Insights

Executive compensation: The ESG train is pulling into the station... Will you be a car or the locomotive?

Analysis
Published on: December 6, 2021
Subjects:  Total compensation, Executive compensation, Performance and bonus, Boards of directors and governance

While it may not be as swift as a high-speed locomotive, the ESG train does have the wind at its back: a wind of change that is sweeping across the economic world and prompting 75% of institutional investors to incorporate new criteria into their analyses1 and to reflect, adapt and innovate. 

From transportation electrification to clean technology development and impact investing, it cannot be denied that a transformation is well underway in response to society’s growing concerns about the environment (E), social responsibility (S) and good governance (G). And it’s about much more than image. 

ESG factors: Risks or opportunities?

In recent years, companies such as Volkswagen and BP have suffered major consequences due to poor management of ESG criteria. These events have damaged their reputation, destroyed careers, sent their share values tumbling and jeopardized their survival. 

Could these situations have been avoided—or at least better handled—if executive compensation had been linked to environmental impact? Probably. After all, in addition to assisting with risk management, incorporating ESG criteria into compensation programs also creates opportunities. 

  • Higher performance: 63% of studies on ESG impact show that companies with a greater focus on ESG criteria have higher performance scores2
  • Higher satisfaction: Organizations with higher ESG standards report higher employee satisfaction and attract more young talent, a significant advantage given the current labour shortage.3  

The chance to mitigate risks and reap a wide range of benefits is prompting many companies to consider linking executive compensation to the attainment of ESG criteria. A review of recent studies shows that nearly 80% of organizations plan to factor ESG measures into their incentive compensation programs (approximately 40% in the short term and 35% in the long term) over the next three years, and a third intend to focus on environmental criteria. 

Linking executive compensation to ESG factors is an excellent way for an organization to demonstrate their commitment to sustainable development. This type of initiative helps drive home the message that your intentions are sincere.

Thinking of taking the plunge? Before you hop aboard the train and assume that you’ll have everything in place in a matter of weeks, keep in mind that:

  • There are certain preliminary steps that must be taken.
  • There is no one-size-fits-all solution for every company or industry.
  • You will need to choose the right approach to get your executives on board and produce the desired results. 

Let’s go over this step by step.

Step 1: Plan out your itinerary

Executive compensation is a key governance factor for an organization. In addition to being fair and equitable, it must be in line with the company’s overall vision and long-term strategy. Starting from scratch? Here are a few tips to guide you through this process:

  • Set up an ESG committee.
  • Adopt a 360-degree approach to ensure you have the support of all of the organization’s stakeholders.
  • Have a clear picture of the current situation: Which criteria are important to ensure the longevity of the organization? Are they measurable? Over what time period? How? Are they realistic? What financial and human resources can we deploy to meet these targets?
  • Prepare a sustainable development report with input from all departments (operations, marketing, finance, human resources, etc.).

In short, for your plan to succeed, the most important step is to clearly define your departure and arrival points and how you intend to measure the distance travelled by a specific date.

Step 2: Select the right ESG criteria

Another crucial step is to establish a thorough selection process for ESG criteria. Additionally, to draw a meaningful link between your ESG objectives and executive compensation, each criterion must be specific, measurable, achievable and time bound. You will also need to strike the right balance between diversity and relevance: 

  • Diversity: Opt for a broader vision and avoid putting undue emphasis on any one factor.
  • Relevance: Assign the right criteria to the right people based on the degree of control they have over achieving them.

Here are a few examples of ESG criteria:

FACTOR

ESG CRITERIA

EXAMPLES

Environmental 

CO2 emissions, energy consumption, pollution, number of trees/km2

Energy consumption, disposal of hazardous materials, GHG emissions, water consumption

Social

Pay equity, social diversity, occupational health and safety, human rights

Impact on communities, health and safety, volunteering

Governance

Transparency, corruption, audits

Shareholder voting, conflicts of interest

Step 3: Set the right compensation targets

Your compensation targets should be well defined and attainable, but also ambitious: the goal is to encourage your executives to better manage ESG-related risk factors while continuously improving your practices. 

Our research shows that among companies that factor ESG criteria into executive compensation, 5% to 50% of executive compensation is linked to ESG considerations (10% on average). No matter the importance you attach to them, the most important thing is to strike the right balance between short- and long-term measures by incorporating ESG targets into both your annual and long-term incentive plans.

Step 4: Communicate effectively

Once you’ve selected your criteria and targets, make sure to communicate them effectively to your executives and investors. To deliver the anticipated results, your executives must understand exactly what your objectives are, how to achieve them and how their pay could be affected by these new ESG criteria. As for your investors, you will need to disclose the reasoning behind the ESG criteria you have chosen to incorporate so that they understand:

  • How these criteria align with executive compensation
  • How they add value to your business
  • How they are assessed
  • How meeting or failing to meet these targets will affect executive compensation

Step 5: Choose the right measurement tools 

Finally, you will need ways to accurately measure how much progress has been made compared to your initial objectives by a certain date. Measurement is the key to success, particularly when it comes to compensation, and the right measurement tools depend on the criteria that need to be evaluated. Luckily, there are companies that specialize in this area and can help you monitor your chosen criteria.

Key takeaways

Whether or not you believe in the importance of ESG criteria or the merits of linking executive compensation to them, they are nevertheless a growing trend and are expected to be adopted by an increasing number of organizations over the next few years. Many of our clients are already looking into this subject and preparing to hop aboard the train.

If you’re planning to follow suit, you will need to be proactive by taking time to reflect, completing all the preliminary steps, clearly outlining your criteria and targets, communicating them effectively and choosing the right measurement tools. 

Remember, there is no one-size-fits-all solution for all organizations. There are plenty of options available to you; the challenge lies in identifying the best approach to motivate your executives and help you achieve your goals.   

Let’s continue this discussion...

Are you thinking of factoring ESG criteria into executive compensation? Talk to our experts!

Authors

  • Samuel Bergeron, M.Sc., ASA, Senior analyst
  • Bridgit Courey, CPA, CA, ASC, Partner

Sources

1Responsible Investment Survey, RBC Global Asset Management, October 14, 2020.

2Gunnar Friede et al., “ESG and financial performance: aggregated evidence from more than 2000 empirical studies,” Journal of Sustainable Finance & Investment, October 2015, Volume 5, Number 4, pp. 210–33; Deutsche Asset & Wealth Management Investment; McKinsey analysis

3greenbiz.com, Workforce strategy in the time of coronavirus: The role of ESG, June 22, 2020
 

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