Connecting the thread of executive compensation to ESG performance

The ESG theme is continuously rising high on the analysis charts of corporate boards, business leaders, consumers, employees, regulators and rating agencies. The idea of connecting the thread of executive compensation to a company’s ESG performance was born out of the need to integrate ESG into a company’s system and is currently trending a lot. Some may argue that attaching ESG, which are non-financial parameters to executive pay, is unfair. But integrating ESG today in a corporate system is not only about the company’s conscience but has also become a tried and tested formula in the market that ensures success, profitability and satisfaction. It can significantly affect a company’s bottom line. ESG today is a compelling need owing to a company’s responsibility towards climate change, a productive and satisfied workforce and good governance. This responsibility is transforming into mandates now with regulators continuously hustling to enact regulations on ESG.

It is observed that many of the S&P 500 companies are doing so. It rose to 73 per cent in 2021 from 66 per cent in 2020. Also, more than fifty per cent of FTSE 100 companies have tied financial incentives to sustainability targets for their CEOs. Companies are seen resorting to different ways to factor ESG into executive compensation. They are either opting for quantitative or qualitative criteria while deciding executive compensation. They either look at the annual financial performance rating of the company or assess qualitative individual performance. Popular approaches include looking at DEI- (Diversity-, Equity- and Inclusion-) related goals, or emission reduction goals by assessing carbon footprint. The methods generally used are “StandAlone Methods” which include quantitative metrics, the “Business Strategy Scorecard”, the “Individual Performance Assessment” linked to the executive’s individual performance rating or the “Modifier” in which the financial performance rating is adjusted by ESG. The metrics differ from company to company based on their sector. For instance, an energy company will probably give more importance to environmental goals and link them to executive pay. On the other hand, an IT company will mostly link the pay to socially orientated goals.

The rationale behind such a step

In order to cater to investors’ demands and regulatory mandates, many companies have set up ESG goals which they aim to achieve in a set timeframe. It is on their priority list. Such ESG goals are also in the company’s financial interests. If executive compensation is tied to the fulfilment of these goals, they can readily be achieved. Executives will try harder and pull up their socks to accomplish the company’s ESG goals. Such a step also enhances social responsibility principles. If a portion of the executive compensation is based on the ESG incentive, it will only augment the ESG process. It will also create a positive image of the company in the eyes of investors. They will perceive the company as being socially responsible.

Surveys have also revealed that this practice is more prominent in countries where ESG reporting is mandatory for companies. It can also majorly be seen in industries that are more carbon-intensive because of the mounting pressure on them to adopt climate-friendly practices. As certain industries negatively impact the planet at a much higher intensity, it is a pressing need for these sectors to reduce their environmental footprints diligently. The introduction of such programmes as linking executive pay will accelerate actions on the company’s end.

Not the end

Connecting this thread will not guarantee that a company will become the best ESG company. It is also not going to guarantee the achievement of ESG goals for a company. Rather, it is an effort in that direction just like many other efforts. It will not solely be responsible for the change but it definitely will be substantially responsible.

Criticisms

Such a practice is also criticised by many. A lot of people feel that tying ESG to executive pay is nothing but a publicity stunt to grab attention. Critics say it is just for the sake of showing the world that the company is taking steps in the right direction. It is a medium for greenwashing. Where transparency of executive pay has always been questioned, it is extremely challenging to verify the genuineness of such a procedure.

Conclusion

The trend is bound to grow in the coming years due to the ever-growing focus on ESG issues. There could be a time when using ESG metrics in executive compensation will be an established practice. The idea is definitely associated with better ESG performance but only time will tell about the practical issues grappling such a thread. The process also currently lacks uniform and consistent standards which may culminate into wrong decisions. Companies can also run a trial period of around one to two years to see if the strategy is working for the company and its business before making such an ESG-incentive pay a permanent policy. It surely can turn into a successful strategy if the company chooses the right metrics, method in consonance with their stakeholder demands.

You can learn more about this topic by opting for our recognised courses — ESG Expert Certification from Directors’ Institute- World Council of Directors.