will be incentivized as “environmentally sustainable” investments across the Union. The European Commission is also looking at whether to expand the taxonomy to address “social” objectives. As this Linklaters blog points out, one issue being considered is whether businesses that want to qualify as “sustainable” in the EU will be required to link executive pay to ESG metrics.

Linklaters explains that a group of experts called the Platform on Sustainable Finance are helping the European Commission with its decision. They’ve published a draft report for comments (this fall, the PSF will make a recommendation to the European Commission, which will then publish its own report by year-end).

The PSF folks seem to conclude that while tying pay to ESG could make sense in light of the strategic importance of E&S goals, there are lots of challenges. The blog summarizes the findings:

The PSF report says that that ESG issues now sit at the heart of good business practice, and for some companies this has become a central strategic pillar. As a result, many companies around the world are linking executive remuneration to ESG goals: reducing carbon emissions, customer welfare or workforce diversity.

So the PSF conclude that executive pay linkage to ESG should be part of the EU taxonomy as it is a reflection of what is happening in the real economy.

The PSF say that businesses are concerned that linking EGS to pay could interfere with companies’ autonomy, but they suggest that companies could choose their own sustainability targets and would not need to incorporate a fixed list of indicators. An option would be to link ESG factors to the long term incentive (LTIP) structure and performance measures, possibly along with malus and clawback (withholding pay at the point of vesting, or recovering after payment). It would also be necessary to manage any unintended consequences of linking ESG to LTIPs, which might lead to, for example, greenwashing or gamification.

The PSF draft report identifies some challenges to this linkage:

1. The difficulty of developing criteria to increase diversity on boards because, for example, in some countries gathering information on employees´ ethnicity or sexual orientation is unlawful.

2 How this initiative would fit alongside the upcoming European Commission proposal on sustainable corporate governance, which is expected to address issues related to sustainability expertise in boards and make it compulsory to include sustainability metrics.

3. How this initiative would fit alongside the proposed regulatory technical standards for the Sustainable Finance Disclosure Regulation (SFDR), which already obliges financial market participants to take into account and disclose board gender diversity. This means that all financial products would have to report on diversity anyway.

4. Setting criteria on executive remuneration may prove to be extraordinarily complex due to the variety of long and short term variables and schemes, and could lead to unintended consequences. All this interlinks with companies’ own business models.

5. It is tricky to compare companies on sustainability-linked remuneration, especially if the targets vary between companies.

The PSF identify an alternative option of having rules around compensation structure, transparency and policy that responsible investors already apply when deciding whether or not to approve executive compensation at AGMs. But they say that this could be perceived as disproportionate and infringing national corporate governance models.

– Liz Dunshee