Executive Pay and ESG Performance

Tom Gosling is an Executive Fellow at the London Business School Centre for Corporate Governance, and Phillippa O’Connor is Partner at PricewaterhouseCoopers LLP. This post is based on a LBS/PwC report by Mr. Gosling, Ms. O’Connor, Clare Hayes Guymer, Lawrence Harris, and Annabel Savage. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

Environmental Social and Governance (ESG) considerations now sit at the heart of good business practice, and for some companies have become a central strategic pillar.

Society needs companies to play their role in addressing challenges ranging from social mobility to climate change. This would suggest that executives should be paid based on ESG performance. But this simple conclusion may not always be correct, and simplistically adding the wrong ESG metric into executive incentives can be unproductive, and worse, counterproductive.

A new report in partnership between The Centre for Corporate Governance at London Business School and PwC reviews what market practice and academic evidence have to say about linking executive pay to ESG. There is no single right answer, but we identify the underlying reasons why a company may (or may not) include ESG in executive pay and the consequences for measure selection. And we set out the principles and decisions required to design a good, effective and enduring ESG pay metric, if that is what a board decides to do.

The pressure to include ESG targets in pay is coming not just from special interest groups but from customers, employees, and, increasingly, investors and 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 CEO pay. Cevian Capital has announced that it will be pushing all investee companies to set out ESG strategies and link them to pay by 2022.

Not so easy

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. One of the issues is the lack of a generally accepted set of ESG metrics. While ESG reporting standards now abound, such as the GRI or the new WEF/IBC standards, finding ones which are appropriate for incentives is much more challenging. Standardised ESG measurement frameworks tend to focus on ‘doing no harm’ as opposed to the more important dimensions of ‘doing good’.

Calibration can be even more challenging than choosing targets. Often companies find that the ESG measure which best aligns to their sustainability strategy is rather difficult to calibrate effectively with the fear of ever moving goalposts.

To link or not to link?

Despite these challenges the prevalence of ESG targets in executive pay is growing. Nearly half of all FTSE 100 companies now have an ESG metric in their bonus or LTIP. 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 executive to keep their job? If neither of these, then is it just virtue signalling? Can ESG be linked to executive pay in a way that avoids being overwhelmed by unintended consequences? Perhaps linking executive pay to ESG is an example of what the early 20th Century commentator H. L. Mencken was talking about when he claimed that “every complex problem has a solution which is simple, direct, plausible—and wrong”.

In our report we aim to shed light on these issues. A brief summary of the findings is given below.

ESG as a core tenet of good business practice is here to stay. But does that mean we should link it to pay? Sometimes, but not always. And maybe less than we’d at first think. Companies and remuneration committees face a genuine challenge to navigate the right route through the competing demands placed upon them. We hope that our report will help them find an answer to this question that works for their circumstances.

Key findings

Market practice in the FTSE 100 shows the changing nature of ESG targets in executive pay

ESG targets are increasingly prevalent in pay

  • 45% of FTSE 100 companies have an ESG target in the annual bonus, the Long-term Incentive Plan (LTIP), or both
  • 37% use ESG in annual bonus with an average weighting of 15%
  • 19% of the FTSE 100 use ESG in LTIP with an average weighting of 16%
  • The most common category of measure in the bonus is Social, including measures focusing on diversity, employee engagement, and health & safety
  • The most common category of measure in the LTIP is Environmental, typically measures focusing on decarbonisation and the energy transition

The nature of ESG targets is changing, with increased use of Environment and Social targets, particularly in LTIPs

  • ESG targets relating to long-standing social and governance metrics such as health & safety, risk, and employee engagement have appeared in bonuses for some time. 33% of FTSE 100 companies incorporate such ‘Old’ ESG measures, 31% in the bonus and 7% in the LTIP
  • ‘New’ ESG targets relate to more recently emerging stakeholder concerns, particularly around climate change, sustainability and diversity. 28% of companies have such measures, 18% in the bonus and 15% in the LTIP

A slight majority of ESG measures are output rather than input measures, with only a minority operating as an underpin

  • 55% of ESG measures in bonus, and 50% in LTIP, are output measures with a quantifiable goal—for example scope 1 and 2 emissions reductions in tonnes against baseline numbers
  • 31% of ESG measures in bonus, and 27% in LTIP, are input measures relating to specific activities a company undertakes—such as making investments in green energy sources
  • Only 14% of ESG measures in bonus, and 22% in LTIP, operate as an underpin, despite this approach being popular with some shareholders

Nearly half of current ESG metrics are not linked to material ESG factors

  • Over half (55%) of ESG targets are based on ESG dimensions categorised as material to the company under the SASB Materiality Map®. But equally, nearly half are not
  • Of the 45% of targets not deemed material in the SASB framework, nearly half (45%) relate to employee engagement or diversity & inclusion—whether this should be deemed immaterial will be a matter of debate. Diversity metrics commonly appear in financial services incentives, following the Women in Finance Initiative in the UK

Pay should be aligned with ESG, but that may not mean ESG targets

If, as is now generally accepted, companies that have strong ESG credentials in the right places perform better, then we could ask whether there is even a need for distinct ESG pay metrics. Research shows that there is strong alignment between shareholder value and ESG outcomes—but that this alignment only fully emerges over periods of 5 years or more, longer than the typical 1 to 3 year performance periods of executive pay. We also know that too much focus on performance targets distorts decision making and can have unintended adverse consequences. So pay can be better aligned with ESG simply by simplifying it and making it longer term (that is, by using restricted stock).

The first port of call for Boards seeking to incorporate ESG into executive pay should be longer term pay with less reliance on short term financial targets

But the natural alignment between ESG and long-term shareholder value may not be enough

We identify several motivations for why companies may wish to add ESG targets to pay in support of shareholder value:

  • Putting ESG targets in pay can communicate priorities and commitment internally and externally
  • The long-term share price is a less potent incentive further down the business
  • ESG can sometimes take too long to show up in share price for lengthening the time horizon of pay to create an effective incentive
  • ESG issues can represent tail risks which may not be well captured by typical incentives

The motivation for including ESG targets in pay may go beyond financial shareholder value

One argument for including ESG targets in pay is that ESG is aligned with shareholder value. Another is that it’s not. If the motivation for ESG metrics goes beyond shareholder value, then boards need to consider carefully the basis on which they are being included. We see three potential justifications.

  • ESG targets can align companies with societal expectations that do not directly link to share price
  • Shareholder preferences may extend beyond financial value creation
  • Companies are now focussed on their purpose—how they benefit society beyond just shareholder value. Action on ESG can be strongly aligned with this purpose, and aligning executive pay with this may be a logical next step

In our report we explore how boards should think about these motivations when deciding whether to include ESG targets.

Putting ESG targets in pay raises significant difficulties

Even where there’s a case to introduce ESG targets into executive pay, the potential implementation challenges are significant and may outweigh the benefits.

  • Even if quantitative measures are available, it may not be clear which to use
  • Specific ESG targets can be hit while the wider ESG goal is missed
  • ESG targets can distort incentives and crowd out intrinsic motivation
  • ESG targets are difficult to calibrate and assess
  • Executive pay is complicated enough already without adding further targets 

How to decide

If the rationale for including ESG metrics is as a path towards long-term shareholder value, then companies should focus on financially material ESG issues

Research shows that where companies outperform on the ESG issues flagged as material under the SASB Materiality Map®, then they outperform financially and in terms of shareholder returns. This is not the case where they outperform on immaterial issues. This means that if a business is seeking to incentivise ESG in order to primarily drive shareholder value, it is material metrics that should be the focus.

But where the goal is less explicitly linked to shareholder value (such as where the ESG issue relates to wider shareholder preferences, societal expectations and purpose) then there are four key decision rules Boards should apply.

  • First, the action should reflect the company’s purpose and values, so as to act as a reinforcement of the relationship and implied contract between a company and its stakeholders, including shareholders and wider society
  • Second, the action should relate to a stakeholder that is material to the company
  • Third, the action should be multiplicative, meaning that the stakeholder value created exceeds the cost
  • Fourth, the company should have a comparative advantage in the action being taken compared to other organisations or bodies

We develop a structured framework of questions helps boards decide whether to incorporate ESG targets into pay

The questions below shouldn’t be considered as a deterministic roadmap. But in general boards should be able to answer most of these questions in the affirmative before moving ahead with ESG measures.

Q1: Why are we considering including ESG targets in pay?

  • What objective are we seeking to support?
  • Are existing incentives incomplete or insufficient?
  • Have alternatives to including ESG targets in pay been considered and rejected?
  • Are there other benefits to includein ESG in pay that we need to take into account?
Q2: Are our chosen ESG measures aligned with strategy and focussed on the big issues?

  • Are the ESG measures aligned to a strategic priority?
  • Do the ESG measures reflect material issues that require a step change in performance?
  • Can we set appropriate stretch?
  • Are there clear and assured measurement criteria?
Q3: Have we considered and mitigated the risks of including ESG targets in pay?

  • Can we measure the ESG priority we want to support?
  • Do the measures capture the ESG priority completely enough?
  • Can we avoid distorting incentives?
  • Can we keep our pay plan simple enough?

How to do it?

For boards that consider that including ESG targets in pay is the right thing to do there are four key design dimensions:

A. Input vs output. Quantitative objectives such as reducing emissions lend themselves to output goals. Shareholders will also prefer objective output measures. But there are situations, such as a strategic transformation, where input goals are also useful for addressing ESG issues that need to be measured in a more qualitative way.
B. Individual KPI vs scorecard. Sometimes an organisation will have one or two critical ESG issues that tower above the others in significance, meaning that focussing on one or two KPIs may be appropriate. In other cases an ESG issue may be multi-dimensional with many different objectives. In these cases, a carefully constructed and transparently disclosed scorecard may work better.
C. Annual bonus vs LTIP. Market practice to date indicates that environmental goals will sit within the LTIP—which makes sense as these issues take several years for step changes to emerge. But some ESG targets, such as health & safety goals, can be robustly calibrated over a single year, and it is better to set well calibrated one year targets than vague long-term ones.
D. Underpin vs scale target. In most cases, ESG metrics will work most effectively as scaled targets, with threshold and maximum performance levels. This is particularly the case for transformational objectives, for example relating to energy transition. However, some issues will have pass or fail performance standards, below which reductions in payout are appropriate. Safety is a one potential example of this.

Closing thoughts

ESG targets in pay have their place but are no panacea.

If the motivation for including ESG targets is creation of long-term shareholder value, boards should consider whether other pay reforms, such as simplifying and lengthening the time horizon of pay could achieve the same objective. Or whether publicly committing to, and reporting on, targets would be as effective.

If a board decides to include ESG metrics in pay in support of shareholder value, then the focus needs to be on ESG dimensions that are material to the company. And they should be alert to potential unintended consequences: distorting incentives, hitting the target but missing the point, measurement and calibration challenges.

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?

Whatever the motivation, any ESG incentives should be aligned with strategy, focused on the most material issues, use clear and understandable targets, and be genuinely stretching to achieve in full.

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.

The complete publication, including footnotes, is available here.

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