Should your CEO’s pay be linked to ESG metrics?

Article by Olivier Lebleu, CFA – Head of ESG, Edelman Smithfield

In the best companies, pay is usually linked to performance. Traditionally, that means financial performance – with bonus payments calibrated against variations of earnings per share or total shareholder return.

Now, the definition of performance is broadening. Executive remuneration is increasingly linked to ESG metrics. A recent study by PWC revealed that 45% of the FTSE 100 have an ESG measure in place for setting for executive pay and that 78% of board members and senior executives agree that ‘strong ESG performance contributes to organizational value and/or financial performance.’(1)

Beyond the UK, Apple, Deutsche Bank, and Volkswagen are just some of the global multinationals who have introduced ESG in their bonus calculations in recent years. So how are boards structuring these ESG linked awards, and what should non-executive directors expect when it comes to investor scrutiny in this area?

ESG factors that can be linked to executive compensation often reflect the company’s purpose and sector of activity. For example, Apple introduced an adjustment to the trigger for leading executives’ bonus payouts, adjusting them by up to 10% based on performance with respect to what they termed ‘Apple Values’, including access to education, diversity and inclusion, data privacy, and supplier responsibility.  

While augmenting bonuses is one approach, a ‘malus’ approach can also be implemented, whereby boards reserve the right to withdraw or reduce bonuses for executives if the company has failed to achieve a particular ESG objective. This is most often seen in the reputational risk area, where damaging problems such as product recalls can do lasting damage to a company’s brand equity.

These links to purpose and reputation, however, do not exempt boards from meeting investors’ expectation for materiality in terms of benchmarking of achievements and transparency of incentive pay calculations. The UN PRI recently published and update on ESG linked remuneration which reminded investors that ‘there are still significant gaps in company practice and disclosure that can exacerbate existing concerns about misalignment of incentives and performance.’ (2)  

Boards must therefore be clear about their goals in linking ESG metrics to executive compensation mechanisms. Ideally, boards will only establish ESG links to executive pay if they have

1)     Established a clear ESG strategy for the company, which can have its roots in the company’s purpose statement but, more importantly, must be anchored by precise measurement of those ESG factors deemed material to the investment case for the company

2)     Consulted and communicated with stakeholders about the company’s ESG strategy, and reported back to them on how their feedback is being incorporated

3)     Set the terms for executive performance measurement in line with achievement of the ESG strategy, with clearly stated and easily measured signposts which can be disclosed at regular intervals

Linking ESG to executive pay is currently fashionable – and can plausibly be argued as helping move the ESG agenda forward. But incentive-setting cannot be done in isolation or merely as a communications exercise – it must be rooted in the achievement of strategic objectives. Boards should ensure that ESG metrics are incorporated with the same rigour than financial and operational measurements of performance, for the benefit of their executives and the company’s stakeholders alike.

(1)   ‘Linking ESG to executive pay goals’ PWC strategy + business, June 19 2021.

(2)   ESG linked pay: recommendations for investors.  UN PRI June 17 2021.

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