How to link ESG goals to executive pay

The case for tying CEOs’ rewards to the attainment of environmental, social and governance goals has gained broad acceptance, but the practicalities of doing this effectively are far from straightforward.

Unilever hit the headlines in 2014 when it paid its then CEO, Paul Polman, a £432,000 bonus for his work on the company’s sustainability reforms. While this case drew criticism from those who saw it as a fat cat profiting from addressing global problems that his firm may have been part of, it fuelled the theory that the best way to persuade business leaders to manage their assets for the public good is to pay them to do so. 

The movement to tie bosses’ rewards to their companies’ environmental, social and governance performance has since gathered momentum. By 2022, more than 90 of the FTSE 100 were incorporating ESG measures into their executive incentive plans, according to a Deloitte study.

Like most things ESG-related, the practice has encountered scepticism. Is the promise of these bonuses really driving business leaders to hit ambitious targets, or do such schemes equate to a Trojan horse, designed to sneak inflated compensation packages into the C-suite under the guise of rewarding corporate social responsibility? 

It can, when done well in the right context, reinforce executive accountability to meet ESG targets. That’s the view of John Dady, associate partner specialising in executive compensation at HR consultancy Aon. For many of his clients, the practice “feels like the next logical step” amid growing expectations and regulatory obligations, he reports. Reflecting on conversations he’s had with them about this, Dady says: “The question has become less about whether or not we should be doing it and more about how we can do it in a robust, reasonable way.”

The main challenge lies in the “tricky practicalities of getting it right”, he adds. The main risk is that the practice could result in more pay, not more effective action, but there are steps that firms can take to avoid this outcome and other pitfalls.

Establish clear measures of success

First and foremost, companies must put well-defined ESG metrics in place. Their absence would suggest a lack of substance, “opening corporations up to accusations of greenwashing or virtue-signalling”, Dady warns. 

The key is to set specific targets – minimum reductions in greenhouse gas emissions and energy use, for instance – for the whole business, advises Birgit Breitschuh, a partner at management consultancy Oliver Wight. “You need to be clear on how you will measure these, which may prove harder than it sounds,” she warns, noting that ESG metrics are tricky to define and harder to quantify.

Organisations must therefore ensure they have the data and reporting capability to know what to measure, says Breitschuh, who adds: “Accept that you won’t get it right first time. You will get smarter if you stick to it and keep improving the alignment across the business’s functions for achieving the goal.” 

Dady recommends separating internal metrics, such as workforce engagement, from external metrics, such as greenhouse gas emissions. “This is an easy way for a firm to narrow down what aspects it should be looking at, while making them as specific and relevant as possible,” he says.

Communicate why you’re doing it

Firms should clearly explain their reasons for introducing ESG-related pay, including the benefits of achieving certain goals and the ineffectiveness of other incentive systems. 

Pay follows strategy, not the other way round, stresses Lauren Chiren, corporate trainer and founder of Women of a Certain Stage, which provides executive mentoring and coaching to guide clients through changes such as the menopause. 

Having helped Amazon, Lloyds TSB and Nike, among others, to tie incentive plans to diversity, inclusion and gender equality targets, Chiren advises that both the ESG goals and their importance should be embedded throughout the organisation and its business planning processes, with specific responsibilities allocated to the most appropriate teams. This should ensure that achieving them becomes part of its everyday decision-making.

“There’s no point in tying executive pay to ESG targets if that doesn’t make sense to the person leading on these – or to the company as a whole,” she says.

What gets measured gets done

A criticism commonly levelled against firms using ESG-related incentive plans is that the practice encourages bosses to pick the lowest-hanging fruit, which would leave them open to accusations of PR whitewashing. If the CEO can achieve extremely high scores across the board, for instance, the scheme is unlikely to look rigorous enough.

With this risk in mind, ESG targets need to be so-called stretch goals – ie, “achievable but challenging”, according to Dady, who adds: “What you don’t want is a situation where a company fails consistently on its financial targets and succeeds on its ESG ones, resulting in bonuses for the bosses. That would not be a good look.”

There are two main mechanisms for paying an executive for good ESG performance: through their annual bonus or their long-term incentive plan. In Dady’s view, the latter is the more appropriate remuneration method for environmental accomplishments. Achievements in other categories can be assessed and rewarded more easily on a yearly basis.

The best approach to take will depend on a range of factors, from the size of the business and its industry to its culture and wider commercial objectives. Choosing and calibrating the right mechanism requires finance teams to compile insights from across the business. They must “really understand the purpose and the practicalities of adding ESG to pay metrics”, Dady stresses.

Ready to take it a step further?

Rewarding the boss to incentivise good ESG performance “is a good place to start”, but it isn’t the only – or the best – way to do so. So says Amy Williams, founder and CEO of Good-Loop, a firm that serves online adverts for businesses while raising money for charity.

She argues that there are some disadvantages to this method. For one thing, it “puts the accountability of ESG performance on one person, when efforts should be shared across the workforce. And it can distract from the good of the business.” 

Williams believes a better way to bake impact into business as usual is to link it to earnings. Good-Loop, for instance, donates from its top line: for every £10 worth of advertising the firm sells, £2 goes directly to the charities it works with. She explains: “If every time you sell more stuff you do more good, then your business model will have an impact baked into it. Your financial goals are automatically also aligned to your ESG goals.”

Jenny Draper, commercial director at Barkers, a consultancy specialising in ESG procurement, agrees that firms could – and should – go further down this road. “It would be more impactful for organisations to donate any funds they’ve withheld from executives who didn’t meet their ESG targets to carbon-reduction or offsetting programmes,” she argues. “This would ensure that the money doesn’t simply go back into the company coffers.”