Linking ESG and Executive Pay
The landscape of corporate responsibility and environmental, social and governance (ESG) issues has altered dramatically in recent years. Some of that transformation is being driven by new regulation - since 2018, there have been over 170 ESG-related regulatory measures proposed globally, more than in the previous 6 years combined, together with a proliferation of best practice frameworks on ESG issues.
This regulatory wave both responds to, and further drives, increased investor interest in businesses’ ESG performance. That interest is in large part driven by returns – sustainable investments were outperforming traditional portfolios before the pandemic and they sustained that outperformance during 2020. We see this link between sustainability, profitability and returns underlined by the 2020 Edelman Institutional Investor Survey, which disclosed a broad consensus that companies prioritising ESG initiatives represent better opportunities for long-term returns.
COVID-19 has only intensified investor, consumer and public scrutiny of businesses’ ESG credentials, throwing a brighter spotlight than ever before on businesses as social actors that - through their employment practices and attitudes to health and safety, executive compensation and pay equity - have the power to reduce or exacerbate social inequalities. Just recently, we saw some of the world’s largest institutional funds decline to participate in Deliveroo’s IPO, citing concerns about sustainability in connection with workers’ rights. Boohoo has also faced pressure from Parliament to tie its executive bonus structure to workers’ rights, as opposed to “runaway” growth.
For any business, making a commitment to doing business responsibly and setting meaningful targets for improving environmental and social impact and strengthening governance is only a starting point. How does a business that is serious about delivering on those targets go about embedding a focus on strong ESG performance into the structures and culture of its organisation?
An increasingly common method adopted by businesses is to link ESG targets with executive remuneration. This is, on its face, businesses putting their money where their mouth is. If a company is truly committed to doing well by doing good, it seems to follow that any performance-related pay should consider performance against ESG targets, alongside financial targets and other relevant measures. Research recently published by PWC shows that 45% of FTSE 100 companies have incorporated an ESG target in their annual bonus scheme, long term incentive plan (LTIP) or both. Typically, whether that ESG target is linked to an annual bonus or LTIP depends on whether the target is short term or long-term.
Environmental goals will usually fall within the ‘long-term’ category. For example, Shell responded to pressure from shareholders in 2019 by including an ‘energy transition’ metric in its LTIP (weighted at 10%). Comparatively, social goals are more likely to be included as a measure in annual bonuses. Apple recently announced that it will add a ‘bonus modifier’ to its 2021 annual cash incentive programme which would serve to increase a total bonus pay-out by 10% if ESG goals based on ‘Apple Values’ and other community initiatives are met. Apple Values include (amongst others) accessibility, education and security and supplier responsibility. Intel’s policy dictates that 50% of its annual bonus is based on ‘operational goals’ which include diversity, inclusion, employee experience and climate change. Nike has recently confirmed that it will tie executive compensation to ESG targets; citing ‘deepening diversity and inclusion’ and ‘protecting the planet’ as key factors.
Restructuring remuneration in this way can be an effective tool to drive accountability and culture change, but it needs to be considered carefully:
- A business’ ESG impact and performance can be hard to measure reliably and consistently and it is difficult to formulate an effective, transparent and fair bonus structure or LTIP without robust quantitative metrics.
- Linking short-term financial incentives such as annual bonuses to ESG targets may have the effect of encouraging short-term, tokenistic action and a focus on quick wins at the expense of tackling more complex problems - quite the opposite of doing business sustainably, with a focus on long-term social and environmental impact.
- In some cases, adapting executive remuneration schemes may not be a viable option. Smaller businesses, for example, may lack the resources and specialist expertise to set appropriate ESG targets and overhauling their pay structure may be unrealistic and disproportionately burdensome.
- Focusing ESG-linked incentives at the executive level may also not be effective to mainstream a focus on strong ESG performance throughout an organisation, although there will naturally be some trickle-down of ESG objectives from executives to their teams.
It is clear that application of ESG in the assessment of corporate behaviour is not straightforward and each business sector will have a different focus. Improving a business’s social and environmental impact involves transparent and ethical behaviour that often goes beyond legal requirements and as such can be hard to measure. Additionally, ESG factors are often intangible to some degree and it can take many years for any significant improvements to be achieved. Despite these difficulties, what is clear is that businesses can no longer ignore the importance of ESG. COVID-19 has reminded us all that businesses do not operate in a vacuum; their conduct has an important and significant impact on wider society. If a business cannot demonstrate a cultural commitment to promoting ESG factors in today’s post-COVID era, key staff, investors, clients and customers may well vote with their feet and prefer the competition.
Executive remuneration can be an effective tool for driving strong ESG performance. However, to be effective, this needs to be considered as part of a wider commitment to ESG goals and focused on what must be both realistic and achievable measures for reward. Public statements and actions, active engagement with owners/investors and, in overall terms, giving the business a solid ‘ESG foundation’ to work from is essential in ensuring that executive pay is then able to drive the necessary behaviours. This, in turn, then validates the commitment to achieving ESG objectives. This inevitably means that predominantly longer, rather than short term, ESG goals and measures must be set to underpin the cultural change of the business. This change needs to then permeate through to all levels of the organisation.
Our experience is that this refocussing requires careful consideration and input from both our legal and HR reward experts to steer a business through the maze of options to get the combination that is best suited and tailored to the particular ESG goals of the business.