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How EY can Help
Connecting remuneration policy with ESG
Executive remuneration is key to driving more sustainable business conduct. Businesses are more likely to deliver on their sustainability objectives if the reward of their senior leaders is directly linked to the achievement of those objectives. Examples of possible objectives include reduction in carbon dioxide emissions, biodiversity-related targets relating to pollution and water usage, employee reskilling and retention targets, and diversity, such as increasing the number of women in management teams.
Another obvious target is the attainment of a specific ESG rating by a recognized rating agency. Nevertheless, a challenge for companies today is the lack of consistency among rating agencies in terms of the criteria they use. Kateřina Bohuslavová, Chief Sustainability Officer and Head of the ESG Office at Czech energy company ČEZ Group, said that different rating agencies measure different criteria and rely on different data. “Not always is their methodology clear, sometimes you have to guess,” she noted. It was noted during the conference that neither rating agencies, nor the proxy advisory firms that provide research and data to institutional investors, are regulated or supervised.
Over the past few years, the EU has made a number of moves to more directly connect executive remuneration with ESG. Under the revised Shareholder Rights Directive, which came into force in 2017, listed companies are required to publish a remuneration policy and to give shareholders a vote on that policy (what is known as “Say on Pay”). But it is down to individual Member States to decide whether the vote should be binding or advisory only.
The Shareholder Rights Directive states that the remuneration policy “should contribute to the business strategy, long-term interests and sustainability of the company and should not be linked entirely or mainly to short-term objectives”. It adds: “Directors’ performance should be assessed using both financial and non-financial performance criteria, including, where appropriate, environmental, social and governance factors.”
Another significant piece of EU legislation is the proposed Corporate Sustainability Reporting Directive (CSRD). The CSRD will require companies within scope to report on a wide range of sustainability issues that are relevant to their business, including information on any sustainability-related incentive schemes offered to administrative, management and supervisory boards. Additionally, under the proposed CSDDD, directors who benefit from variable remuneration must be incentivized to develop corporate strategy that helps to combat climate change.
Giving the investor perspective, George Dallas, Policy Director for International Corporate Governance Network, an investor-led network, said that the link between ESG and remuneration is well established, growing and supported by the investor community. He explained that investors view remuneration as a way to help ensure “long-term, sustainable value preservation and creation”.
Nevertheless, tying executive remuneration to ESG is hard to do well, not least because of the lengthy time horizons involved. The practice can also come with unintended consequences. Dallas warned that, in some cases, remuneration metrics could potentially be “false proxies” that reward behaviors that “are not necessarily consistent with either the goals of sustainability or good profitability”. Additionally, it is important to consider how the financial objectives of a compensation plan are balanced with ESG objectives to ensure that executives do not receive a substantial share of their bonus if they perform very well on one set of objectives but poorly on the other.
Alice Machová, Climate Change and Sustainability Services Leader at Ernst &Young Audit s.r.o in the Czech Republic, pointed out that an absence of robust data is currently an obstacle to the development of remuneration strategies that are effectively linked to ESG. Many companies do not yet have access to data that is sufficiently reliable for them to base remuneration on it. This is likely to change as a result of the CSRD, however, since companies will need to collect more non-financial data to comply with their reporting requirements and also get limited assurance on the information they report.
Impact of the Corporate Sustainability Reporting Directive
The CSRD will come into force from January 2024 onwards, in a phased approach. Companies that are required to report under the directive will use a set of sustainability reporting standards (ESRS) that have been developed by EFRAG. In total there will be 12 standards: two “cross-cutting standards” that cover general principles and disclosure requirements plus five environmental standards, four social standards and one governance standard.
One of the cross-cutting standards, ESRS 2 General Disclosures, requires disclosures about general governance topics such as the role of the AMSBs1, the information provided to them, sustainability aspects covered by remuneration schemes and the sustainability due diligence statement, as well as the risk management and internal controls over sustainability reporting. The governance standard, ESRS G1, focuses on business conduct and covers topics such as business ethics, corporate culture, late payments, anti-corruption and bribery.
Board oversight will be needed for reporting that is undertaken in line with the CSRD. Fredré Ferreira, Senior Technical Manager at EFRAG, said that boards should ensure that they’re prepared for the directive to come into force. This involves knowing where the relevant data will come from, what data controls are in place, how the company will meet the auditing requirements, and which material risks and opportunities their company should be reporting on under the standards. It was important not to try to report on everything covered by the ESRS, she warned, or companies risk providing information overload, which is not useful.
Another important consideration for boards is establishing whether the company has sufficient sustainability expertise. It may be necessary to recruit external experts as well as undertake some internal reskilling. When it comes to data collection, it is important to draw on the expertise of the financial reporting team, which will have useful existing knowledge of how data flows within the organization.
Review of the G20/OECD Principles of Corporate Governance
The G20/OECD Principles of Corporate Governance are a set of principles that help policy makers to evaluate and improve the legal, regulatory and institutional framework for corporate governance, with the aim of supporting economic efficiency, sustainable growth and financial stability. First issued in 1999, the Principles are currently being reviewed, with the revised Principles set to be issued in 2023. The conference panel discussion on this topic was moderated by Carmine Di Noia, Director for Financial and Enterprise Affairs at the Organisation for Economic Co-operation and Development (OECD), who has overseen the review.
The review is taking into consideration a range of priority areas, including the management of environmental, social and governance risks. Accordingly, the revised Principles will have a new chapter (chapter six) on sustainability and resilience, which will bring together guidance on corporate governance matters related to sustainability, addressing not only disclosure but also the role of shareholders, boards and stakeholders.
Odile de Brosses, President of the European Corporate Governance Codes Network and a member of the EuropeanIssuers Policy Committee, said that while she generally agreed with the content of the revised Principles, she was concerned by the “suspicious tone” in relation to group structure and the implication that groups existed to enable tax evasion. She pointed out that groups have existed for over 100 years and their purpose is not to organize tax evasion, but to allow companies to operate in a more efficient manner.
A further concern was raised by Pascal Durand-Barthez, Vice-Chair of the Corporate Governance Committee, Business at the OECD and a member of ecoDa’s Advocacy Committee. He said that the revised Principles give “a little too much attention” to listed companies given that unlisted companies are also very important and vital to the economy of most countries. He pointed out that family companies, in particular, tend to be highly focused on sustainability since they take a long-term perspective.
Durand-Barthez also noted that sustainability is not only about managing risks, it is also about seizing opportunities. Companies can thrive from seizing the opportunities that sustainability presents. Furthermore, he emphasized the importance of regulatory stability, saying that companies become fatigued as a result of complex regulations that change all the time.
Massimiliano Turconi, Chief Audit Executive for Italian communications group TIM and vice president of the European Confederation of Institutes of Internal Auditing, commented that it was crucial to distinguish between the role of internal audit and external audit in the corporate governance model. In certain countries, internal auditors are even requested to express an independent opinion on the adequacy and effectiveness of the governance model for the board.
“Well-designed corporate governance policies support the sustainability and resilience of corporations and, in turn, contribute to the sustainability and resilience of the broader economy,” said Di Noia.