It might be helpful to the Committee if you say whether there are any aspects of the Bill on which you do not feel qualified to comment, or if you are happy to be drawn on all aspects.
Excellent. Members may wish to direct questions to specific witnesses; otherwise direct them among yourselves as appropriate.
Before calling the first Member to ask a question, I remind all Members that the question should be limited to matters within the scope of the Bill and that we must stick strictly to the timings in the programme order the Committee agreed. I hope that I do not have to interrupt mid-sentence but will do so if need be.
First, on the Green investment bank, I call David Mowat.
Mr Lee, I have just been looking through your written evidence and a sentence in it caught my eye:
“A number of pension funds have made clear that they will not be able to buy green bonds unless they have yields which compensate them for the lower liquidity or credit risk”.
For clarity, what do you mean by that?
Paul Lee: The point a number of pension schemes have been making is that they cannot buy green bonds simply because they are green; they need to be attractive financially in specific ways for the schemes to feel able to invest in the bonds. Specifically, because presumably those bonds will be specifically attached to the Green investment bank or other green vehicles, the likelihood is that they will be of lower liquidity and therefore less attractive financially for schemes to invest in, so there would need to be some commensurate compensation for that lower liquidity in terms of a higher yield.
In your evidence, you say that there is pent-up demand for people to invest in such green activities. If that is the case, why do we need the Green investment bank for it to happen? What is causing the market failure that the Green investment bank is addressing?
Paul Lee: There is pent-up demand for infrastructure investment. Clearly, that infrastructure investment could, but does not have to, be green infrastructure.
Where is the market failure? Frankly, there is an issue with the bulk of infrastructure vehicles that are available for pension schemes and others to invest in. Those vehicles are structured very much like private-equity-style vehicles, so they have a specific, limited time span, and they tend to gear up the returns. The attractive thing about infrastructure investment for pension funds, insurers and other long-term investors is that they should provide bond-like returns in perpetuity, or something close to perpetuity. If the Green investment bank can assist the market to create infrastructure vehicles that deliver that bond-like return, then absolutely there is pent-up demand.
If I could just press you, why has that not happened, if pent-up demand is there? Why has someone else not put into place the products that would meet that demand?
David Paterson: Perhaps I could amplify a little bit on that. The NAPF, in conjunction with the Pension Protection Fund, is in the process of putting together such a fund, which would be aimed specifically at pension funds. It is designed to address some of the drawbacks that Paul has outlined. That is literally in the market as we speak, in terms of trying to generate interest from the pension funds.
Otto Thoresen: From the insurance sector’s point of view, we are working jointly with the Treasury at the moment to try to identify how those types of projects can be structured to make them investable from the insurance perspective. Of course, what is happening there is the development of European regulation—Solvency II—which creates more demands on the types of investment that we can commit assets to.
Otto Thoresen: It is to do with risk, which is quality looked at through a different lens. David is absolutely right that the match in terms of the long-term nature of the income that can flow from such investments is interesting to us. However, it has become increasingly difficult, as the Solvency II regulation develops, to be able to invest substantial amounts of our assets in such projects.
Good afternoon, gentlemen. Does the Bill as it stands with regard to the Green investment bank give you the investment and your members the confidence to invest in a low-carbon economy? If not, what else needs to be included in the Bill?
Paul Lee: I think the Bill is fit for purpose. The question is what the Green investment bank delivers under the Bill. The two key things that we need the Green investment bank to deliver are the infrastructure side of it that we have just discussed and assistance in ensuring that we have the right sort of vehicles available for it; and an effective channel for the market to communicate with the Government, particularly to ensure that there is consistency in regulation and in the return opportunities from the various green investments that might be made alongside and through the Green investment bank. Without that certainty, no pension fund and no insurer will feel confident to make the long-term investments that are necessary.
Could you give us some examples? What would give the market confidence, and what does the role of the Green investment bank in that respect look like? Does the Green investment bank take on the risk on behalf of the market? Does it leverage in additional private sector money? What would a good investment look like?
Paul Lee: There are a number of different ways that it might be structured. The Green investment bank could take the top layer of risk, leaving a more secure return for the private markets—something closer to that bond-like return that pension funds and insurers need. It could facilitate investment alongside the Green investment bank, and structuring of vehicles that are capable of investing and delivering those bond-like returns. It is very possible for the Green investment bank to do that under the terms of the Bill. It is how it chooses to deliver in respect of its responsibilities.
Is the question of the bank being allowed to borrow an issue for you? Would it provide additional confidence if the bank was allowed to borrow before 2016?
Paul Lee: I actually think that there is enough funding available before that date for the bank to do anything that would realistically be needed, so that probably is not an issue. Of course, 2016 is only the first date at which it might be able to borrow; should that date get pushed out, that might become more problematic. I think as long as that timetable is roughly stuck to, it should be satisfactory.
May I ask all three gentlemen a final question about the Green investment bank? Are there any improvements or recommendations that you can make to the Committee about the governance, or proposed governance, of the Green investment bank to make sure that it is the best in class, given that it is, I understand, the first public bank since about 1848?
Otto Thoresen: If I may broaden it slightly into the general issue around infrastructure, I agree with Paul that what is in the Bill looks fit for purpose. The practical proof of the pudding is in the eating; it is in how we engage as projects begin to be identified, and the extent to which we can make the structures work. That is about good consultation and engagement with the people who are likely to provide the investment to make it happen.
The Green investment bank will also have to act as the quality controller and risk assessor—as a gateway to leveraging private sector money on the supply side. I was wondering how important you thought, on the demand side, a programme of public sector procurement focused in on the green economy would be to support further private sector investment? The public sector would be pulling through and creating a market, which would lower private sector risk. How important would that be to maximise the amount of private sector investment supporting green investment?
Paul Lee: I have to say that we tend to favour the private markets rather than the public demand. As long as the regulatory framework is clear, there ought to be clear demand for this sort of green infrastructure, as long as there is an effective price of carbon and consistent regulation, and returns available for solar, wind and the various forms of generation, waste disposal and all the other aspects of green investment that are needed. I am not sure that public procurement needs to have that big a role in this. It ought to be possible through the private sector.
By way of example, imagine that I could design a simple roof tile that doubled as a solar panel, which would cover every school in Britain and generate economies of scale, and which could be scaled up to exportable volumes. If we needed public sector procurement to do that, would it provide a big platform for future profit purposes? Do you not envisage any such opportunity in either consumer or infrastructure markets at all?
Otto Thoresen: I think what I am hearing is that for something to be investable you have to understand the extent to which the business case is sound. In a situation such as this, a large part of the business case will be about renewing the infrastructure in the UK, some of which will be private but much of which will be public. That is my observation, but it is not an area in which I have particular expertise.
But in key strategic things such as the Severn barrage, which had £30 billion of private equity, you do not necessarily need public sector money at all. Is that the view?
Mr Thoresen, I am interested in your views about how the new Competition and Markets Authority established by the Bill will link in with the Financial Conduct Authority, which was set up by the Financial Services Act 2010. Can you explain your concerns and the risks involved in changing the competitive landscape at the same time in both areas?
Otto Thoresen: Clearly, the financial services sector and the insurance sector operate in some markets that are substantially about financial risk and risk to consumers through financial outcomes, and some markets that service consumer needs, which are far more broadly based, and where this entity will operate in terms of ensuring good competition. Just as within the Financial Services Authority’s new regime—where prudential regulation and conduct regulation take place under the twin peaks model and you have to be clear about how the operation of those two entities will mesh and work together effectively—and given that the conduct authority, under the new twin peaks model for financial regulation, has a competition objective in terms of the operation of the market, a competition authority such as this one must be clear about how it will operate with the FCA. Some sort of modus operandi or memorandum of understanding, which explains where the roles overlap and where they are separate, will be necessary to ensure that we do not end up with duplication or conflict in how regulation is imposed.
Is the industry concerned about that? It seems to me that changing one regulatory regime is complex enough, and changing two is hazardous, but changing two that interact at the same time means that the wings are really going to fall off in a vital area such as the financial services industry. Are you concerned about that?
Otto Thoresen: At the moment we have to operate with more than one regulator, and in the new world we will do that also. The need for quality conduct regulation in the financial services sector is clear, and we support strongly what the Government are attempting to achieve here. All we are saying is that we should keep an eye on this as we develop the detail, to minimise the risks of overlap and confusion.
Are you getting clarity from Government, or—with respect to Ministers here—do you get conflicting pieces of advice and opinion from, say, the Treasury and the Department for Business, Innovation and Skills?
Otto Thoresen: The financial services regulatory developments are running ahead of this one, so our main focus is engagement with the Treasury around the development of the FCA. Nothing in our engagement with BIS or any other Department suggests that we will not be listened to on this issue, and I am quite happy with the level of engagement we are getting.
David Paterson: I suppose I should speak on this. The answer is yes, there is a problem with executive pay. We all know that pay at the top of UK industry has moved well ahead of the growth in average earnings and, for that matter, the level of stock markets over the past 10 or 15 years, so there are sensible questions to be asked about the linkage between pay and performance and whether that is working as effectively as it ought to do. It is one the key questions that we as investors have been trying to address in our discussions with companies, going back for the past two or three years in fact. We wrote to the chairmen of the FTSE 350 companies three years ago, and we put down a marker on three points that we have continued to emphasise: we want restraint in the structure of pay, transparency around the measures used to measure success and simplicity around the way in which these sometimes quite complex pay packets are put together for the benefit of the senior staff at our larger companies. We continue to press that message home whenever we have an opportunity. I think that we are seeing a certain amount of movement, but there is still quite a long way to go.
David Paterson: I think the Bill is helpful, in the sense that the binding vote on pay, which is not something that we had advocated, frankly, is in fact a constructive move. If it is to be really effective, the piece that will work best from the point of view of shareholders is actually the advisory vote on what has been implemented by way of pay in the previous year. That is something that I think will give the binding vote more meaning than simply leaving the binding vote on its own. The combination is actually quite a powerful one.
Mr Paterson, may I push you on this? Previously, my understanding was that the NAPF was not in favour of binding votes on pay. Have you changed your position now?
What is your view of the remuneration committee? I read your really interesting discussion paper on this, and your recommendation was that you did not need a binding vote but could vote against the chairman or members of the remuneration committee. Do you still stand by that? Could you give me examples where that has worked successfully and pay has been restrained as a result?
David Paterson: Shareholders in the UK are in an unusual position by comparison with many other countries in that they actually have a vote every year on the re-election of the directors of the board. That power only came into play this year, and we have seen it being used a little bit this year. It is a power that investors, frankly, used advisedly and relatively infrequently, and that is how it ought to be used. There have been examples in the course of just the past few weeks when it has been used and significant votes against individual directors have been lodged. The impact of those negative votes, because they have never got to the 50% mark, will be seen in the course of the rest of this year, as boards review the significance of those votes and work out how they ought to respond to their investors.
In general, do big institutional shareholders like pension funds and insurance managers need to be doing a lot more when it comes to directors’ remuneration?
David Paterson: They do not run the companies. The companies are run by the boards on behalf of the shareholders and of the company at large. There is already a significant amount of engagement between shareholders and companies, and that is going to become an increasingly important feature of the investing landscape as we go forward. So there is scope to do things better, and more of it.
But shareholders own the business. That is the key point, isn’t it? They need to have more power to allow them to direct the strategy for their business.
Paul Lee: We can never direct the strategy. We have no interest in becoming shadow directors and actually controlling the board and the company. Our role as shareholders is to call the board to account, to challenge them, to press them and to push them to do their job better. It is crucial in binding or advisory votes on remuneration or any other issue to ensure that the dialogue between shareholders and boards is made more effective rather than less effective. Votes are not the end of the story. They are just part of a continuum of dialogue between shareholders and boards, and it is extremely important that that dialogue is encouraged, and that the focus is not solely on votes. Votes are important, and clearly we vote actively on behalf of our clients, but we also engage actively with the directors to ensure that those votes and what we intend by them is fully understood and responded to.
Following on from that—this is my final question, Mr Brady—are we looking at this in the wrong way, and focusing solely on directors’ remuneration when this is a good opportunity to think about how we could improve corporate governance and make the UK’s corporate governance framework still the best in class for the 21st century? Mr Lee, you have written eloquently about the management of risk, and how boards often fail on that. What is the Bill missing in respect of making sure that the UK’s corporate governance code is the best it can possibly be? That question is to all three of you, please.
Paul Lee: I will start. I think the UK’s governance code is already the best in class. You will probably be aware that there is ongoing consultation right now, which closes next month, and is making some changes, particularly on the audit committee side, which in most companies has responsibility for risk. Those changes in our view are extremely helpful and positive, and will continue to ensure that the UK’s governance code is the best in the world.
Our perspective is strongly that legislation will rarely be the solution for better governance. Better governance will be delivered by codes, and best practice guidance that is considered, thought about, and then delivered by boards, rather than imposed on boards in a way that constrains them and forces them into a particular mode of action. What we need is boards that are empowered and cajoled to do the best they can, rather than being constrained and limited to only one set of tramlines.
Otto Thoresen: I would start with the point that Paul made earlier, and David also made about the role of the board to provide governance oversight on executive management, how the business is being run, and the extent to which the business’s strategy, direction and risk management are appropriate. Shareholder engagement is with the board of the entity, and the pressures and challenges that we should bring are through that board.
What you have seen in the last six months with the shareholder spring is a number of different areas of tension or frustration which had built up in the relationship between investors and boards, manifesting itself through significant votes on an advisory basis on remuneration reports. What has been going on is perhaps more frustration about moderate performance in a business being rewarded with high rewards—something about the linkage between performance and reward—and poor consultation between firms and the investment community, so not consultation so much as one-way communication with not much listening. Certainly, when we went public with the letter we wrote to the banks in December from the ABI, it was because we felt that our consultation was not getting anywhere, or was not changing things. We have seen many of those frustrations shown in the last six months. For me, the move to a prospective binding vote gives one an opportunity to engage in strategy for the business as well as remuneration—an alignment of remuneration with strategy.
The other point that is really important to the members of the ABI is, how is the value that is created in the firm being shared between shareholders through dividends, employees and executives through reward and, particularly in financial businesses, how is capital retained in the firm to ensure that it can weather whatever economic storms it might have to face? I believe that that discussion gives us an opportunity to step up the quality and richness of the engagement with the boards of companies
David Paterson: There is not much I would add, except to say that Otto has finished in the right place: the key is effective engagement with those companies where there are seen to be significant issues for shareholders. The code, and the stewardship code, look as though they have all the right ingredients. It is execution that is important as much as re-codifying or new codes.
I am going to press you a bit. I do not buy much of what you said. In the bubble, you and your members had hundreds of billions of pounds under management. Given that we are being asked to legislate now, we need frankness from you about what you should have done in the good times. I think there has been a dereliction of responsibility. You have not been activist. The dinosaur is just waking up. What should you have done better? What should your members have done? What is the failure that you and your members were part of? We need to work out whether the Government proposals are sensible. We need more frankness from you. Sorry; that might have come across as a bit full-on.
David Paterson: When I look back at the crisis—I have seen several, being quite an old man in this world —I think that one of the key differences this time has been the mismatch between, if you like, the encouragement to take risk and the need to deliver returns for shareholders. I think that is where things went wrong. As shareholders we should probably have been more cognisant of the risk issues. There were a number of occasions when we said to companies, “I think that particular performance target for your executive is pretty ambitious. Is that going to create the wrong atmosphere and the wrong culture in the business?” But we did not say that very often, frankly, and we certainly did not say it at many banks, which is where one ought to have been saying it. If one is looking at things that might have been done differently, that is something that we can reflect on.
Otto Thoresen: I will keep going until I find one that passes your test. I will tend to talk about the financial sector—not surprisingly, given the economic events of the last few years. For me, we have allowed complexity to get built into executive remuneration. The driver for complexity was to try and align outcomes more closely with shareholder outcomes. In fact, it has got in the way of understanding exactly what drives outcomes, and therefore it makes it more difficult to engage around whether it is appropriate or not.
If I am allowed one more, I think there has been something about an acceptance or not enough challenge around how effective boards actually are. What is the make-up of the board? What skills are within the non-executive directors of the board? To what extent is there a push towards diversity on boards? There has been a recent focus on that from a gender point of view, but diversity is a far bigger issue than just gender. Because of that, you have a risk of allowing groupthink to continue in organisations, when in fact if you could address that more aggressively, you could get a more sustainable governance system to deal with the next unexpected event. At the moment, we are quite focused on how we should have dealt with what has just happened and how we should have avoided it happening, rather than thinking about what could be happening next and what we might have to deal with next.
Paul Lee: I am not sure whether this will count as a mea culpa. When I look back at our engagement with the banks—the financial sector—I tend to think we were talking about the right issues and pushing on the right issues, but in retrospect we were not pushing hard enough. Particularly, we were not pushing hard enough when those banks were unresponsive to the dialogue that we were seeking to have.
At the time, we at Hermes EOS were a smaller organisation with fewer clients. We therefore had less clout in those dialogues. In the past few years, not least because of the crisis, we have added a number of clients for our service of assisting them to be good owners of companies, and that gives us more influence, and more confidence that we can push harder—and we will continue to push harder. The more asset owners who join that sort of activity who become good stewards of the companies in which they invest, the better off we will all be. Innovations such as the stewardship code in the UK, which also happens to be out for consultation at the moment and is already a major stride forward in the governance of the investment chain as a whole, have been hugely positive in driving asset owners to think much more actively about their responsibilities as owners of companies. That can only be positive, and it is working through the system, not least in some of the votes that we have seen in the last little while.
Otto Thoresen: From the ABI’s point of view, we feel that the proposals, particularly those on the binding vote on prospective pay policy, are a very positive addition to what is already in place. I think that that gives us enough with which to follow through on the engagement that we have started over the past 12 months to keep, as Paul said, the pressure on. We feel comfortable with what we believe is being proposed here.
I will ask your colleagues for their views, but if I were an ordinary shareholder I would have a great sense of conservatism regarding how you guys approach things, and great concerns, because you are not proposing anything more or anything stronger.
Otto Thoresen: I have a very quick comment. I understand that, but remember a comment that has been made a number of times: that the really important thing here is to allow boards to be effective in providing oversight of executive management’s running of businesses. The balance that you have to strike is to have enough leverage to apply pressure and challenge but also to allow people to get on with running their business. That is why we are conservative about laying more regulation or legislation on top of a system that substantially works in many sectors but has not worked as well as we would have liked in some sectors.
I have a few very brief questions. First, do you think that the Bill gets the balance right when it asks members to vote on policy issues compared with voting on specific things such as exit payments? Secondly, Paul made the point that a lot of it is about getting the education and communication right, so what specific suggestions do you have about what could be done differently to get it right?
Thirdly, if we are focused on linking pay and performance, if the Bill goes through, what impact will it have on how boards change the overall pay structure and strategy? There is probably some confusion—dare I say; and I think that some of it is on purpose—about what a job is worth in terms of basic pay, and what the bonus is. If I look at different industry sectors, what gets paid and is considered to be the pay for the job, and what the bonus is, are weighted in a way that is different from that in other sectors. In some sectors part of the bonus is seen as standard pay.
David Paterson: May I start by saying that I would not underestimate the impact that the changes that have been proposed by Government will have on how those who participate in corporate governance and remuneration go about and think about their jobs? The changes are much more far-reaching than perhaps you recognise, because they will have an impact on how we do our jobs.
As far as the specifics are concerned, there is a challenge in the Bill for investors, in that it is up to us in the first instance to describe to companies what we think is an appropriate disclosure of forward-looking remuneration policy. Companies will not always agree with us: this is part of the give and take of the business we are in. If we do not collectively say that we think these are the standards we are looking for, in terms of future policy, base pay, bonus, share awards and other benefits, we will have missed a trick, frankly, and that is something that I have been discussing with my colleagues at the Investment Management Association and the Association of British Insurers in recent days. There is a challenge for us there, which we have to address.
There is also scope for improved clarity of disclosures, as I mentioned earlier. Transparency is really important in this area. Part of that will be helped—there are different views—in the single number, which people have been talking about as a way of trying to get all this pay stuff into one bucket. It is a complex number, frankly, but if every company applies the same regime to identifying that single number, we will then have an easier job in comparing the BPs, the BTs and the BAs—for the sake of the Bs—across industry. That will, I think, help us.
I think that I have asked two thirds of your question. I have not answered the end, I am afraid.
Welcome to the panel. In the NAPF response to the BIS executive remuneration discussion paper, with regard to question 7, you said: “The NAPF do not believe that an employee vote on remuneration would be beneficial; however we do see merit in employee consultation on remuneration.” How would that work in practice? Would you like that included in the Bill?
David Paterson: I am a great believer in best practice—compliance-based regimes rather than legislation—but I will answer the question. It seems to us that there is a need, as I said earlier, several times, for more transparency around the whole remuneration issue. It is not a question simply of boards and management explaining to shareholders. I think they have to explain within their companies as well.
There is a real need to set out the company’s policy for paying staff across the piece, so that everyone can understand exactly why they are entitled to this slice, as against the different slice that is paid, say, to a senior executive. There is a lot of room for improved communication within companies, as well as between companies and shareholders.
In my opinion, short-term appointments or terms imposed on FTSE 100 boards can lead to short-term strategies, which can be higher-risk. I should like to have your view on that. Is it not a fact that the Bill should deliver on directors’ remuneration, despite Mr Wright’s hobby-horse of lower directors’ pay? It is not a matter of lower pay or higher pay, but the right pay for the right performance. Do you believe that the Bill can deliver that? If not, what does it need to do to deliver that? Surely, the right pay must be the aim.
Otto Thoresen: I agree with your last point. Some of the votes that have happened in the last six months have been about people feeling that there is a disconnect between the company’s performance and the level of pay awarded, rather than being, as they have sometimes been interpreted as, a vote against high pay per se. I think the disconnect has been driving the voting.
The prospective binding vote is where the opportunity arises for us to engage well on that subject. One of the risks we run, which we have to guard against in the execution, is that it might just become a box-ticking exercise, with a boilerplate solution to communication and engagement with shareholders. It should be an opportunity to get under the skin of where the business is going and whether the incentive packages are being designed the right way to reward people for success and not for failure. It should be, but that will be in the way we—
David Paterson: I would simply add to that the link I made earlier between the advisory vote on the implementation of policy and the forward-looking binding vote. The connection is very important because on the one hand there will be a proposal for what we are going to do as a remuneration committee, as a board, and on the other hand it will be, “Here’s how we’ve done it.” The two must connect.
Order. I am afraid that brings us to the end of the time available for the Committee to ask questions of the witnesses. I thank all the witnesses on behalf of the Committee.