Linking executive pay to ESG goals

While creating a link between executive compensation and environmental, social and governance issues is a useful lever to influence behaviour and show seriousness of intent, is it enough to affect major change?

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.

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.