The role of corporate governance in sustainability and why the Commission’s CSDDD proposal might do more harm than good
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The Commission’s proposal for a Corporate Sustainability Due Diligence Directive (CSDDD) aims to “improve corporate governance practices” in order to “to deliver on an economy that works for people, including to improve the regulatory framework on sustainable corporate governance”. In this post, I claim that key parts of the proposal are, to this end, counterproductive.
The underlying idea behind the Commission’s Sustainable Corporate Governance initiative is that shareholders and stock markets force companies to act in the short-term, which to the best of our understanding, even though the narrative on “quarterly capitalism” is elegant and simple, is not true. In reality, shareholders and equity financing drive the green transition and demand that company management consider climate risks, because shareholders as investors are interested in companies' long-term results as being decisive for the present-day value of their shares and the future return on their investment. A study by the European Central Bank, analysing data from 1990 to 2013 from 50 countries, illustrates this well. It finds that for a given level of economic development, financial development and environmental regulation, CO2 emissions per capita are lower in economies that rely more on market-based equity funding. The study points to two key explanations for the relationship between the use of equity financing and lower carbon emissions. “First, stock markets reallocate investment towards less polluting sectors” more effectively than other types of financial markets. Second, equity markets “also push remaining carbon intensive sectors to develop and implement greener technologies.” The authors conclude that “carbon-intensive industries produce more green patents as national stock markets deepen.” Mats Isaksson (former head of the Corporate Governance and Corporate Finance Division at the OECD) thus conclude that, in general, “broad and deep public equity markets that present investors with the ability to diversify the firm-specific risks associated with technological innovation lower the overall societal cost of capital for research and development that result in new patents, products and processes that have a smaller carbon footprint.”
A vibrant European stock market is not an end in itself, but as we can see, one important reason why the EU should try to strengthen and grow its stock markets is that they have a key role in the green economy transition. It is partially for this reason that existing EU law seeks to give shareholders influence over management, see, for example, the SRDII based on the idea that shareholder control is a fundamental part of an efficient equity market, and also why EU law seeks to give shareholders the necessary information for their investment decisions by obliging companies to report, including the rules on sustainability reporting and the taxonomy.
This was one of the key criticisms against the Commission’s 2020 initiative, both by academics, the Regulatory Scrutiny Board and Member States. When the CSDDD was presented, it was clear that not all parts of the 2020 initiative that should have been laid to rest had been abandoned. These most prominently include what the proposal contains on directors’ duties, climate plans and environmental remunerations.
Take the idea of environmental remuneration. It seems like Article 15.3 in the proposal states that companies are to take into account sustainability metrics in their plans for variable remuneration. While a noble idea, one of the key issues that regulation needs to deal with to make equity financing attractive and, in the end, ensure that stock markets are effective, is the agency problem. A core part of corporate governance which tries to deal with this problem is that shareholders, in the words of Fama and Jensen, are given the right to hire, fire and set the compensation of top-level managers. Thus, variable remunerations are one of the oldest tools used to align management and shareholder interests. Many of the most sustainability-focused investors, such as the Norwegian Oil Fund, take an eloquent approach on this: the variable remuneration of directors’ should be transparent and simple by being based only on long term shareholdings, on order to ensure that management acts with the long-term and sustainable interests of the company in mind. The shareholders’ control over remuneration was also, as one might recall, one of the reasons that the SRDII included rules on remuneration plans and remuneration reports.
The proposal on environmental remuneration fiddles with at least the compensation-part of the shareholder control rights and thus makes it harder for shareholders to oversee and control management, and it can be argued that Art. 25 on directors’ duties of the proposal also entrench management by decreasing accountability to shareholders. Vibrant equity markets not only provide ordinary households with opportunities to diversify their long-term savings and supply companies with equity capital, they can also serve as an important contributor to solving the climate crisis. Since the proposed CSDDD is likely to weaken these functions and contribute to the already declining use of stock markets as a way of financing in the EU (which often is explained with over-regulation), it must be taken very seriously. In a time when the ability of the equity market to handle risk and to further innovation and sustainable growth might be what we need most of all, the stakes of introducing experimental and unfounded corporate governance standards like the CSDDD are simply too high.
Erik Lidman is Associate Professor of company law at the Stockholm School of Economics.
This post has first appeared on the ECGI blog. This post is published as part of the OBLB series on 'The Corporate Sustainability Due Diligence Directive Proposal'.
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