Issuers are increasingly being asked to incentivize ESG performance through executive compensation plans. But it’s not always as simple as adding ESG to the mix immediately, as Ben Ashwell, Tim Human and Garnet Roach report
If certain ESG metrics have a material impact on a business’ performance – which is widely accepted – then it follows that investors, regulators and proxy advisers will likely seek assurances that executives are incentivized to meet expectations.
In this feature, we look at the efforts being made around the world to tie ESG metrics to executive compensation. Due to the difference between pay packages in different parts of the world, we have focused our reporting on three key regions: North America, Europe and Asia.
While the ESG data ecosystem can make one’s head spin, it’s also true that there is more consensus between issuers and investors on ESG materiality now than there has ever been. Each year brings more inaugural sustainability reports across North America and greater discussion of ESG during routine investor meetings, earnings calls and annual meetings.
This shared definition of a company’s material ESG risks and opportunities is leading to greater investor expectation that managers will be compensated – at least in part – based on their company’s performance relative to those risks and opportunities. As the Covid-19 pandemic forced employee safety, security and productivity to the foreground of investor conversations, it will likely also prompt greater scrutiny of executive compensation packages.
Similarly, the conversations we are having across society about racial equality, justice and equity will likely become a more prominent governance issue, akin to the established dialogue about gender diversity.
The last 12 months have raised a number of pressing issues that could shape future discussion of executive compensation packages, coupled with the existential threat of climate change and the financial risk associated with global temperature increases.
Will investors look unfavorably on CEOs who maintain their pre-Covid-19 compensation packages, having furloughed or laid off staff? Will large bonuses be paid to executives at companies that experienced significant Covid-19 outbreaks? And what expectations do investors have of companies to link ESG to executive compensation metrics?
‘Investors are going to start asking more often for progress on ESG,’ says Robin Ferracone, founder and CEO of Farient Advisors. ‘Combine that interest with the effects of Covid-19 and the SEC asking companies to enhance their human capital management disclosures and companies will need to tell more of a story about how they’re thinking regarding ESG integration.’
Robin Ferracone, Farient Advisors
How many companies currently link ESG to executive compensation? Linking ESG to executive compensation is still in its infancy in North America – excluding sectors like energy and utilities, where environmental metrics are inherent in the company’s business model – and there are differing accounts of how common it is. Separate studies from ISS Corporate Solutions and Pearl Meyer suggest that between 15 percent and 20 percent of companies in the S&P 500 tie ESG to executive compensation, but other surveys put that number much higher.
Jun Frank, ISS Corporate Solutions
‘Incorporating ESG metrics into pay makes sense at a high level,’ says Jun Frank, executive director at ISS Corporate Solutions. ‘How to design it and how to set the targets is more difficult, however. I believe most companies in most industries are now in an exploration phase. To the extent that you’re talking to investors and soliciting their feedback on what they expect from you, that seems like an appropriate step to take.’
When it comes to the design of the compensation plan itself, the companies that do link ESG to a component of executive compensation tend to favor baking it into short-term incentive plans (Stips), rather than long-term incentive plans (LTIPs). Analysis by ISS Corporate Solutions shows that in the S&P 500, 14.6 percent of companies link ESG to Stips, while only 1 percent link to LTIPs.
One of the challenges of linking ESG to executive compensation currently is that it requires a clear articulation of material ESG issues that is understood at the board level. Without that, ESG ties to compensation could ring hollow, says Courteney Keatinge, senior director of ESG research at Glass Lewis.
‘What concerns me is when I don’t think there has been sufficient conversation about why companies chose the metrics they did and what thought went into that,' she explains. 'I have a lot of conversations with companies about inclusion in the Dow Jones Sustainability Index, for example, and linking that to executive compensation metrics. But does that really help shareholders and the company in the long term, or do they just want to check a box and have investors give them a gold star?’
Courteney Keatinge, Glass Lewis
The vast majority of board directors in North America spent their careers in executive roles at public firms at a time when ESG wasn’t a prominent issue. While boards and compensation committees are rapidly becoming more proficient with ESG materiality – often aided by teach-ins and off-season shareholder engagement – Ferracone says it’s more important for boards to take their time on linking ESG to executive compensation than to rush it and produce links that seem inauthentic.
‘I recommend that companies pilot a measure for a year because they won’t have any experience of creating a baseline of performance,’ Ferracone says. ‘What should our diversity metrics look like? Should we include ethnic and gender diversity? How do we measure that in different parts of the world? How do we measure employee safety? It can be complex and companies should go through a year of piloting it first.’
Keatinge agrees. She says she has seen situations where companies have linked executive compensation to employee safety in the past and it has created a culture where workplace accidents are then under-reported. Rushing into these complicated issues can have an adverse effect, she warns.
A first bite of the Apple In early 2021 Apple attracted headlines when it announced in its proxy statement that executive cash bonuses could increase by up to 10 percent if the company achieves its ESG goals. ‘This change is intended to further motivate Apple’s executive team to meet exceptionally high standards of values-driven leadership in addition to delivering strong financial results,’ the company writes in its proxy statement.
Apple’s compensation committee will have the discretion to increase or decrease bonuses by up to 10 percent based on how the company’s named officers uphold its values and community initiatives. Apple did not respond to a request for comment.
The amount of cash bonus up for grabs is in line with other early adopters for linking ESG to executive compensation: a study from Pearl Meyer reveals that 67 percent of firms that link pay to ESG metrics say that between 5 percent and 10 percent of pay is determined based on ESG.
The decision by Apple’s compensation committee to link ESG to executive compensation is at least partly in response to a shareholder proposal asking for such measures last year. The proposal, filed by Zevin Asset Management (ZAM), received 12 percent support at the annual meeting. Pat Tomaino, director of responsible investing at ZAM, says engagement on this topic goes back much further than just the last two years.
Pat Tomaino, Zevin Asset Management
‘We wrote to Apple in 2017-2018 and filed a proposal in 2019-2020,’ Tomaino tells IR Magazine. ‘We were asking the company to tie executive compensation to ESG metrics of its choosing – we wanted it to determine which were most important to it. I took the proposal to Apple’s annual meeting in 2020 and presented it. The whole time we had engagement with Apple’s legal team, which was trying to understand what we were asking for. It didn’t offer a response, so we refiled.
‘Then, in the fall of 2020, things heated up in terms of constructive dialogue. For us, it’s always productive to move change through constructive dialogue, rather than just shareholder proposals. We spoke to the legal team and compensation experts. Late in the year we heard from the company that some changes were being planned and we would be interested in them.’
Tomaino – who has filed similar proposals at Amazon, Alphabet and Kroger – describes Apple’s move as ‘a very solid first step’, adding that often ‘companies will find reasons not to do something but [engagement with Apple] didn’t feel like that.’
The next step in pleasing a responsible investor like ZAM is to disclose the specific ESG metrics the compensation committee considers to be most relevant to the company’s business. ‘My biggest concern is that this becomes a black box in the future,’ Tomaino says. ‘Companies have ESG metrics they use in their reporting. What investors need in next year’s proxy is a specific account of performance against the selected ESG metrics and how that affected the bonuses that were paid.’
The Covid-19 pandemic has disrupted the output and share price of many public companies. For compensation committees, this raises the question of whether performance-based pay targets should be adjusted. Amid this debate, they need to consider how investors will respond to short-term incentives being changed.
ISS has published an FAQ document on how it will interpret the effects of the pandemic on compensation plans in the US. The proxy adviser makes it clear that moving the goalposts on short-term performance targets may be acceptable as long as it is appropriate and accompanied by additional disclosure explaining how the board made the decision. Regarding long-term incentives, ISS is less receptive to alterations.
‘Investor feedback indicates that these programs should be designed to smooth performance over a long-term period and not be altered after the beginning of the cycle based on a short-term market shock,’ the FAQ authors write. ‘Accordingly, changes to these in-progress cycles will generally be viewed negatively.’
In Canada, ISS’ interpretation of pay for performance is unchanged.
Many European companies already incorporate ESG metrics into executive pay. In a study of 365 issuers from major indexes in continental Europe and the UK, 68 percent have at least one ESG metric in their incentive plans, according to Willis Towers Watson.
But companies are under pressure to go further. Investors want to see stronger links between ESG, strategy and pay. In particular, they are pushing for significant metrics on key sustainability topics, like climate change and diversity.
If you go back four years, firms with ESG metrics in executive pay tended to be from certain industries, explains Peter Reilly, a senior director at FTI Consulting. He highlights the energy and materials sectors, where you could find compensation linked to measures like emissions or health and safety.
Peter Reilly, FTI Consulting
That picture has changed significantly, however, and today there are new announcements almost every week, adds Reilly. ‘There is a market-wide trend because, increasingly, every listed company either recognizes internally that this is key to its business strategy and risk, or it’s being told that by its largest investors,’ he says. Pressure points External pressure is playing a key role in reshaping pay packages across Europe. Investors, regulators, proxy advisers and reporting bodies are nudging firms – with varying levels of force – toward more integration between ESG and compensation.
At a regional level, the Shareholder Rights Directive II has mandated say-on-pay votes across the continent. While some countries already gave shareholders a vote on pay, others have seen a big rise in scrutiny. The directive also calls for investors to analyze corporate performance through an ESG lens, increasing expectations that pay and sustainability should be integrated.
National corporate governance codes are playing their part, too. For example, the updated French code says ESG measures should be included in executive compensation. ‘If you look at EU markets, the French market is taking a lead,’ says Aniel Mahabier, chief executive at CGLytics.
Further pressure is being exerted by investor groups. Last November the UK’s Investment Association, which represents more than 250 members with around £8.5 tn ($11.8 tn) in assets under management, adjusted its ‘principles for remuneration’ to be clearer on expectations around non-financial performance metrics.
‘ESG measures should be material to the business and quantifiable,’ states the association in the principles. ‘In each case, the link to strategy and method of performance measurement should be clearly explained.’
At Amundi, Europe’s largest asset manager, expectations around ESG and compensation continue to evolve. In 2020 it asked companies to include ESG metrics in their LTIP and voted against those that did not. This year it is going further and calling for climate performance measures in sectors with heavy exposure to global warming.
‘We really want top management’s compensation to be linked to the climate strategy,’ says Caroline Le Meaux, head of ESG engagement at Amundi. ‘We will vote against any viable items if there are no climate-related KPIs. And, for all sectors, we still have ESG KPI requirements for variable compensation.’
Pay practices Social issues are currently the most likely to be included in European executive pay, says Willis Towers Watson. Its study finds they are used by 61 percent of top European companies, covering areas like HR, safety and diversity. By contrast, 39 percent of companies use governance metrics and 33 percent environmental. ESG factors are far more likely to appear in Stips (66 percent) than the LTIP (19 percent).
The emerging practice in Europe, says Willis Towers Watson, is for companies to make use of ‘meaningful environmental and sustainability metrics’. One such business, according to the research, is Anglo American, which last year said up to 20 percent of its LTIP would be based on three ESG factors: waste management, energy efficiency and emissions reduction.
‘This provides a clear link with our sustainable mining plan, which commits us to ambitious goals relating to a healthy environment, particularly in relation to climate change and greenhouse gas emissions,’ the firm writes in its 2020 annual report.
A further trend is the growing weight of ESG metrics within each plan. Many firms are doubling the weighting or adding additional measures, says Reilly. ‘Now, you may have health & safety and customer satisfaction; before you had one or the other,’ he notes.
At time of writing, most firms had not yet revealed their remuneration plans for 2021. Volkswagen, however, spoke to IR Magazine about the introduction of a new ESG multiplier for the annual bonus. The world’s largest car-maker will use a multiplier that incorporates the three aspects of ESG. It includes a decarbonization index, which will help track Volkswagen’s progress toward its goal of net-zero emissions by 2050. There is an opinion index, based on an employee survey, and a diversity index that monitors area including the proportion of women in management positions. Finally, governance and compliance-related measures are taken into account.
‘The multiplier has been added as a new dimension,’ explains Michael Brendel, head of supervisory board communication at Volkswagen. ‘For us, it defines the balance between key financial performance indicators and ESG targets.’
While most ESG metrics are in the short-term plan, Amundi argues that climate change and diversity should both be in the LTIP. On climate, Le Meaux says it’s important to make sure executives are preparing their business model for a low-carbon future. ‘For that, they have to have something in their LTIP,’ she says.
Turning to diversity, some argue metrics should affect the annual bonus because that will bring about quicker results. But Le Meaux believes that for real change to take place within an organization, there needs to be a multi-year approach.
‘If you do it on the short term, companies will artificially [make] the executive committee diverse by hiring external people,’ she says. ‘You want to make sure that, at every level of your company, you offer the same chance to all kinds of people.’
External assessment Most companies decide pay based on internal measures. A small but growing number, however, are turning to external metrics to mark their performance. For example, Danone, the Paris-based global food company, uses CDP’s ranking system to decide whether it has performed well on its climate-change program.
CDP operates one of the world’s biggest sustainability questionnaires and scores companies in three areas: climate change, water security and deforestation. Danone currently gets an ‘A’ – the top rating – in each of these categories.
Eduardo Sancho García, Morrow Sodali
External metrics can cover areas such as index inclusion, third-party ratings or use of key reporting frameworks like those of SASB or TCFD, says Eduardo Sancho García, corporate governance and sustainability adviser for Morrow Sodali, who is based in Madrid.
‘Business-related metrics are more popular, but external ones are growing,’ he says. ‘Ideally, the latter would not take any of the space of the former because I think they can co-exist.’
The process of selecting appropriate measures and sourcing data to support them is a challenge for many companies. But the growing corporate focus on sustainability is helping to uncover options, notes Reilly. ‘Increasingly you’re seeing data points that companies are able to track,’ he says. ‘Once you have them, you can integrate them into pay.’
For Le Meaux, the key point is that companies select the right performance measures for the right purpose. In the short-term incentive, it should be something operational, she argues, while in the LTIP, ‘they have to choose some strategic ESG KPIs'.
StarHub, the Singapore-headquartered telecoms company, has never received an investor query around ESG and executive pay. ESG in general is growing as a topic of conversation but not in how it impacts compensation, even though – unusually for companies in the region – StarHub does in fact link ESG to senior pay, is in the process of formalizing its approach and is happy to discuss its plans.
At present, ‘executives who are responsible for ESG-related KPIs – such as good corporate governance, transparency, diversity, talent management, succession planning, employee engagement, personal data and cyber-compliance – within our operations are rewarded for achieving or exceeding their performance targets,’ says Veronica Lai, chief corporate officer at StarHub. She adds that these ‘rewards are cascaded [down] to various staff in the departments who contribute toward our main corporate targets.’
Veronica Lai, StarHub
Lai says investors are increasingly interested in ESG more broadly, if not yet specifically in how it relates to compensation, but the company has already seen the benefits of its ESG-pay link internally.
‘It has given us the impetus for greater clarity in our sustainability strategy and approach, tightened our target setting and [helped] formalize roles and responsibilities,’ she notes.
Now StarHub wants to take this further. ‘We are in the process of formalizing our ESG-pay-link framework to develop a set of metrics applicable across the entire company,’ Lai continues. ‘Once we [have done this], we intend to include this information in our sustainability report to bring greater transparency and credibility.’
Not a talking point A Willis Towers Watson survey from December 2020 notes that almost 70 percent of firms in the Asia-Pacific region plan to introduce ESG measures into their LTIPs over the next three years, while 61 percent plan to do the same with their annual incentive plans. But few want to go on the record or expand on the brief statements provided in their reporting.
‘Asian companies are behind Europe and North America, both in disclosing their ESG efforts generally and in tying their executive pay to ESG initiatives,’ says Trey Davis, executive compensation leader for Asia-Pacific at Willis Towers Watson.
Trey Davis, Willis Towers Watson
‘Partly, Asian companies generally are behind the rest of the world in adopting these kinds of ESG metrics. But – probably more importantly –there is just a lack of disclosure around all kinds of executive compensation issues in Asia.’
It’s not an issue specific to ESG. There are a number of reasons companies generally don’t talk about compensation, including a lack of regulation such as say-on-pay votes, and a lack of investor and media pressure. On the investor side, a lot of that is down to the fact that many companies have a majority-block shareholder or are family-owned. On the media side, Davis highlights the fact that ‘pay levels for senior executives in Asia are much lower than they are in the rest of the world, so we don’t have as many articles around, quote-unquote, excessive CEO pay.’
But he adds that, internally at least, attitudes around ESG and compensation are changing. Most of the boards and clients Willis Towers Watson works with on this in Asia ‘see ESG as necessary for ensuring the sustainability and long-term success of the company,’ explains Davis, citing how vocal big, global investors are on their views of ESG issues as essential to company success.
Unintended consequences The fact that there hasn’t been historically ‘excessive’ pay at executive level in Asia is a key factor in this discussion and because of this ‘investors must be careful what they wish for’ if they push for a greater percentage of compensation to be put at risk, warns Pru Bennett, a partner at Brunswick Group and member of the Asian Corporate Governance Association.
Pru Bennett, Brunswick Group
Although the global drive for better corporate governance paints the tying of ESG metrics to executive remuneration as a given positive, it is a complicated issue – particularly when applied to more modest salaries.
Bennett cites Japan as an example: Japanese CEOs, she says, don’t want to be paid 100 times more than their workers ‘because that’s not part of Japanese culture’. But investors have increasingly pushed for a greater portion of executive pay to be set against measurable variables. And if just 25 percent of the pay is fixed and remaining remuneration is at risk, then there may be ‘unintended consequences,’ she points out.
Firstly, executives simply can’t live on fluctuating compensation when take-home pay falls below a certain level. ‘Japanese CEOs can’t live with 100 percent one year and 25 percent the next,’ Bennett says, warning that this is likely to lead to the ‘ratcheting up of compensation over time’. It might also lead companies to take greater risks, which aren’t always right for that firm.
A December 2020 study by Willis Towers Watson shows that Bennett’s concerns are already at play. ‘After years of modest increases, recent analysis of CEO compensation in Japan and four other countries finds a significant increase in total compensation paid to CEOs in Japan – a 20.5 percent increase in fiscal 2019 compared with 2018 – which was driven by a significant expansion of long-term incentives,’ write the report authors.
‘While Japanese CEOs continue to be compensated at notably lower levels than top executives in the US and Europe, the structures of compensation plans in Japan are starting to mirror those of European companies that place a heavy emphasis on performance-linked pay.’
The report also notes an ‘increasing number of companies paying their CEOs at levels more comparable with their European counterparts'. In 2017, eight Japanese companies paid out more than ¥400 mn ($3.7 mn at the time) to their CEOs. This climbed to 11 companies in 2018 and 13 in 2019.
Preparing for the future If companies – and investors – in the region decide this is the right route for them, then what needs to change to drive the trend forward? And how should companies go about starting to add ESG metrics to executive compensation plans?
In Asia, ‘you do not have a public remuneration report that has to be published each year and that is subject to a shareholder vote,’ Bennett says. ‘Once that happens, I think there will be more discussion, [but at present] there’s very little discussion around compensation. There’s very little benchmarking so it’s just not a topic companies need to talk about.’
But for those companies that want to be more open and, like StarHub – which has won numerous awards for its ESG efforts – do more to bring compensation and ESG metrics together, Davis says the key is to tie your goals to company purpose.
‘Just adopting ESG goals to say you’ve adopted them is not going to be helpful – it’s not going to drive change,' he explains. 'In fact, it’s going to dilute the effectiveness of your compensation program by confusing executives over what’s important and what they should be focused on. Whatever goals you’re looking at, they must support the overall business strategy.’
