What impact will new EU legislation have on pay transparency and ESG reporting? At Aon’s fringe event at Genesis 2024 in December, Aon’s Keaton Hoffman – Partner, Executive Compensation, Talent Solutions and Matthew Robinson – Life Science Industry Leader (Aon UK), explored the evolving role of environmental, social and governance (ESG) in executive incentives with the implementation of the Corporate Sustainability Reporting Directive (CSRD).
European Life Science companies are busy getting to grips with the EU’s CSRD - a reporting structure that’s reshaping ESG practices, particularly in integrating sustainability metrics into executive incentives.
The directive is a legal impetus that mandates detailed, transparent disclosures including environmental and social metrics, aligning corporate strategies with sustainability goals to ensure accountability from mature businesses across Europe, including in the life sciences sector.
Companies are required to report information on twelve aspects of ESG, as set out in the European Sustainability Reporting Standards (ESRS). And if they don’t have plans in place, they have to be prepared to explain why not.
These metrics will be publicly disclosed in separate sustainability reports, which allows for comparative analysis across companies. While it initially targets large firms, it will eventually extend to mid-cap companies.
“CSRD creates a new reporting structure that unlocks new ways of measuring incentives. The focus is on aligning ESG metrics with core shareholder value elements in incentive plans,” Keaton Hoffman said, adding “That’s why it’s important to choose the appropriate metrics and mechanisms for paying out incentives.”
With CSRD, executive incentive plans are intrinsically linked to ESG metrics and transparency is the watchword. It requires companies to disclose details of their incentive plans and the rationale for chosen metrics, and to use sustainability metrics to influence pay outcomes.
Scoping CSRD Compliance and Metrics
In terms of scope, CSRD compliance begins with Europe’s largest firms, aiming at companies with more than 250 employees, 40 million euros in revenue, or 20 million euros in total assets, though they will have different timings to comply between 2024 and 2027.
Hoffman noted that: “Even mid-sized, pre-commercial organisations, particularly in the cell and gene therapy space, are already going to be triggering that threshold. So, if you're a small organisation, it may not directly impact you today, but it gives you a sense of what that trajectory would look like, and how far you are from some of those metrics.”
CSRD will drive relative benchmarking, shifting focus from absolute targets to peer comparisons.
The directive also impacts corporate governance, with potential for clawback mechanisms from executive bonuses for misreported ESG metrics.
ESG metrics typically represent 10-25% of the overall corporate score, with a trend toward higher weightings over time. Companies typically have between one and three sustainability metrics per plan, with a median of two, which generally provide a balance between various sustainability objectives. Crucially, while ESG metrics target topics such as CO2 emissions reductions and greening production processes, they also focus heavily on social metrics. Examples include women's representation, health and safety, and employee engagement.
Hoffman explained: “The most prevalent social metric is diversity, equity, and inclusion (DEI). Within a European context, that's women's representation within their workforce, their board, and new hires, in almost 95% of cases. As we start to get more standardisation around this, we can expect to see the gender pay gap number appearing in more companies reports.”
“Employee engagement may not register as part of sustainability, but most firms are bucketing these scores under this ESG umbrella. And the societal and community angle, in a healthcare context, could be improving market access to underserved communities,” he added.
Sustainability Metrics: How Life Sciences Compares
Ahead of CSRD’s full implementation, Hoffman compared the 600 highest valued companies listed within Europe (via the STOXX 600 index) – including those in Switzerland, UK, Norway that fall outside of CSRD’s direct scope - and highlighted that 70% of firms currently include ESG metrics in short-term incentive plans and 60% in long-term ones. Firms operating in the healthcare sector, including life sciences organisations, are ahead of the curve in terms of adoption of sustainability metrics in short-term plans, but are behind the curve when it comes to adoption in long-term plans (~40% with long-term sustainability metrics in healthcare vs. 62% across general industry).
While in general industry metrics incentive plans tend to be balanced between environmental and social objectives, within the life sciences sector, there is less emphasis on environmental metrics in favour of social and governance.
Within the healthcare sector short-term plans, employee metrics (e.g., employee engagement) are the most popular metric, followed by DE&I and emissions reductions. This contrasts with general industry where employee metrics are the fourth most prevalent metric, after emissions, DE&I and health & safety (in that order).
For long-term plans, selected metrics at healthcare sector companies were primarily focused on emissions reductions, similar to the pattern across general industry, with DE&I and societal/community goals the next most prevalent metrics.
‘Greenwashing’ in Incentive Plans
For the life sciences sector, ‘greenwashing’ and the implication of inaccurate reporting has an impact on corporate governance. With the concept of ‘malice and clawback,’ which applies to financial misstatements, a firm has an obligation to recoup an incentive that was misallocated.
Companies are generally more robust in publishing their reporting measures than previously, which makes it easier for them to compare how effectively they are reaching their ESG targets.
Hoffman highlighted the importance of firms having robust policies to address misstatements and ensure accountability for quantitative achievement of sustainability metrics and noted that company clawback policies should extend to cover misstatements in sustainability reporting as well as financial reporting.
Adapting To Relative Benchmarking
The ESG landscape is constantly evolving, and companies are increasingly going to have to think about how to incorporate ESG metrics in their executive incentive plans.
Historically, sustainability objectives have been absolute targets specific to each company’s stated goals. But how do you set fair and competitive targets? What proportion of senior leadership should be women? How quickly should we reduce our emissions to meet a net zero objective?
In the new CSRD landscape, firms and investors will have the ability to compare a company’s performance more easily on some of these metrics against peers in their industry or market index. As a result, as we see commonly across shareholder return metrics in incentive plans, firms will increasingly be able to set relative goals against a basket of peers. Rather than setting a goal of having a gender pay gap of less than 5% within the next three years, firms may prefer to set a target against an objective external benchmark, say, to be below the median gender pay gap of similarly situated peer companies. Relative benchmarking allows firms to set stretching targets without foreseeing exactly what defines a good or excellent level of achievement on that metric over time and could lend itself particularly well to DE&I objectives.
“There's a harmony between pay transparency work and the CSRD objectives, and with more data we could see some of these metrics evolving over time,”
“The key thing for companies is to think about the right metrics in your organisation, the strategic milestones and annual KPIs, and the time horizon to achieve some of those goals,” Hoffman said.
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