In the last few months, a steady stream of companies have announced the introduction of ESG-linked executive pay to bolster sustainability credentials, including Deutsche Bank, Volkswagen and Apple. The moves appear to be in line with a broader trend: a 2020 Willis Towers Watson survey found that four in five companies are contemplating similar measures over the next three years, elevating environmental and social factors in their incentive plans.
Regulators globally have put forward proposals to accelerate this development via soft and hard laws around integrating ESG factors in executive remuneration. In fact, the PRI has recently supported a proposal by the EU to mandate inclusion of ESG issues into executive pay under the Sustainable Corporate Governance initiative. ESG factors are value-enhancing but not effectively accounted for by the stock market. In our view, if structured appropriately and implemented effectively, ESG-linked pay could:
- increase firm value;
- rebalance the excessive emphasis on short-term performance targets in typical remuneration packages, which run contrary to long-term financial and sustainability objectives; and
- create better accountability on sustainability-related performance across management. (Read about academic research on the issue here)
At the same time, PRI’s previous work on ESG-linked pay has shown that there are still significant gaps in company practice and disclosure that can exacerbate existing concerns about misalignment of incentives and performance. As highlighted in our response to the EU initiative, further examination and guidance on ESG-linked pay is necessary to ensure that it is fit for purpose and does not lead to unintended consequences or pay padding. Vague ESG factors can add to the complexity of remuneration structures, excessive focus on certain ESG metrics could hinder sustainability objectives (e.g. linking metrics such as time lost to injury to pay could discourage accurate reporting and risk monitoring), and ESG targets that are too easily achievable may unnecessarily boost pay for executives, particularly during economic downturns.
As integration of ESG-linked pay becomes more prevalent, investors will need to take a position and evaluate what this means in practice and how it can be improved. This article provides recommendations for investors as to how they can drive more meaningful integration of ESG metrics in executive pay.
Recommendations for investors
The PRI recommends that investors:
I. outline a clear position in favour of substantive links between ESG and pay;
II. encourage investee companies to systematically identify relevant ESG factors;
III. step up stewardship activities for companies that:
a. have not taken measures to incorporate ESG criteria in their pay plans, particularly when they are exposed to significant environmental and social risks;
b. do incorporate ESG factors but fail to do so in a meaningful way (e.g via excessive focus on qualitative and vague measures, using metrics that do not reflect the ESG priorities for the business or including them as a very small portion of overall remuneration); and / or
c. do not provide sufficient transparency on the mechanisms in place or the impact on realised pay for investors to properly assess the efficacy of ESG-linked pay.
IV. consider supporting shareholder proposals on ESG-linked pay in line with their voting principles.
The following sections provide more detail on each investor action outlined above.
I. Outline a clear position
The PRI recommends that ESG-linked pay forms part of investors’ expectations for companies on remuneration. Investors should articulate their position, outlining what they deem as appropriate types of factors and targets; how ESG factors should be balanced with financial factors; and what practices should be avoided. Investors should also explain how their considerations on ESG-linked pay influence or contribute to voting decisions on remuneration, so companies have greater clarity of investors’ positions ahead of the AGM season.
Some investors have begun to do this. For instance, NEI Investment states that it looks for “clear linkage of pay to performance against the company’s strategic objectives based on financial, environmental and social metrics of long-term value that allow for an appropriate risk-taking and do not encourage misconduct”.
Trillium’s 2020 proxy voting guidelines state that the company votes against on say-on-pay proposals if any of the following apply:
- CEO pay is excessive compared to its peers;
- equity awards vest in less than five years; and
- CEO pay is not tied to ESG performance.
Similarly, Robeco’s stewardship policy explicitly acknowledges inclusion of relevant ESG metrics as a core component that is evaluated within its remuneration framework.
This trend can only be expected to grow as disclosure on remuneration becomes more detailed and comparable, facilitated by regulatory requirements such as the Shareholder Rights Directive and corporate governance codes that make specific reference to ESG-linked pay.
II. Encourage investees to identify relevant ESG factors
Identifying relevant ESG factors for a company’s operations is the most critical step in implementing ESG-linked pay. Any investor-company conversation on the subject should start with a discussion of the board’s processes for determining and reviewing relevant ESG factors for their business.
Investors have often taken the view that boards should use their discretion to select ESG factors that are relevant to their operational context, size and industry when integrating with pay. The PRI agrees that a formulaic approach would not be desirable, given that companies are exposed to unique sustainability risks and opportunities. However, investors must ensure that these choices are not ill-conceived – for instance, companies in carbon-intensive sectors ought not to ignore the implications of climate change to their business.
Investors should also encourage companies to disclose how selected ESG factors drive value and align with the organisation’s sustainability strategy and / or its broader purpose – companies should not restrict attention to ESG issues that are financially material in the short term. Relevant ESG factors should be selected based on a nuanced understanding of what impacts the financial or the operating performance of a company and how an entity’s operations and products impact stakeholders and the environment, in the context of broader societal goals and planetary boundaries. Selected factors should also be regularly reviewed to ensure they are fit for purpose, reflect stakeholder views and can adapt to critical events like COVID-19 or regulatory developments.
That said, not all relevant ESG factors can be easily quantified, and boards may be forced to make certain trade-offs to reach the right balance of environmental, social and governance measures for the purpose of pay. Where companies face challenges in identifying the right metrics or targets for certain ESG issues, they should endeavour to disclose these issues, as well as describe the process undertaken, so investors and stakeholders can understand the rationale and provide input in an informed way. Over time, it is likely that challenge from investors and stakeholders will improve the rigour and process that companies employ to link ESG factors to pay.
III. Step up stewardship activities for:
a) Companies that do not incorporate ESG-linked pay
Where portfolio companies do not consider ESG-linked pay, investors should challenge the board or the management and encourage the company to make a commitment to include ESG criteria in remuneration design. If material ESG factors are being discussed in the sustainability reports as value drivers and the board has responsibility for sustainability governance, then it is reasonable to question why such factors are not reflected in the remuneration package. Similarly, where companies are exposed to material ESG risks, but executives have failed to act, there may be merit in tying those ESG factors to pay to incentivise the desired change. After all, it is within investors’ remit to ensure that executives are incentivised to generate long-term shareholder value. Accordingly, investors should signal to portfolio companies that failure to incorporate meaningful ESG measures into pay within a certain timeframe will result in a vote against, for example, pay plans, the chair of the remuneration committee etc.
b) Companies that fail to integrate ESG in a meaningful way…
… in terms of balancing and prioritising ESG factors
It is often observed that certain ESG factors get more prominence in remuneration packages than others. Research commissioned by the PRI and undertaken by Glass Lewis on extractives and utility sectors (covering 83 companies that are included in major stock indices in North America, Europe, and Australia) found that safety measures account for the most frequently incorporated factors, constituting 34% of all ESG factors linked; while climate factors only account for 8%. Governance factors are rarely used by firms in these sectors.
The study also found that extractive and utility companies demonstrated limited inclination to incorporate social metrics and targets in pay – only a handful of companies in Europe and Australia use diversity or other social factors. Despite the COVID-19 crisis shifting stakeholder focus to social factors, issues such as worker protection, supply chain issues and digital rights  are often poorly reflected in performance criteria related to executive remuneration. However, some companies with high-risk exposure have recently faced pressure to integrate social factors into pay to improve corporate commitment and accountability. For instance, British fashion retailer Boohoo recently faced demands to integrate metrics related to workers’ rights into executive pay following grave concerns about its social performance during the pandemic.
We recommend that investors monitor the use of ESG factors in executive remuneration and query companies or use negative votes where risks are severe and the progress is inadequate, for example on social issues, climate etc.
… when it comes to providing specific targets and metrics
One of the key criticisms levelled against ESG-linked pay is that it can enable greenwashing and pay padding. Such concerns are valid, given that many companies continue to use vague ESG factors that are hard to measure or are misaligned with the company’s strategic priorities.
Investors must therefore ensure that selected ESG factors genuinely stimulate systematic progress towards sustainability ambitions and do not reward executives for business as usual (e.g. maintaining compliance with laws and regulations) or for improving perceptions regarding sustainability performance (e.g. by tying pay to inclusion in sustainability indices, which are rarely specific to companies’ ESG performance).
Furthermore, investors should verify that companies have established and disclosed specific metrics that are linked to clearly defined and stretching targets. While there has been some improvement in this area, companies’ practices are often inconsistent. For example, companies may have greenhouse emission targets aligned with their executive pay, but these targets do not fully match up with their transition plans or a Paris-aligned climate scenario – such targets should be scrutinised.
Where investors find that companies have adopted ESG metrics in pay for the primary purpose of ESG signalling and they are not supported by substantive targets, investors should use engagement in combination with a negative vote to communicate concerns. Such posturing from investee companies could dilute the intended impacts of ESG-linked pay and create cynicism around legitimate use.
… in terms of considering the relative weight
While financial targets such as Total Shareholder Return (TSR) or Earnings Per Share (EPS) tend to be the driving force behind performance-based incentive plans, ESG-linked pay often forms a small portion of the overall remuneration package. ESG factors affect, on average, around 15% of the overall executive remuneration package.
Where investors find that ESG-linked pay does not make up a meaningful component of remuneration, they should query how these companies plan to increase the weighting of ESG factors. Even though investors may not have set views on the optimal level of ESG-linked pay within variable remuneration, they should ascertain that it is balanced appropriately with financial factors and can influence improvement in sustainability performance.
… when it comes to time horizons
Companies should ideally incorporate ESG metrics into long-term incentive plans to enable longer-term decision-making. However, in practice, companies tend to favour ESG metrics in short-term incentive plans, potentially because of concerns that the performance period can affect the impetus to act on sustainability goals. Where this is a concern, investors should advocate that the annual KPIs contribute towards meeting longer-term sustainability objectives rather than being one-off targets.
c) Companies that are opaque about the mechanics of ESG-linked pay
Another relatively common issue is poor transparency around how ESG-linked pay works and the impact it has on total realised pay, making it difficult for investors to understand if executives’ performance is being measured in a fair and holistic manner.
For example, the use of integrated ESG metrics can be problematic in certain circumstances. PRI’s commissioned research finds that although a large proportion of extractive and utility companies, particularly in the US, embed integrated ESG metrics in pay (where ESG factors across multiple categories relating to environment, social and governance are tied together in one metric), many of them fail to disclose relevant targets against the integrated metric or award incentives even when established criteria have only been partially met. This is particularly troubling when a sizeable portion of the remuneration is based around these metrics.
Similarly, companies sometimes provide limited clarity when linking ESG and pay via mechanisms such as underpins and modifiers. Underpins require executives to meet a sustainability target to avail awards from other incentive plans (for instance, companies may need to demonstrate a zero-fatality record before earning incentives for the achievement of financial targets). Modifiers increase or decrease incentive awards generated by other achievements, depending on whether ESG targets have been met. While these may be effective options and a thinking outside the box approach should indeed be welcomed, investors must ask for clear explanations on how these mechanisms work in practice – they must probe how and when they have been used and the way discretion has been applied, especially in the case of adjusting pay upward.
iv. Consider support for shareholder proposals on ESG-linked pay
There has been a steady increase in shareholder proposals on ESG-linked pay over the last few years, urging companies to consider incorporating metrics related to, for example, drug pricing, privacy and diversity. Investor support has ranged from 10-20% for these proposals.
As noted in our recently published Making voting count paper, voting in favour of shareholder resolutions should not be reserved for escalation following unsuccessful engagement. Instead, voting on proposals should be used to provide feedback and reinforce messages shared through private engagement. Where investors favour ESG-linked pay, they must vote in alignment with this position. However, where they have reservations in relation to certain types of resolutions, e.g. those that require companies to integrate specific metrics within remuneration, this view should be clearly outlined in their voting principles or guidelines. In addition, if there are concerns about the quality and content of the proposed resolution and an against vote is put forward in contradiction to an investor’s voting principles, the rationale for the voting decision should be promptly disclosed.
Further stewardship measures
Investors should also exercise their stewardship responsibilities by:
- responding to policy consultations and actively communicating expectations to policy makers on ESG-linked pay; and
- asking proxy advisers about their position on ESG-linked pay and discussing how they can strengthen voting guidelines and recommendations on the topic.
As efforts to harmonise disclosure on ESG evolve, we can expect companies to be better positioned to tie current and forward-looking relevant metrics and targets to pay. However, the absence of a globally consistent and comparable set of ESG metrics should not be used as an excuse to dodge board obligations to identify material ESG factors and integrate them into pay. It is only with ongoing dialogue and communication of investors’ expectations that we can expect greater rigour in ESG-linked pay over time.
2 See: German corporate code (Article 23); the French corporate governance code and the EU consultation on sustainable corporate governance
3 Edmans, A. (2011), ‘Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices’, Journal of Financial Economics 101
4 Flammer C, Hong B, Minor DB. 2019. Corporate Governance and the Rise of Integrating Corporate Social Responsibility Criteria in Executive Compensation: Effectiveness and Implications for Firm Outcomes, Strategic Management Journal, 40(7): 1097-1122
5 See Li.W and Young, S. (2016). ‘An analysis of CEO Pay Arrangements and Value Creation for FTSE-350 Companies’, Report commissioned and funded by CFA Society of the United Kingdom; Edmans, A., Fang, V., and Lewellen, K. (2016) ‘Equity Vesting and Investment’, The Review of Financial Studies, Volume 30, Issue 7, July 2017, Pages 2229–2271, https://doi.org/10.1093/rfs/hhx018
6 For instance, Carbon Tracker has documented in its recent report how oil and gas executives continue to be rewarded to perform at odds with energy transition. https://carbontracker.org/reports/fanning-the-flames/
7 Flammer C, Hong B, Minor DB. 2019. ‘Corporate Governance and the Rise of Integrating Corporate Social Responsibility Criteria in Executive Compensation: Effectiveness and Implications for Firm Outcomes’, Strategic Management Journal, 40(7): 1097-1122
9 In several jurisdictions, investors are offered a vote on remuneration. In some regions, these ‘say on pay’ proposals have evolved from being advisory to binding, securing investors a significant opportunity to voice their concerns about pay structures
12 Companies, however, continue to rely on metrics such as employee engagement scores, customer perception, satisfaction and complaints
14 See here for more details: https://www.unpri.org/covid-19
16Glass Lewis paper, commissioned by PRI, available on request
17 Climate Action 100+, one of the largest investor initiatives on climate change, has placed demands on target companies in high-carbon industries to integrate ambitious climate metrics and goals in their executive remuneration packages: https://www.climateaction100.org/progress/net-zero-company-benchmark/
19 Glass Lewis paper, commissioned by PRI, available on request
21 Glass Lewis paper, commissioned by PRI, available on request