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ESG Focus: Executive Remuneration In The Spotlight (Part 2)

ESG Focus | Aug 06 2019

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

This part continues from Part One, published on 1 August 2019.

Australian focus: Hello remuneration strikes

Remuneration strikes on the rise
-Regulators ordered to step up
-Trend to incorporate ESG metrics

By Sarah Mills

Corporate freedom in Australia is among the greatest in the world but that could change.

The traditional passivity of Australian shareholders is shifting. 

In 2018, the number of ASX100 companies to receive a strike against their remuneration tripled on 2017, and there were many close shaves.

In 2018, large strikes were received against National Australia Bank, Mineral Resources ((MIN)), Westpac ((WBC)), Telstra ((TLS)), and AMP ((AMP)).

A second strike vote this year would force a vote on board spills.

According to AON Hewitt Australia, the companies that received strikes tended to be those that took a wait-and-see approach rather than pre-emptive.

According to a report from JP Morgan: “Across the ASX200, support for remuneration reports is in decline.

“Over the most recent AGM season, a record 17 companies received strikes with at least 75% of shareholders voting against the remuneration reports compared with seven companies receiving strikes over the previous corresponding period.

“The trend has continued through the second half of 2019 with CSR receiving a first strike against the remuneration report at the 2019 AGM. “

Royal Commission heralds change

The Haynes Royal Commission into the finance industry last year has identified executive remuneration as a key area of reform.

It has provided a blueprint for remuneration that will most likely extend beyond the walls of the financial sector.

The Final Report’s recommendations did not specify a ratio of fixed to variable pay, nor proposed caps but focused instead on increasing the transparency of the remuneration process and the role of remuneration in driving culture and governance.

In line with international trends, it recommended limiting the use of financial metrics in the design of long-term incentives – across the whole organisation not just executives – to help avoid repeats of some of the major banking scandals of the past decade.

Hayne’s recommended Australian Prudential Regulation Authority (APRA) set the limits on the financial metrics in the long-term variable component of bank remuneration schemes for senior executives, and APRA is in the process of transforming remuneration structures in the finance industry.

Three problems with pay

Following up on the recommendations, APRA published a review identifying three problems with pay:

  • “Employees at lower levels of organisations received downward adjustments to pay that were not always matched by corresponding adjustments at an executive level to recognise line accountability.
  • “Performance measures for pay incentives were too focused on shareholder metrics such as Total Shareholder Return (TSR) – and that this had the potential to drive behaviour that does not support long-term organisation success and sustainability. 
  • “Shortcomings in oversight by remuneration committees requiring stronger governance of executive pay.”

The long and short of it

APRA’s April 2018 ‘Information Paper on Remuneration Practices’ at large financial institutions found that bonus pool amounts are still largely based on short-term performance measures, with little evidence of explicit consideration of longer-term risk measures.

Nor had those sampled developed mechanisms or processes for the adjustment of the bonus pool to respond to significant risk events.

In an interview with the ABC World Today in July, about APRA’s discussion paper for a new prudential standard, APRA’s deputy chair, John Lonsdale, reiterated the regulator’s commitment to enhancing focus on long-term incentives.

“In the financial sector, APRA has observed an over-emphasis on short-term financial performance and a lack of accountability when failures occur, especially among senior management.

“This has contributed to a series of damaging incidents that have undermined trust in both individual institutions and the financial industry more broadly.

“Crucially from APRA’s perspective, these incidents have damaged not only institutions’ reputations, but also their financial positions.”

Lonsdale also warned that executives may have to wait seven years to claim all their bonuses, and companies would be given the power to claw back incentives for up to four years.

These sentiments echoed a previous speech by APRA Chairman Wayne Byres titled ‘Helping to regain trust’.

The current structure of long-term incentives in Australia is particularly problematic in this regard (TSR focus), and is out of step with how best practices in remuneration are evolving internationally… This will also have to change.”

Byre expects the use of TSR fall will eventually fall to just 25% of long-term incentives in Australia.

Boards have struggled to gain acceptance that new approaches are needed. So it seems inevitable that regulatory intervention and a greater degree of prescriptions will be required to shift practices,” says Byre.

Regulators ordered to step up

Morgan Stanley notes that Australia has the most concentrated corporate oligarchies in the world and expects the Australian Competition and Consumer Commission (ACCC) will play a major role in policing executive pay.

The Royal Commission recommended that APRA and ASIC take supervisory roles in setting and monitoring remuneration standards).

Taken together, it seems that regulators believe there is too much weighting on financial metrics in performance assessment for pay incentives (hard targets) and not enough weighting on broader non-financial measures that also drive company performance and sustainability, such as organisational culture and customer satisfaction (soft targets),” reports the AICD.

APRA’s discussion paper for a draft prudential standard suggested a weighting of 50% financial metrics and 50% soft metrics – as starting point for consultation.

APRA has proposed the following key reforms:

  • “To elevate the importance of managing non-financial risks, financial performance measures must not comprise more than 50 per cent of performance criteria for variable remuneration outcomes; 
  • “Minimum deferral periods for variable remuneration of up to seven years will be introduced for senior executives in larger, more complex entities. Boards will also have scope to recover remuneration for up to four years after it has vested; and
  • “Boards must approve and actively oversee remuneration policies for all employees, and regularly confirm they are being applied in practice to ensure individual and collective accountability.”

Rather than regulate employee pay structures, the regulator has gone straight to the top.

APRA will not be determining how much employees get paid. Rather, we want to empower boards to more effectively incentivise behaviour that supports the long-term interests of their entities. By reducing the risk of misconduct, we hope to see better outcomes for customers and higher returns for shareholders in the long-term,” APRA’s Lonsdale told the ABC.

BEAR extends it reach

Meanwhile, APRA introduced an extension of the Banking Executive Accountability Regime (BEAR) in July 2018.

Administered by APRA: Extension of the Banking Executive Accountability regime BEAR introduced in July 2018.

BEAR sets out accountability for deposit taking institution and, among other things, remuneration, key personnel and notification obligations for ADIS.

A paper on the issue was published in October 2018, and small banks will be brought under BEAR as of July 2019.

Beyond the finance industry

ASIC, as part of its new strategy, has included executive remuneration as part of its Corporate Governance Taskforce. 

“Remuneration is a clear driver of conduct,” said ASIC Commissioner John Price in a speech on improving conduct and restoring trust.

“We will be looking at whether executive-remuneration structures, grants and vesting of variable remuneration are driving the right behaviour and accountability of executives in Australia’s listed companies.

 “ASIC will be looking at whether executive remuneration structures, grants and vesting of variable remuneration are driving the behaviours and accountabilities of executives in Australia’s listed companies,” said Price.

“An initial issue we will be considering is focusing on the decisions by the board remuneration committee to award and grant variable remuneration.”

Linking executive pay to ESG KPIs

APRA’s proposed reforms are likely to reach beyond the financial industry when implemented.

In particular, the regulator seeks to elevate the importance of managing non-financial risks, including specific ESG-related risks, and recommends that financial metrics be confined to just 50% of performance criteria for variable remuneration outcomes at the outset.

This is likely to affect the cost and availability of funding for Australian corporations particularly the resources sector initially, as well as on their culture and governance.

While environmental risks are likely to be the prime focus in the first instance, this is likely to broaden to social risks within the next few years.

Discussions are abreast to add sustainability measure to metrics such as return on investment, earnings per share, revenue and non-financial measures such as customer satisfaction, employee satisfaction and safety.

As a result, the way in which banks measure these risks will increase in sophistication.

It is conceivable that the business equivalent of a FICO score could apply to ESG financing criteria for companies.

Global ESG remuneration trends

Morgan Stanley’s report says asset managers are attempting to determine the right approach for integrating ESG into portfolios, and says considering ESG alongside financial criteria is emerging as the most common global application, particularly as the risk for non-compliance rises.

According to the academic journal Economic Letters ‘Shareholder activism and equity price reaction’, several companies are already embedding corporate social responsibility more deeply within their firms by tying executive pay to ESG and corporate and social responsibility targets.

It cites Royal Dutch Shell’s plans to tie executive remuneration to three-to-five-year targets for net carbon footprints from 2020.

These links will be most evident initially in energy and resources companies given the world’s carbon focus and their operational dependence on water, energy and operational health and safety issues, and is likely to extend to sectors such as finance and pharmaceuticals in the near term.

United Nations has its say on ESG and pay

 The UN-backed Principle for Responsible Investment has recently produced a report that identified the major ESG factors behind companies’ long-term financial performance and proposed ways of linking them to executive pay.

 In an article featured on the IPE website, Rob Lake, director of responsible investment at PRI, says:

 “Integrating relevant ESG factors into executive remuneration is in a way, the next frontier for thinking about how companies can take ESG factors seriously and how investors can play a part in that.

 “For the overwhelming majority of companies there are indeed ESG factors that are crucial to long-term financial performance, and if they are that significant, it makes sense to find a way to focus senior management’s attention on delivering those objectives by linking executive pay to those relevant factors in an appropriate way.

Meanwhile, the ABC has reported that pay for chief executive officers hit record highs in the year to June 30, 2018.

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