“This will play itself out – can’t we just ignore it?”. Before last year, this was perhaps still a reasonable – if potentially unfashionable – question companies might ask about the emergence of environmental, social and governance (ESG) issues and how it affects them. But the spotlight shone by the events of 2020 on societal and environmental issues has raised questions about the role and responsibilities of businesses in the 21st century.

Linking executive pay to ESG metrics

Few things say more about how seriously a company takes an issue than the extent to which it is prepared to link it to the pay of its managers: no performance, no (or reduced) pay. It therefore makes sense that the events of 2020 acted as a catalyst on the trend of linking executive pay to ESG metrics. What’s more, it seems that the trend will persist beyond the finish line of reverting to the “old normal”.    

Although not accepted with unanimity, there are emerging suggestions that there is a positive correlation between a robust ESG framework and an organisation’s financial resilience. Strong ESG credentials usually require a strong understanding of the various risks and opportunities (for example, climate-related risks) facing a business, and having the right strategies to tackle them. Companies that take wider stakeholder interests more seriously, and thus diversify beyond traditional measures of performance, may be more cognisant of the impact of non-financial risks and therefore better placed to weather unforeseen changes in circumstances.

Linking the achievement of ESG targets to executive pay is a logical step for companies that genuinely take these interests, objectives and risks seriously. In that sense it is no different from linking pay to financial metrics – if you want to ensure your business achieves a given outcome, only pay your people if it does. In October 2020, we undertook a review of the FTSE 100 companies’ remuneration reports, which showed that 35 had disclosed that ESG factors had a tangible impact on executive pay. Of those, 23 had included it in their short-term bonus awards, 4 had included it in their LTIP and 8 had included it in both.

Many ESG metrics are appropriate for short-term plans such as annual bonuses. But, as familiarity with and confidence in ESG metrics develops, it may become more common to see them alongside traditional financial metrics in long term incentive arrangements, such as executive share plans.  

The evolution of ESG metrics

Part of this confidence can only come through a better consensus on what the suitable metrics really are. Investors will want to know that such metrics are both meaningful in themselves (and don’t simply “greenwash” a company’s operations), and that they provide a measure of performance that can be meaningfully compared against other companies, most notably their competitors.

Perhaps with causal effect, the increasing prevalence of ESG metrics in executive pay has evolved in tandem with efforts to standardise how ESG performance is both measured and disclosed. Both the World Economic Forum and European Banking Authority have recently published discussion papers setting out appropriate ways to disclose against various ESG measures.

In the UK, on 1 January 2021, a new listing rule came into effect requiring commercial companies with a UK premium listing to explain in their annual reports whether their disclosures are consistent with the recommendations of the Taskforce for Climate-related Financial Disclosures (TCFD). For more information on this, see our recent blog post.

Developments like these signal a broader movement towards embedding ESG as a permanent fixture of corporate governance, and will inevitably necessitate an enhanced focus on the quality of metrics used in executive pay. While Covid-19 has accelerated the uptake of ESG-based remuneration practices, it looks less like a fleeting trend and more like something that will stick around long after we have beaten the virus.

Article first published on www.REBA.global (28 January 2021)