What’s the incentive to ‘incentivise’ ESG outcomes?

It is now broadly accepted that ESG considerations should be incorporated into corporate strategy to ensure a sustainable business. Recently, some shareholders and investors have increasingly agitated for executive pay to be more tightly linked to ESG priorities. Consequently, there has been a significant shift in how companies – and how many companies – incorporate ESG performance into their reward approach.

There’s also been an evolution in how companies communicate the link between pay and ESG to the market. Reward frameworks that incorporate ESG metrics are typically now emphasised by companies in public disclosures such as remuneration reporting, as is how remuneration outcomes were ultimately impacted by ESG performance.

That said, much of the enhanced connection between ESG priorities and pay has only occurred within annual bonus plans, or short-term incentive arrangements, with 85 per cent of ASX 100 companies incorporating an ESG component.

Despite that, many ESG priorities are long term in nature – think reducing carbon footprints, or the maturing of risk and governance practices – and yet long- term incentive arrangements in Australia rarely include an ESG metric, with less than 10% of the ASX 100 doing so.

Linking executive remuneration to ESG to make it a priority can be used as a tool to reinforce accountability and drive progress towards achievement of objectives that will ultimately build shareholder value. After all, the old adage ‘ what gets paid for, gets done’ is true, right?

So, it begs the question, what is driving a low adoption rate of ESG metrics in Long Term Incentive (LTI) arrangements?

There are four key obstacles.

First, ESG strategies lack maturity. Strategy should inform performance and reward practices, not the reverse. ESG metrics should be articulated, reported on, and progress tracked as part of strategy implementation. Too often, companies are articulating ESG metrics for the first time when attempting to incorporate it into their reward frameworks. Currently, where nearly half ASX200 companies have publicly identified ESG opportunities, only 21 per cent have sustainability as part of their core strategy, demonstrating that few companies are positioned to effectively link ESG metrics to reward.

Secondly, the probability of accurately forecasting and setting ESG targets over the long term is low or at least, untested. Given ESG objectives are still in their infancy, the ability of companies to accurately and fairly forecast associated performance expectations is questionable. When setting performance targets for financial measures, most companies have a long history to draw from and external analysis to leverage – such as economic forecasts.

Setting performance targets for non-financial measures, including those related to ESG, can be challenging over an annual period when such performance has never been tracked, let alone three to four years ahead. Linking environmental metrics to pay and establishing associated performance targets is particularly immature, whereas companies have already been utilising ESG targets relating to health and safety, employee engagement and/or diversity for quite some years.

Challenges in forecasting long term goals for ESG metrics mean there could be big wins and losses when it comes to variable pay that are more a result of unintentionally setting targets that are too easy or too hard, rather than true shifts in ESG practices and outcomes for an organisation.

Thirdly, there are divergent stakeholder views as to the value in linking achievement of ESG objectives to pay when we consider the views of proxy advisors, the community, government, regulators and academics.

Some shareholder representative bodies believe it could send a message that ESG accountabilities are not part of the ‘day job’, that is, management of a company’s ESG strategy could be viewed nowadays as a basic expectation of an executive, and therefore rewarding or incentivising for ESG performance is unnecessary. Some academics are of the view that linking ESG priorities to reward outcomes has the potential to take away from the intrinsic purpose and motivation for executives to ‘do good’ for our environment and for our communities.

Finally, there’s a belief that a formal link to pay increases is not the only way to reinforce accountability.

Much attention is being given to companies demonstrating remuneration consequences for executives who don’t deliver on their accountabilities, for example, through a reduction or cancellation of bonuses or unvested LTI. In fact, there are many ways to reinforce accountabilities via reducing someone’s portfolio or responsibilities: not promoting someone, terminating someone, or using board or management discretion to adjust pay downwards when ESG concerns or considerations are not taken seriously.

What should be front of mind?

First, ensure a clear ESG strategy as part of your overall corporate strategy, with metrics that are measurable.

Ideally, such metrics would be in place for one to two years before tying them to pay so you can get a feel for how volatile or predictable performance might be.

This still signals the importance that the company is placing on its ESG strategy, including considering the interests of broader stakeholders by planning for and ultimately including it into the reward approach.

Then, minimise additional complexity where possible.

It is difficult to incorporate all aspects of ESG into a reward approach, with the focus being on simpler plans, fewer metrics, more quantifiable targets. So, don’t simply add ESG metrics to the current incentive plan, think about reprioritising, removing, or reweighting existing metrics to better reflect the current view of strategic priorities.

Next, don’t overweight it.

In a recent PwC global study, Paying for good for all, investors and senior leaders were broadly aligned on what weighting should be applied to ESG in incentives between a range of 10-20 per cent – with investors more likely to push for the higher than lower end of the range.

Finally, be transparent about the metrics, targets and the resulting reward outcomes.

Increased transparency with regards to how companies define ‘good’ performance, both in relation to ESG specifically, and also holistically, is now a baseline expectation.

Establishing and achieving ESG goals drives value and is often simply the right thing to do. Connecting those goals more closely with executive pay seems the obvious next step, but it needs to be thought through properly, because getting it done well is no mean feat.

Emma Grogan is a reward advisory services partner at PwC Australia.