Pay for Good Linking Senior Executive Pay to ESG Goals
Pay for Good Linking Senior Executive Pay to ESG Goals
By Dr. Murugappan
COVID-19 has dominated the business agenda the last 3 years. But despite, or perhaps because of, this there is increased focus on the immense long-term challenges companies face: environmental degradation and a changing society. Arguably the most significant of these is climate change. The world must halve greenhouse gas emissions in the next decade to avoid warming of more than 1.5 to 2C. Action can no longer be postponed to the future. Put in pay terms, this gives just three back-to-back LTIP cycles to transform every sector of the global economy. Companies are at the heart of this change, and increasingly recognise their responsibility to decarbonise to protect investors, employees, customers and the societies they serve.
On its own climate change would be the greatest challenge humanity and business has ever faced. But alongside this, companies are facing pressure around their role in a broad range of environmental and social challenges: the loss of biodiversity, deforestation, water pollution, plastic consumption, wealth inequality, employment conditions, diversity, and inclusivity and many more. The pressure is coming not just from special interest groups but from customers, employees, and, increasingly, investors and regulators.
Investors face scrutiny from their clients on how they are responding to ESG issues. ESG integration is increasingly viewed by investors as a vital part of the investment process. This is supported by the body of evidence pointing to the importance of material ESG factors to long-term risk-adjusted company performance. Companies that prioritise sustainability continuously engage with their material stakeholders, making them better placed to react to social, economic, and regulatory changes.
Financial regulators have long been interested in the G of ESG. But the E and S are also coming under scrutiny. Regulators see climate change as a material risk to financial stability. The transition and physical risks posed by climate change challenge the resilience of bank loan books and insurer policy portfolios. It's only natural, given this context, that attention is turning to how ESG factors are being linked to executive pay. If CEOs say that ESG is so important then surely, they should put their money where their mouth is and agree to be paid accordingly. Calls to link executive pay to ESG targets are now widespread and not just coming from pressure groups and NGOs but also from investors and financial regulators.
In a high-profile example, European investors in Shell encouraged the company to add climate goals to its long-term incentive plan following their 2017 commitment to reduce their Net Carbon Footprint. BP has announced a similar change to incentives following CEO Bernard Looney's strategy announcement in 2020. Financial regulators and governments are asking firms to consider incorporating climate and diversity goals into senior executive pay. Indeed, in almost every shareholder engagement in the last 12 months the question of ESG in pay has arisen. Nearly every Remuneration Committee is asking if, and how, ESG should be incorporated into executive incentives. Apple, the world's most valuable company, has recently added an ESG modifier to its pay scheme, signalling that change may be about to increase pace in the US too. But linking ESG and pay is not easy. By and large investors do not yet have a consistent or rigorous view about what 'good' ESG performance looks like and so there is no clear guidance for companies on a 'good' ESG performance measure.
Despite these challenges the prevalence of ESG targets in executive pay is growing. Willis Towers Watson analysed 886 companies across 3 regions regarding incentives and ESG integration and found that 2 out of 3 companies in Europe and North America incorporate ESG as part of their incentive plans. Their implementation mechanism varies in the pretexts of including threshold or basic level of performance required for some or all the payout under other metrics to occur STI or LTI. Another pretext is to include an ESG modifier to overall STI or LTI formula that modifies the payout up / down by certain percentage for all participants. Lastly but not least, they could also include quantitative metrics into STI / LTI payout formula. They also found that many companies incorporate ESG metrics as a KPI with an approximate weightage of 20%. Yet some boards and investors question whether it is right to include ESG metrics in pay at all. If ESG is aligned with business strategy and long-term value, why does it need to be separately measured? If ESG defines a firm's licence to operate then why is it rewarded rather than being table stakes for the senior executives to keep their job?
There are two broad schools of thought that are evident in public discourse on the issue, one based on the idea that ESG is aligned with shareholder value, the other that it isn't. The two views often appear to be held simultaneously by the same person where humans go, cognitive dissonance is never far behind. But there are important differences in the implications for the approach taken, and who gets to decide:
If ESG is aligned with long-term shareholder value, then why do we need ESG targets in pay at all? Why isn't rewarding long-term shareholder value enough?
If ESG isn't aligned with long-term shareholder value, then how does the board decide which ESG factors should be prioritised and how do they secure legitimacy for making that choice?
Performance pay can lead to better outcomes where what we mean by success is clear and can be holistically measured (e.g., long-term shareholder value). But in areas where measurement is complex and multi-dimensional, we often eschew incentive pay, for good reason. The risk that the intrinsic motivation of the ESG goals is crowded out by the extrinsic motivation of the incentive. Executives become motivated to hit the goals to increase their bonus, rather than because they believe that doing so is the right thing to do. Second, the risk that flawed and incomplete ESG targets fail to capture the full extent of the ESG goal. Without incentives, the executives would have been intrinsically motivated to deliver ESG performance; with incentives, they may focus more on the targets in the incentive plan, lessening progress on the wider goal. Third, executives view pay as unfair if they have delivered strong ESG performance but not been rewarded since the incentive measures the wrong factors. So, if we take the view that ESG is aligned with long-term shareholder value, then perhaps the answer is to make pay more long-term, rather than to introduce more metrics.
When incentivising an ESG factor that has an ambiguous or negative impact on shareholder value then boards need to be clear on the justification for their action. Is it to meet shareholders' non-financial preferences? Is it to accord with societal expectations? Is it because the ESG factor represents a litmus test for the company's purpose? If so, how are these being assessed and traded off against shareholders' financial expectations? Shareholders themselves need to be sure that their own clients' views are being faithfully represented and that they understand any trade-offs involved.
It's vital that boards are allowed to retain discretion to align pay with ESG in a way that is suited to their circumstances. There needs to be recognition that this may or may not imply incorporation of ESG targets. Incorporating ESG targets into executive pay can play a role in helping some businesses be a force for good in addressing the immense challenges we face today. But adding ESG to pay is not a simple equation. The answer is not always what we expect, and the risks of getting it wrong are substantial.
Paying for good while paying well is a hard thing to do.
