Linking Executive Pay and ESG Performance

ESG Performance

By Vincent McCarthy, CFA

During a course I delivered recently, one of the executives in attendance raised the point that even though there is more talk of consumer and investor interest in sustainability, a CEO’s performance is ultimately measured by traditional financial metrics, including the share price.

Yes, financial performance will always be at the core of measuring performance in the business world. However, sustainability will be a major source of disruption across all industries, and it represents a huge opportunity for companies that adapt. A CEO needs to understand the impact of sustainability on their business as part of meeting and exceeding traditional financial metrics.  

The question of time horizon comes into play when considering the best path to take. The obsession with beating ‘the street’s quarterly earnings estimates’ and rapidly gaining market share perpetuates a culture of short-termism. Yet the essence of sustainability is to shift the focus towards the long-term impact of decision making.

It is important to put the right structures in place to ensure that long term sustainability goals are not compromised by the pressure to meet short term financial goals. The decisions taken today should align with the strategy for the future. Executive pay can be a powerful tool to align performance with the long-term objectives of shareholders.

A CEO needs to understand the impact of sustainability on their business as part of meeting and exceeding traditional financial metrics.  

Making the Link

At the heart of the culture of short-termism in business is an incentive-based system that places greater value on the short term than the long term. This has led to more calls for ESG performance and executive pay to be explicitly linked.

After some pushback last year, Apple recently announced  that the cash bonus element of executive pay will include an ESG component which could sway the final number up or down by 10%. However, they remain in the minority. And it is not enough.

The reality is that despite the momentum behind responsible investing and ESG, the majority of companies are yet to materially link ESG performance and executive compensation. Executives are broadly measured and rewarded on the same financial metrics as they have always been.

Davos Deliberation

Stakeholder capitalism was the theme for the World Economic Forum’s 2020 conference – the annual event in the Swiss Alps town of Davos – and the issue of ESG and executive pay was discussed at the International Business Council Meeting.

In the press release that followed the meeting, the WEF went with the uplifting headline: “CEOs Welcome Alignment of Executive Pay to ESG-Related Criteria”. The key points cited were:

  • Move will address widening pay gap between bosses and workers, says union rep.
  • Majority of CEOs at the International Business Council meeting in Davos indicate support for alignment.
  • Investors expected to step up pressure on executive pay to limit climate-change liabilities

Maha Eltobgy, Head of Shaping the Future of Investing at the World Economic Forum, said “the alignment of executive pay to some ESG-related criteria was widely supported by chief executive officers who participated in yesterday’s International Business Council meeting in Davos to deliberate a set of metrics to help companies track performance against long-term priorities.”

The downside has been a wave of greenwashing, whereby some organisations are more focused on creating the appearance of being sustainable rather than the follow through.

The Measurement Challenge

The pushback against linking ESG performance and executive pay appears to be around what to measure and how to measure it. This is perhaps a reminder that organisations are still coming to terms with how to integrate ESG within their business, never mind executive pay. In other words, if the board does not have a handle on the material ESG factors of the organisation, how can they put in place a set of indicators to measure a CEO’s performance against these unknown set of factors.

Take a step back for a moment. ESG is the framework to understand the sustainability of an organisation across the three pillars of Environmental, Social and Governance. As consumers and investors have put increased pressure on companies to incorporate sustainability into their business model, we have seen a steady flow of more ambitious targets being announced, particularly around carbon emissions, energy efficiency and supply chain management.

So where is the measurement challenge? The point I am making is that these sustainability commitments are material factors that are measurable. If they are not measurable then they are not realistic targets; they are meaningless.

Greenwashing – A Game of Public Perception

The announcement of sustainability commitments is typically choregraphed to maximise the PR benefit – in other words it is not just about being more sustainable, it has also become an exercise in publicly showcasing one’s commitment to sustainability. This is to be expected in a world where sustainability is being valued more. Brand awareness around this theme is important.

However, the downside has been a wave of greenwashing, whereby some organisations are more focused on creating the appearance of being sustainable rather than the follow through. There is a level of shamelessness that is cringe worthy. That has always existed though, in some form or another. Authenticity is far from a given in business, politics, and all walks of life.

If ‘sustainability is at the heart of your business’ or if ‘sustainability is in your DNA’ – which is common language now from companies  – then it has to be lived through clear sustainability metrics that can be aligned with executive pay, just as is the case with traditional metrics. Otherwise, it is just greenwashing. This is not about perfection. It is about authenticity with respect to commitments and claims being made around sustainability. Performance measurement brings accountability.

In 2050, the CEOs of today will be on the sun lounger or pushing up daisies. Companies must have a clear measurable path for all long-term goals including around sustainability, and the compensation of the executive teams of the day will need to be aligned to keeping the company on track.

Active Stewardship Today

In the 2020 Global Pension Assets Study, by the Thinking Ahead Institute of Willis Towers Watson, of the findings from the last 20 years of global pension assets growth the number one missed opportunity was “stewardship”.

“The 20-year story is one of missing the opportunity to influence and mitigate corporate misalignments – like executive pay, and other poor leadership and boardroom practices.”

Asset owners and the various stewards of capital – investment consultants, investment managers, advisors, trustees – must hold companies and their executive teams more accountable. The approach to date has been too passive. That is not a revelation. It is particularly important with respect to sustainability because many of the goals are decades into the future.

Some of the sustainability goals can stretch out to 2050! In 2050, the CEOs of today will be on the sun lounger or pushing up daisies. Companies must have a clear measurable path for all long-term goals including around sustainability, and the compensation of the executive teams of the day will need to be aligned to keeping the company on track. The independence of the board will be critical, and all relevant stakeholders have a role to play in increasing accountability.  

Failure to do so will continue to undermine people’s trust in the financial system, which is already at a low point. It will also mean there will be little chance of achieving a more secure future. 

The time for deliberation has passed. 

End

Vincent McCarthy, CFA