Paying Well By Paying for Good

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

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

The need for businesses to take action on ESG issues is a given. Companies recognise that addressing climate risk or improving product sustainability will be critical to unlocking shareholder value growth, and shareholders and society at large expect companies to play their role in tackling the pivotal issues of our time. Pay should support these goals. But aligning pay with ESG won’t always require inclusion of ESG metrics in pay.

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

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).

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

Putting ESG targets in pay can communicate priorities and commitment internally and externally

Incentive targets can provide a clear indication of where a company is placing its focus and what it expects to achieve. Financial performance targets have long been seen by investors as a good guide to performance expectations. In the same way, ESG targets in executive pay can send a powerful signal about a company’s ESG intentions. Setting ESG targets in pay can be a way of mobilising the organisation to shift the dial on an important priority.

The long-term share price is a less potent incentive further down the business

Employees below the most senior tiers of management often feel less able to directly impact share price. For these employees, the alignment between long-term shareholder value and ESG may not be an effective incentive to take action that conflicts with the short term financial targets they have been set—meaning companies may wish to include specific ESG goals for these employees. Consistency, fairness and the importance of “setting the tone from the top” may therefore demand that executive incentives also include ESG.

ESG can sometimes take too long to show up in share price for lengthening the time horizon of pay to create an effective incentive

For many important ESG issues the market is only slowly efficient, and these factors may take a number of years to show up in share price. Because Boards must compromise between these long-term horizons and realistic CEO requirements about when they get paid, it is not always possible to use deferred share awards with a time frame long enough for ESG to be fully reflected in the stock price.

ESG issues can represent tail risks which may not be well captured by typical incentives

Ignoring some ESG issues can result in higher profits and shareholder value for a period of time. But there is a risk that, if ignored, ESG issues will result in sudden tail events with cataclysmic business and reputational consequences—think health & safety. An ownership model based on long-term stock may address this, but traditional incentives, focussed on shorter term metrics, may not be well placed to address these risks, and a counterbalance to ensure such ESG factors are considered may be justified—creating alignment not just to profit, but to how it was achieved.

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

Businesses may have an interest in showing they are on board with the big societal issues of the day. The “rules of the game” as defined by society go beyond the rule of law. This may be reflected in governance codes, voluntary initiatives, or simply reading the runes. Doing the right thing is important, and quite often the consequence for failing to do so is a loss of custom or of talent. Society will expect companies to take actions that might not immediately show up in share price, and there may be times when companies want to demonstrate their commitment to societal goals through how they set incentives.

Shareholder preferences may extend beyond financial value creation

Shareholders may have preferences that extend beyond shareholder value. This may relate to desire of investors to make socially responsible investments, the desire to support minimum labour standards or diversity goals, or where a shareholder wants to reduce carbon footprint across their portfolio. Often this can conflict with the pure shareholder value maximisation objective in a company—such as where an investor’s best bet to reduce overall portfolio carbon footprint is the reduction of emissions in an Oil Major, even where this results in lower profits from that holding. In these cases, it can make sense for ESG measures to be included in executive pay to align to these non-financial shareholder preferences. Where shareholder preferences are used as the justification for including ESG measures, it’s important to have a mechanism for collecting those preferences, especially given that views may differ between investors.

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

Where an ESG initiative is aligned to the declared purpose of a company, there is a rationale for this to be embedded in executive pay. Purpose must flow through every facet of an organisation, from day-to-day behaviours in the workforce, interactions with customers and the priorities of the CEO. If ESG is critical part of purpose, then it may be appropriate to feature it in executive pay.

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

ESG can be difficult to measure reliably. The lack of consensus on how to assess ESG has led to a proliferation of KPIs. The same company can be scored very differently by different assessors even on the same ESG dimension. It is difficult to strike the balance between being overly simplistic and excessively complex.

ESG targets can be hit while the point is missed

For example, hitting a board level gender diversity target while doing nothing to address management diversity or the gender pay gap may even be counterproductive by distracting attention from the fundamental issues. ESG goals will have qualitative dimensions that can rarely be captured in ESG metrics.

ESG targets can distort incentives

Setting pay targets for ESG can crowd out intrinsic motivation. And if a company has multiple important ESG dimensions then including just some in pay risks distorting management focus.

ESG targets are difficult to calibrate and assess

Non-financial and strategic incentive targets consistently pay out more than objective financial measures—by around 10% points on average. This suggests difficulties faced by boards with robust calibration of targets.

Executive pay is complicated enough already

Adding ESG targets to already multi-dimensional packages adds another layer of complexity with all the unintended consequences that may arise.

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.

How to do it

For boards that decide that ESG measures should be included in pay, there are four key design dimensions to consider.

1. 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.
2. 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.
3. 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.
4. 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.