Worklife 2.0 The role of remuneration in the sustainability agenda – European Commission study

At the end of July, the European Commission (EC) published a study on directors' duties and sustainable corporate governance, examining the factors that drive public companies to focus on “short-termism” i.e. achieving short-term benefits for shareholders at the expense of long-term benefits.

According to the study, one driver of short-termism is board remuneration structures that “incentivise the focus on short-term shareholder value rather than long-term value creation for the company”. The EC identifies that the current practice of share-based board remuneration coupled with limited integration of ESG metrics into remuneration structures does little to shift the focus away from short term financial return.

According to the EC, this results in:

• Companies sacrificing investments in areas such as R&D, CAPEX and employee development as directors are not incentivised to take business decisions that contribute to sustainability.
• This has a knock-on effect on sustainability as it slows down the company’s transition to sustainable value creation.
• Ultimately, the longer-term sustainability risks are ignored, as well as the future impact on the business, shareholders, investors and wider society.

The study proposes three EU-level solutions that could help rebalance the “shareholder primacy” status quo.

Non-legislative “soft” options:

1. Option A: A Commission led and funded campaign aimed at companies to encourage them to link board remuneration to long-term, sustainable value creation.
2. Option B: A Commission recommendation for Member States to introduce in their respective national frameworks:

• a provision to restrict executives’ ability to sell shares they receive as pay; and
• a provision to make compulsory the inclusion of non-financial ESG metrics, linked to a company’s sustainability targets, in executive pay schemes.

Legislative “hard” option:

1. Option C: Commission proposal to amend the Shareholder Rights Directive II to align executive remuneration policy with long-term and sustainability goals, in particular by:

• regulating executives’ ability to sell the shares they receive as pay; and
• making compulsory the inclusion of non-financial, ESG metrics, linked to a company’s sustainability targets, in the executive pay scheme.

Under option A, companies would be encouraged to review their remuneration arrangements and to consider their role in shaping the ESG agenda (a trend that will be familiar to some listed companies already), but they would presumably retain a degree of flexibility as to their response. The EU’s conclusion is that this option may create an element of social pressure, but that its meaningful impact will be limited.

Given its status as a recommendation only, there is obviously a question as to whether all Member States would decide to take action under option B (and, if so, the parameters of any restriction that they may choose to impose). The relative flexibility offered by this option carries with it the potential disadvantage of a patchwork approach unfolding across the EU, which may undermine the EC’s purpose of encouraging an EU-wide focus on sustainability.

Recognising the crucial role companies play in helping to combat climate change, the EC appears very much in favour of going down the “hard” option route. The soft options are set against the ominous warning that the EU will miss its Paris Agreement target to reduce emission levels by 2030 unless urgent action by all stakeholders is taken. The business environment in which European companies operate has become increasingly more sustainability-focused. Adopting a light-touch proposal may seem like a backwards step in the context of calls for greater regulatory action in respect of remuneration (see for example, the Commission’s earlier range of recommendations (2004/913/EC, 2005/162/EC, 2009/385/EC) on remuneration policies in listed companies).

Although many listed companies will already be considering the role that remuneration plays in delivering on ESG objectives, there is no explicit requirement to link board remuneration to non-financial ESG metrics in most Member States. An amendment to the Shareholder Rights Directive II under option C would therefore represent a fundamental shift and is ranked in the study as likely to be “effective to a large extent in promoting corporate governance practices that contribute to company's (sic.) sustainability.”

When considering the social impact of option C, the EC recognised the temptation of linking executive remuneration exclusively to social indicators that are easier to quantify such as employee or consumer satisfaction which can be measured through annual turnover and surveys. The EC also made the point that option C does not oblige companies to factor non-financial fundamental rights metrics into numerical remuneration calculations.

As a result, companies are likely to prioritise and pursue only those metrics included in the executive remuneration structure, side-lining excluded yet equally important indicators. Nevertheless, given the practical difficulty of quantifying a number of these indicators (particularly those at a human rights or social level), this may be a necessary consequence that could be potentially off-set by a company’s existing disclosure obligations (for example, the annual modern slavery statement that UK companies must publish).

Further questions remain as to how exactly to achieve the proposed option C. If option C became a legislative reality, such a proposal would have to identify and prescribe indicators that are both readily quantifiable by companies, and would bring about a significant, positive change at an environmental level. At the same time, the requirement must also remain flexible enough to allow companies to tailor sustainability indicators to their specific industry and business. In addition, some companies may go to greater efforts than others to align remuneration policies with sustainability objectives. Who will be able to judge whether policies are up to scratch, and will they have any enforcement power? The EC makes clear that any amendments would be introduced with contributions from expert groups and after consultation and the slow pace of legislative change means that any amendment may be some time away.

While Member States are in the midst of confronting coronavirus, the prospect of legislative change in respect of already complex remuneration arrangements may not rank highly on national political agendas. Nevertheless, as the study makes clear, there is a growing sense of urgency to effect meaningful change, and remuneration arrangements seem likely to be in the legislators’ sights when considering how best to progress ESG issues.