Increasingly, companies are linking executive pay to the accomplishment of sustainable goals and nearly half of FTSE 100 companies have set measurable ESG targets for their CEOs, according to PwC. A growing number of companies are also receiving shareholder inquiries about tying executive compensation to sustainability performance and the practice is becoming more appealing to ESG-focused investors. Public pressure is also playing a part, especially given that CEO pay in the US has skyrocketed 1,322% since 1978.
Business leaders themselves are starting to realise that a solid ESG framework pays off. A Willis Tower Watson survey of 168 board members and senior executives found that 78% agree that strong ESG performance is a key contributor to financial performance. A public announcement linking executive salary to ESG performance by a company demonstrates a commitment to sustainability and a will to be held accountable if goals are not met. Organisations that have made such announcements in recent years include Apple, McDonald’s and BP.
Apple announced that an ESG modifier would be incorporated into its annual cash incentive programme for executives at the beginning of 2021 and it would have the potential to swing the total bonus pay up or down by 10%. BP has similar incentives in place for meeting environmental targets while McDonald’s includes diversity goals in its executive compensation.
While incentives linked to ESG metrics may sound relatively simple, there is a certain element of risk involved. Focusing on a relatively narrow ESG issue can distract companies from concentrating on a broader objective while organisations have to determine whether it is worth focusing on a short or long-term timeframe. It is also critical to identify how success is determined and incorporate performance scales to achieve ESG targets. To create the best possible strategy, it is important to have company-wide insights and a board that is willing to take risks in order to set uncomfortable targets.
PwC recommends companies keep four dimensions of ESG remuneration in mind when including ESG measures as part of pay:
Internal and external targets: Input measures are internal targets that a company uses to benchmark itself and are not measured by activities leading towards a stakeholder outcome. Output measures are external targets based on stakeholder impact. While both are valid, they need to align with a company’s strategic priorities.
Individual KPIs and scorecards: It is important to keep track and measure progress towards sustainable goals. If a company’s approach is multidimensional, it needs to be carefully constructed and transparently disclosed.
Long term incentive plan and annual bonus: Be specific when creating ESG goals. It is usually better to set ambitious well-calibrated one-year targets rather than vague long-term ones.
Underpin and scale targets: It is good practice to identify how to determine success and this can involve the creation of performance scales to achieve ESG targets, especially for transformational objectives such as emissions reductions.