The Sustainalytics Podcast | Aligning Executive Action to Strategy With Sustainability-Linked Compensation

Adam Gorley: Hello and thanks for tuning into the latest episode of the Sustainalytics Podcast! I’m Adam Gorley, Producer with Sustainalytics, and I’ll be your host today as we look at sustainability-linked compensation.

Many companies around the world are introducing programs and practices to improve their sustainability with respect to the environment, social issues, and corporate governance. These organizations are examining the ESG issues that are most material to them, setting goals and targets to address those issues, and developing methods to measure the results so they can understand their progress.

But despite all that valuable effort, it’s also essential to put in place a process to align action with those goals. To effectively meet this challenge, many organizations are starting to incentivize executives by linking a portion of their compensation to the company’s performance on specific ESG metrics. Is this something your organization has introduced or considered implementing? We’d love to hear your thoughts. You can get in touch at [email protected].com.

In this episode, you’ll hear about ESG-linked compensation from two of Sustainalytics’ in-house experts on the topic: Upasna Handa, Senior Associate, Product Commercialization, and Henry Hofman, Associate Director, Corporate Governance Research. We’ll be looking at how tying executive compensation to ESG performance can enhance a company’s accountability and transparency and the challenges organizations are facing. We’ll also talk about the types of metrics firms use for ESG-linked compensation programs, how you can ensure your company’s ESG-based incentive program is credible and transparent, and much more.

But first, let’s take a closer look at what sustainability-linked compensation means. In essence, it’s a variation on the standard practice of linking executive compensation to financial and operational metrics, such as profit, growth, employee turnover, customer churn, and so on. The key difference is that sustainability-linked compensation is tied to non-financial ESG metrics. Upasna outlines some of them:

Upasna Handa: While the details of ESG-linked executive compensation vary from company to company, and also from sector to sector, there are some common issues or common metrics that performance is measured against. For example, across the environment pillar, we often see emission levels, sustainable production, energy efficiency, and waste management. Across social and governance, we see diversity and inclusion, culture, employee engagement, and community. And across the governance pillar, we see corporate governance, shareholder relations, and board composition pretty often across industries.

AG: Companies may be choosing these particular ESG issues to respond to stakeholder pressure, meet or prepare for regulations, enhance their reputation, reach new markets, and other reasons. But, as Upasna notes, the specifics will depend on the individual firm. Henry adds:

Henry Hofman: Ultimately, we expect the firms to be able to identify which metrics are most important to them and most relevant to their business model to ensure that executives are being incentivized in the correct way to achieve meaningful change.

AG: Unfortunately, while ESG pay-links are based on a tried-and-tested business practice, they come with several unique and important challenges. While most companies understand clearly the strategic financial and operational risks they face, their targets and key performance indicators (KPIs), and how to measure them, the same cannot be said for the material ESG issues (or MEIs) companies face. Basically, this is unfamiliar territory for many organizations. Upasna explains some of the core challenges facing companies when it comes to tying executive compensation to ESG metrics:

UH: The major challenges in incorporating ESG metrics into executive pay includes structuring the ESG-linked pay. So, clearly articulating material ESG issues, ensuring the board understands them, deciding on appropriate KPIs, and also measuring the success of these ESG programs based on those.

Another important component would be the time period that we're looking at when it comes to structuring to effect meaningful changes. An important question here would be: will a short-term or a long-term timeframe be the most effective for our company? Is it better to set ambitious well-calibrated one-year targets rather than vague long-term ones? And also, because companies looking to progress on core strategic priorities need to incentivize top leadership to think more long-term, so are we going to have those KPIs as more long-term incentive plans? Environmental goals sit comfortably within long-term incentive plans as of now because of the long-term orientation, but some ESG targets, such as health, safety, gender pay targets, and even diversity and inclusion targets, can be calibrated over a single year.

So, for example, BP uses ESG metrics in both its annual bonuses and its long-term incentive plans. Starting in 2020, the bonus has a 15% weightage on safety, which was a well-established metric, and on the environment, which relates to short-term emission reduction targets. The long-term incentive plan now has a 40% weighting to strategic goals including input measures around renewables, energy transition, etc.

AG: We’ll come back to how companies are meeting the challenges in a few minutes. Before that, I want to explore the important question of value. Specifically, how can linking executive pay to ESG metrics enhance a company’s accountability and transparency?

UH: When we talk about accountability, tying variable compensation to ESG performance provides an additional tool for firms and boards to hold their executives accountable, while they're communicating their principles and objectives with employees, investors, regulators, and other important stakeholders. This is especially important when it comes to companies in high ESG risk industries, which may have more difficult material ESG issues to address.

And coming to transparency, when companies incorporate ESG into incentive plans, their boards, investors, employees, communities, and other stakeholders have a valuable tool to track their progress on ESG issues.

AG: So, ESG pay-links are growing in popularity due to increased demand for accountability and transparency, but how is this trend affecting different regions and industries? Not surprisingly, some places and types of business are seeing more activity than others when it comes to linking compensation to sustainability metrics. Here’s Henry Hofman:

HH: Looking at the data, I think there's some interesting patterns that emerge. It’s probably important to note as well though that our research is obviously based on publicly disclosed information, so there is a bit of a correlation between those regions that tend to have just generally good governance disclosures and where we see stronger examples of ESG being related to pay.

But having said that, the European companies and U.S. companies based on our data are the highest adopters with 17% and 13% of our universe incorporating ESG metrics into their executive remuneration, either as a part of their long-term compensation plans or their short-term programs. There are some other countries outside of Europe and the U.S. that have particularly strong practices: Australia and South Africa both stand out as having a high adoption rate.

AG: As Henry suggests, the likely reasons for these numbers are fairly clear. Where there are strong corporate governance regimes, active stakeholders, investor pressure, effective say-on-pay mechanisms, and so on, those are the regions where you’ll find more companies implementing ESG pay-links.

But what about industries? Are organizations in some sectors more likely to adopt ESG pay-links?

HH: So, I think that's really interesting, and the data suggests that those industries that are most often in the public eye, I would say, for perhaps having ESG practices that are less than ideal — there's no hard and fast rule — but those industries do tend to have a reasonable uptake. So, we're talking about precious metals and diversified metals, oil and gas producers, refiners and pipelines, and utilities. These are the industries that we are seeing that actually have the higher takeup in terms of setting ESG metrics and linking it to executive compensation.

I would say though that, even within these industries, there's still at most only about a 30% takeup. So, there's certainly a long way still to go.

AG: This leads us to the issue of regulations. While it is common to hear about broad ESG and sustainability-related regulations — particularly with respect to reporting — the development of requirements specifically related to compensation is still in the early stages. I’ll let Upasna fill us in.

UH: There are multiple efforts from government, industry, and professional bodies around the world to establish more ESG reporting standards for disclosure, measurement, remuneration, and so on.

Starting off with The Investment Association in the UK, this body has released a document titled, “The Principles of Remuneration,” which includes guidance on how to develop ESG bonuses and compensation schemes.

We have the Shareholder Rights Directive II from the EU. These are actually say-on-pay provisions that provide shareholders with the right to vote on remuneration policies and reports. And the updated directive requires numerous additional European countries to regulate shareholders’ right to vote on executive board pay. Many more companies that have ESG pay-links must now disclose their own plans.

Coming to the U.S., we have the U.S. Tax Code. Amendments now enable firms to increase bonuses with their assessment of a company's commitment to ESG principles. Another very important change that has taken place in the U.S. is a push for ESG-linked compensation from the SEC. The SEC Commissioner Allison Herren Lee is urging corporate boards to make changes in line with the agency's push for more ESG disclosures and also tying executive compensation to ESG metrics.

AG: And this brings us back to the challenges companies face when it comes to implementing an ESG-linked compensation program — and how they can overcome the obstacles. Recall, the key challenges include: uncovering the ESG issues that are material to your organization; clearly articulating the MEIs so that the board understands their importance; determining appropriate goals and KPIs; and measuring progress.

Regulations also pose a challenge, but the good news is that the same steps an organization takes to tackle the broader challenges will also help them prepare to meet regulations. Moreover, by investing the time and effort to get it right, organizations will help ensure they are setting up their ESG pay-links in a credible and transparent way.

UH: So, companies can actually prepare by ensuring the relevance and the materiality of their key performance indicators or KPIs and the level of ambition demonstrated by the sustainable performance targets or the SPTs to ensure transparency. This is important when we look at any ESG metrics, so we need to make sure the KPIs and the SPTs are in place.

It is, of course, important to understand also what your peers are doing as well as the investor perspective. But more than that it is crucial to understand your own ESG agenda and how you want to measure the success.

To have a credible and effective ESG compensation program, that would involve multiple elements including a clear articulation of material ESG issues, solid board engagement and buy-in from senior leadership, selection of appropriate metrics supported by operational data, and the means for measuring that success.

Selecting the right ESG metrics is not an easy task, so for most board members, they find it challenging to narrow down the discussion on suitable ESG metrics out of the hundreds of options presented. The consensus is not to consider this as a “check the box” kind of exercise, but to identify metrics that are linked to more of the company's purpose and the ones that truly drive long-term sustainable value creation for the firm.

AG: While it might not be an easy task, companies that do not take meaningful steps toward “sustainable value creation” will likely have trouble growing their business over the long term. That’s essentially why practices that align executive action to strategic priorities — like ESG-based compensation — are so important: it’s one thing to set goals, but taking the necessary steps to achieve those goals is where change and growth happens.

Looking to the future, we can expect to see more companies around the world adopt ESG pay-links as good corporate governance practices advance, stakeholders take a more active role in calling for accountability, and regulators step in to guide the process and prevent greenwashing.

That’s it for this episode of the Sustainalytics Podcast! If you want more details on ESG-linked executive compensation, please visit Sustainalytics Resource Center and download our recent ebook, “Real ESG Accountability: Tying Executive Compensation to ESG Performance” or see the link in the show notes. Have a question or a suggestion on what we should talk about next? You can email us at [email protected].com.

Thanks again to our guests, Upasna Handa and Henry Hofman, and thank you for listening. Until next time!