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How to incentivise senior management to achieve ESG goals

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How to incentivise senior management to achieve ESG goals

By Dan Peyton, managing partner of McGuireWoods' London office and head of the UK employment law practice. Marc Naidoo, sustainable finance partner in the London office of McGuireWoods.

In the 1950's, doctors proudly advertised cigarettes until data and lobbyists revealed the hypocrisy and inherent conflict of interest of that practice. Hindsight is 20/20 as they say, and it is easy for us in the present to laugh and make such a practice "meme-able". However, at the time the money involved was no laughing matter, there was just a lack of accountability and information in relation to something that was considered a norm.

Fast forward to present day, and we are seeing similar practices that were once deemed acceptable and, more importantly profitable, being scrutinised through the lens of data and accountability. From concerns raised with the daily operations of corporates, to representation and diversity in the corporate landscape, the myriad of accountability facing corporates is akin to a rebuild in fundamentals from ground up. The difference now is that the 21st century is by and large an information age, and the easily digestible buffet of information removes the proverbial kevlar and opens institutions up to the firing line. As regulators, investors and the general public close the net on unsustainable practices, corporates should embrace the change as the foundations that are laid now, will save embarrassment in the future.

The word "rebuild" is purposely used in this article, as it is important to understand that previously accepted methods of allaying the concerns of sustainability concerned stakeholders are no longer, well, sustainable. A charity here, a donation there and the occasional sprinkling of lobbyist engagement are no longer seen as performance indicators of good corporate practices, but rather the baseline. The ramifications of increased accountability are wide reaching, and corporates can no longer address one facet of organisational practices, but rather a holistic view is required. In this regard, we need to evaluate corporates not only in their approach to business dealings, but additionally on their internal behaviour and protocols.

As with any rebuild, a solid foundation is essential. Before any wide scale change to the ways corporates manage their profit and loss is made, an existential exercise is required in regard to: what makes an organisation sustainable?

To what extent can employment law and HR issues have an impact on advancing the ESG agenda?

We have seen in other areas the way in which legal regulation has the effect of consolidating and advancing issues of wider social concern.  For example, legal regulation around the topic of gender pay gap reporting was introduced partly in response to increasing public pressure and corporate concern around workplace gender equality issues.  The effect of that regulation has been quite effective in focussing the minds of employers on the issue of gender-based pay differentials and turning an issue of moral concern into an area of compliance high on the corporate agenda.  This regulation has also been effective in identifying the gender pay gap as a symptom of a wider problem rather than its cause, namely, the issues of retention and promotion of women to the senior ranks within businesses.  In that sense, the reporting regime has helped in moving aspects of the debate away from equal pay headlines to consideration of at least some of the underlying issues.  However, its limitations have also been exposed as a method of actually effecting change.  In part, this is because other aspects of the range of legal changes needed to solve the problems of retention of and promotion of women to the upper-echelons of the corporate world have yet to be implemented (for example, issues around mandating the provision of workplace childcare and stronger regulation around flexible working).

There are, however, other instances where aspects of law appear to be ahead of other related legal and cultural changes needed to enable legal regulation to have its intended effect in advancing a social agenda.  Since 2015, parents have had the legal right effectively to share between them the maternity leave periods previously only available to new mothers.  However, various reports and available statistical evidence shows that take up of this entitlement is still very low.

In the context of the potential impact of employment-related legal regulation on the ESG agenda, there are already some ways in which the legal framework around corporate governance lends some support to ESG issues.  Under s.172 of the Companies Act 2006, in order properly to discharge their legal duties, directors are required to have regard to the impact of company activities on the community and this obligation is underpinned, for example, by provisions in the Remuneration Code requiring those companies subject to the Code to report on their implementation of these obligations and increasing transparency and accountability to shareholders in respect of failures to do so.

Dan Peyton from "McGuireWoods"

Dan Peyton from "McGuireWoods"

In the end, however, businesses' conduct is really a product of the conduct of their leaders and employees.  This would suggest that a key piece of the puzzle is for employers to incentivise behaviours which reflect and advance the ESG agenda and to penalise those that do not.  We have seen this exercise before in the context of the financial services industry in the context of implementing proper risk management standards.

The most common means for incentivising good behaviours are to reward them financially and to promote compliance as one factor on career progression.  This is often easier than it sounds, because it needs clear standards that need to be met, clear standards that need to be followed which can be objectively measured and quantified for the purposes of triggering the additional rewards that should follow good behaviours.  The other side of this coin is penalising non-compliance with governance standards, both through denying financial reward to those who do not exhibit sufficiently good behaviours and also using familiar HR processes to incorporate desired ESG standards in the assessment of performance and to impose disciplinary sanctions against those who exhibit bad behaviours.  This seems the easier part of the equation, but in reality shares a common problem with the issue of reward.  Both issues bring us back to a central point, which the extent to which the market imposes broader business risk and financial reward for advancing the ESG agenda, and treats compliance with that agenda as something more than as an issue of corporate responsibility, but as an issue of commercial value.  In the absence of that value, employers may find themselves in a position where they are being asked to deny rewards to (and in some circumstances to discipline) the employees who add the most value to their businesses.

In the context of debt finance, market participants now also face the daunting challenge of compliance with a Pandora 's Box of regulations and "guidelines". These third party requirements are sometimes borne from the need to place a flag in the rapidly evolving ESG landscape, whilst others actually add value. However, as market participants know, the debt raised through sustainability metrics is not cheap. Costs accumulate on both the buy side and the sell side, in that (i) borrowers face additional costs relating to penalties, third party verification and increased reporting covenants; and (ii) lenders face additional costs in raised capital to be deployed sustainably through crowd in mechanisms i.e. offering to take deposits at discounted rates. The inclusion of further guidelines seems at times to be unnecessary and possibly overly cumbersome on an already cumbersome process of raising debt.

Marc Naidoo from "McGuireWoods"

Marc Naidoo From "McGuireWoods"

Sector specific guidelines are helpful, provided that they are promulgated by on the ground experts. Similarly, there is a case to be made for geographical considerations as well. For instance, it is a tad unfair to demand that corporates in fast growing developing nations be 100% sustainable. These nations require infrastructure, and infrastructure is effected through commerce. To penalise lenders for lending to market participants in these economies would be counter-intuitive as sustainable finance is more than just "environmental", "social" and "governance". The market needs to move away from this simplistic view of "ESG", and move towards a more mature understanding of geo political and geo economic factors. For instance, a country that requires power at a fundamental level is not going to wait for renewable energy, as their demand is more pressing.

Ironically, there is sophistication in simplicity. The tenants of sustainable finance are: do good, but also do no harm. This coupled with the backdrop of the United Nations Sustainable Development Goals provides a more than adequate barometer of how sustainable financing transactions are. Perhaps with an overlay from sector or geographical specific experts and robust internal commercial protocols, we then start seeing the sustainable finance landscape becoming, well, more sustainable. Regulations cannot be seen as one size fits all, but the interplay of the above metrics would add to the already solid foundation created by the internal policies of an organisation.

Do good? This is arguably the easy part of sustainable finance. The robust nature of the European Union Taxonomy, means that market participants can source deals where there is a tangible global benefit in the use of proceeds.

Do no harm? Well this is where the lines blur a bit. Every action has a consequence, and what might be good for some, could be bad for others. For instance, in the boom of electric vehicles, fossil fuel power is still required to build vehicle and battery plants. Some renewable energy displaces local communities, or face the short shelf life of electricity generating components, which then require large scale recycling. So how does one mitigate the adverse consequences of "doing good" financings? In an ideal scenario, financings could move towards a landscape of being purely sustainable, however as mentioned above, this is not always possible.

A pragmatic approach should be adopted, particularly in relation to financiers. Where in larger scale banks a full guns blazing approach may be taken to sustainable finance, newer market participants should start of modestly. The inherent problems with sustainable finance are risk, scalability and inconsistent return profiles across a portfolio (which then feeds back into scalability and risk and perpetuates the cycle). In starting modesty, newer market participants can mitigate these challenges over time to build a healthy sustainable finance portfolio, the rebuild analogy is apt once again

The first step any financier faces is the internal appetite and attitude to risk. As we have discussed earlier, change to an organisation's policies is not always easy, but is required. Financiers need educated risk committees on sustainable finance and the trade-off required to foster deal growth, without increasing margins on debt. Strong internal policies would serve as an incentive for credit teams to be more robust in their approach to sustainable finance transactions. Moreover, this would allow smaller, more "risky" transactions to be allowed through the gate.

The return profile of a transaction is linked to deal size. Whilst we have spoken above about the need to start small, that is not a long term solution. Scalability is still an issue with fresher market participants, but this also links to the credit discussion above. It is chicken and egg. However, there is no reason why these two concepts cannot grow organically together. The larger the number of smaller transactions, the easier the ability to create deal templates and teachable moments. Once financiers hone in and, to the extent possible, perfect these smaller deals, the opportunity for larger scale roll out becomes more feasible. A shortcut to larger scale transactions is through the use of de-risking mechanisms. It is always useful to engage with a development finance institution, in particular one that operates in a deal's jurisdiction. The institutions have a variety of products that can aide in crowding in private sector capital (which then also addresses the credit risk issues discussed earlier). Partial risk and first loss guarantees still remain viable de-risking mechanisms. As the adage goes, for every $1 that the World Bank Group de-risks, there are $4 of willing private sector capital. This also explains why borrowers prefer not to borrower from development finance institutions, but rather de-risk the structure to bring in more private sector capital.

Although starting modestly has a benefit, the trouble arises in the secondary market where smaller scale debt is harder to trade. The same difficulties face funds where the differing return profiles across a large number of smaller investments makes portfolio stability troublesome. In this regard, market participants should see this as an opportunity to diversify transactions so that there is an organic netting out which, in turn, makes portfolios healthier, and more appealing. A useful exercise would be to review existing deals within an organisation and retrospectively class some of these deals as sustainable after evaluating the same against the metrics we stated earlier in this article. This is a useful way of "fattening" up a portfolio, and thereby rewarding an organisation for previously having done the right thing.

This article has explored many crucial themes relating to sustainability and sustainable finance and how entities should approach both during these sustainable rebuilds. However, it must be noted that these themes have been explored at a high level, and could each be worthy of their own discourse. But, we believe in starting slow. These are themes that need to be systematically and carefully considered in order to ensure longevity going forward. Keeping both internal and external stakeholders is crucial in all of this to avoid any prospective embarrassment in the future. The world is changing, and rebuilds are fundamental to that, it is the circle of life.

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