Executive pay & ESG Performance: Hindering Link?

This week AllianzGI announce to begin voting against companies that Don’t Link Exec Pay to ESG Performance.

This move unprecedentedly illustrates how the investment and asset management world position the relation between Executive Pay and ESG Performance.

So what is Executive Pay?

More important, why should they link to ESG performance?

Executive compensation packages are frequently related to the achievement of a set of specified results, whereas typical employees receive fixed pay packages or wages, which makes the way executives are compensated significantly different from the way salaried employees are compensated. Executive compensation, often known as executive pay, refers to compensation plans created especially for a company's senior executives, business leaders, and executive-level staff. Benefits including salary, perks, incentives, insurances, etc. are all included in executive compensation.

For the past 20 years, incentive-based pay for senior management and CEOs has been on scheme of almost every single company. The aim to align the interests of management and shareholders has been a major driving force for this, with the justification that executives would perform better and provide greater value to shareholders if they are highly incentivized.

Traditionally, CEO performance has been evaluated against objective ‘hard’ data through key performance indicators (KPIs) which include a number of financial metrics namely: revenue; attributable profit; market share, etc...

However, this ship has sailed.

New trend is emerged. ESG Performance as indicators of Executive Pay

The Conference Board Center recently released a report titled "Linking Executive Pay to ESG Performance," which essentially states that attaching a percentage of CEO salary to ESG principles is becoming a common governance practice. In fact, according to survey data, the proportion of S&P 500 companies using ESG performance indicators is steadily rising, rising from 66% in 2020 to 73% in 2021. In which, the adoption of diversity, equality, and inclusion (DEI)-related goals, which increased from 35% in 2020 to 51% in 2021, is the method that the Survey found to be the most often embraced. Also, a growing number of S&P 500 corporations (from 10% in 2020 to 19% in 2021) are connecting executive compensation to carbon footprint and emission reduction goals.

Over the past two years, a number of well-known firms have made announcements relating ESG targets to executive pay, including Apple, BP, McDonald's, and Starbucks.

• Apple stated in January 2021 that it planned to increase or lower executive rewards by up to 10% depending on how well it was doing in achieving its ESG targets. The IT giant has just unveiled a new net zero pledge, a target probably linked to executive incentives, without saying which measurements will be used.

• An environmental target is one of the performance metrics on the scorecard that determines the annual reward for BP executives. BP increased the weighting of the environmental aim from 10% to 20% in 2020.

• McDonald's integrated diversity objectives in its CEO pay in 2021. The fast-food corporation aims to achieve gender parity in leadership by 2030 and has increased its executive representation from underrepresented groups to 30%.

• In a letter to staff members dated October 2020, Starbucks CEO Kevin Johnson promised that the business would "hold ourselves responsible at the top levels of the organization" by tying executive pay to the success of its efforts to promote inclusion and diversity. The company aims to have at least 30% BIPOC representation at the corporate level and 40% of all roles in retail and manufacturing by 2025.

Interestingly, more than 75 percent of board members and senior executives said that their companies' good ESG performance is a major factor in their financial performance, according to a recent global poll by Willis Towers Watson.

The above mentioned survey also shown that there is no “one size fits all” approach in how companies factor ESG into executive compensation. In fact, there are several different methods was found, namely:

• The “Stand-Alone Method,” which incorporates ESG through specific (often quantitative) metrics;

• The “Business Strategy Scorecard,” which incorporates and evaluates ESG goals as part of a larger scorecard of ESG or nonfinancial business priorities;

• The “Individual Performance Assessment,” in which ESG is taken into account as part of an executive's individual performance rating

• The “Modifier,” by which ESG is used to adjust the financial performance rating, the overall rating, or the payout under a compensation plan.

However, it is that simple to link Executive Pay to ESG Performance?

The answer is definitely not. In fact, it accompanies with many challenges.

• "Check the box" practices: There is a real threat that company/executives only focus on tick the box to get compensation by the end of year, instead of making any genuine impact.

• Miscalibration: A threat of setting easy targets to ensure the achieving of compensation.

• Impact measuring: Measuring the full impact of including ESG performance goals in compensation is more challenging than measuring the impact of traditional operating or financial metrics.

References

1. What is executive compensation

2. Linking executive pay to ESG goals

3. Why more companies are linking CEO pay to ESG?

4. Linking executive pay to sustainability goals

5. ESG & executive pay: A look inside the trends.