4 November 2020
The European Banking Authority (EBA) has published a discussion paper on the management and supervision of Environmental, Social and Governance (ESG) risks for credit institutions and investment firms, providing a comprehensive proposal on how ESG factors and risks could be included in the regulatory and supervisory framework for credit institutions and investment firms. Responses to this discussion paper will influence the report on ESG risks that the EBA is mandated to develop under the latest iteration of the Capital Requirements Directive (CRD V) and the Investment Firms Directive (IFD). The consultation runs until 3 February 2021 and a final report is anticipated to be published by June 2021.
The discussion paper is fairly extensive and includes an explanation of what ESG factors and risks are, how and through which transmission channels they materialise, why they matter from a financial point of view and what can be done to support their full incorporation by firms and supervisors to enhance the resilience of the financial sector. Of particular interest to us, the EBA identifies a need to incorporate ESG risks into each firm’s internal governance arrangements and supervisory framework in a proportionate manner, including through the firm’s remuneration policies and practices. This alert summarises the comments relating to remuneration.
Chapter 6 of the discussion paper outlines a number of perceived shortcomings in how firms currently incorporate ESG risks into their internal governance practices, including an assessment that remuneration policies are generally not integrated with the relevant firm’s business strategy, core values and long-term interests so as to account for ESG risks, to ensure sound risk management and to mitigate excessive risk taking in this area. This is despite the fact that firms that are currently regulated under the fourth iteration of the Capital Requirements Directive (CRD IV) should already ensure that remuneration policies are consistent with and promote sound and effective risk management and not encourage risk-taking that exceeds the firm’s level of tolerated risk.
The discussion paper notes that:
- a robust and appropriate incentives-based mechanism is important to support the achievement of an appropriate risk culture and should account also for ESG risks;
- aligning the remuneration policy with the firm’s ESG objectives, e.g. long-term resilience of the business strategy under ESG considerations and risk appetite, is important to avoid conflicts of interest when business decisions are taken;
- remuneration policies that create appropriate incentives for staff members to favour decisions in line with the firm’s ESG considerations would facilitate the implementation of ESG risk-related objectives as the staff members would benefit from meeting the long-term ESG risk-related objectives for the business activities of the firm, e.g. in the context of ‘green credit-granting’ or reducing exposures highly affected by transition risk; and
- the impact of the remuneration policies on the achievement of sound and effective long-term risk management objectives from the point of view of ESG considerations may be especially relevant when it comes to the variable remuneration of staff who are ‘material risk takers’.
The discussion paper then makes the following policy recommendations:
- for firms that have set ESG risk-related objectives and/or limits, they should consider implementing a remuneration policy that links the variable remuneration to the successful achievement of those objectives, while ensuring that ‘green-washing’ and excessive risk-taking practices are avoided;
- firms should establish a framework to mitigate and manage conflict of interest which incentivise short-term-oriented undue ESG-related risk-taking, including ‘green-washing’ or mis-selling of products;
- firms should consider ESG indicators when taking into account the long-term interests of the firm in the design of their remuneration policies and its application; and
- in Chapter 7, the EBA recommends that an assessment of the ESG risks, including an assessment of how ESG risks are incorporated into a firm’s remuneration policies and practices, should also be incorporated in the supervisory review for credit institutions.
The EBA recognises that some aspects of the points listed above may not be fully applicable for the economic activities of investment firms, as opposed to credit institutions, but notes that the need to capture the ESG risks in the internal governance and risk management of investment firms, reflecting the specificities of their activities, is equally valid.
- The EBA is holding a public hearing via webinar on 26 November 2020.
- The deadline for consultation responses is 3 February 2021. A consultation response can be submitted on the webpage that can be found here.
- The responses to the discussion paper will influence the EBA’s final report on the management and supervision of ESG risks for credit institutions and investment firms that they intend to publish in June 2021. The final report may lead to future legislative changes and guidance / standards.
The recommendation that firms take steps to incorporate ESG risks into their remuneration policies and practices and align ESG objectives with the remuneration policy reflects a general trend towards linking ESG risks and objectives to pay. Regulators, investors and other stakeholders are all increasingly concerned with how companies approach and integrate ESG considerations into their remuneration strategies, particularly at the executive level.
We recently conducted a review of the remuneration reports published by the UK’s FTSE 100 companies. This review included an analysis of if and how those FTSE 100 companies incorporate ESG metrics into their executive remuneration. We found that a majority of those companies do now incorporate a broad range of ESG metrics into their executive remuneration. This is particularly the case for financial services firms, which we identified in our review as being a leading sector for incorporating ESG targets into executive compensation.
The EBA’s recommendations are not, however, limited to executive compensation. Once the final report is published and legislative or guidance changes are implemented, market practice will develop over time and the regulatory expectations will become clearer. In any event, it is clear that the EBA will expect ESG risks and objectives to be incorporated into the remuneration policies and practices on a wider basis than just to executives, where proportionate.
It is notable that the discussion paper and its recommendations constitute only one aspect of the European Union’s focus on ESG and financial services. For example, the EBA recently closed a survey on ESG disclosures and the upcoming Disclosure Regulation, which is anticipated to apply from 10 March 2021, will require certain firms to include in their remuneration policies information on how those policies are consistent with the integration of ESG risks and publish that information on their websites. Firms should take note of the continuing focus on this area and stay aware of future developments in this space and the impact that these may have on remuneration.
If you would like to discuss this update, or anything else, please do contact us.