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A bit of context, before we get to the Executive Pay element...
Whilst Environmental, Social & Governance (ESG) has been on investors’ agenda for several years, this year has seen a real watershed moment and ESG is becoming more prominent. This means that these key messages are starting to work their way through from investors, to business leaders, to HR and even to employees and customers. Furthermore, disclosures in corporate reporting have started to make ESG more transparent and higher up on the organisation’s agenda. Even for organisations that do not have to report, if they are wanting to attract investors it is crucial for them to demonstrate ESG adherence.
Before Covid-19, many organisations looked to the UN Sustainability Goals to provide them with an environmental and societal purpose, but the pandemic has thrown up new challenges, as well as opportunities to make a difference. From an investor view is it about how to drive value creation. Having a clear sense of purpose and impact that resonates with employees and customers that are far better informed these days drives that value creation. There is a large amount of evidence that suggests that being clear and positively impacting an appropriate ESG agenda does result in a more profitable organisation. This enhanced focus on the ESG agenda requires executives to understand the impact of ESG via their supply chains, operations, and their workforce. There are many different ESG metrics out there, but they are not necessarily right for all organisations. An organisation, based on their own environment, sector, and business operations, will need to decide what ESG metrics to implement within the business.
The next most important aspect is understanding what metrics an executive should be measured against: whether they are motivated to achievement via incentive plans or whether tasks are within the day to day duty of the CEO. The World Economic Forum and many other influential organisations list areas that companies should track and measure against. WEF have twenty-one core metrics centred on four pillars:
- People: Reflects a company’s equity and its treatment of employees. Metrics include diversity reporting, wage gaps, and health and safety. This is where Innecto’s approach to Responsible Reward plays a part and is where HR can influence the outcome.
- Planet: Reflects a company’s dependencies and impacts on the natural environment. Metrics in this pillar include greenhouse gas emissions, land protection and water use.
- Prosperity: Reflects how a company affects the financial well-being of its community. Metrics include employment and wealth generation, taxes paid and research and development expenses.
- Principles of Governance: Reflects a company’s purpose, strategy, and accountability. This pillar includes criteria measuring risk and ethical behaviour.
Executive Pay and ESG metrics
ESG is proven to drive the long-term value of an organisation, so why wouldn’t ESG be included and incentivised within the executive package? The problem is there is still a lack of clarity around the best approach. What we know is that there is a broad suite of ESG metrics and good practice out there. What is not clear is what metrics are appropriate and what is part of the CEO or Executive team daily duty and what should be incentivised, and whether these are long- or short-term measures. As responsible owners, investors are increasingly investigating practices on ESG metrics and how these link to exec pay. Currently not all of these are quantitative and not all of these have other important bonus clawback and malus structures which can increase or decrease the performance.
Short term vs long term
Short term in the past has not really delivered the desired value creation for organisations. ESG are both ongoing/continuous sustainability and this is long term. Any gamification needs to be mitigated and any risks need to be managed. No short-term attitude will fit with the ESG ethos and principles. Investors believe that three years is too short and recommend that seven years broadly covers a business cycle – companies and sector cycle. However, some organisations run it in five year cycles. If restricted stock is in place, holding for seven years and keeping hold of it for a period of time after keeps CEOs/Executives on the hook for decisions they made after the stock holding period.
Metrics
There is not a ‘one size fits all’ approach and not all ESG metrics are great metrics. It is truly about understanding the organisational operating model, sector, and environments in which it operates, the touch points on the supply chain and internal workforce. Not all ESG metrics are easy to clarify and quantify. Therefore, there needs to be confidence around how to manage and track performance on the tangible metrics - such as waste and CO2 emissions targets - and the not so tangible, such as enhancing livelihoods or impact on local community. A good test is to challenge each metric to check its worthiness of incentivising through pay/bonus.
Base pay or bonus?
Another question that we need to ask is, should this ESG metric be part of the CEO/Executive Leader daily duty? Is it right to incentivise a requirement such as maintaining compliance or treating employees fairly? If a CEO is not doing this as part of their core duties then this raises other issues around their business fit. Incentivising some metrics could generate the wrong behaviour, encourage key stakeholders to act without integrity and/or have unintended consequences. There needs to be an understanding of the bigger picture, such as restructuring Organisational Design programmes. It is worth being clear on the long term and correct purpose: for example, huge wage bills, excessive headcounts, inefficient processes and practices. Organisations cannot shy away from redundancies if needed because of the impact on society, but without action the business may not survive.
Weighting & modifying metrics
How do you weight and/or modify the metrics? This depends upon the importance, the probability of an instance and the risk of doing or not doing an action. Some organisations are advocating for sustainability measures that are equal in measure to financial performance metrics, but this may not be necessarily right for all organisations. It is not possible to prescribe a particular approach to weighting, it is purely business related. Forcing an ‘what other companies do’ approach is likely to result in unintended consequences on performance.
Governance
There needs to be the right amount of checks and balances oversight. Whilst some organisations disclose a high-level overview, they do not disclose enough around the detail, such as the metrics, rationale, design features (clawback and malus) and payments. Poor corporate governance has been found to have a negative impact on financial success. Governance is the key - without good governance in place (execs’ KPIs) and the strong management it fosters, environmental and social responsibilities policies are unlikely to be adopted. It starts with the Board!
Conclusion
What an organisation wants and what investors want is to have transparency, behavioural change and outcomes that create long-term value. They want this to trickle down through the layers so there is clarity around the purpose of the organisation and how they impact the environment and society. They want to see the right behaviours, the right ethos, clarity around accountability and control which comes through on the governance angle. If employees understand and trust in the system, they will be key in creating value and creating a sustainable business for the long term.
Innecto understands where responsible reward approaches can touch on many areas of ESG. In addition, our expertise around the creation of pragmatic and sustainable executive incentive plans provides a solid foundation for any organisation that not only relies on investors, but wants to do the right thing because they understand the business’s wider impact. If you'd like to discuss this in more detail, please contact me: I can be reached by emailing sarah.lardner@innecto.com or calling +44 (0)20 3457 0894.
