Use of ESG measures in executive pay plans now widespread

Nearly half of FTSE 100 companies use an environment, social and governance (ESG) measure when setting targets for executive pay, a joint report released today by PwC and the London Business School’s Centre for Corporate Governance shows. The study sets out how ESG targets are shifting from traditional areas such as employee engagement and risk towards newer stakeholder concerns around the environment, sustainability and diversity.

The Paying well by paying for good report reviewed ESG targets disclosed in the pay plans of FTSE 100 companies’ annual reports published in 2020, combining the findings with the academic evidence relating to ESG targets. The report shows that 45% of FTSE 100 companies currently have an ESG measure in either their annual bonus targets or long-term incentive plans (LTIP). Just over one-third (37%) of companies have an ESG measure in their bonus plan with an average weighting of 15% while around one in five organisations (19%) include them in their LTIP with an average weighting of 16%.

The report shows that not only are ESG targets becoming more prevalent but that their nature is changing. One third of companies currently use traditional ESG metrics relating to employees, such as health and safety and employee engagement, or governance - typically risk management. These metrics can broadly be directly linked to shareholder value. However, 28% of companies now use measures relating to newer ESG concerns such as the environment, especially climate change, or social issues, which most commonly relate to inclusion and diversity.

 

Phillippa O’Connor, Reward and Employment leader at PwC, said:

“We’re seeing an explosion in interest from investors and companies in linking executive pay to ESG targets. This is now feeding into practice, and very soon we’ll be in a situation where a
majority of large companies have ESG targets in pay.

“The nature of targets is also changing. Traditional metrics with a direct link to shareholder
value, like health and safety and employee engagement, are being supplemented with metrics that address broader societal concerns, such as climate and inclusion and diversity. This is consistent with boards taking a broader view of their responsibilities to stakeholders, as required by the UK Corporate Governance Code and the Companies Act.”

The study also assessed the ESG targets used in pay against the Sustainability Accounting
Standards Board (SASB) Materiality Map, which identifies the ESG factors that are material for  each industry. This framework has robust academic support as research has shown that those companies that focus on its material dimensions reap the benefits of ESG in terms of enhanced shareholder returns. Around 55% of the measures used by FTSE 100 companies were found to be material to the framework.

While there is a lot of momentum behind adoption of ESG targets in pay, the study strikes some notes of caution. It says the difficulty of translating ESG goals into targets in a holistic and reliable way leads to many potential unintended consequences. Furthermore, ESG targets may undermine intrinsic motivation, and lead to companies focusing on only the ESG targets in the pay plan, at the expense of other important ESG issues.

 

Tom Gosling, Executive Fellow at London Business School’s Centre for Corporate Governance, said:

“It's striking that nearly half of the ESG measures being used in pay aren’t deemed material to shareholders by the benchmark SASB framework. This may in part reflect SASB not being up to date with the latest ESG concerns. But it will be interesting to see how this plays out over time as most investors are making it clear they expect companies’ ESG activities to focus on the areas that contribute to long-term shareholder value.

“The increased focus on integrating ESG considerations into company strategy and operations is welcome. But this doesn’t mean we should automatically include ESG targets in pay. There are lots of practical difficulties, and scope for unintended consequences, in linking pay to ESG. And there’s a risk that more ESG targets simply results in more pay, due to the difficulty of knowing how stretching these targets are.”