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Environmental, social and governance (ESG) issues have been high on the corporate agenda in recent years, with shareholders demanding greater accountability and transparency from companies. 2023 will see a larger cohort of companies make climate-related disclosures in their annual report aligned with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and a significant proportion of listed companies submit new remuneration policies to shareholders for approval. This article examines investor expectations in 2023 on ESG-related issues, including emerging best practice on the use of ESG metrics in remuneration policies. 

ESG involves the combination of environmental, social and governance concerns under a single conceptual framework (see: ).

Environment

ESG’s environmental component assesses the effect a company has on the environment and how the environment affects the company. It takes into account factors such as a company’s carbon emissions, effect on biodiversity, waste management and pollution and the company’s response to climate change. 2022 saw the first set of mandatory reporting by premium listed companies against the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), which was the subject of our . In 2023 we will see standard listed companies and other quoted companies and large companies and LLPs make TCFD-aligned disclosures in their annual reports.

Against this backdrop, several investor bodies have made climate change a central issue for 2023:

• in a new section of its guidelines, Glass Lewis has said that companies, particularly those whose GHG emissions represent a financially material risk, should provide a clear and comprehensive disclosure of their risks, including how they are being mitigated and overseen. Where companies with increased climate risk exposure have not provided thorough TCFD-aligned disclosures and/or have not explicitly and clearly defined board oversight responsibilities, Glass Lewis may recommend voting against a responsible member of the board or other relevant agenda item
• ISS has said that it will generally recommend voting against the board chair of companies that are significant GHG emitters in cases where the company does not disclose detailed climate-related risks in accordance with the four TCFD pillars and appropriate GHG emissions reduction targets
• the Investment Association (IA) will ‘amber top’ the annual report of any company in a high risk sector that does not make disclosures against the four pillars of TCFD to cover all industry sectors. The IA has also stated that it expects directors to provide a statement in the annual report that they have considered the relevance of the risks of climate change and transition risks associated with achieving the goals of the Paris Agreement
• Pensions & Investment Research Consultants (PIRC) has said it expects companies to set out a climate scenario that deals with keeping warming within a 1.5-degree Celsius scenario stating clearly the science–based policies and targets, in line with the Paris agreement and the Glasgow Climate Pact. PIRC also expects that governance of climate be fully embedded in a company’s risk management, around the three key pillars of policy, disclosure and governance
• the Pensions and Lifetime Savings Association (PLSA) has called for companies to reference the TCFD framework in their reporting and for better disclosure from companies of their impact on the environment, including Scope 1 and 2 emissions and, where relevant, Scope 3 emissions.

Alongside the current requirements, a new initiative may soon have an impact on regulation. The Taskforce on Nature-related Financial Disclosures (TNFD) framework is a company which aspires to design and implement a risk management and disclosure framework enabling organisations to disclose and act on evolving nature-related issues. The TNFD is recognised by the as a leading organisation in advancing nature and biodiversity-related reporting.

Social

ESG’s social component evaluates a company’s treatment of various groups, including workers, clients, and local communities. Examples of this include ensuring employee and customer safety, promoting diversity and inclusion, preventing modern-day slavery, engaging with the community, safeguarding data and privacy, and managing supply chains. The field of social responsibility is becoming more heavily regulated, with laws and regulations such as gender pay gap reporting, the Modern Slavery Act 2015, health and safety laws and product regulations setting a minimum standard of performance for companies in areas that were previously not heavily enforced.

The issue of diversity and inclusion continues to be an area of focus for investors and regulators:

• in April 2022, the FCA amended the diversity targets in its Listing Rules for listed companies with financial periods beginning on or after 1 April 2022. The new targets are at least 40% of the board are women; at least one of the senior board positions (chair, chief executive officer, senior independent director or chief financial officer) is a woman; and at least one member of the board is from a minority ethnic background. The Disclosure Guidance and Transparency Rules (DTR) requirements to disclose details of the board diversity policy have also been extended to cover the remuneration, audit and nomination committees and to clarify that companies can consider a wider range of diversity characteristics when reporting on board diversity policies
• Glass Lewis and ISS have updated their voting guidelines to reflect the new Listing Rules and DTR diversity targets. ISS has also said that for ISEQ 20 constituents and AIM-listed companies with a market capitalisation of over £500m, it will generally recommend against the nomination committee chair (or other directors on a case-by-case basis) if there is not at least one woman on the board.

Governance

The governance aspect of a company evaluates how it conducts its operations in terms of audits, board diversity, internal controls and shareholder rights. These factors provide investors and other stakeholders with a way to assess the company’s performance and hold it accountable. Specific examples of these factors include anti-bribery and corruption policies, business ethics, board diversity and anti-competitive behaviour.

The UK government has indicated its intention to establish greater audit committee oversight by the regulator and to encourage greater shareholder engagement in the audit process. This is echoed by ISS in its latest policy guidelines where it argues that the FRC’s 2016 recommendation that there should be a minimum of three audit committee meetings may be insufficient, given the importance of the committee’s role. For 2023, ISS will note where four or fewer (for FTSE 350 companies) and three or fewer (for FTSE All-Share companies) audit committee meetings have been held during the reporting period.

For more information on ESG-related legislation, see: .

Recommendations for remuneration policies

ESG considerations are increasingly becoming an area of focus for directors’ remuneration.

Remuneration policies should be tailored to the business

An emerging theme from investors is that remuneration policies should be tailored to the business:

• in their Guidelines on Responsible Investment Disclosure, the IA companies to assess whether the remuneration committee can take into consideration performance on ESG issues when setting remuneration of executive directors.
• in , Glass Lewis supports companies’ considerations of environmental and social factors in their strategic planning, but believes that each company’s use of E&S metrics in remuneration plans should be based on their specific circumstances. The company should provide clear disclosure to shareholders to show the connection between the E&S criteria and its strategy.
• Legal & General Investment Management , businesses ‘that are exposed to high levels of [ESG] risk should include relevant targets that are…aligned to the company’s strategy’. For example, companies that ‘can have a significant effect on climate change should link part of their pay to delivering on their climate mitigation goals’
• ������’s encourage the use of ESG performance conditions as long as these are quantifiable and substantial to the company’s business. IA emphasise that personal objectives should align with the organisation’s long-term goals and should not be limited to ‘actions which could be classed as “doing the day job”’.

Remuneration targets should be quantifiable and science based

There is also a growing consensus among proxy advisers that company ESG targets must be quantifiable, and science based to avoid greenwashing:

• LGIM advises companies to use targets that are meaningful and measurable
• The IA advises remuneration committees to consider the management of ESG risks as ‘performance conditions in the company’s variable remuneration’ but it is crucial that the variables are ‘quantifiable and clearly linked to the implementation of the company’s strategy’. The IA also recommends that targets be in line with approaches such as the Science Based Target initiative
• quantifiable targets are also mentioned by ISS as imperative to ESG performance conditions, and that expert approval of targets must be sought, to ensure that these are science-based

Market Tracker will continue to monitor the developments in ESG legislation and best company practice for remuneration policies.