Is Greed Good When It’s Green?

A new FCA discussion paper paves the way for closer links between sustainability objectives and executive remuneration. 

Investors’ efforts to encourage companies to tie ESG and sustainability-related targets to their executive remuneration plans appear to be bearing fruit.  

A recent report by investment consultancy firm WTW noted that 77% of major companies across the US and Europe (including the UK) now include ESG metrics in either their annual or long-term incentive plans (LTIPs), up from 69% in 2022. Further, 37% of assessed UK-based companies incorporate ESG-related measurements into their LTIPs and almost two-thirds include environmental metrics in their schemes.  

“Fundamentally, incentive structures send a strong signal to management [as to] what to focus on, and therefore it’s important to ensure the right motivations are built into remuneration plans,” says Kimon Demetriades, Stewardship Analyst at Allianz Global Investors.  

The fact that a growing number of companies are connecting sustainability goals to pay is testament to the “increasing pressure wrought by investors across a wide array of [ESG] themes”, adds Lewis Johnston, Director of Policy at NGO ShareAction.  

But the UK’s Financial Conduct Authority (FCA) is now keen to understand “the tone from the top”, seeking feedback on how regulated firms’ governance, incentives and competencies support their integration of sustainability-related considerations into business strategies. As well as gaining a better grasp of ongoing challenges, the watchdog wants to know whether existing rules need to be augmented.  

We think remuneration is a crucial tool to help align corporate outcomes with long-term sustainability aims,” the FCA said in its discussion paper, which is open to feedback until 10 May.  

Despite the demands of some, investors are not yet leading by example. Only six of the top 100 asset owners by assets under management (AuM), which oversee a combined US$18.7 trillion of assets, publicly disclosed their own variable pay targets for ESG factors in 2021, according to a report published by Capital Monitor and Global Data last year.  

ShareAction’s ‘Point of No Returns’ report further noted that most asset managers are only just starting to set sustainability-related KPIs and objectives linked to remuneration, “though this most often applies to staff in responsible investment teams, and fewer than a third of managers have set such KPIs for all members of their executive board”. 

“The inclusion of ESG and sustainability themes within executive pay creates greater transparency of a firm’s overall commitment to ESG – it’s a requirement to literally put your money where your mouth is,” says Phillipa O’Connor, Workforce ESG Leader at PwC.  

Dipping a toe 

O’Connor says that the FCA has entered the debate on executive pay and sustainability in “a thoughtful way that is extremely constructive” by taking stock of what regulated firms are already doing in this area.  

“There is value in having domestic bodies share views around such important topics, especially where they can promote/drive debate,” agrees Demetriades from Allianz Global Investors. 

The FCA assessed the public disclosures of 15 large firms, spanning banks, insurers and asset managers, the majority of which are members of the Glasgow Financial Alliance for Net Zero, to understand how they are typically embedding sustainability-related considerations into remuneration and incentive arrangements.  

Targets broadly fell into four categories: the firm’s own carbon footprint, diversity and inclusion at a board level, sustainable financing, and financed emissions. All firms have made at least one voluntary climate-related commitment, backed by a pay target, to achieve net zero by 2050 or sooner.  

“Our analysis did not find any examples of firms’ applying performance adjustments to bonuses based on performance against sustainability-related metrics,” the FCA added, noting that all assessed firms said they have the ability to “apply discretion to reduce awards”.  

Existing and developing frameworks require investors and companies to tie ESG and sustainability-related commitments to executive remuneration, such as the Task Force on Climate-related Financial Disclosure (TCFD) and the International Sustainability Standards Board (ISSB). Entities are expected to set quantitative targets against which they can be held accountable, such as increasing the amount of executive remuneration impacted by climate considerations by 10% by 2025. 

However, allowances have been made for qualitative disclosures. The TCFD framework, which has been mandated by the UK government, allows organisations to “include descriptive language on remuneration policies and practices, such as how climate change issues are included in balanced scorecards for executive remuneration”. 

“It’s helpful that the FCA is taking a holistic view of this area and is considering all the regulatory levers at their disposal,” says Demetriades. “It contributes to regulatory effectiveness, reducing unnecessary conflicts between different pieces of regulation.”  

The FCA also referred to a study published by environmental disclosure platform CDP, which said that investors’ financed emissions are on average over 700 times higher than their direct emissions. The regulator said it is “increasingly expected” that investors include Scope 3 emissions in their targets.  

The paper acknowledged that sustainability-related goals like reaching net zero are long term, and progress against pay targets won’t be seen overnight. However, “credible sustainability-related objectives will be translated to short- and medium-term targets and milestones”, the FCA said. 

Last month, AXA Investment Managers announced that it is including ESG targets in the deferred remuneration of its senior executives and will be reporting on progress annually. Its targets include an AuM target for 50% of the manager’s real estate portfolio to be aligned with the CRREM trajectories by 2025, a 25% reduction in the carbon intensity of its corporate portfolio by 2025, and reducing the firm’s operational CO2 footprint by 26% by 2025. 

“Initiatives coming from within businesses and from investors to tie executive remuneration packages to [sustainable] factors are great, and they are welcome, provided they are effective. But, in the long term, there does need to be some kind of legislative and regulatory reform attached to that [which] builds on some of the initiatives that are already out there in the marketplace,” says Johnston from ShareAction. 

“At the margin”  

But is linking ESG and sustainability-related targets to executive pay even the right way forward? 

Alex Edmans, Professor of Finance at London Business School (LBS), told ESG Investor that, “despite being a strong advocate for ESG and sustainability, I have substantial concerns about linking pay to sustainability targets”.  

Edmans’ opposition boils down to the fact that ESG issues are too complex and multifaceted to be reduced to a small number of measurable KPIs. The process then becomes too ‘tick-box’ by only counting what can be counted, he said, and risks firms focusing on ESG above other factors that are also an important part of driving company success, such as innovation and cybersecurity. 

Tim Goodman, Head of Corporate Governance at Schroders, says the firm does not see ESG metrics in pay “as a panacea to address sustainability issues”, but rather any well-governed company “should be meeting financial and ESG goals holistically”. 

However, “the FCA is consulting in an environment where the government has committed to the UK being the first net zero-aligned financial centre globally,” points out Richard Belfield, WTW’s Executive Compensation and Board Advisory Practice Leader, Europe, adding that this may suggest the FCA is “thinking about more rapid action [in this space] than we might see elsewhere”. 

Belfield nonetheless cautions that guidance from the FCA should “be at the margin, rather than something that would entirely transform the picture [of executive remuneration] we are currently seeing”. 

PwC’s O’Connor agrees, saying it’s important to ensure “companies have the latitude to [implement ESG pay targets] in a way that works for them”.  

“There is some comfort to having a briefing from the FCA on this as, should we lose momentum, there’s always the option for the FCA to intervene at a later date,” she adds.  

For some, there is a demoralising aspect to the fact executives are even being financially incentivised to focus on sustainability-related goals. Conor Constable, Stewardship Manager at UK proxy advisors Pensions and Investments Research Consultants (PIRC) says the firm has a “hard-line position against bonuses and executive remuneration”.  

Drawing on ‘the carrot versus the stick’ analogy, Constable questions the rationale for making the carrot even more appealing.  

“Does it serve the shareholders, the employees and wider society? Or does it serve the executive directors and the consultants that are paid a lot of money to advise on their executive remuneration schemes?” he asks. 

Constable appreciates the need for pragmatism, as it’s unlikely the FCA will propose an overhaul of executive remuneration. Guide rails to improve the transparency and measurability of the ESG metrics underpinning executive pay targets “would be a strong place for the FCA to start”, he notes. 

Streamlining metrics  

The variety in types of metrics and their quality is an ongoing issue.  

Last month, PwC published a report which assessed how 50 of the largest European companies have tied carbon targets to executive pay. It found that 71% of assessed companies currently targeted by the investor-led Climate Action 100+ (CA100+) engagement initiative and 50% of assessed non-CA100+ companies had translated their decarbonisation strategy into an explicit carbon measure in executive pay with a separate weighting. Just 14% of these assessed companies actually have targets that are “significant, measurable, transparent, and with a disclosed link to strategy”, the report said. 

“The question being asked now is: How do you have a high-quality ESG metric? Should there be some kind of regulatory overlay that defines those parameters?” posits O’Connor. 

ShareAction’s Johnston argues that regulatory intervention doesn’t need to directly target executive remuneration to have a positive impact on firms’ overall sustainability-related performance, noting that other actions, such as mandating transition plans, will “really drive moves towards a net zero economy and taking action on social issues”. 

The exact direction the FCA is going to take on this will be informed by feedback submitted from now until May.  

The UK’s Investment Association (IA) and Invesco have both confirmed with ESG Investor that they are planning their responses to the FCA consultation. 

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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