EU to have mandatory linking of ESG to executive pay?

The European Commission is considering whether the existing EU green taxonomy (under the Taxonomy Regulation) should be extended to cover social issues. A group of EU experts called the Platform on Sustainable Finance (PSF) have been tasked with helping the Commission decide this. They have just published, for consultation, a draft report on a social taxonomy. The report includes a discussion on linking ESG to executive pay (pp. 45-47).

Timing and relevance to the UK

The consultation closes on 27 August. The PSF will submit its final report to the Commission in the Autumn so that the Commission can publish its own report by 31 December. For the wider consultation issues, see this blog post from my colleague Sara Feijao. 

Post Brexit, this is not immediately relevant to UK businesses. But organizations operating in the EU may well be affected if there is EU level legislation mandating some form of linking executive variable pay to ESG factors. And there may well be a spill-on impact in the UK. The draft report states that a study of 365 issuers from major indexes in continental Europe and the UK found that 68% have at least one ESG metric in their incentive plans. 

What does the draft EU report say on linking ESG metrics to executive pay?

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. 

It will be interesting to see what sort of proposal on linking ESG and executive pay will be included in the PSF's final report, and how this is reflected in any Commission proposals in its own report.