Sustainability

Linking ESG to executive pay: companies and investment firms need clearer, more consistent standards

Linking executive compensation to environmental, social, and governance (ESG) performance has been shown to help drive accountability and progress on the sustainability agenda. 

Tying executive compensation to ESG performance (or other non-financial performance indicators) isn’t new – more than half of FTSE 100 companies set measurable sustainability targets for their CEOs, and link progress to pay as a way of incentivising them to address common industry-specific risks. Energy companies are beginning to link pay to environmental goals like emissions reduction, while the materials sector focus on safety standards, and healthcare on employee engagement and well-being.

Research has also shown ESG-linked pay is positively associated with shareholder returns, based on analysis on the FTSE 350 between 2009 and 2011, as well as the S&P 500 between 2004 and 2014. Indeed, as we’ve already seen in the energy and utilities sectors and elsewhere, progress on the sustainability agenda can have a positive impact on the bottom line.

Yet in practice, companies are in the early stages of adoption. Fewer than one fifth of the companies in the Russell 1000 index, a broad index of corporate stocks, link ESG metrics with executive pay. Application has also been patchy, too, while a lack of clear and consistent standards on linking executive pay to renumeration leaves room for companies to introduce soft or unambitious targets that fail to move the needle.

For us, the most important question here is: does it actually work? To understand whether ESG-linked executive pay really does deliver on its intended objectives, we analysed how the concept was being applied across sectors and regions, focusing primarily on the change in carbon intensity – total scope 1 and 2 greenhouse gasses per unit of sales – over the past few years in the financial, utilities and energy industries.

High emitters pay more, but tying ESG to compensation has resulted in lower emissions

To see whether ESG-linked executive pay influences sustainability progress, we analysed carbon emissions intensity for 916 companies that have implemented such policies globally between 2015 and 2019 (381 utilities, 441 financial companies, and 94 energy firms) using salary and sustainability data from MSCI (we excluded companies for which data was incomplete).

Unfortunately, we found that companies with higher absolute emissions intensity tend to pay CEOs significantly more than companies with lower emissions, across the three industries (see chart below).

On the face of it, this would suggest companies linking ESG performance with CEO pay are not effectively bringing about the kind of progress on sustainability they aspire to, but it’s important to take these results with a grain of salt. They lack detail on how specific companies align individual metrics to CEO compensation, and only indicate whether the company has incorporated links to sustainability performance in its pay policies. The data neither defines the type of target, nor takes into consideration the incentive’s effectiveness either when a company announces the linkage or across time. Clearly, the data needs to improve.  This presents some hard truths for companies, investors and other stakeholders: the clear need for accountability and transparency.

What about the link between executive pay and changes in carbon intensity over time? We compared companies that do and don’t tie executive pay to ESG performance between 2015 and 2019.The results are consistent and positive (see below): across the three sectors we analysed and excluding a handful of outliers, companies that tied executive compensation to the achievement of ESG performance improvements reduced their carbon emissions more than those that didn’t.

More emissions, more money

Source: MSCI, NatWest Markets

Change in carbon emission intensities between 2015-19 across (from left to right) Energy, Financials, and Utilities sectors

Source: MSCI, NatWest Markets

The results are encouraging, but the data has important shortcomings that need bearing in mind. For instance, financial companies have better outcomes in reducing their carbon emissions intensity because it is relatively easier to control their own corporate operations, but the data doesn’t reflect the carbon intensity of their lending portfolios.

Furthermore, what counts as “ESG-linked compensation” is too broad. There is little indication of when such policies were put in place, or the specific targets being set. In some cases, businesses across all three sectors are using soft or easily achieved ESG targets to guarantee executive compensation – rather than incentivising a material improvement in sustainability outcomes. Clearly, more standardised disclosures are needed by companies (and investors) to prevent their misuse.

A blueprint for action: towards clearer, more consistent standards for ESG-linked executive pay

We think there has never been a better opportunity to improve sustainability-related corporate disclosures, including those related to ESG-linked pay. Companies should choose sustainability targets that are relevant for their core business or industry and avoid vague or generic ESG metrics; to that end, we list a few suggestions below that may be good starting points.

Environmental:

  • Reduction of GHG emissions as a direct result of reduction initiatives, including Scope 1, 2 and 3 where possible and gases (CO2, CH4, N2O, HFCs, PFCs, SF6, and NF3)
  • Reduction of energy consumption, percentage of renewable energy usage, and resource depletion
  • Total weight of waste generation in metric tons and management of significant waste-related impacts

Social:

  • Employee engagement and inclusive diversity represented in senior and middle management measured by outside firms and benchmarked to sector-based performance, similar to Danone’s approach in 2021
  • Occupational health and safety measured in injuries and cases of ill health/deaths in a given year, workers covered by occupational health and safety management system based on legal requirements measured in percentage terms or recognized as complying with the highest local standards
  • Risk for incidents of child, forced or compulsory labour based on offshored or cross-continental operations in areas with lower standards of living

Governance:

  • Monetary losses from unethical behaviour stemming from dealings with fraud, insider trading, anti-trust-competitive behaviour, market manipulation, malpractice, or violations of other related industry laws and regulations
  • Disclose the organization’s governance around climate-related risks and opportunities, including processes and frequency by which the board committees are informed about climate-related issues, whether the board considers issues when reviewing strategy, and how the board monitors and oversees progress. These can all be both written and then ranked for level of rigor by a third party or quantitatively measured on a scale after review
  • Remuneration performance criteria in the policies relating to the highest governance body’s and senior executives’ objectives for ESG topics connected to the company’s stated purpose, strategy, and long-term value. This disclosure allows for a comparison of explicitly stated incentives addressing major sustainability objectives and allows for reviews of fixed/variable pay, sign-on bonuses, termination payments, clawbacks, and retirement benefits

These are only a few ESG metrics that can be used across sectors to tie management incentives. Further guidance in identifying appropriate metrics based can be found at the International Sustainability Standards Board and its affiliate organisations:

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