Should a company’s ESG performance determine its chief executive’s pay?

November 2022 | SPOTLIGHT | BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

November 2022 Issue

Linking specific components of executive compensation to environmental, social and governance (ESG) performance metrics is increasingly a way to both highlight a company’s commitment to its sustainability goals and to focus senior executives on their role and responsibility in delivering on these ambitions.

According to a recent study, 42 of the top 100 European companies include ESG in one form or another as a variable component of executive pay. The proportion of European companies doing so has shot up, from 4 percent in 2008 to 39 percent in 2021. France had the highest number of such companies (71 percent) as of 2021. The UK experienced a meteoric rise in ESG metrics in chief executive compensation plans from a mere 8 percent in 2008 to 54 percent in 2021.

What is driving this shift? What is the core thought that is encouraging companies to link portions of their executives’ pay to company ESG performance?

Regulatory action, investor demands and a heightened global awareness of sustainability all contribute to companies ensuring that their top personnel are truly engaged and invested in building sustainable corporations.

Legislative changes are ramping up expectations for companies to demonstrate that their executive pay practices align with their ESG performance and long-term value creation. ‘Say-on-pay’ regulations in several European countries are adding further provisions to encourage the sustainability link.

The Shareholder Rights Directive II also provides for ESG in company disclosure and increased transparency about non-financial metrics in remuneration plans. More specifically, European investors now have the right to vote on both the remuneration policy and report, thereby increasing pay accountability in European companies.

Several national corporate governance codes are considering accountability for sustainability there. The French code now recommends that ESG measures be included in executive compensation, for example.

Investors are increasingly looking for companies to include ESG issues in long term incentive plans, short term bonuses or both. A 2021 survey of 600 institutional investors across six countries, representing firms managing approximately $20 trillion, revealed that two-thirds of the investors were in favour of executive compensation linked to ESG measures.

Allianz Global Investors’ 2022 voting policy, for example, reveals its expectations for European large-caps to include ESG key performance indicators in executive remuneration policies. The group intends to vote against such pay policies in 2023 if they lack such data. Cevian Capital called upon “European public companies to start, or accelerate, the development of ESG targets for integration into compensation plans to be put to a shareholder vote at annual general meetings in 2022”.

Regulatory amendments and rising stakeholder expectations are synced with a better understanding of sustainable development goals and their value. Even extra-European jurisdictions such as the US, Australia and Canada are linking executive compensation to ESG. Within certain Australian industries such as extraction and energy, for example, governance regulations and systems encourage boards to link pay and strategy and to care for the environment as a deep-seated value.

Compensation programmes must clearly identify the specific components of executive remuneration which are being linked to ESG performance. These may typically be short term or long term incentives, which should be specified by companies as goals in their annual objectives. Such transparency would also help companies meet investor expectations. When companies do decide to link ESG metrics to executive pay programmes, they should consider three prerequisites for a credible and transparent compensation programme to avoid the risk of being accused of a tick the box mentality or greenwashing.

First, companies should identify the specific and measurable issues linked to their ESG strategy in terms of business relevance, stakeholder relevance and impact on sustainable development. These will vary by industry and by company.

Second, companies must balance long term and short term incentives. To be credible, ESG measures linked to pay targets must be challenging and long term. Payout despite non-performance in the short term, especially in this context, may lead to increased scrutiny and backlash from stakeholders. Companies might have to review their payout system to strengthen the long term ESG goal delivery.

Lastly, the ESG metrics must measurable. Companies must consider how to report on the specifics of ESG-linked remuneration – weighting, achievement and outcomes – taking into account any disclosure requirements to which they are subject. A reliable and audited reporting system provides the necessary checks on whether ESG targets linked to remuneration have been achieved.

If implemented correctly, pay policies with built-in ESG variables have multiple benefits. They can enhance the perception of a company’s commitment to sustainability and delivering value to its stakeholders. Additionally, incorporating ESG measures into executive pay could affirm the link between sustainability, financial performance, and the creation of intangible value. Linking the remuneration of certain C-suite executives to specific and measurable ESG metrics could be a very effective way to steer a company toward achieving its sustainability targets. It could also rebalance the excessive emphasis on short term performance targets in typical compensation packages, which run contrary to long term financial and sustainability objectives.

However, this is possible only if topics material to the company’s overall strategy and corporate purpose are identified and stakeholder interests are balanced. A well-designed policy fosters a dialogue with investors interested in sustainability, who expect executive remuneration to be aligned with a company’s ESG performance.

Companies should carefully structure this integration so that it will measurably improve the company’s sustainability performance – and not result in negative unintended consequences. If ESG metrics are not ambitious enough, for example, they could incentivise executives to improve the performance of relatively easy to achieve or quantifiable metrics and discourage them from focusing on other significant, but hard to quantify, dimensions of sustainability performance.

In the absence of a thorough and reasoned materiality analysis, companies run the risk of limiting themselves to only certain arbitrary ESG metrics. This may arise out of a focus on a relatively small number of stakeholders and may offer incentive for executives to consider other stakeholders, especially those with needs that are complex or hard to quantify. Furthermore, companies might not disclose enough information to enable external and objective review of whether payouts are based on meaningful sustainability performance.

Companies run the risk of rewarding their executives despite overall dismal ESG performances if metrics are not aligned and meaningful. In an unfortunate outcome of a variable pay policy in terms of ESG compliance, for example, one company paid its chief executive a $272,000 bonus for achieving its ESG goals in the same year that the company had one of its worst oil spills.

In this specific case, the reward was a result of the policy that factored in only the number of oil spills in a year but not the total volume of oil spilt. The bottom line is that companies should weigh the potential benefits and risks of incorporating ESG metrics against their own ambition and culture before making any decisions.

ESG metrics can cover a multitude of topics: governance, human capital, social issues and environmental performance. Companies need to be prepared for the challenging task of working out which metrics are best as long term or short term incentives, and which should be qualitative or quantitative. Companies should avoid enlisting numerous variables in tracking performance since not all ESG metrics may add value to the exercise, given the varying nature of businesses and their economic ecosystem and purpose.

Their main aim must be simplicity and transparency. Rather than rushing to add more features to a remuneration programme, companies should carefully evaluate the costs and benefits of adding ESG metrics. More broadly, they must consider ways to strip out complexity and ambiguity, which can be counterproductive, as vague ESG factors and excessive focus on ESG metrics compliance could both unnecessarily complicate remuneration structures and hinder sustainability objectives.

Anuj Saush is the center leader of the governance & sustainability center Europe and Manali Paranjpe is an associate director of the governance & sustainability center Europe at The Conference Board. Mr Saush can be contacted on +32 (2) 675 5405 or by email: anuj.saush@tcb.org. Ms Paranjpe can be contacted on +32 (2) 675 5405 or by email: manali.paranjpe@tcb.org.

Anuj Saush and Manali Paranjpe

The Conference Board