2 July 2021
The European Banking Authority (EBA) has published a report and factsheet setting out its proposals to further align remuneration within credit institutions and investment firms to Environmental, Social and Governance (ESG) risks within those firms. This report follows a consultation process that ended in February 2021. EU legislators will now review the report and will consider whether to make any legislative changes. The EBA will also use the report as a basis for the development of guidelines on the management of ESG risks by firms and the supervision of ESG risks by regulators. The EBA invites firms to actively reflect on the content of the report and its recommendations.
In November 2020, the EBA launched a consultation in relation to the inclusion of ESG factors and risks into the regulatory and supervisory framework for credit institutions and investment firms. This report contains the results of that consultation and sets out recommendations relating to the definition and assessment of ESG risks, the management of ESG risks and the supervision and evaluation of ESG risks by regulators. The report also identifies weaknesses in how firms currently incorporate ESG risks into their governance practices.
Key remuneration-related observations
The key remuneration-related observations are as follows:
- There appears to be a general failure to integrate remuneration policies into the firm’s business strategy, core values and long-term interests in a way that accounts for ESG risks, ensures sound risk management and mitigates excessive risk taking in this area.
- A robust and appropriate incentive-based mechanism is important for achieving an appropriate risk culture. When designing their ESG risk strategy, firms should evaluate how to account for ESG risks in their remuneration policies. This is particularly relevant to the firm’s material risk takers.
- Aligning the firm’s 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 for avoiding conflicts of interest when business decisions are taken.
- Remuneration policies that give the right incentives for staff to favour decisions in line with the firm’s ESG risk-related strategy would facilitate the implementation of ESG risk-related objectives and/or limits, as the staff would benefit from meeting these targets. The impact of remuneration policies on the achievement of sound and effective long-term risk management objectives, with regard to ESG considerations, may be especially relevant when it comes to the variable remuneration of material risk takers, and in particular when they have responsibilities for defining and implementing ESG-related strategy.
Key remuneration-related recommendations
The EBA notes in the report that they see the need for firms to proportionately incorporate ESG risks into their internal governance arrangements, including by ensuring that remuneration policies are aligned with the firm’s long-term interests, business strategy, objectives and values. The EBA has issued recommendations for firms that are intended to help to achieve this.
The key remuneration-related recommendations are as follows:
- Firms should consider ESG indicators and ESG risk-related objectives and/or limits when taking into account the long-term interests of the firm in the design of remuneration policies and their application, including considering the implementation of a remuneration policy that links the variable remuneration of the firm’s material risk takers, taking into account their respective roles and responsibilities, 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 conflicts of interest which incentivise short-term-oriented undue ESG-related risk-taking, including ‘green-washing’ or mis-selling of products.
- The EBA recommends that EU legislators adapt legislation in directives and regulations applicable to the banking sector to incorporate ESG risk-related considerations and enable the implementation of the EBA’s recommendations set out above.
- The supervisory review of firms should proportionately incorporate ESG risk-specific considerations into the assessment of the firm’s internal governance and wide controls, including monitoring how ESG factors and risks will be incorporated into the firm’s remuneration policies and practices.
Tapestry comment
ESG is definitely the topic of the day and various EU bodies have been active in this space. This report is the latest in an increasingly long line of initiatives that seek to ensure the effective management and supervision of ESG risks and considerations, following the recently effective Taxonomy Regulation and Sustainable Finance Disclosure Regulation.
Although this report covers a much broader scope than just remuneration, the EBA’s focus on aligning remuneration to ESG risks is notable. Although the recommendations set out in the report do not result in an immediate change to any rules or guidelines, the EBA has said that they will use the report to develop further guidance for firms and they have encouraged EU legislators to seek to adapt legislation to enable the implementation of their recommendations, including certain of the remuneration recommendations noted above. This may mean that we will see more prescriptive expectations or requirements in relation to the incorporation of ESG risks into remuneration policies and practices in the future. We will monitor the position and will issue an alert if we see any such developments.
As a consequence of the UK leaving the EU, these recommendations will not directly apply to UK-regulated firms. That said, the UK is also active in the ESG space (for example, the Financial Conduct Authority are consulting on extending climate related disclosures to standard listed companies and on ESG integration in UK capital markets) and so we may see a similar focus on aligning remuneration to ESG risks from the UK regulators at some point.
In any event, the direction of travel is clear and the legal framework surrounding ESG is evolving worldwide and firms should explore how to tackle ESG risks and challenges, including by using their remuneration policies and practices as a tool to manage and mitigate risk. It is important to remember, however, that the link between remuneration and ESG, while important, is part of a larger risk management and mitigation puzzle that needs to be considered holistically by firms.
If you have any questions on this or anything else, please do get in touch. We would be delighted to help.
Matthew Hunter