Stephen Murphy

How is ESG Investing Impacting Executive Pay?

What do a Mexican food chain, an air conditioning company and one of the world’s largest activist investors have in common? They are all tackling the challenge of how to incentivise executives to advance corporate sustainability goals.

Over the past half a decade, the investing world has witnessed a paradigm shift in the values driving investment.

This shift in values is evident from investor sentiment, which has seen a monumental surge in environmental, social, and governance (ESG) and socially responsible investing (SRI).

The essence of ESG and SRI 

In ESG investing, investors focus on the correlation of ESG factors with the company's performance and make decisions based on how these factors will impact an investor's returns.

However, in SRI, investors map their portfolio to their beliefs and values.

COVID-19 has reminded us that businesses do not operate in a vacuum; their conduct has an important and significant impact on wider society.

If a business fails to demonstrate a cultural commitment to promoting ESG factors in today’s post-COVID era, key staff, investors, clients, and customers may well vote with their feet and prefer the competition.
In the last year, there has been a broad shift in corporate governance focus towards social issues, including human capital management – the ‘social’ factor within the acronym ESG.

An evolution of salary structure

In what can only be described as an attempt to accelerate its bold 2030 sustainability commitments, an American-Irish industrial manufacturing firm, Trane Technologies, moved to tie ESG metrics to executive and employee compensation.

In a May 2021 statement, the company announced a revised annual incentive plan which holds top executives and senior leaders accountable for meeting the company's ambitious social and environmental sustainability goals.

In addition to tying leaders' annual cash incentives to ESG metrics, all salaried employee performance plans must now include at least one goal tied to the company's 2030 sustainability commitments. The world-renowned Chipotle Mexican Grill also recently introduced a metric to tie executive pay to ESG goals.

Linking executive pay to ESG, as in the example of Trane Technologies, Chipotle, and an increasing number of other companies, should be viewed with caution, to ensure metrics are designed appropriately and not an exercise in ticking sustainability boxes without driving long-term value.

Take Boohoo Group for example who are the latest publicly listed company to tie executive remuneration arrangements to specific ESG targets to demonstrate commitment to sustainability and the societal impact of its operations.

Off the back of widespread reports of unethical practices in its supply chain this past year, the UK-based fashion retailer has linked 15% of its executives’ annual bonuses to its “Agenda for Change”, an initiative the company launched in 2020 to promote ethical and sustainable working practices across its supply and logistics network.

An independent review by U.K. lawyer Alison Levitt found Boohoo previously prioritized profit and growth and ignored labor violation red flags but cleared the company of any direct involvement. Levitt made a series of recommendations that are incorporated in Boohoo’s Agenda for Change reform plan.

Linking remuneration to ESG investing goals would mark a significant shift for a retailer that has, until now, tied executive pay to aggressive share price and sales growth targets.

However, it is not only firms who are pushing for executive pay to be linked to ESG targets.

In an early 2021 press release, Swedish activist investment firm Cevian Capital released a statement on incorporating ESG metrics into senior management compensation plans for European public companies.

Cevian stated:

‘in order to accelerate and secure meaningful ESG progress, there must be strengthened alignment between the desired outcomes and the companies and individuals we expect to produce them.’

Cevian, well known for acquiring significant minority ownership positions in European public companies, promised to ‘hold companies and their directors to account through its engagement, and, if necessary, a combination of voting on director elections and compensation plans’.

This is, on the face of it, businesses putting their money where their mouth is.

Three considerations when restructuring remuneration

If a company is truly committed to doing good, it seems to follow that any performance-related pay should be linked to ESG targets, alongside financial targets, and other relevant measures.

Research published by PWC shows 45% of FTSE 100 companies have incorporated an ESG target in their annual bonus scheme, long term incentive plan, or both.

Restructuring remuneration can be an effective tool to drive accountability and culture change, but when integrating this type of shift, the below needs to be considered:

  1. A business’ ESG impact and performance can be hard to measure reliably and consistently, and it is difficult to formulate an effective, transparent, and fair bonus structure without robust quantitative metrics.
  2. Linking short-term financial incentives such as annual bonuses to ESG targets may have the effect of encouraging short-term, tokenistic action and a focus on quick wins at the expense of tackling more complex problems - quite the opposite of doing business sustainably, with a focus on long-term social and environmental impact.
  3. In some cases, adapting executive remuneration schemes may not be a viable option. Smaller businesses, for example, may lack the resources and specialist expertise to set appropriate ESG.

ESG investing – no longer ignored

It is clear the application of ESG in the assessment of corporate behavior is not straightforward and each business sector will have a different focus.

Improving a business’s social and environmental impact involves transparent and ethical behavior that often goes beyond legal requirements and as such can be hard to measure.
Additionally, ESG factors are often intangible to some degree, and it can take many years for any significant improvements to be achieved.

Despite these difficulties, what is clear is that businesses can no longer ignore the importance of ESG goals.
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