ESG & Executive Remuneration in Europe

In our article ‘ESG and Executive Remuneration in Europe’, forthcoming in the European Business Organization Law Review, we provide a qualitative and quantitative analysis of the trends in executive remuneration tied to ESG parameters among the 300 largest companies by target capitalization in Europe, as listed in the FTSE EuroFirst300.

The relevance of sustainability has grown exponentially within society and financial capitalism. Key concepts such as stakeholder capitalism and sustainable finance have greatly contributed to the contemporary debate on the role of financial markets and corporations. In this context, the role of managers and their duties towards shareholders and society at large remain subjects of ongoing discussion. As part of these conversations, executive remuneration and its role as a catalyst for the adoption of sustainable practices within corporations have become focal points in debates surrounding sustainable corporate governance. An increasing number of listed corporations have begun to devise new ESG metrics and targets with the aim of implementing more structured forms of ESG compensation within the overall executive compensation package. Therefore, incentives are increasingly oriented to long-term value maximization, which should allow companies to satisfy stakeholder interests in the long run, while maximizing shareholder value. Furthermore, parts of the incentives are often linked to ESG metrics, such as either the company’s impact on climate change and other environmental issues, or its impact on employees’ welfare and society in general. Recent scholarship has casted doubts on these practices, emphasizing a relevant lack of effectiveness surrounding the first observable developments. According to this line of thought, ESG compensation is not an exception as similar problems have emerged in other ESG-related contexts, particularly in the areas of ESG ratings and data providers, and of portfolio structure.

To better understand the developments concerning executive compensation and ESG, our article proposes both qualitative and quantitative analyses. Firstly, it highlights the key issues related to executive compensation and contextualizes them in different periods of time, briefly considering how remuneration practices evolved and their relationship with corporate governance theories, spanning from the traditional idea of shareholder value maximization to more progressive approaches such as shared value and social value primacy. Furthermore, the article offers a quantitative analysis of how major corporations in Europe are integrating ESG factors in their remuneration policies. It analyzes all the companies of the FTSEurofirst 300 Index, which includes the 300 largest companies ranked by market capitalization in the FTSE Developed Europe Index. The hand-coded dataset identifies specific parameters in the different ‘E’, ‘S’ and ‘G’ contexts, considers their impact on executive compensation and looks more precisely into plans to implement long-term incentives as well as to change the structure of compensation, with an emphasis on fixed versus variable compensation. Consistent with other areas of ESG finance, the data suggest a lack of clear patterns emerging from corporate practice, highlighting the need for consolidation even in this context. Finally, in commenting on the data emerging from the dataset, the article proposes some policy recommendations.

Consistent with the findings on S&P 100 North American companies, data would suggest that companies are converging towards similar strategies in identifying key stakeholders. ESG targets and metrics for remuneration exclusively focus on specific stakeholders, such as employees, customers and, more generally, the environment and local communities, addressing their respective needs and interests. This may be surprising as one would expect the emergence of multiple diverging strategies, even as part of a broader ESG business strategy, due to the uncertainties surrounding ESG-related matters. One potential criticism could be that European companies’ executive remuneration policies fail to fully capture the complexities associated with stakeholder capitalism, in the sense of considering the heterogeneity of stakeholders as a class. However, an alternative and more optimistic view would be to consider the novelty of these practices and the challenges in accurately defining their core elements. From this point of view, the identification of limited stakeholder groups and their related narrow interests can be explained by the argument that corporations have taken a pragmatic approach. They are cautious not to set overly ambitious targets and only highlight the most relevant stakeholders in their remuneration policies. By carefully identifying the most relevant stakeholders and taking into account their most relevant dimensions, each company contributes to an effective representation of stakeholder capitalism, where a plurality of stakeholders exist. In doing so, each company more concretely and directly engages only with the most relevant categories of stakeholders, rather than creating a general engagement with stakeholders, which would be unrealistic and impossible to implement.

Considering the time horizon of ESG metrics, the data show that 91 companies (61.90% of the sample) tie short-term incentives to ESG performance; 37 companies (25.2%) tie both long-term and short-term incentives to ESG performance; the remaining 12% connect only long-term incentives to ESG performance. The alleged long-term orientation of stakeholder capitalism would suggest a prevalence of long-term incentives tied to ESG. However, some ESG-related targets may not necessarily require a long-term horizon to be implemented, such as equal gender representation on boards of directors and in management. On the contrary, more complex targets, such as shifting the business model to zero emissions, may require a multi-year business plan for implementation. The prevalence of short-term incentives is a crucial aspect of ESG compensation. Indeed, the creation of short-term incentives does not necessarily conflict with the pursuit of ESG-related goals or the establishment of sustainable practices within complex business organizations. Not all targets require a long-term time horizon; even those that necessitate a multi-year strategy for implementation can be broken down into micro-stages to achieve in the short term. Therefore, the creation of short-term incentives for pursuing this goal makes sense and, to some extent, should be encouraged as a good practice which is functional to a long-term strategy directed at limiting or eliminating gas emissions. Furthermore, short-term targets and metrics could contribute to mitigating the problems generated by their frequent vagueness. In fact, short-term objectives can be more easily monitored, assessed, and corrected if needed, than long-term ones.

Despite focusing on specific stakeholders and selecting narrow sub-interests, the adopted ESG targets and metrics are generally not easily reviewable and comparable. They often lack clear and objective goals, so that it is difficult to understand the reasons for adopting these metrics and targets, while companies fail to disclose outcomes and provide relevant contextual information. The lack of measurability and, as a direct consequence, reviewability can be analyzed through two different approaches, prompting important questions regarding the financialization of sustainability and its limits. The first approach views the lack of external reviewability as a major issue, contributing to the amplification of traditional agency problems. This absence of external reviewability would result in reduced transparency and increased information asymmetry concerning boards and executives. Ultimately, it could lead to an increase in boards and managerial discretion, posing a threat to an effective shift towards sustainable strategies within business organizations. An alternative approach is to question whether the establishment of discretionary mechanisms for directors and executives, alongside the partial lack of external reviewability, is inherently negative. In many jurisdictions, the business judgment rule – or similar mechanisms – empowers directors and managers with the discretion to take business decisions. Executives, being insiders, find themselves in a position to implement the best business strategies. If ESG-related matters are an increasingly important component of business strategy, it should be deemed acceptable to extend a similar level of discretionality to ESG-related problems and strategies.

A more general consideration pertains to the nature of ESG targets and metrics for executive compensation within the debate on stakeholder capitalism. A first question is whether precise ESG targets and metrics for executive compensation are the most effective way to drive managerial change in corporations. This aspect is linked to a fundamental issue, namely, the overreliance on financial approaches and methodologies to explain the shift towards stakeholder capitalism or new paradigms implementing an alternative view to shareholder capitalism. Is transposing such financial approaches to the area of stakeholder capitalism the most effective method for elucidating and monitoring the intricate transformations affecting the social dimension of corporations? Indeed, it is questionable whether this conventional financial approach would be suitable to properly emphasize other, more complex considerations concerning the necessity of undertaking a profound cultural shift within business organizations. If the priority is contributing to the implementation of a cultural shift, even vague and difficult-to-measure targets would be important for triggering more critical approaches to traditional business culture, potentially leading to even more fundamental changes in the long run. As a result, ESG metrics and targets in remuneration policies would provide guidance for managers in their decision-making, particularly at this early stage of development characterized by uncertainty in measuring ESG factors. This is consistent with a view on the function of executive compensation, which is no longer solely about incentivizing executives to maximize value for shareholders, but also about incentivizing them to create social value. This result is achieved by linking the measure of compensation not only to the financial performance of the company but also to its social performance. If a substantial part of the compensation is linked to the creation of social value, executives are specifically incentivized to pursue sustainability objectives as well.

Policy options

The goal of capturing the complexity of stakeholder capitalism by enlarging the number of constituencies to consider for remuneration purposes is not necessarily the best long-term objective for corporations and regulators. Policy makers could promote a debate aimed at guiding corporations towards the adoption of the best ESG metrics in executive compensation, depending on their activities, leading to the identification of specific stakeholders and dimensions realistically connected to the context where they operate.

A major issue is standardization. Standardization could be a formal advancement, but what matters most is external reviewability. To pursue this goal, business organizations would need to better justify and contextualize the adoption of their targets and metrics. If the priority for regulators is to achieve higher levels of standardization, which might enhance measurability, comparability and reviewability of managers’ practices, ad-hoc disclosure mechanisms should be created. This could be a way to enhance homogeneity within the field and foster stronger private initiatives that pursue the same goal of standardization.

Looking at the lack of reviewability and measurability at the level of remuneration policies, it raises the issue of establishing independent external review mechanisms for ESG practices. This could involve enhancing the role of external auditors or advisory bodies to objectively assess companies’ ESG metrics and targets. An increasingly prominent role by established and properly independent market actors in this area would contribute to the establishment of corporate governance practices, bringing clarity in multiple areas. The current financial and regulatory debate on ESG ratings and data providers will be beneficial under many respects, and it will contribute to fostering ESG-related corporate governance matters.