Commentary

ESG and Corporate Pay: A Measure of Intent

Alberto Lopez Valenzuela, Founder and CEO of analytics solutions provider alva, says rigour and transparency are essential when aligning pay with ESG performance.

Activism used to be a word associated with the disgruntled fringes of society. Today, it is just as likely to be uttered in the boardroom. Corporate activism has become commonplace, which is just one reason why businesses are taking ESG policies increasingly seriously.

Thanks in part to the pandemic’s impact on so many aspects of life, the business world is facing a renewed focus on the environment, and social issues around inequality and racism. Activism around movements such as Black Lives Matter has sent a stark message – people will no longer put up with the status quo.

Take the world’s biggest asset manager, BlackRock. Last January it announced that it would give the same weighting to ESG reporting as it has to traditional financial reporting, and that it would vote against those companies who failed to meet standards.

This policy became manifest when it was revealed that BlackRock had voted against shareholder resolutions around climate change 80% of the time in 2020. The company identified 244 companies making insufficient progress towards combating climate change. It took shareholder voting action against 43 of them and put the remainder ‘on watch’.

The business case for accountability

It is clear that this is more than being seen to be doing the right thing from an ethical standpoint. There is a business case to make directors more accountable, with a growing emphasis on rigorous ESG reporting that’s numerically tied to executive remuneration.

Pay-related ESG policy is becoming more commonplace – law firm Macfarlanes recently researched FTSE 100 companies and revealed that 35 of the firms had disclosed that ESG factors had a tangible impact on executive pay. Of those, 23 had included it in their short-term bonus awards, four had included it in their long-term incentive plan and eight had included it in both.

There is a shift towards a more concerted approach, with firms embedding environmental targets into corporate culture and tying them more substantially to bonuses and long-term incentive schemes.

According to research by Willis Towers Watson, four out of five (78%) companies are planning to change how they use their ESG measures in executive pay plans for the next three years; 41% plan to introduce ESG measures into their long-term incentive plans, while 37% intend to introduce measures to their annual incentive plans.

The latter is evident at tech giant Apple, which has adopted greater rigour around ESG targets. From this year, management annual bonuses will go up or down a not-insignificant 10%, depending on whether or not ESG-linked KPIs are met.

Meanwhile, according to PwC, 35% of FTSE 100 companies include an ESG performance measure as part of incentives, 27% include an ESG measure in the annual bonus and 13% intend to use a measure in the long-term incentive plan.

Achieving ESG alignment

But aligning ESG with incentive plans is no easy matter. Willis Towers Watson noted that more than half (52%) of businesses deemed target setting to be among the greatest challenges, while 48% cited performance measurement identification and 47% cited performance measure definition.

So how do companies go about tying ESG performance to executive pay? The overriding advice is to align ESG targets with strategies and goals already woven into your business. Start simply, by measuring something already in place, and build out from there.

Setting targets is clearly a challenge. Some are more easily measurable on an annual basis, such as putting a diversity policy into place, or hitting employee wellbeing targets. From a pay perspective, these can be tied into annual bonuses. However, others are longer term and might have an ultimate outcome, such as cutting emissions entirely, or reducing fossil fuel consumption across the business. These are the sorts of target that should be linked to longer-term incentives.

Rigour and transparency are essential. ESG targets need to be as measurable as financial targets, preferably using audited numbers – a language shareholders can identify with – based on established standards.

But there are many areas of ESG activity that aren’t represented in easily reportable figures, don’t have generally accepted measurement criteria, or which defy clear definition.

Furthermore, the importance and prevalence of different areas of ESG activity varies from sector to sector and indeed from company to company. There is a huge risk that many companies will be oversimplifying their ESG reporting to just what can easily and consistently be measured, rather than what actually matters.

Challenges ahead

What is needed is an objective, reliable system of scoring that can accurately, consistently assess how different stakeholders perceive a company’s ESG credentials – and represent those credentials in a useful way.

Clearly, there are major challenges ahead if business is to truly incorporate ESG into corporate strategy and link it to remuneration. Businesses cannot afford to ignore mounting stakeholder pressure.

It is only reasonable that business leaders reap the benefits should they succeed, but suffer penalties should they fail. By linking pay to ESG, performance itself becomes another, very significant measure – one of seriousness of intent.

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