ESG & executive pay: A look inside the trend
ESG & executive pay: A look inside the trend
The social dimensions of ESG (Environmental, Social, Governance) have received a lot of attention in the last two years. As the world was put on lockdown by the global COVID-19 outbreak, the focus of ESG discussions shifted from an environmental to a social agenda. During the pandemic, companies were scrutinized for how they handled employee health and welfare. And the emphasis on social issues intensified even further after the death of George Floyd sparked a movement for racial justice.
The polarization of race and gender isn't the only source of inequality in today's society. The pandemic worsened economic wealth gaps, resulting in substantial pay discrepancies between workers and executives, for which companies have been increasingly criticized.
The Economic Policy Institute found that CEO pay has skyrocketed 1,322% since 1978. In 2020, CEOs were paid 351 times as much as a typical worker, a year when 114 million jobs were lost due to the COVID-19 pandemic. This surge in CEO pay has aided the expansion of the incomes of the top 1%, leaving less economic growth opportunities for ordinary workers and widening the income gap between the top 1% and the bottom 90%.
As a result, many are advocating for policy changes that would both reduce incentives for CEOs to extract economic concessions and limit their ability to do so, for example, by reinstating higher marginal income tax rates. Linking CEO pay to ESG targets is another strategy that has gained traction in recent years.
In 2021, a report by PricewaterhouseCoopers, the London Business School, and the Centre for Corporate Governance at Copenhagen Business School sought to dig deeper into this issue and explore what market practice and academic research have to say about linking executive pay to ESG.
Spoiler: the answer is not so simple.
Linking executive pay to ESG goals
Public companies from all sectors are adopting ESG agendas to address the mounting pressures of environmental challenges and social injustices at a corporate level in order to remain competitive and highly regarded, both externally and internally.
Sustainability achievements and ESG strategies are now frequently recognized alongside traditional key performance indicators (KPIs). According to the Governance & Accountability Institute, 92% of companies in the S&P 500 Index issued sustainability reports in 2020. And a recent global survey by Willis Towers Watson found more than three-quarters of board members and senior executives said strong ESG performance is a key contributor to financial performance. So, it’s no surprise that the report found 45% of FTSE 100 companies now have an ESG measure in executive pay.
Many well-known companies have announced linking ESG targets to executive pay over the past two years, including Apple, BP, Chipotle, McDonalds, and Starbucks.
- In January 2021, Apple revealed that, based on progress toward its ESG targets, it aims to enhance or decrease executive incentives by up to 10%. Without explicitly specifying which measurements will be utilized, the tech giant also recently announced a new net zero promise, a goal likely to be connected to executive incentives.
- The annual incentive for BP executives is determined by a performance scorecard that includes an environmental goal. In 2020, BP boosted the environmental target's weighting from 10% to 20%.
- Chipotle Mexican Grill stated in March 2021 that it has created a new metric linking executive compensation to ESG targets. The company's progress toward meeting its sustainability targets will be linked to 10% of officers' annual incentive bonuses.
- In 2021, McDonald's included diversity goals in its executive compensation. By 2030, the fast-food conglomerate wants to achieve gender parity in leadership and plans to increase the number of executives from underrepresented groups to 30%.
- Starbucks CEO Kevin Johnson stated in an October 2020 letter to employees that the company would "hold ourselves accountable at the highest levels of the organization" by linking executive pay to the success of the company's inclusion and diversity efforts "effective immediately." By 2025, the corporation wants BIPOC representation to be at least 30% at the corporate level and 40% of all retail and manufacturing roles.
By linking CEO salary to ESG performance, companies hope to hold their executives accountable, demonstrate their commitment to sustainability, and fulfill significant investor demands. But does it work?
The larger picture
Including ESG metrics in executive pay packages is a tangible way to address sustainability goals; however, it’s not without its challenges. As companies seek to tie CEO compensation to ESG, they run several risks. The Journal of Economic Perspectives reported that incentivizing pro-social goals can undermine intrinsic motivation. Or focusing on a narrow aspect of an ESG issue, such as C-suite diversity, could distract from reaching a broader objective, such as an inclusive company culture.
There’s also a calibration risk. Pay needs to follow strategy, not drive it. A strong strategy requires company-wide insights and a board willing to set unconventional and sometimes uncomfortable targets. A company must first understand the purpose and practicality of its ESG metrics before linking those goals to CEO incentives.
The report encourages boards and investors to address some key questions as part of the journey to integrating CEO pay and ESG objectives, such as:
- Why are we considering including ESG targets in pay?
- Why is it necessary to measure ESG separately if it is aligned with company strategy and long-term value?
- Why is ESG rewarded rather than being a requirement for an executive to stay their job if it defines a company's license to operate?
- Have we considered and mitigated the risks of including ESG targets in pay?
- Are our chosen ESG measures aligned with strategy and focused on the big issues?
Putting ESG targets in pay can raise significant difficulties. The potential implementation challenges are significant and may outweigh the benefits. Companies and boards also need to think about which quantitative measures to use, which may not be clear. For example, should a company use:
- Specific ESG targets that can be hit while the wider ESG goal is missed?
- ESG targets that can distort incentives and crowd out intrinsic motivation?
- ESG targets that are difficult to calibrate and assess?
The other question to consider is: does linking CEO compensation to ESG goals satisfy investors? The answer is: not always. The rationale for linking ESG targets to pay could be about more than just maximizing shareholder value.
For example, a company may want to align with societal expectations that do not directly link to share price. Or shareholder preferences may extend beyond financial value creation. Ultimately, companies may be required to take steps that go beyond shareholder profit as they focus on their purpose and demonstrate a contribution to society.
Designing ESG remuneration
As leaders and remuneration committees wade through these challenging questions and considerations, the PWC report offers four dimensions to keep in mind when including ESG measures as part of pay.
Internal & external targets need to be aligned to the company’s strategic priorities, and the company needs to be able to collect, analyze, and communicate the data that shows whether targets have been met. Internal targets, such as investments in green technology, are used by companies to benchmark themselves. The activities that lead to a stakeholder outcome are measured, rather than the outcome itself. External targets are based on output metrics, such as total emissions produced or staff engagement scores.
When it comes to keeping track of and monitoring progress against ESG targets, individual KPIs & scorecards are critical. A holistic approach to ESG is most powerful, even if a company has a few crucial ESG issues that stand out above the rest, such as a net zero commitment. Broad considerations such as diversity and inclusion, employee welfare, supply chain issues, and environmental impact are all part of a solid ESG strategy. To keep track of benchmarks and targets, they should be carefully established and use an openly published scorecard.
Companies must decide whether to use a long-term incentive plan (LTIP) or an annual bonus. Because of their long-term focus, several environmental goals align better with an LTIP. However, some ESG goals, such as health and safety objectives and even gender pay targets, can be effectively assessed in a single year. In either case, setting aggressive, well-calibrated, one-year goals is preferable over imprecise long-term goals.
Lastly, it’s critical to identify how to determine success. Companies must be clear about baseline targets vs. stretch targets. Some metrics should be regarded as obligatory. The healthcare industry, for example, may require that health and safety objectives be satisfied to the bare minimum. In such cases, failure to meet these criteria may result in bonus reductions rather than a road to larger payments. In other circumstances, ESG targets will require performance scales to be developed, particularly if the CEO must reach a high and difficult level of accomplishment. This is especially true when it comes to revolutionary goals such as lowering emissions.
Moving forward with ESG pay incentives
Setting and achieving ESG goals benefits society and the environment as a whole and has been shown to increase a company's financial and reputational worth. As society and investors demand that businesses be held accountable to a broad range of stakeholders, tying ESG objectives to executive remuneration appears to be a sensible next step. It must, however, be done with care and attention because it is difficult to execute effectively.
ESG materiality assessments
With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.
An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.