Don’t Turn Sustainability into Compliance Exercise, Academic Warns Europe

Commission consults on plans to reduce short-termism by reforming corporate governance.

Plans by the European Commission (EC) to discourage short-termism by company directors through corporate governance reforms could backfire, turning sustainability into a compliance exercise, according to a leading academic.

The Commission’s DG Justice and Consumers last week launched a public consultation on possible changes to the EU regulatory framework aimed at enabling companies “to focus on long-term sustainable value creation rather than short-term benefits”. The consultation follows the July release of a study on directors’ duties and sustainable corporate governance, prepared by consultants EY, and builds on policy commitments made by the Commission in its 2018 Sustainable Finance Action Plan.

Alex Edmans, Professor of Finance and Academic Director of the Centre for Corporate Governance at the London Business School, warned that legislating sustainability might lead to “compliance rather than commitment” in a recent blog post on the University of Oxford Faculty of Law website.

“For example, companies may focus only on the quantitative sustainability measures included in executive pay contracts, rather than the very many qualitative dimensions of sustainability,” he said, arguing instead that any regulatory changes should encourage a long-term focus, rather discourage attention to shareholder value.

“A far more effective approach is to emphasise the business case for sustainability – that it is in a company’s own interest to take sustainability seriously, as doing so improves long-term company performance and thus shareholder value,” wrote Edmans.

The Commission’s consultation seeks feedback on a number of potential changes, including a broader definition and strengthened enforcement of the duties of directors, inclusion of non-financial performance targets in their remuneration structures and the introduction of mandatory supply chain due diligence requirements.

Although supportive of the Commission’s efforts to ensure “business works for wider society, not just short-term profit”, Edmans highlights various issues with its approach as well as the underlying assumptions of the EY report.

First, he notes that shareholder value is an inherently long-term concept. “The study frequently uses the phrase ‘short-term shareholder value’ and its variants. This makes no sense, because shareholder value is an inherently long-term concept – it includes all of the future cash flows of a company,” he writes. “A company that cuts value-creating investments in stakeholders is maximising short-term profit but harming shareholder value. Thus, the solution to short-termism is actually a greater focus on shareholder value, not less.”

Further, the study is said to imply that stakeholder and shareholder values are inversely proportional. However, Edmans believes the size of the pie created by economic activity is “not fixed”, and that a greater focus on long-term shareholder value, as opposed to short-term profit, leads also to an increase in stakeholder value. “In contrast, reducing the CEO’s accountability for shareholder value can lead to her pursuing her own interests, shrinking the pie for both shareholders and stakeholders,” he said.

The report recommends tying the remuneration of directors to sustainability and non-financial performance targets. But Edmans states that focusing on quantitative ESG metrics can often ignore qualitative aspects and must be used with caution. “While companies should set targets and report on progress, they should beware of focusing excessively on meeting goals else they may ‘hit the target, miss the point’,” he said.

Edmans also criticised the evidence presented in the EY report as “very one-sided” and “low-quality”, “At times, it reads as if the authors have already decided that companies and markets are short-termist, that short-termism is a cause of most of society’s major problems, and then have searched for all evidence – regardless of quality – to support this contention,” he wrote.

The consultation will close on 8 February 2021, with a formal proposal expected to be published in the second quarter of 2021.

While a number of policy options are on the table for the Commission, not necessarily legislative, comments from the European Commissioner for Justice earlier this year signal that mandatory due diligence could be implemented as a directive or regulation.

“The publication of this consultation marks an important step in the EU’s sustainability/ESG policy programme, demonstrating how wide its ambitions reach,” according to a research note published by law firm Allen & Overy.

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