Linking Executive Compensation and ESG: Navigating a Minefield

Photo by Alexander Mils on Unsplash

ESG issues are shaking up boards and CEOs. As a result, companies are increasingly considering tying CEO compensation to ESG issues. Some of the marquee companies that link executive compensation to ESG include Apple, McDonald’s, Rio Tinto, Royal Dutch Shell, and Unilever.

European and British companies have taken the lead. According to a survey by Pay Governance, 90% of UK and European companies included ESG metrics in their incentive compensation plans. Compare this to the US, where only 21% of the companies linked ESG metrics to CEO compensation.

With shareholders and consumers making ESG issues a priority, companies are being forced to respond by linking executive compensation to ESG targets. The push for tying CEO compensation to ESG metrics also comes from activist investors willing to punish companies that do not tie ESG targets to executive compensation.

There are two compelling arguments for linking pay with ESG performance. First, many believe that good ESG practices will boost a company’s bottom line. Thus an incentive to improve ESG performance will improve financial performance. Second, it is commonly believed that rewarding performance is the best way to ensure performance.

Although linking CEO pay to ESG performance is on the rise, many issues need to be addressed:

  1. Many companies try to deflect attention from poor performance by highlighting executive compensation linked to ESG factors. For instance, Shell has underperformed the S&P 500 by a wide margin and its profits have been weak and even amde a loss last year.
  2. What percentage of the compensation is linked to executive pay? If only a small fraction is linked, the CEO may not worry too much about ESG actions and yet receive significant compensation.
  3. ESG factors linked to executive compensation may be easy wins that enable the CEO to still take a fat pay packet. For instance, targets may be linked to diversity measures which can be easily achieved by hiring the right mix of candidates. Or, they may be linked to carbon reductions that are achieved by simply buying carbon offsets, whose genuineness is often questionable. Alternatively, recycling targets can be achieved by outsourcing recycling activities. The tougher can of long term carbon emissions get kciked down the road.
  4. ESG actions have a long term impact, whereas CEO tenures tend to be relatively short – median CEO tenures are around five years. This creates a mismatch – with results of ESG actions coming well beyond the CEO’s tenure. Most CEO’s will baulk at such long term goal setting.
  5. Some focus on a few KPIs, whereas others design multidimensional scorecards covering a wide range of focus areas. It is often easy to mistake the woods for the trees. The challenge lies in creating a scorecard that is sufficiently comprehensive to cover a range of ESG priorities and at the same time remain manageable.
  6. Finally, the benefit of linking pay to ESG performance lies in measurement. With imperfect measures and data gaps in ESG, it often becomes difficult for goals to be set.  

Boards and executive compensation committees can counter some of these issues. Unfortunately, many boards and executive compensation committees come from an earlier generation and lack an appreciation for ESG issues. This lets many CEOs get their way on ESG linked compensation.

A good system to link CEO compensation to ESG factors involves:

  • A value driver analysis will help companies understand which ESG factors have a short term impact value and which ones have long term value.
  • Create a methodology by balancing various metrics (both leading and lagging) to determine nonfinancial metrics linked to ESG. 
  • These metrics can then go into executive compensation measures. Programs can be designed to align with value drivers enabling the company to go from point A to B.

Corporations are at a crossroads. Boards and CEOs are debating what their fiduciary responsibilities should be in a world where the focus on ESG is continually growing from the society. Although establishing and achieving the ESG goals is the right thing to do, connecting executive pay and ESG needs to be done with care and thought. It’s challenging but doable.