The way executives are rewarded differs substantially from the way salaried employees are remunerated, in that executive compensation packages are often linked to the achievement of a set of predetermined results, while traditional employees receive fixed pay packages or wages. As a result, if the company underperforms its annual objectives, the executives at the helm would receive a smaller fraction of their potential pay.
Incentive-based pay for executives and senior management has become almost ubiquitous over the past two decades. This transformation in developed economies has been largely driven by the desire to align the interests of management and shareholders, under the logic that executives will perform better and deliver more value to shareholders if they are heavily incentivised.
Traditionally, CEO performance has been evaluated against objective ‘hard’ data through key performance indicators (KPIs) which include a number of financial metrics such as underlying EBIT / EBITDA; attributable profit; and total shareholder return / value generated. More recently, these have also been extended to include alternative measurable non-financial metrics such as reducing total greenhouse gas emissions or improving occupational health and safety.
However, a growing consensus has been voicing that there is something deeply flawed with the model of executive pay. Put at its simplest, executive pay had risen dramatically during a period when the Western economic model had not been at its strongest. As a result, in the aftermath of the financial crisis, some corporations began to shift away from objective measures to include softer measures in an effort to modify corporate culture and align to the goal of long-term sustainability rather than short-term targets.
A new set of criteria
In this respect, organisations all around the world are reacting to social and cultural shifts driven by the general public. In particular, the corporate world is now responding to the rising pressure to embrace the concept of doing well by doing good. As a result, sustainability targets and metrics are now being routinely acknowledged alongside traditional KPIs.
Today, nearly half of the FTSE 100 companies (about 45%) have set measurable environmental, social, and governance (ESG) targets for their CEOs, and have also begun to introduce ESG targets in executive remuneration packages. A recent global survey carried out by Willis Towers Watson found that more than three-quarters of board members and senior executives have indicated that strong ESG performance is a key contributor to the financial performance of their firms.
The four dimensions of ESG remuneration
It may therefore be safe to assume that, in order to continue to remain competitive, relevant, and maintain respect and reputation amongst its customers and employees, corporations must establish an ESG agenda, regardless of economic sector. Additionally, as international and national policy is becoming ever more focused on limiting and reducing the impact of climate change, it is possible that the inclusion of such an agenda may become a litmus test for financial regulators to assess whether banks, asset managers, and insurers are taking climate change seriously enough.
By incorporating ESG metrics within executive pay packages, decision-making by top level management is expected to take ESG into greater consideration. However, this brings challenges of its own. There is a risk of hitting the target but missing the point, where a ‘tick the box’ mentality is fostered rather than genuine improvements on ESG matters. An example may be a bank that is reducing its own carbon emissions, while still financing companies or projects associated with large carbon footprints.
There is also the risk of miscalibration of targets, in that companies may set out easily achievable strategic targets that they know they will hit. It is therefore important that ESG factors are integrated directly into the strategy of the firm, with pay incentives being used as a tool for mobilising the executives behind a new set of priorities. Pay should therefore follow strategy; it shouldn’t drive firm strategy.
Choosing ESG measures for pay, and calibrating them properly, requires boards to bring together insights from across the firm's internal teams and address the needs of the future through an unconventional and sometimes uncomfortable lens. Below, we present four key design dimensions that leaders and their remuneration committees need to weigh up when considering ESG measures as part of pay.
- Internal and external targets
- Individual KPIs and scorecards
- Long-term incentive plan (LTIP) and annual bonus
- Underpins and scale targets
Internal and external targets
Internal targets comprise input measures that can be used to measure and compare against the firm’s prior results. They are measured by activities that lead toward a stakeholder outcome, not by the outcome itself. Conversely, external targets make use of output measures that are used to assess the degree of impact derived in relation to the stakeholder impact (e.g. the total carbon footprint of the firm). While either measure is valid, each one needs to be readjusted in accordance with the organisation's strategic priorities in order to collect, analyse and communicate the data needed to assess whether targets have been met.
Individual KPIs and scorecards
It is important to keep track of and measure progress towards ESG goals. Some companies prefer focusing on trying to achieve several critical ESG issues with a few essential KPIs, whereas others may take a more of a general holistic approach including metrics such as diversity and inclusion, employee welfare and supply chain issues to their ESG agenda. In this regard, a carefully constructed and transparently disclosed scorecard will allow firms to track such benchmarks and ensure a fair balance is achieved between metrics in order to not overcomplicate the process and end up with some measures being disregarded instead. A pragmatic approach is essential to maintain the sustainability of such KPI’s over the long-term.
Long-term incentive plan (LTIP) and annual bonus
Environmental goals tend to sit more comfortably within a LTIP set out by organisations, given their relative long-term orientation. However, other ESG factors such as gender-equality as well as health and safety, which have gathered significant traction in Malta, can be calibrated over a single-year. The analysis of the FTSE 100 companies found that 55% of ESG measures related to pay were tied to bonuses and 50% were linked to the LTIP.
Underpins and scale targets
One can make use of performance scales in order to establish ESG targets, for example when measuring objective targets such as a reduction in CO2 emissions. This tends to apply for most transformational objectives, but may not always be the case. Certain metrics such as those found within health and safety may be difficult to quantify. Due to the increased subjectivity present there is a greater likelihood that such measures will be taken advantage of by senior management.
The corporate world is therefore at a crossroads, where companies and leaders are debating their fiduciary responsibilities, while society is demanding that businesses be held accountable to a wider constituency. Inevitably, as the drive to combat climate change continues to take centre stage and policy becomes more stringent, establishing and achieving ESG goals will be fundamental to a firm's long-term success. Connecting these goals more closely with executive pay would be a natural next step, however it is important that these are done with care and thought, so as to ensure financial incentives are truly driving the ESG agenda.
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