Linking ESG Outcomes To Pay Is A Skyrocketing Trend

The idea of making executive pay somewhat conditional on a company’s good deeds isn’t new. But the trend has grown massively in the last decade.

A recent discussion paper published by ZEW – Leibniz Centre for European Economic Research, and drawing on the ISS Executive Compensation Analytics database over 10,000 companies globally, explores this rapid rise. “Executive Compensation Tied to ESG Performance: International Evidence,” authored by Shira Cohen, Igor Kadach, Gaizka Ormazabal, and Stefan Reichelstein, finds that in 2011, only 1% of these companies were using environmental, social, and governance (ESG) metrics in executive compensation. By 2021, that figure had leapt to 38%. There was a marked increase from 2018.

There are already some industries where more than half of companies have adopted this practice, according to coauthor Gaizka Ormazabal, a professor of accounting and control at the IESE Business School, at Spain’s University of Navarra. He expects growth to continue until it reaches a point where most companies are including ESG in executive pay decisions.

Even for those businesses that haven’t yet implemented this practice, it’s likely on their radar. One 2020 survey found that four out of five companies were considering linking ESG to pay within the next three years.

Why are companies doing it?

Certain companies are more likely to use ESG metrics when determining pay packages. According to the discussion paper, it’s more likely in countries that require some kind of reporting on these fronts, in industries that have high environmental impacts, and among big and more volatile companies.

But these patterns don’t explain fully why a company would choose to make non-financial outcomes relevant to executive pay. “These things could be…responsible for part of the variation, perhaps a substantial part of the variation, but it’s definitely not the end of the story,” says Ormazabal.

There are many potential reasons for factoring ESG into executive pay. This might be in a company’s financial interest, given that climate risks and social unrest, for instance, are likely to affect many companies’ bottom lines.

This practice can also act as a signal to the socially conscious – particularly to investors. Indeed, large or influential investors have been important in pushing companies toward adopting ESG in pay decisions.

A common criticism is that ESG-tied pay is a box-ticking exercise. It’s hard to know how sincere these efforts are, partly because of the lack of transparency around pay practices.

But while research is limited, there is some evidence that the practice is associated with better ESG performance and more long-term thinking. The discussion paper finds that one clear benefit is lower CO2 emissions, especially in the EU.

In contrast, ESG-tied pay isn’t associated with better financial returns, at least in the short term. Ormazabal says that there’s some evidence that investors are willing to give up some returns in order to improve certain ESG parameters, like climate risks.

How are they doing it?

One person who’s skeptical about the trend is Simon Rawson, the director of corporate engagement at ShareAction, a nonprofit that encourages responsible investment. “More and more big companies are including ESG metrics in executive pay packages but few, if any, are doing it in a way that seems likely to drive more sustainable business practices,” Rawson comments. “Some are ineffective, and in fact encourage oil majors to chase higher levels of fossil fuel output, with emissions reduction goals dwarfed by remuneration for growing a company’s fossil fuel production. Others are inappropriate, with executives receiving better remuneration for meeting what should be baseline expectations around worker health and safety.”

As there’s no standard guidance, and measurement of ESG remains challenging in general, the devil really is in the details. “Most of the controversy is based on the how, rather than on the why,” according to Ormazabal. “There will be a lot of evolution in the how,” as companies experiment and learn, and if regulators adopt ESG reporting standards.

A key regulation in this regard could be the EU’s corporate sustainability reporting directive, which was approved on November 28. “I would expect that some of these metrics are just going to follow the standards,” says Ormazabal, but this will remain something to watch in the years before the directive starts to affect reporting.

One consideration is how much of pay should be affected. If the level is set too low, it’s unlikely to have any substantial effect. The average tends to be about 15% of overall compensation. And if ESG-linked pay is essentially considered an add-on, it could result in pay padding.

For Chipotle, 10% of the CEO’s annual bonus is dependent on a range of ESG factors including sustainable food sourcing and diversity, equity and inclusion (DEI). For Schneider Electric, 20% of the CEO’s bonus relies on the company’s sustainability impact, which incorporates targets around renewable electricity, training on anti-corruption, and many other factors.

Because ESG is so broad – almost anything could be creatively interpreted as applying to ESG – it’s not necessarily hard for companies to cherry-pick certain elements that burnish their reputations. Analysis by the UN’s Principles of Responsible Investment has found that extractive companies and utilities tend to focus on worker safety, almost ignoring climate impacts and governance, and paying insufficient attention to supply chains.

Overall, ShareAction’s Rawson argues that it’s not enough for a company to add ESG considerations to compensation decisions, when CEO-to-worker pay gaps are enormous and emblematic of inequality. “Responsible investors must look beyond box-ticking references to ESG in corporate pay policy and question whether sustainability is at the core of business strategy.”

In other words, the presence of ESG-linked pay isn’t enough to ensure that a company is behaving responsibly. But if deployed thoughtfully, it could be one in an arsenal of tools to push corporations toward more positive impacts.