Linking Remuneration To ESG audio version  |  12 mins  |  Listen now

Long before it became a recognisable acronym, ESG used to be the icing on the cake for traditional CEOs; something nice to have, as long as it didn’t get in the way of making the profits that generous incentive schemes would translate into the lucrative bonuses and share options that many saw as their birthright.

Now remuneration experts Alvarez & Marsal say a majority of FTSE350 companies use ESG criteria as well as profits growth to help determine annual bonuses and long-term incentive plans.

Accountants PwC say the proportion of FTSE100 companies including some sort of ESG measure in their executive incentive pay plans rose from 45 per centin 2020 to 58 per centin 2021.

Global businesses including Apple, Royal Dutch Shell, BP, Volkswagen, Unilever and BMW have tied board members’ salaries or bonuses to such key performance indicators (KPIs), while 66 per cent of investors told PwC that ESG performance measures should be used to help set executive pay.

The hope is that hitting executives in the pocket will be the spur they need to taking actions to help achieve the United Nations Sustainable Development Goals, mitigating the effects of climate change and delivering social justice across societies. And it may not end there, with some ESG experts predicting that the pay of all workers will one day be at least partly determined by how much they have striven to save the world.

‘There are certainly benefits to linking executive pay to ESG goals but achieving these goals often requires engagement by a company's or institution's entire workforce, so an ideal system would offer bonuses or incentives to all employees when certain ESG metrics or objectives are met,’ says Jacob Appel, director of ethics education at New York’s Icahn School. ‘Even a small incentive in this regard can go a long way toward changing workplace and institutional culture.’

Frank Krikhaar, head of ESG at communications consultancy Camarco, who has spent more than a decade advising companies ranging from Swiss bank UBS to energy group Tullow Oil and supermarkets chain Sainsbury’s on sustainability, adds that linking all levels of pay to ESG performance is a ‘useful tool’ in the corporate arsenal if a company wants to accelerate its sustainability performance.

‘It incentivises teams across all levels in the company to further embed ESG into their decision-making and is also a strong signal to external stakeholders, specifically investors, who see it as a sign of a mature and strategic approach to ESG,’ he says

‘It can be helpful to show that pay is aligned to the values of a company. Embedding ESG in remuneration decisions helps companies address the big issue of how to operationalise an ESG strategy and targets. It aligns everyone towards the same outcome and impacts.’

For communicators, this development could be a double-edged sword. The most senior advisers have long lamented that it is they who often must point out disconnects between pay and performance in the C-suites of their corporate clients.

The same communicators are then called upon to defend wage freezes, job cuts and other austerity measures. Now they face having to explain to both their masters and the rank and file that their financial well-being may depend on compliance with sustainability measures, gender and race diversity ratios and progress towards achieving Net Zero carbon emissions.

Narda Shirley, founder of Gong Communications, sees problems ahead. ‘Because of the growing reputational fears around greenwashing, we are starting to see a lot of clients thinking about linking ESG performance to executive pay to demonstrate that they are serious about the commitments they have made to get to Net Zero,’ she says.

‘As this practice becomes more widespread, it will become an expected hygiene factor rather than a serious differentiator, particularly among listed companies whose investors are scrutinising Net Zero transition pathways more closely and even threatening to divest where they are unconvinced of serious intent.

‘The danger is that unless people are given the levers to pull that can determine ESG performance and the mandate to act, the practice will become a way of scapegoating poor performance.’

James d’Ath, director of ESG at financial analysis provider Edison Group, sees the development as part of the movement away from using the enhancement of shareholder value as an all-defining measure of corporate progress.

‘Certainly, with large companies, an increasing number are using ESG performance as a measure in executive pay,’ he surmises. ‘Is this a move away from shareholder capitalism to stakeholder capitalism? Possibly. We saw that come through a few years ago, redefining the purpose of a company to focus more on serving all, rather than just focusing on shareholder returns.

‘Many companies now acknowledge that this is the right thing to do, whilst there is also increasing pressure from society to make businesses more accountable. But in some ways this acknowledgment is the easy part. The hard part is initiating a system that connects executive pay to ESG in an effective and genuinely impactful way.

‘Boards need to understand a company's specific intersect between sustainability and financial performance. This will require them to examine their operations and be able to identify where to and justify why they are assigning certain key performance indicators and targets.’

Perceptions have definitely changed in the City. Asset manager Schroders now links fund manager and analyst remuneration to sustainability goals as part of a new company-wide ‘engagement blueprint’, while Germany’s Allianz Global Investor announced in February 2022 that it will vote against major companies that fail to link their executive salaries to ESG metrics. BlackRock, the world’s largest asset manager, has vowed to put sustainability at the heart of its investment decisions.

Jared Dubey,senior managing director at Athos II Holdings, a New York-based firm with holdings in sectors ranging from technology to energy and healthcare, says: ‘It would be interesting to see executive pay, particularly executive performance shares, linked to ESG goals in an internal ranking system against which executives get performance-linked options for placing higher than their industry competitors.

‘Similar programmes are already in place for metrics such as revenues and sales, with executives at some firms getting options for shares worth up to ten times their salaries, based on performance rankings.

‘It would need a third party such as one of the big four accountancy groups to compile and monitor the rankings, but they could be a strong incentive to transform businesses from the executive level, provided that the ESG goals are legitimate.’

That could be a sticking point. ‘It’s a good idea to make ESG a component of the formula for calculating executive pay,’ says Matthew Bishop, the former Rockefeller Foundation director and author of Philanthrocapitalism: How the Rich Can Save The World. 

‘If delivering ESG targets is rewarded, it is more likely to be prioritised. However, it underscores the need to make sure ESG goals are meaningful, not just hype, and aligned with the long-term goals of the company.’

The key, says Appel, is to be clear about what the ESG goals and metrics are and to make sure that they are beneficial. ‘You don't want to create situations where institutions are incentivised to meet ESG goals in one area at the expense of doing damage or creating externalities in another,’ he says.

‘For instance, you don't want a company to strive to reach certain environmental metrics through engagement with regimes involved in human rights abuses. Being able to agree on specific ESG goals, and the right goals, is crucial toward making such a system work.’

Jamie Plotnek, director and head of ESG at strategic communications consultancy Hawthorn Advisors, believes that this starts with acknowledging that making progress towards long-term ESG targets can sometimes be directly at odds with immediate profit and growth goals, which are often weighted more heavily in bonus structures.

‘Today's bottom line usually beats a brighter tomorrow,’ he says, ‘so the structure for targets, measurement and accountability need to be considered carefully. If climate goals don't cover the full value chain, there is a temptation to outsource your direct emissions to third parties.

‘When you are considering more qualitative metrics, such as those related to negative social impacts like supply chain labour rights, there could be a temptation not to look too closely into the issue.’

Unfortunately, however, ESG is an area that finds it difficult to be specific. Richard Cook, managing director of Champion Communications, defines the sustainability holy grail as ‘building ESG into the DNA of businesses’.

‘Executive bonuses are often an element of this,’ he admits, ‘but actually we see the most successful examples are when organisations have it built into their culture so that diversity, inclusion and sustainable practices influence decisions, products and services.’

Given, which styles itself as ‘the agency for purpose-driven brands’, praises NatWest Group’s scheme to link purpose performance to incentives for senior management in its latest Insider’s Guide to Purpose as an example of its belief that delivering genuine change needs to be linked to executive rewards and long-term incentives.

An active and visible leadership is needed to make things happen, argues director James Edney. As role modelling and a consistent narrative aren't enough, a link to ESG performance shows an additional level of commitment and is a signal to investors that environmental, social, and governance issues are taken seriously at the most senior level. However, relevance and accuracy are crucial for that link to be effective and meaningful.

‘When that link is made to executive pay,’ says Edney, ‘it needs to be to the most material impacts that a business has. It isn't enough to link performance in generic ESG metrics to executive pay. Accuracy of performance has to underpin everything.

‘Even something as established as measuring carbon is fraught with difficulty for large complex businesses when assessing Scope 3 emissions, where often their biggest impacts will sit. Linking ESG performance to executive pay is an important and powerful tool, but it needs to measure what is most material, and it needs to measure it accurately.’

Such measurement is far from uniform. Krikhaar complains that transparent data on companies’ ESG performance is not always available or reliable, particularly at the beginning of the ESG journey. There can be so many possible ESG data points, that it becomes relatively easy to find easily achievable targets and linking these to executive pay can have the opposite effect to the one that’s desired.

He says communicators can help by ensuring that relevant ESG performance data points are shared in context and providing detail on the calculation of the remuneration decisions.

‘There are several core ESG data points that have emerged as generally agreed indicators of performance and most companies will be able to fairly accurately measure these ESG KPIs,’ he says.

’However, except for some environmental indicators, there is not yet a global standard for measuring, calculating and disclosing these ESG metrics, which leaves scope for confusion. Better measurement is required to ensure we’re not comparing apples and oranges.’

Until then, carrots and sticks may be a better metric if we are to really say goodbye to Welch’s world and begin to put a higher value on the preservation of our environment and society.

After all, even ‘Neutron Jack’ described shareholder value as ‘the dumbest idea in the world’ in a 2009 interview. Putting a price on the planet that’s paid from the pockets of its people may be one of the smartest.