ESG issues and executive pay: insights from company dialogue

The investor-company dialogue and research uncovered key additional insights to the recommendations of the 2012 guidance:

Companies should align the issues identified in sustainability reports with those integrated into pay packages. Any differences between the issues identified in sustainability reporting and those used in pay should be supported by a balanced and transparent rationale to assure investors that ESG factors that are likely to impact shareholder returns are well understood.

Among companies participating in the dialogue, most ESG issues integrated into pay had been identified as key in the company’s sustainability reporting, but companies generally do not seem to have a structured process for doing so, or provide a rationale. The research shows that the range of factors that companies integrate into pay remains narrow, especially when compared to the variety of issues highlighted in sustainability reports. It is common for a company to highlight specific material risks in the annual or sustainability report, such as regional licence to operate, but employ only a sole ESG metric in pay, such as safety, with no further explanation. None of the utilities companies in the research sample included climate change metrics such as greenhouse gas emissions in pay metrics.

Not providing such a rationale may undermine the company’s commitment to sustainability and raise questions among stakeholders. In order to build trust, ensure shareholders’ understanding and gain investor support, companies should disclose, as clearly as possible, the link between material ESG performance and pay, or explain the absence of any such link.

Companies should explain how ESG issues could affect financial performance, and how this is reflected in long-term incentive plans. Companies that choose not to incorporate ESG metrics into executive pay plans, or only link them to short-term incentive schemes, should adequately explain how ESG issues are reflected in financial performance and the delivery of long-term strategy.

The last few years have demonstrated that ESG issues not managed correctly by the C-Suite can have devastating effects on a company’s reputation and financial performance (e.g. Volkswagen and GSK).

During meetings, investors asked companies how ESG issues are incorporated into pay packages, and whether they could be more integrated into long-term incentive plans (LTIPs). Almost all companies in the dialogue emphasised a conviction that ESG performance is a key driver of financial performance, which is captured by financial metrics such as total shareholder return (TSR), which are in turn a key component of many pay plans. Some companies therefore reasoned that if pay-outs under LTIPs were based on TSR, with challenging targets for the next three to five years, overall ESG performance may be satisfactorily accounted for.

Despite the long-term nature of ESG issues such as employee satisfaction, safety, water quality, emissions and spill prevention, the research showed that metrics for these issues are applied to short-term incentives far more often than to long-term incentives, with no explanation as to why. The proportion of companies explicitly incorporating ESG issues into long-term pay in 2014 was just 15%.

Companies should provide more transparency over how targets for ESG performance are set, how performance is measured against the targets and how discretionary powers are used.

Most companies that participated in the dialogue have governance structures and processes to ensure board oversight of operational ESG issues and performance. This is important given the remuneration committee’s responsibility to select appropriate ESG metrics and assess performance against a concrete set of targets.

However, while the research showed that a large majority of the companies disclosed ESG metrics related to pay, there was a significant lack of transparency on the specific targets set, and how performance is assessed against them: just over a quarter of companies in the sample had clear targets for ESG metrics.

For the majority of companies in the dialogue and the research sample, the board can exercise discretion to reduce or eradicate pay-outs based on poor ESG performance (determined by accidents or fatalities, for example). Discretion came across as a key tool companies already employ, and may use more, to assess performance against ESG issues. While companies agreed that discretion should always be accompanied by a meaningful rationale, the research showed that the companies in the sample did not provide detailed information on how discretion would be applied.

The research also showed that only a few companies have a more formalised approach towards ESG performance and pay, using structures such as gateways (through which earned incentives based on financial targets may only be paid when performance against ESG issues has been satisfactory) or bonus-malus structures (whereby failing to meet ESG targets, or exceeding them, will lead to a reduction or increase in any incentive award that might be generated by other achievements).

Companies should consider the role of their external remuneration consultants and ensure they have the necessary expertise to help select appropriate ESG issues and set metrics.

As is standard practice, most companies in the dialogue employed external remuneration consultants to help find the right financial metrics, to set targets and weighting and for peer benchmarking.

However, the majority of companies could not rely on their remuneration consultants to help select appropriate ESG issues and set metrics, other than to provide advice on weightings or examples of other companies’ practices.

This suggests a potential lack of expertise on ESG issues amongst remuneration consultants and raises questions about its impact on companies’ ability to identify and incorporate into executive pay the ESG metrics that could affect company performance in the short and long term.