Linking executive pay to ESG goals

Although not yet wide­spread, the idea of tying exec­u­tive com­pen­sa­tion to envi­ron­men­tal, social and gov­er­nance (ESG) goals to help dri­ve busi­ness sus­tain­abil­i­ty is gain­ing trac­tion.

Accord­ing to the lat­est Edel­man Trust Barom­e­ter Spe­cial Report: Insti­tu­tion­al Investors, more than two-thirds, up 17 per cent over 2019, would like to see this link in place. They now asso­ciate adop­tion of ESG mea­sures with per­for­mance and growth and con­sid­er remu­ner­a­tion a use­ful lever to ensure it hap­pens. 

Unsur­pris­ing­ly then, a study by Willis Tow­ers Wat­son reveals that 78 per cent of employ­ers intend to change how they use ESG met­rics in their incen­tive schemes over the next three years. Two in five plan to include them in long-term plans, while 37 per cent expect to intro­duce them into annu­al schemes. 

To demon­strate the seri­ous­ness of their intent, pio­neers such as Apple are even start­ing to move beyond more pop­u­lar dis­cre­tionary mea­sures to adopt hard­er met­rics. As of this year, the company’s annu­al bonus pay­ments will rise or fall by up to 10 per cent based on how well exec­u­tives do against key per­for­mance indi­ca­tors (KPIs) linked to its ESG pro­gramme.

Why link executive pay to ESG goals?

So what is going on here? Why is enthu­si­asm grow­ing for this approach, how wide­spread is it and just how effec­tive is it like­ly to be? Stephanie Giampor­caro, asso­ciate pro­fes­sor in respon­si­ble and sus­tain­able finance at Not­ting­ham Busi­ness School, says that while so-called cor­po­rate social respon­si­bil­i­ty con­tract­ing is cur­rent­ly a mar­gin­al trend, it is one that is devel­op­ing rapid­ly across indus­tri­alised economies. 

Accord­ing to Not­ting­ham Busi­ness School research, the num­ber of com­pa­nies on the UK’s FTSE All-Share Index going down this route dou­bled to near­ly 14 per cent between 2011 and 2019. In France, on the CAC All-Share, the fig­ure is cur­rent­ly more like 18 per cent, while it’s 9 per cent on the US Rus­sell 3000 Index.

This shift is the result of pres­sures from a range of sources. The invest­ment com­mu­ni­ty start­ed pay­ing atten­tion to ESG issues after the Unit­ed Nations pub­lished its Prin­ci­ples for Respon­si­ble Invest­ment Ini­tia­tive in 2006 and they have been ris­ing up the agen­da ever since.

The sit­u­a­tion came to a head last Jan­u­ary when the world’s largest asset man­ag­er Black­rock indi­cat­ed it would give clients’ ESG per­for­mance equal weight with tra­di­tion­al finan­cial mea­sures, such as cred­it and liq­uid­i­ty risk, and vote against boards that failed to adhere to recog­nised stan­dards in the area. 

In this con­text, tying exec­u­tive com­pen­sa­tion to ESG per­for­mance pro­vides a use­ful tool not only to demon­strate seri­ous­ness of intent, but also to pro­vide a “mech­a­nism that bet­ter aligns behav­iour today with sus­tain­able out­comes in the future”, says Anna Sky­laka­ki, senior man­ag­er at glob­al wealth and asset man­age­ment con­sul­tan­cy Alpha FMC.

Benefits of focusing on long-term ESG goals

Amy Wil­son, UK engage­ment lead for respon­si­ble invest­ment man­age­ment firm EOS at Fed­er­at­ed Her­mes, agrees. In her view, explic­it and mea­sur­able ESG mea­sures can help “dis­in­cen­tivise deci­sions that may ben­e­fit the short-term, but threat­en long-term val­ue”. 

“We are often con­cerned about high pay and whether it tru­ly reflects good per­for­mance in the long term as schemes may heav­i­ly incen­tivise exec­u­tives to hit a num­ber of finan­cial goals over a rel­a­tive­ly short time frame, but give no con­sid­er­a­tion to crit­i­cal issues like low-car­bon tran­si­tion,” she says.

On the busi­ness side of the things, the UN Glob­al Com­pact, the Glob­al Report­ing Ini­tia­tive and an array of nation­al and inter­na­tion­al reg­u­la­tions have pushed organ­i­sa­tions into tak­ing ESG more seri­ous­ly. Grow­ing pub­lic scruti­ny and high­er expec­ta­tions of cor­po­rate behav­iour from cus­tomers have also played their part.

As a result, the per­cep­tion is that link­ing exec­u­tive com­pen­sa­tion to well-for­mu­lat­ed ESG goals can help to focus minds and mit­i­gate organ­i­sa­tion­al risk. But there are down­sides to this approach. 

Wil­son explains: “There are lim­i­ta­tions to any approach that sees pay as a proxy for strat­e­gy and per­for­mance man­age­ment. It’s not pos­si­ble to reduce com­plex jobs like run­ning a busi­ness down to a small set of met­rics, and no per­for­mance indi­ca­tors over­ride the need for exec­u­tives and boards to use their judg­ment and make the right deci­sions for the long term.”

Why tying executive pay to ESG goals is not enough

Anoth­er chal­lenge, says Anna Lun­g­ley, chief sus­tain­abil­i­ty offi­cer at adver­tis­ing firm Dentsu Inter­na­tion­al, is that if KPIs are not well thought out, they may dri­ve the wrong behav­iour, which can in turn lead to unin­tend­ed con­se­quences. In Lungley’s view, KPIs should always relate to ESG goals that are impor­tant to, and mean­ing­ful for, the organisation’s long-term strat­e­gy and pur­pose to ensure they make a demon­stra­ble and mea­sur­able mate­r­i­al dif­fer­ence. 

Whether or not remu­ner­a­tion-based incen­tives should be applied, there are cur­rent­ly two schools of thought. One says they should be linked to annu­al bonus­es and the oth­er to long-term incen­tive plans. Skylakaki’s pref­er­ence is for the lat­ter, not least because “the time hori­zon for ESG met­rics is nor­mal­ly mea­sured in years or even decades”.

To be tru­ly effec­tive though, sim­ply tying exec­u­tive com­pen­sa­tion to ESG goals alone is not enough, although undoubt­ed­ly it has an impor­tant role to play. Jason Longhurst, chair of the UK Busi­ness Coun­cil for Sus­tain­able Devel­op­ment, explains: “If ESG goals are locked onto exec­u­tive pay, it’s about the dif­fer­ence between account­abil­i­ty and respon­si­bil­i­ty. There has to be a whole­sale, sys­temic com­mit­ment or oth­er­wise it can just come across as tokenism.”

Wil­son agrees. In her opin­ion, while pay incen­tives have a role to play, they are not “the only or even the best way for a com­pa­ny to ensure it is focused on its mate­r­i­al, long-term ESG risks and oppor­tu­ni­ties”. Instead, they ben­e­fit most from being guid­ed by a pur­pose that not only serves their share­hold­ers, but also wider stake­hold­ers, soci­ety and the envi­ron­ment itself. 

“The company’s strat­e­gy, gov­er­nance struc­tures and cul­ture should all be aligned to achiev­ing this. In oth­er words, address­ing mate­r­i­al sus­tain­abil­i­ty issues should be built into the core of the busi­ness,” she con­cludes.