Executive pay should reflect firms’ ESG goals

This article is part of
Winter Investment Monitor - December 2014

Investors expect corporate executives to be compensated based on their company’s financial performance.

With increased awareness around responsible investment however, investors have begun to see not only the risks but also the benefits and opportunities around sustainability factors. Little wonder then that investors are starting to ask companies to incentivise sustainability performance and build environmental, social and governance (ESG) criteria into compensation packages.

Longer timeframes are also being set for executive’s remuneration packages to curb companies’ tendencies to constantly be at the behest of short-term goals.

Numerous studies show that capital is likely to flow into companies that can demonstrate good governance in terms of disclosure and transparency around a host of issues, from environmental risks to corruption.

Developing accountability mechanisms that recognise the correlation between ESG factors and business performance makes good sense.

There is as yet no universally agreed guidance on how to link ESG metrics to executive pay, but the consensus is clear: including ESG issues within executive management objectives and incentive schemes is a key factor in the creation and preservation of long-term shareholder value.

To be fair, there are many challenges to linking ESG with executive remuneration, including the lack of a universal standard of reference for boards, senior management and remuneration consultants to assess relevant ESG risks and opportunities. There is also the risk of developing executive incentives in isolation, rather than taking a more inclusive approach towards sustainable performance.

Finally, there is the danger that different performance factors may compete with each other within compensation packages and remuneration reports, many of which are unnecessarily complex in design.

Investors have an important role to play by engaging in a wider dialogue with companies to ensure ESG issues comprise a meaningful component of overall remuneration and that incentives are being aligned with long-term strategic plans. This means investors will be confident that stakeholders across the investment chain are looking well ahead in their view of value creation.

Shareholders are also increasing their level of involvement. Since 2012, when many investors began to question executive pay, shareholder activism has been on the increase.

This year, companies including Burberry and Barclays have had to face questions around executive compensation, while Fidelity has been raising concerns about this issue and has been voting against long-term incentive plans that are less than three years.

Both shareholders and intergenerational institutional investors can help drive companies towards developing ESG criteria that is relevant and robust, with metrics that capture the wider definition of ESG issues and their increasing importance in the definition of shareholder value.

There is already an emerging view in civil society that executive remuneration remains excessive, unresponsive to community values and deliberately complex.

As always, transparency is critical as investors are more likely to engage with boards that ensure senior management is suitably incentivised and rewarded for their ability to position the company to meet sustainability challenges that are now clearly identified but not yet addressed in the corporate and political landscape.