23 Mar 2022

How will the Sustainable Finance Disclosure Regulation affect executive pay?

The Sustainability Finance Disclosure Regulation (SFDR) officially became applicable in March 2021. The regulation covers the financial market and financial advisers operating in the EU. The disclosure requirement sets the tone and specific targets of what sustainability-related information must be disclosed.

One of the most important highlights of the regulation is to avoid potential greenwashing of financial services and products by providing more detailed sustainability related information. The regulation would give investors the opportunity to measure investee companies’ sustainability reporting and values holistically.

The next step

In 2022, investors in the EU will start implementing the next step of this legislation. The SFDR introduces the concept of principal adverse impacts (PAI), which seeks to measure and report on quantitative metrics and explicit different between environmental, social and governance (ESG) measures. PAI would also mean that investee companies would have to report on more granular level addressing their impacts and actions being taken to address them.

The quantitative adverse impact indicators are the centrepiece of and, for those affected by SFDR, a central challenge in complying with this new reporting regime. In addition to classifying their financial products and integrating the SFDR’s multiple new reporting mandates into their disclosure processes, affected financial market participants (FMPs) are understandably focused on the significant data availability issues associated with the PAIs. At the same time, investors would be well served to evaluate their stewardship practices and consider the critical, ongoing role they will play in SFDR compliance.

How will this affect executive compensation?

One of the main parts of the SFDR is the requirement of investee companies to disclose information on how remuneration policies are consistent with the integration of sustainability risks. In a report by the Diligent Institute in August 2021, the data suggested that ESG integration in compensation policies is growing across Europe.

Our research suggested that the number of companies linking ESG metrics to executive compensation is on the rise. From 2008 to 2020, the average percentage of companies linking ESG metrics to chief executive officer (CEO) pay increased from 4% to 34%. The data suggests that French companies are leading the charge in Europe, with 74% of companies in the country including ESG metrics in CEO compensation plans. Countries such as Norway, Italy, and Ireland, meanwhile lag behind France, the UK, and the Netherlands.

Growth in the utilities sector

By sector, our findings again suggested the utilities sector has had the highest growth in companies incorporating ESG related metrics in executive compensation. In 2008, none of the utilities companies in our sample had linked ESG metrics to executive pay. By 2020, this has risen to 64%. Sectors such as healthcare and information technologies, meanwhile, lag: around 22% and 25% of companies in these sectors respectively had ESG related key performance indicators in their annual and or long-term incentive plans.

Overall though, the percentage of companies incorporating ESG metrics into their compensation plans is still increasing rapidly. Last year, 37% of companies were expected to link ESG to compensation across Europe. The research also suggested that social metrics are likely to be the favoured choice. While there is a noticeable trend on emphasis on ESG-related metrics in executive compensation, we find that they are more prevalent in annual bonuses rather than in long-term incentives, lessening their impacts. Looking ahead, it is to be hoped that ESG metrics will be included in long-term plans relatively more than short-term incentives.

Greenwashing fears

While these measures are encouraging, it again brings to the fore the question of greenwashing. SFDR will likely impact the importance of these metrics to investee companies’ strategy.

SFDR would, among other things, open investee companies to greater scrutiny in all areas of strategy, including executive compensation in sustainability inclusion. Companies would have to ensure that metrics included in executive compensation plans are aligned with their sustainability values. SFDR would in essence enrich sustainable value creation in executive compensation plans.

Article provided by Diligent