Paving the way towards sustainable corporate governance in the EU

We believe that good corporate governance is critical to the long-term health and well-being of an organisation and a vital requirement for market stability and ensuring trust in institutions. So, we were pleased that the PRI responded to the EU Commission consultation on its planned sustainable corporate governance initiative. The overall aim of the initiative is to better align the interests of companies, their shareholders, managers, stakeholders and society while helping companies to better manage sustainability-related matters in their own operations and value chains with regards to human rights, climate change, and the environment.

While we largely agree with and support many of the points raised by the Commission, we would strongly recommend further clarification and analysis on a number of these points ahead of any legislative proposal.

Strengthening due diligence will benefit companies and investors

The introduction of a due diligence duty binding on companies in order to ensure that they are aware of the risks and impacts around the environment and human rights is an area on which we welcome action. A mandatory environmental and human rights due diligence legislation would go a long way to ensure that shareholders and other stakeholders are considered in the governance, strategy and operations of EU companies. From an investor perspective, an EU due diligence duty binding on companies would enable them to compare corporate performance against this baseline standard for improved investment decisions and stewardship activities, and in the process, help to drive better financial, economic, environmental and social outcomes. Identifying and managing risk and impacts to people and the environment is core to the success and resilience of a company.

Such an EU due diligence duty should be binding on all companies with operations within the EU of a specified size, including those not headquartered in the EU, and should build on recognised international standards such as the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises. The Commission should also ensure that these standards are reflected in member-state legislation to achieve a level playing field across member states. Appropriate accountability and enforcement of the due diligence duty will be necessary to make the duty effective and ensure it provides access to remedy for people subject to harm from corporate activities.

Raising the bar for directors – but with a considered approach

At present, there is no explicit duty in EU law for directors to generally act in accordance with the company’s long-term interests, shareholders’ views or to incorporate stakeholder interests. As such, the interpretation and precise formulation of directors’ duties, and the processes they must take into consideration, varies across member states. To our mind, a sustainable corporate governance regime means directors must consider the interests and needs of all stakeholders and the social and environmental impact of company operations. Stronger alignment between the interests of shareholder and non-shareholder stakeholders is often a vector of performance that matters to investors.

However, we would urge the Commission to undertake a rigorous legal and impact analysis to support any EU legislation on director duties. The analysis should determine the extent to which clarification of directors’ duties will result in the desired shift in focus towards long-term sustainability, and how this will also support existing corporate governance regimes that consider stakeholder interests to varying extent across member states.

Linking executive pay to sustainability metrics

Designing executive compensation packages to encourage sustainable value creation is another issue that we have examined in detail over the last several years. It’s simply not good enough to reward executives based on financial performance only—a more holistic approach which embraces sustainability considerations should be considered given the overwhelming evidence on how ESG factors drive value. The Commission’s suggestion to establish a mandatory requirement to incorporate ESG factors in executive pay packages is one that we support. It is important that boards integrate the appropriate sustainability criteria into executive remuneration, based on relevance to strategy, business operations and material impacts. However, we don’t believe that a specific percentage of ESG-linked pay should be mandated without further research, as it may exacerbate the potential for unintended consequences - such as companies overweighting ESG factors that may be easier to quantify or adopting operational targets that would be easily met through the course of the business.

Consistency is key to success

The initiative is a positive first step, for which we commend the Commission, but the practicalities of the proposals included in the consultation must be considered going forward. This includes: ensuring consistency across related reforms developed by DG JUST and other EU directorates – for example, investors duties; as well as recognising that each country in the EU has different legal frameworks and corporate governance codes and ensuring EU member state wide reforms build on where there is existing good practice.

Managing ESG risks while also unlocking new opportunities should be an essential part of every organisation’s long-term strategic plans. We hope that the sustainable corporate governance initiative will enhance expectations regarding companies and their directors’ accountability for considering the impact of these issues on stakeholders.

This initiative is an important step further towards greater transparency and disclosure across the corporate spectrum. For progress to continue being made, we urge investors to further examine the proposal that the Commission intends to present this summer, and double down on their engagement and discussions, both with policy makers and portfolio companies. We are at a critical juncture for European businesses and investors. It’s time to take action now.

The PRI’s full response can be read here. 

This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories. Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice. If you have any questions, please contact us at [email protected].