Executive pay – buying virtue

Sustainability and ESG are central to business strategy in the 2020s. With this being the decade when short-term targets need to start aligning with long-term aspirations, there are increasing calls for boards to put their money where their mouth is and to pay CEOs based on achievement of ESG targets.

The use of ESG targets in pay is increasing

And they are responding. Paying well by paying for good, a study by the Centre for Corporate Governance at London Business School in collaboration with PwC, found that in 2019/20 nearly half of large UK companies included ESG targets in pay, a proportion that has already increased substantially since the start of this year.

There’s a growing consensus that this is the right thing to do. Shareholders are increasingly on board: in a standout example, Cevian Capital has demanded that all its European investee companies include ESG targets in pay by 2022. Regulators see executive pay as a way to drive change: the PRA suggested in 2019 that banks consider putting climate targets in remuneration and the FCA, PRA, and Bank of England have issued a discussion paper in which one of the proposals requires regulated firms to link pay to diversity and inclusion objectives.

Targets increasingly reflect emerging environmental and social issues

The nature of ESG targets is changing too. Conventional targets focus on issues such as health and safety, employee engagement, risk and governance, used by one-third of FTSE-100 companies. In 28% of companies these are being supplemented by a new generation of ESG measures focussing on environmental targets, especially climate change, and social targets such as diversity and inclusion. These developments reflect the growing understanding of the materiality of climate change to the future of many companies but also reflect changing societal expectations on issues such as diversity and equality.

Interestingly, this also points to evolving motivations for including ESG targets in pay. Most companies and investors would say they view ESG targets as stepping stones to long-term shareholder value creation. Including ESG targets in pay ensures that these important factors, which may not show up in profits for some years, are given due attention by executives. But an alternative view, held by some sceptics of shareholder capitalism, is that ESG targets need to be included in pay precisely because they are not aligned with shareholder value. On this view, ESG targets are necessary to ensure that CEOs do not over-prioritise shareholders in their actions.

Materiality matters

The SASB® Materiality Map aims to identify, by industry, the ESG dimensions that are material to a company’s long-term financial performance. The framework has strong empirical backing. Research has found that companies that performed well on the ESG dimensions deemed material by SASB did indeed deliver better shareholder returns than those that did not. Outperformance on immaterial ESG dimensions did not lead to outperformance. Interestingly, companies that performed well on dimensions deemed material but poorly on those deemed immaterial did best of all, suggesting that a focused approach to ESG delivers the best outcomes. All these findings support the relevance of the SASB framework in assessing financial material ESG factors.

The LBS-PwC study found that nearly half of ESG metrics used in pay plans are not based on material measures according to the SASB® Materiality Map. This suggests that ESG targets are being included for other reasons than shareholder value.

Motivations beyond shareholder value

What motivations could boards have for including targets that are not aligned with shareholder value? One may be that shareholders want them.

It’s long been recognised that shareholders may have preferences that extend beyond financial value maximisation. Investors may want companies to go faster on climate change than pure economic incentives suggest the company should go. This could be because they view reduced returns in, say, an oil company being a price worth paying for lower emissions and reduced climate impacts on other companies in their portfolio. Alternatively, an asset manager may have commercial incentives to take a particular stance on ESG issues to attract assets from a target client segment. An asset manager’s profit is increased as much or more by gathering new assets as by increasing the value of those assets.

An interesting case study is Shell. Having announced, in 2017, a new strategy to cut the net carbon footprint of its products in half by 2050, investors pushed for an explicit target to be put in the company’s Long-term Incentive Plan (LTIP). The LTIP targets have played a central role in an ongoing debate between Shell’s management and certain of its stakeholders over the pace of change at the Oil Company.

A second motivation for companies may be to show that they are meeting societal expectations. A sustainable business maximising value for its shareholders must, as Milton Friedman pointed out, follow the accepted societal norms of the day. Increasingly the lack of diversity in senior leadership positions in many industries is viewed as unacceptable. Although the evidence of a financial business case for improving diversity is mixed, societal expectations may require progress regardless.

The UK’s Women in Finance Initiative is a good example. Under this politically sponsored initiative, firms are expected to set pay targets for improving diversity, as a way to encourage focus on something that might not automatically have been focussed upon otherwise, because of the lack of short-term impact on profits.

A third motivation may be to reinforce the organisation’s purpose. Companies increasingly use their purpose as a way of creating shared expectations between the company, its shareholders, and other stakeholders, about how that company will act in the world and manage different stakeholder interests in pursuit of long-term value. ESG targets can be used to help communicate these priorities not just externally but also throughout the company.

Unilever’s purpose of “making sustainable living commonplace” has been at the heart of its strategy for creating value for a number of years, and the detail of what this means is set out in the Unilever Sustainable Living Plan (USLP). In 2017 the company reinforced this through including a measure linked to the USLP for 25% of the LTIP plan awarded to thousands of senior managers. Unilever did this to reinforce a balanced set of priorities with the management team, reflecting the company’s purpose. Indeed, mobilising an organisation behind a new set of priorities is perhaps the strongest argument for including ESG targets in pay.

Boards need to be clear on their motivation as it affects their mandate. If shareholder value is the motivation then the ESG factors incentivised should be material to the company. If it’s shareholder preferences then the company needs to be sure that they are interpreting those preferences correctly. If it’s to align with societal expectations then boards need to be sure that the ESG issue is one where the company can have an outsize impact, is better placed than others to do so, and the ESG dimension affects a material stakeholder group. If it’s to align with the company’s purpose then the board needs to be prepared to explain why this is the case and how that purpose leads to long-term value.

Be careful what you wish for

Linking pay to ESG is not without its problems. As Goodhart’s law states: when a measure becomes a target, it ceases to be a good measure.

Many ESG issues are multidimensional and cannot easily be reduced to a few measurable KPIs. So the risk of hitting the target but missing the point is significant. For example, diversity targets focussed on board representation can be hit relatively easily while entirely ignoring the profound cultural change required to get balance in the workforce. In many complex areas we don’t pay for results because we recognise the unintended consequences that may arise. An obvious example would be the risk of “teaching to the test” if we paid teacher’s according to the grades of their students.

Targets can distort behaviour. There’s strong evidence that executives manage company performance in order to optimise achievement against pay targets. This is one of the arguments for including ESG targets in pay: to act as a counterbalance against the short-term profit incentives built into many pay plans. But introducing competing metrics, with spiralling complexity, may add to and not reduce the problem.

Recent work suggests that CEOs are primarily motivated intrinsically and by the desire to enhance their reputation. Trying to use financial incentives to encourage good behaviour could backfire by crowding out intrinsic motivation. Instead of introducing ESG targets as a counterweight to financial targets, perhaps it would be better to remove targets altogether and pay senior executives with shares that they need to hold for the long term. This simpler approach would take advantage of the natural alignment between many ESG issues and long-term shareholder value.

Finally, non-financial and strategic targets in pay plans tend to pay out consistently higher than financial targets – by around 15% points on average. Boards rarely set targets of this type that they don’t expect to meet. ESG targets are likely to reflect actions the company would’ve taken anyway, and it will be almost impossible for outsiders to test how tough they really are. There’s a high likelihood that more ESG targets in pay will just lead to more pay, not more ESG.

How best to do it?

Despite the problems, the momentum towards including ESG targets in pay seems unstoppable. If so, how can it be best done?

1. Use existing measures aligned to strategy. Something’s gone wrong if you’re making up a measure to put in a pay plan. Measures should be drawn from those already used to track company priorities. And should represent a material ESG issue for the company.
2. Focus on the big issues requiring a step change. Identify the ESG issues that sit above all others in their importance to the business, and where is a real step change in performance required. Agreement on the necessity and validity of ESG targets will be much easier when these conditions are met.
3. Set tough targets. There’s a major risk that ESG targets pay out at 8 out of 10 on average with no appreciable improvement in ESG performance. This would undermine credibility in pay plans and create the circumstances for a backlash. Setting appropriately tough targets is likely to mean focussing measures on the outputs you’re trying to achieve rather than the inputs needed to get there.
4. Use clear and assured measurement criteria. You shouldn’t need a PhD in sustainability to understand your pay plan. Use measures that are readily understood and can be rigorously assured to build confidence in your pay plan.

The motivations for including ESG targets in pay are impeccable. But the obvious solution isn’t always the right one. The law of unintended consequences looms large. There’s a big risk of making matters worse rather than better. More and more companies will include ESG targets in pay – the momentum seems unstoppable. Following these four guidelines and being alert to managing the risks will help you avoid the pitfalls.

But it’s not easy to buy virtue.

 

Tom Gosling is an Executive Fellow at the Centre for Corporate Governance at London Business School and an Advisory Board Member at the Financial Reporting Council