By Vaishnavi Ravishankar, Senior Analyst, ESG, PRI
The role of performance-based pay is to incentivise better performance and align rewards with company success. Incentive schemes can influence behaviour and even organisational culture, sometimes negatively. Wells Fargo’s scandal is a case in point. Although the company’s vision was focussed on customer satisfaction, the aggressive sales targets linked to employee bonuses led to fraudulent mis-selling of products, causing serious reputational challenges and financial setback.
If done right, incentives should help us achieve the opposite effect of what we saw at Wells Fargo – including driving transformational sustainability outcomes and mitigating ESG risks. One way of doing this is through incorporation of ESG factors into pay design. While this is not a new concept, it is often poorly used and executed. So, at PRI in Person, this year, we had a closer look at the benefits and challenges of companies’ use of ESG-linked pay. Benjamin Yeoh (RBC Global Asset Management) highlighted the arguments for incorporating ESG factors into pay while Scott Zdrazil (LACERA) talked us through the practical considerations and challenges.
The case for ESG-linked pay
We heard some strong arguments for why ESG factors should be incorporated into pay. Firstly, executive remuneration is a matter of concern for investors when the levels of pay don’t correlate with corporate performance or value generated in the long-term. This is not uncommon, given that incentive plans don’t often work as intended. Secondly, there is evidence to suggest that ESG factors result in positive financial returns and hence portfolio performance. Given that the market doesn’t account for these factors adequately1, it would be sub-optimal not to consider them in incentive plans to help deliver long-term sustainable performance.
Given that the market doesn’t account for ESG factors adequately, it would be sub-optimal not to consider them in incentive plans to help deliver long-term sustainable performance
There are indeed challenges linked to integration of ESG issues into pay that need to be duly considered for the benefits to materialise. One that is often referred to is the challenge around use of ESG factors that are difficult to quantify. Vague ESG metrics can lack rigour and easily become “pay padding”. Therefore, it is essential that performance measures are carefully selected in the context of the wider sustainability strategy and relevance for the company. It is good to bear in mind, as mentioned by Scott Zdrazil during the PRI in Person session, “not every ESG metric is a great metric”.
Role of remuneration committees
The selection of appropriate factors, relevant metrics and targets appears to be no small feat for remuneration committees in the era of complex businesses. However, the directors should know their businesses best and therefore be able to identify the factors that drive long-term success. While investors may not be keen to micro-manage and dictate what those factors should be, they expect to receive appropriate justifications when the pay design is scrutinised.
Evidence suggests that excessive reliance on short-term financial targets may be contributing to short-termism2. Balancing pay with long-term sustainability factors will likely realign priorities and shift the time horizon. Unfortunately, there are a few impediments. Firstly, more often than not sustainability factors are incorporated into annual bonuses as opposed to long-term incentive plans. Secondly, they tend to be focused on past performance i.e. are backwards-looking. Thirdly, they aren’t appropriately sized and carry a small weight relative to financial targets. These issues need to be remedied to enable more effective pay plan incorporation.
There are concerns that targets related to ESG factors could be manipulated. For instance, executives could negotiate ESG targets that are easily achievable/not challenging enough to increase their pay outs during times of economic downturn. However, concerns around gamification are not just relevant to ESG metrics – no pay metric is perfect. For instance, there has been some coverage of controversies around using share buybacks to hit EPS targets. Hence, companies should be encouraged to clarify the rationale for the selection of ESG metrics and investors should be able to question and determine their appropriateness.
Could use of ESG metrics result in perverse incentives? The answer is yes, perhaps. For instance, using recordable incident rates as a safety target in the executive pay package may discourage accurate and timely recording of safety incidents. A similar argument may apply to the recording of cyber security incidents, etc. Again, this is not a problem that applies to ESG metrics alone – sales targets may incentivise steep drug price increases, compromising access to healthcare and the use of oil and gas reserves could undermine ambition around climate action. However, appropriate oversight and use of remuneration committee discretion should reduce the likelihood of such situations.
In summary, investors thinking about their position on extra-financial factors in compensation may have several issues to think through – from the business case to perverse incentives. Nonetheless, there is growing interest in their use and implications. And if we want sustainability to be embedded in compensation, we need to overcome the challenges we heard about – through dialogue and sharing learnings.
Indeed, as investor collaboration and policy measures to achieve a sustainable financial system strengthen and grow, this will be an important question to answer: how can ESG factors be integrated into executive remuneration to incentivise and reward sustainable performance over the long-term?
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1. Edmans, A. (2011), ‘Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices’, Journal of Financial Economics 101
2. For example: 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