Should Bosses be Paid to be Green?

Investors ask corporates to tie ESG-related targets to remuneration schemes, but complex pay packet structures makes impact hard to measure.

Investors have often debated whether it’s more effective to proffer the carrot or the stick when engaging with investee corporates on social and environmental issues. A growing number are choosing to believe the old proverb: You catch more flies with honey than vinegar.

To better galvanise executives into taking action, many investors are asking for ESG-related targets to be incorporated into remuneration schemes. In response, some companies are tying a percentage of executive pay to relevant KPIs.

Amundi Asset Management announced prior to the 2021 voting season it would vote against executive compensation plans that didn’t contain ESG indicators. The asset manager noted that inclusion of ESG targets would be to the “long-term benefit of the company and its shareholders”.

“If executive pay packets reflect a more balanced range of stakeholder interests, with targets linked to social or environmental as well as financial measures, it follows that they will also act with greater regard to society and the environment. Including ESG targets in the CEO’s remuneration package demonstrates that these targets are a priority at the highest level of the organisation,” says Rachel Kay, Researcher for UK think tank the High Pay Centre (HPC).

On paper, this seems like an effective way of ensuring investors and corporate executives are aligned in their ambition to improve firms’ environmental and social performance.

However, executive pay is already complicated for investors to navigate. Whether it’s the tangled structure of an executive’s pay packet, the overwhelming number of underlying KPIs or the calculations needed to work out if an incentive target has been met, there is much homework to be done before calling for ESG-related pay at annual general meetings (AGMs).

Pay outweighing action

Before adding ESG to the mix, investors need to understand the complex structure of executive pay packets, experts say. How are executives’ total annual incomes justified? How much of their remuneration is already tied to KPIs?

Hendrik Schmidt, Corporate Governance and Stewardship Expert at German asset manager DWS (€793 billion AUM), says at least 20% of a total executive pay package should be tied to KPIs. “Anything less than 20% isn’t material,” he notes.

The pay packets of executives is already a sensitive and increasingly scrutinised subject, as they typically earn a great deal more than the average employee. And the compensation gap between executives and the rest of the workforce is increasing, according to American think tank the Economic Policy Institute. In 2019, compensation earned by CEOs of US-listed companies outweighed the average worker by a ratio of 320:1, increasing from 293:1 in 2018 and 21:1 in 1965.

Eoin Fahy, Head of Responsible Investing for Dublin-based KBI Investors (€12 billion AUM), says finely-balanced consideration is needed from investors to make sure compensation is “at least proximately reasonable” when compared with both peers and the rest of the corporate workforce.

Investors should hold corporates accountable if there is a big discrepancy between the amount a CEO is earning compared to the rest of their workers, experts say. This is easier said than done, especially when salary is often a fraction of financial reward.

Amazon Founder Jeff Bezos was paid US$81,000 per year and US$1.6 million in total compensation before stepping down as CEO.

Furthermore, executives of carbon-intensive companies are awarded eye-watering remuneration packages despite their continued impact on the climate. Ryan Lances, Chairman and CEO of oil and gas major ConocoPhillips, received US$28 million in compensation in 2020, of which his salary accounted for US$1.6 million.

Companies should assess the long-term impact an individual executive may have on corporate performance before calculating their remuneration, according to a 2019 report by HPC and the Chartered Institute of Personnel and Development (CIPD). The more value it’s believed an executive will bring to the company, the more justifiable the big pay packet, the report noted.

Say on Pay

When the Say on Pay initiative was first introduced in 2002 – giving shareholders an advisory, non-binding vote on executive remuneration schemes – it awarded investors an extra mechanism to hold corporates accountable if pay packets were deemed unreasonable or to targets were missed.

But because they’re typically non-binding, investors are relying on corporates to respond appropriately. Many corporates are proving reluctant to listen.

In June, UK supermarket group Morrisons suffered a huge shareholder revolt, with 70% of investors voting against its executive pay structure, which granted CEO David Potts and two senior managers a total of £9 million in pay and bonuses. Despite the majority, the vote isn’t binding and Morrisons has yet to succumb to pressure and reverse the decision.

A Say on Pay study by Willis Towers Watson recorded 56 failed Say on Pay votes in the 2020 US AGM season, with the highest number of failures occurring at smaller companies outside of the S&P 1500.

If companies prove unwilling to address concerns, investors can take more drastic action, for example by voting against individual director re-elections to the board, or the compensation report.

“In cases where we don’t see any reaction from the corporate to a dissenting vote, we want to make sure that we hold the board accountable,” agrees Schmidt.

This is what happened in the case of UK sports retailer JD Sports. When it emerged that JD Sports’ owner, Peter Cowgill, received almost £6 million in bonuses since February 2020 – at the same time as the company acquired more than £100 million in government support throughout the pandemic – investors weren’t pleased.

Cowgill defended the pay-out, leading to investors holding the Remuneration Committee accountable. JD Sports’ Chair of the Remuneration Committee, Andrew Leslie, was subsequently ousted after 11 years on the board when he failed to secure enough votes for re-election from independent shareholders.

Complicated metrics

Companies are incorporating too many KPIs in their executive compensation frameworks, making it more challenging for bosses to meet targets and for investors to track them.

In January, HPC hosted a corporate stakeholder roundtable discussing the issue. “Investors agreed that companies use too many metrics in executive pay [which is an] issue for investors who have limited time to engage with this level of complexity,” Kay says.

To assess how executives are prioritising individual KPIs, investors need to track performance relating to specific targets, compare this with competitor performance across the same areas and assess target progress over the medium to long term.

Executive pay “takes up too much time” that should be spent on other issues, such as social and environmental impact, according to a 2020 report published by Pensions and Investment Research Consultants (PIRC).

The work of remuneration committees also requires input from HR departments, legal teams, external consultants and investors themselves. With many cooks in the kitchen, it’s a “considerable drain” on resources to merely outline the KPI payment structure of upper management, HPC and CIPD noted in the 2019 report.

Furthermore, one executive’s remuneration packet – and therefore set of targets – may be different to another executive at the same company.

Another complication is the mere fact that not every target can be achieved within the same timeframe, so executives may not financially benefit from fulfilling a KPI for a few years.

KPIs either contribute to long-term incentive plans (LTIPs) or short-term incentive plans. LTIPs concern targets that span over three to five years typically, whereas short-term incentive plans refer to KPIs that can be achieved within a year and rewarded through an annual bonus.

A KPI contributing to an LTIP could be a five-year decarbonisation target, whereas a KPI contributing to a short-term incentive could be the development and implementation of a diversity and inclusion policy.

But many feel LTIPS are becoming unwieldy. “LTIPs should be replaced as the default model for executive remuneration with a less complex system based on basic salary, with an incentive to deliver sustainable long-term performance provided by a much smaller restricted share award,” the 2019 HPC and CIPD report argued.

Regulatory focus 

Poor practice around the world, says Athanasia Karananou, Director of Governance and Research at the UN-backed Principles for Responsible Investment (PRI), has led to “momentum for regulatory intervention”.

Policymakers are demanding more visibility of the target-setting process, according to the Organisation for Economic Co-operation and Development (OECD). The OECD updated its Corporate Governance Factbook in June, which analysed over 50 jurisdictions on their approaches to corporate governance.

The majority (88%) of jurisdictions require or recommend that corporates disclose their remuneration policy, as well as the level or amount of remuneration at aggregate levels.

However, 92% of jurisdictions have introduced only general criteria on the structure of remuneration, the OECD notes, with 52% establishing recommendations on a ‘comply or explain’ basis.

Italy requires that variable remuneration, if rewarded, is based on clear performance criteria which takes corporate and social responsibility into account. The Norwegian Code recommends that corporates don’t grant share options to board members. In India, if the aggregate pay for all corporate directors exceeds 11% of the company’s total profits, then director pay needs to be approved by both shareholders and the government, OECD said.

Slow introduction of ESG targets 

Given the established practice of linking executive remuneration to financial performance targets, it’s unsurprising that investors are asking for environmental and social targets to be tied to executive pay.

“If companies are going to use LTIPs and bonuses, then our recommendation would be that these should include ESG targets, and give them greater weightings [than other KPIs],” Kay says.

This is beginning to happen, even in some unlikely settings. Oil and natural gas company Callon Petroleum has adopted ESG metrics for 2021 annual bonuses with a 15% quantitative weighting which will include flaring, and safety and spills targets, alongside a qualitative assessment on the sustained progress towards decarbonisation.

Both corporates and shareholders will benefit from a heightened focus on ESG, according to Vaishnavi Ravishankar, Senior Specialist on Governance at PRI. ESG-related issues are “no longer tangential to firm performance”, she says.

Alongside bolstering a company’s social and environmental performance, ESG-linked pay can provide broader financial benefits over time, such as increasing firm value and rebalancing the “excessive emphasis” on short-term performance targets in typical remuneration packages, Ravishankar adds.

But ESG KPIs will only drive performance if they are relevant to the corporate in question, according to a report by multinational law firm Clifford Chance. For example, a thermal coal policy is necessary to the long-term success of an oil and gas major but not a tech company. ESG measures used in LTIPS and bonus plans should be industry-focused.

Environmental and social targets should also be “sufficiently stretching and not achievable simply as part of the day job”. If vague ESG KPIs are added as an afterthought to appease investors, these targets risk being “counterproductive for businesses”, the law firm warned.

Nearly half (45%) of FTSE 100 companies are now incorporating ESG targets within their annual bonus targets or LTIPs, according to a recent report by the London Business School’s Centre for Corporate Governance and Big Four accountancy firm PwC.

However, overall KPIs remain heavily geared towards financial returns, according to a 2020 HPC and CIPD report. Last year, financial metrics had an average 82.4% weighting of maximum incentive pay across the FTSE 100. Workforce-related targets accounted for 5.9% and environmental targets for 0.7%, the report noted.

E versus S

‘E’ is the main focus of ESG KPIs, experts say, with companies most frequently implementing climate or transition-related targets.

This could be partly attributed to pressure from investors via initiatives such as Climate Action 100+ initiative (CA100+). CA100+ is made up of over 450 investors managing more than US$40 trillion in AUM, aiming to engage heavy-emitting global corporates on their climate-related performance.

Recommendations outlined by CA100+ include the CEO and at least one other senior executive’s remuneration arrangements incorporating a climate change performance target and a KPI relating to decarbonisation efforts.

Alongside growing investor pressure, the Covid-19 outbreak and activism around movements such as Black Lives Matter have highlighted the power of corporates to either reduce or perpetuate social inequality through their employment practices and workplace management.

A number of social KPIs adopted by executives are short-term and relatively easy to measure, such as implementing a diversity policy or setting employee wellbeing targets. Employee-related metrics accounted for an average of 11.2% for short-term annual bonuses, the 2020 HPC and CIPD report noted.

The three most used employee metrics for executive bonuses last year were health and safety, employee engagement, and diversity and inclusion, the report added. However, long term social KPIs are less frequently adopted because it remains challenging to measure factors such as employee absence rates, costs and inclusivity.

“Adopting a standardised approach to measuring human capital will allow investors […] to benchmark the performance of organisations and [subsequent] CEO remuneration,” HPC and CIPD said.

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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