Incentivising sustainability: can you force your CEO to care about ESG?

Remember January? Those pre-lockdown days, when CEOs could still flock by private helicopter to the World Economic Forum in Davos, Switzerland, to drink champagne, make lofty speeches and discuss distant and not-so-distant risks such climate change, cyber insecurity and pandemics.

It was in that now distant context that Klaus Schwab, founder and executive chairman of the World Economic Forum, announced a new Davos Manifesto for stakeholder capitalism. The manifesto calls on companies to pay their taxes, root out corruption and respect human rights. Crucially, citing “skyrocketing” executive pay, Schwab also included a call for executive remuneration to “reflect stakeholder responsibility”.

At Davos, attending the launch of a Bank of America-fronted initiative to develop standardised environmental, social and governance (ESG) metrics, CEOs “widely supported” the idea that their pay should be linked to ESG criteria. Siemens was held up as an example of a company that was getting it right (see here for our run-down of ESG-linked pay packages).

It wasn’t just Davos talk, either. Investor-focused ESG ratings increasingly expect to see an explicit link between ESG metrics and executive pay. State Street Global Advisors, the world’s third-largest asset manager, published a new ESG Oversight Framework for Directors in January, stating that it would engage with boards on “how they are overseeing and incentivizing management to consider and measure performance of financially material ESG issues”.

A few months later, of course, scrutiny has turned to whether companies are cutting executive pay in response to the coronavirus crisis. Investors and rating agencies now speak of the risks associated with boosting CEO rewards during a pandemic.

One company in the spotlight is supermarket chain Kroger, which is now phasing out the $2 an hour “hero bonus” it announced for workers in March. Journalists have inevitably combed Kroger’s recent proxy filings for proof of double standards, finding that Kroger CEO Rodney McMullen “was paid over $20m despite failing to meet goals in several key areas, including internal customer or employee satisfaction… Moving forward, Kroger is eliminating the metrics related to customers and employees completely.”

So if ESG targets fail to prevent scrutiny of CEO payouts, and may be dropped when executives fail to achieve them, what’s the point?

The general argument is that executives need to be incentivised to think beyond the short-term bottom line – to consider the ESG factors that impact the longer-term reputation, competitiveness and, ultimately, profitability of the business. If CEOs are the rational, selfish beings that economic theory says they are, then it follows that the best way to make sure they pay attention to ESG factors is to give them plenty of shares for doing so.

Company boards should therefore define the most appropriate factors for their business model – perhaps the employee accident rate, or customer satisfaction, or energy use, or a broader measure of “sustainability progress” (see examples here) – and link progress on these to cash and stock awards for top executives.

A relatively small but growing number of companies are doing just that. A study by Vlerick Business School shows that the majority of UK CEOs have at least one non-financial KPI in their short-term bonus plans, although only 21% have long-term incentives linked to ESG factors. Meanwhile, according to ISS, the rates for S&P 500 companies in the US are at less than 5% for short-term incentives and less than 1% for long-term incentives. Globally, according to Sustainalytics, 9% of FTSE All-World companies currently link executive pay to ESG criteria, although many are focused on health and safety risks in the materials, energy and utilities sectors.

These low percentages, particularly for LTIPs, are usually reported in negative terms. “UK chief executives are much more incentivised to improve the share price of an organisation compared to other nations across Europe,” says the Vlerick report. But companies have an obvious response to this criticism. “If ESG factors are really so important to long-term business success,” they can say, “surely they will impact our share price in the long run? Why specifically include ESG in our LTIP, if it’s reflected in total shareholder return anyway?”

Of course, there are responses to this argument – that not all ESG risks manifest over a three to five-year horizon, that stock markets are famously bad at pricing in systemic risk, and so on. But it’s not the only reason why we should be wary of a simplistic focus on executive pay.

For instance, who gets to determine the ESG metrics that matter? Should the decision be left up to the board, or should other stakeholders – employees, regulators, activists – have a say? Take the example of Shell, which has included “sustainable development” metrics in its annual bonus for several years. Critics rightly pointed out that Shell could achieve its targets, focused on safety and upstream/direct GHG emissions, without any transition away from fossil fuels. Following pressure from activist shareholders, Shell announced last year it would introduce a new “energy transition” metric to its LTIP. The metric stands out for its future focus, encompassing not just a lagging measure of net carbon intensity (including customer emissions), but leading metrics linked to growth in Shell’s low(er) carbon business units.

Some companies choose to put the metric outside their control. For example, Danone’s long-term share award is linked to performance in the CDP Climate assessment, with 100% awarded if Danone receives an “A” rating for three consecutive years. However, such an approach opens the incentive plan to the capriciousness of ratings agencies – an adjustment in methodology or weighting could have significant financial consequences.

The current Covid-19 crisis will only increase expectations of companies to show that they are reflecting future ESG risks and opportunities in their business strategies. Investors and regulators are stepping up the pressure to report against standards such as TCFD. Incentives could be a key component of companies’ response – but they need to be focused on appropriate, material, future-focused metrics. Not for nothing did a recent UN PRI report flag “a lack of expertise on ESG issues among remuneration consultants” as a barrier to progress[1].

To ensure effective incentivisation, companies need an awareness of ESG risks and opportunities embedded in strategic planning, an understanding of key impacts, a responsiveness to stakeholder priorities, and a culture that ensures sustainability is reflected in day-to-day decision-making. We’ve got the manifesto, now let’s see some action.

[1] In any case, it’s one thing to create an incentive, it’s quite another for executives to actually act on it. Studies suggest that executives respond differently to incentives based on factors such as their career experiences. Paul Polman considered becoming a priest on his way to CEO of Unilever, and partly attributed his sustainability focus to a role at P&G where he saw the company’s impact on local communities in Newcastle. It seems unlikely that he would have been swayed by a few tweaks to his LTIP.

 

Charlie Hodkinson-Ashford, Senior Consultant, NA

Source: CC News Feed

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