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Getting ESG and CEO incentives right

Author: ICAEW Insights

Published: 28 Jan 2022

As firms rush to implement climate change and ESG principles, questions on pay and incentive arise. Recent research advises caution and offers guidance.

The hot topic over the past 18 months has been how to incentivise and effectively remunerate CEOs on ESG, whether it is a decision for the board, or shareholder voting on the remuneration strategy of invested companies.

As an example, nearly one in five (19%) of UK CEOs currently have their personal annual bonus and long-term incentives linked to their greenhouse gas emissions reduction targets, according to PwC’s 25th Annual CEO Survey.

Executive pay and the way CEOs are paid has an impact on a firm’s ESG performance, but this can work either way, Vlerick Business School research also shows. The fine-tuning for chairs of remuneration committees or asset manager shareholders voting on pay is by how much, and what incentives work over the longer term.

Research findings

The PwC report revealed that only a third (34%) of the UK CEOs surveyed had made a net zero commitment, compared to 22% globally, and 31% of UK CEOs (26% globally), had set a carbon neutral commitment. This is set to change, as 33% of the largest firms by revenue said they would commit to ESG targets in their bonus and incentive plan. And almost half (47%) of the 4,500 that PwC surveyed said they had long-term corporate strategies focused on reducing emissions. 

Professor Xavier Baeten, Director of the Executive Remuneration Research Centre at Vlerick Business School, told ICAEW Insights his study found that the inclusion of ESG indicators in incentives systems did not have a significant impact on their own on ESG performance.

“The way that companies and boards currently set targets on ESG is from rather a low maturity,” said Baeten. “Companies try to set ESG targets without having a full-blown sustainability strategy that is based on setting targets on material topics that the company has been thinking about, and engaging stakeholders on what is important for them.”

The Vlerick study examined pay levels and incentive systems of CEOs of the STOXX Europe 600, featuring 150 firms from the UK, and names like Adidas, Santander, Unilever and Tesco.

Baeten added that he was frequently asked by board members for a list of effective ESG KPIs, but that his answers depended on the nature and focus of the business. His advice is to first develop sustainable focus and material sustainability through analysis of process and incentive. “You need to engage with stakeholders, you need to ask them what the value creation is for the company. You need to set the priorities and then you set targets. Only then do you translate them into executive pay,” says Baeten.

Assessing levels

There is increasing pressure on companies in certain sectors to make sure that they are incorporating ESG measures into remuneration, and that it is at the right level.

Andrew Ninian, Director of Stewardship and Corporate Governance of the Investment Association, which represents 270 asset managers managing more than £9.4trn worth of assets, said investors wanted companies to get incentives right. Firstly, the management of ESG risks should be incorporated into the company’s strategy, and executives should be rewarded for implementing the strategy and management of material ESG risks. Investors recognise that this may take time, although he expected most to start including ESG into remuneration this year.

“To incorporate the management of ESG risks into the company strategy and remuneration structure including working out what the right metrics are to use will take time and we know a lot of companies are doing that work. We asked investee companies to flag where they are on that work this year.”

There is also some debate as to what is the right level for ESG incentives. “Is 10% of an incentive sufficient to drive behaviour, or should it be 25%?” said Ninian. “It depends on the business or sector, a maximum of 25% feels right for most shareholders.”

Balance and incentives

Baeten agrees, stating that there needed to be a balance between financial and non-financial gain. “What we see today is most companies put away 10-15% on ESG, but that is very marginal. You really must strive to have a higher rate on sustainability if you really mean it.”

A proportion of long-term incentives equalling more than 100% of base pay leads to a lower ESG performance, the Vlerick research found. “Don’t overuse long-term incentives or put a weight on them that is too high,” said Baeten, as the research found that at least 135 firms had done so and had suffered poorer ESG results.

The research advised a balanced approach to CEO pay: to not overdo incentives, or the weight of long-term incentives. “In the criteria that is determining the incentives and their size, make sure that you’re not putting too much focus on profit in the short term and too much focus on total shareholder return,” said Baeten.

Crucially, it’s important for there to be some relatability of the executive to any long-term incentives, as the more complex they are, the less they motivate CEOs. “We see that a lot of the bonus systems we have are very technical and they slip out all of the intrinsic motivation that they seem to be controlling,” added Baeten.

 Key ESG negative remuneration findings

  • Firms that granted a large part of the CEO’s remuneration in the form of long-term incentives (eg, performance shares) have a lower ESG performance.
  • Accounting-focused incentives and environmental KPIs were found to have a negative relationship with ESG performance for overly complicated bonuses.
  • In terms of the long-term incentives, making use of Total Shareholder Return as a KPI negatively affected ESG performance.

Key ESG positive remuneration findings

  • Strategy-focused KPIs in bonus systems, such as implementing a new digital strategy, positively impacted ESG performance.
  • Younger CEOs were linked with better ESG initiatives, as were CEOs who had been an inside hire, working their way up through their company.
  • Researchers found that the average board tenure had an impact on ESG performance, with younger board members implementing more effective ESG strategies. Smaller firms and those with smaller debts and total assets also had a greater ESG performance.

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