Should companies follow the trend of tying executive pay to ESG performance?

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By George Scott

Organisations are increasingly committed to measuring their performance through the triple bottom line, shifting their understanding of success away from profit alone, to incorporate ‘People, Profit and Planet’. With 69% of chief executives embedding ESG into their business as a means of value creation, ESG risks and opportunities are rising up the corporate agenda and proving integral as part of corporate long-term strategies [1].To mirror the increasing commitment to social and environmental targets, organisations have sought new ways to track non-financial performance and ensure delivery of these targets.

A global study by the Journal of Accounting has found that in 2021, 38% of listed organisations link executive pay to ESG performance, up from just 1% in 2011 [2].However, the uptake varies globally; in the EU, over 60% of companies have tied compensation to ESG metrics, whereas only 16.5% of US firms have matched this approach.

Organisations seek to link CEO pay to non-financial metrics as a way to demonstrate credibility of targets, or illustrate the importance of improving ESG outcomes, or more simply to follow market trends. With a growing number of sustainability assessments and certifications such the PRI, B-Corp and Positive Luxury’s 1.0 Assessment providing more favourable ESG scores for businesses who link executive pay with ESG targets, it is important for companies to implement this practice in a way that will deliver business value alongside tangible positive impacts for people and the planet.

Data shows that linking pay to ESG targets does deliver stronger ESG performance but is yet to demonstrate a short-term positive impact on financial performance [2]. Conversely, the practice of including ESG metrics in compensation packages is being implemented more frequently by firms who engage with any of the three largest institutional investors (BlackRock, State Street and Vanguard), suggesting that investors value this practice. As investors are focused on delivering higher returns and lowering risk, the correlation highlights that this practice should be viewed as an indicator of business resilience in the long term. It is therefore important for businesses who are seeking access to capital to consider what market signals they will send by adopting this approach. Currently the number of factors being incorporated into ESG pay is small when compared to the broad range of topics that companies are choosing to disclose against in their sustainability reports. Generally, social factors are the most common type of metrics being used, as over 60% of the S&P 500 companies using some kind of human capital-related metric, with diversity and inclusion metrics being the most common. By comparison, only 14% have used one or more environment-related metrics [3].To maximise the benefit of ESG pay strategies, companies will need to explain the rationale behind the chosen metrics and link these to material issues.

Whilst the financial performance impact is still being calculated, highly specific metrics have a stronger correlation between targets and outcomes, such as defined CO2 emission-specific metrics, with information relating to scope and percentages provided. Ensuring non-financial targets are founded in data will ensure simpler measurement, tracking and evaluation against progress. Credit card company American Express paid 15% of executives’ annual bonuses for diversity, talent and culture achievements, but it was not clear whether this was based on a minimum quantitative target or whether any increase would suffice [5].The lack of reported data therefore undermined the value of this practice and companies seeking to use this approach should do so publicly and transparently.

For this reason, businesses must recognise that performance-linked compensation is likely to drive action against the relevant KPIs, and therefore, they should clearly stipulate minimum requirements that need to be met to unlock this form of compensation. This should ensure that executives cannot trade off poor performance in one business area whilst being rewarded in another.  In the past year, annual bonuses for UK water company executives rose despite most firms failing to meet sewage pollution targets, so it is important that both financial and ESG metrics are considered together. This case even formed part of the Labour Party’s key pledges to stem water pollution, by proposing regulator Ofwat would have the power to block water companies from paying bonuses to executives if they break pollution requirements.

As linking executive pay with ESG targets is a growing and evolving business consideration, companies need to have a considered approach for their selection and implementation of this practice. To deliver financial returns as well as drive impact, businesses should plan for the long term with clearly defined targets that have been identified as material to their business type, size and sector. This is underpinned by data and transparency on what targets have been selected, why and what it takes to adequately meet them, whilst mitigating potential harm in other business departments. Targets need to be periodically evaluated, with interim targets mapping progress, and will support companies that want to demonstrate a serious and effective approach in an ever-evolving ESG landscape.

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