The Concept in Brief

Linking environmental, social & governance (ESG) performance to executive remuneration is a recent trend in the governance space, especially in Europe. The underlying philosophy is that rewarding company managers for their contribution to achieving company ESG targets will improve performance; however, the concept is still unproven, and whether and to what extent it improves sustainability performance remains unclear. Implementation is not an easy task either, and other approaches would be more impactful.

• The investor community is now increasingly looking for board and other top executive compensation to be linked to corporate performance on ESG criteria.
• In order to meet the objectives of the exercise, ESG measures linked to pay must be challenging and long term, measurable and auditable, and clearly connected to an appropriate executive compensation program.
• More work needs to be done by all stakeholders to understand the impact of ESG compensation on corporate culture.

This report explains not only the “why” but also the “how” and identifies some of the drivers for firms to link ESG metrics to pay; potential benefits and drawbacks; and, when companies decide to introduce or expand their use of ESG metrics, three principles to consider as they design their remuneration program.

Insights for What’s Ahead

Some firms view linking executive compensation to ESG performance metrics as one way to highlight their commitment to their sustainability goals and to focus senior executives on their role and responsibility in delivering on these ambitions. But while doing so, companies should carefully structure this integration such that it will measurably improve the company’s sustainability performance—and not result in negative unintended consequences. For example: if ESG metrics are not ambitious enough, they could incentivize executives to improve the performance of relatively easy to achieve or quantifiable metrics and discourage them from focusing on other significant, but hard to quantify, dimensions of sustainability performance. Also, companies run the risk of rewarding their executives despite the overall dismal performance of the company if metrics are not aligned and meaningful. Companies should weigh the potential benefits and risks of incorporating ESG metrics against their own ambition and culture before making any decisions. If they decide to incorporate ESG metrics, there are practical steps, outlined in this publication, to ensure a credible and transparent compensation program.

• There is and will continue to be pressure on public companies to incorporate ESG measures into their executive pay programs. An increasing number of investors (e.g., Allianz Global Investors, Legal & General) are calling for ESG inclusion into executive remuneration. Regulatory proposals in the EU (e.g., Shareholder Rights Directive II) are going in the same direction. Businesses cannot ignore these changing expectations, but before they jump on the proverbial bandwagon, compensation executives should engage in constructive dialogue with stakeholders to create the freedom and space to decide what is most appropriate for long-term sustainability performance.
• Due to limited evidence, the link between improved ESG performance and remuneration is not definitive, so companies should carefully decide how to introduce or expand their use of ESG measures in incentive plans. There are diverging views on the usefulness of ESG measures in executive pay both in the academic world and the investor community. Companies should evaluate these pros and cons against their own ambition and culture to decide potential changes to their remuneration system.
• When companies decide to link ESG metrics to executive pay programs, they should consider three prerequisites for a credible and transparent compensation program to avoid the risk of being accused of a tick-the-box mentality or “greenwashing” (providing false or misleading information about sustainability impact):
  • Material issues linked to strategy Companies should focus on the specific and measurable issues that are most material to the company in terms of business relevance, stakeholder relevance, and impact on sustainable development. These will vary by industry and by company.
  • Balance long-term and short-term incentives To be credible, ESG measures linked to pay targets must be challenging and long term. Payout despite nonperformance in the short term, especially in this context, may lead to increased scrutiny and backlash from stakeholders. Companies might have to review their payout system to strengthen the long-term delivery of ESG goals.
  • Measurable and auditable Companies must consider how to report on the specifics of ESG-linked remuneration—weighting, achievement, and outcomes—taking into account any disclosure requirements to which they are subject. A reliable and audited reporting system provides the necessary checks on whether ESG targets linked to renumeration have been achieved.

Long Story Short

Business leaders need to engage in thoughtful dialogue with their investors and other core stakeholders to decide whether ESG-based pay will help the company achieve its short-term and long-term sustainability goals and how it may be counterproductive—for example, in the absence of a materiality analysis or lack of due diligence in making sustainability claims.

Key questions:

• What is in the best interests of all the business’ stakeholders—would ESG metrics help or hinder the business’ ability to serve all its stakeholders?
• Is management already held accountable for prioritizing sustainability practices through the current strategy, culture, and business processes, or is something more needed?
• Is there a clear enough line of sight from ESG initiatives to business results and stakeholder value creation, or would linking ESG metrics to executive pay provide greater clarity?