Summary: Research shows that organizations that adopt a long-term incentive scheme for their executives display more “long-termist” behavior such as investing in innovation and stakeholder relationships. But while the efficacy of tying incentives to long-term outcomes is well established, many organizations are still dragging their feet and failing to incorporate such incentives into their executive’s pay packets. Five questions that can serve as a helpful starting point for companies to develop sustainable compensation programs. What is the goal? What ESG targets are material to the organizations performance? What weighting will sustainability-linked measured be given over what timeframe? What are the targets? And what disclosures will be made to the investing community and other stakeholders.
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Global businesses have reached a sustainability inflection point. Stakeholder expectations and heightened investor scrutiny are putting organizations under pressure to articulate their societal roles more clearly, prioritize environmental and social objectives within their business strategies, and demonstrate progress to stakeholders. We also know that employees are prioritizing their employment decisions based on an organization’s purpose, culture, ESG goals, and diversity, equity and inclusion (DEI) priorities. Yet for the most part, corporations have been neglecting a powerful lever for advancing their sustainability agendas: executive compensation.
A gap has opened up between pay and purpose in most executive suites. Most top teams are incentivized against short-term financial performance, which differs from organizational purpose statements that typically reflect aspirational long-term financial and non-financial goals. This creates a disconnect between the purpose of an organization (its contribution to society) and executive pay (what type of “performance” gets rewarded). By realigning these two things, corporations have the opportunity to transform executive compensation from a reputational risk factor to a catalyst for change.
Research shows that organizations that adopt a long-term incentive scheme for their executives display more “long-termist” behavior, such as investing in innovation and stakeholder relationships. But while the efficacy of tying incentives to long-term outcomes is well established, many organizations are still dragging their feet and failing to incorporate such incentives into their executive’s pay packets.
There are several reasons for this. Foremost is that in the current global economic and geopolitical climate, business leaders are having to deal with pressing disruptive forces while focusing on short-term financial metric performance. In some cases, just “keeping the ship afloat” is the primary focus. But there are other challenges, too, including:
- ESG regulation is fragmented and evolving, with many rules yet to be finalized and stable ESG metrics to be implemented.
- ESG data collation methods aren’t standardized.
- Target setting and calibration methodologies are often untested, and best practices are still scarce.
Yet while it’s certainly complex, the transition to a sustainable economy is an inevitable process. With the volume of pending legislation and increased reporting demands, organizations will have no choice but to comply. They can either elect to be reactive to these changes or to be a front runner. Inertia has its own risks too.
Combining research from Reward Value Foundation with EY’s Total Reward advisory experience, we have identified five questions that can serve as a helpful starting point for companies to develop sustainable compensation programs.
What is the goal?
What does the organizations aim to achieve with its compensation plan? How do these objectives link to the corporation’s purpose and strategy?
The scheme needs to go beyond the usual “attract and retain the right people” objective. It must be a catalyst for positive change in the organization and for its stakeholders.
It’s critical that this goal is clearly defined as it will inform all subsequent compensation plan design choices, against which the variable pay plan will be evaluated — particularly around which ESG metrics could have a material impact over a relevant time horizon.
Which metrics matter?
Next, organizations should determine which ESG metrics matter — and which don’t. On which topics does the organization invite its stakeholders to measure its progress? What financial, social, and environmental impact does it expect to make by prioritizing these topics?
For example, reduction of greenhouse gas (GHG) emissions is positive and is possibly on everyone’s agenda. But if you’re in the financial services industry, reduction of GHG emissions of your own premises will have a limited impact, whereas reduction of emissions related to your investment and/or loan portfolios would be more impactful. Such materiality is a key issue for the relation between ESG and business performance.
Santander has included this approach in its single incentive (short and long-term) approach. It measures the role it has as a financial institution towards society through the levels of green finance raised and facilitated through the bank’s loan portfolio, and the decarbonization in its investment portfolio. The deferred component of the bank’s executive director and senior management incentive scheme is dependent on the achievement of these sustainable finance criteria.
British supermarket giant Tesco introduced a new compensation plan in 2022 that illustrates another way that materiality can be included. As part of its performance share plan, the supermarket chain included food waste reduction into its long-term incentive scheme for its executives. This approach is supplemented with other ESG measures, such as carbon reduction and leadership team diversity.
How do you weight the incentives and over what timeframe?
Once materiality is assessed, it’s important to determine priorities — or the weighting — of incentive scheme metrics to drive the right behaviors.
While organizations are paying more attention to ESG topics in compensation, the weight allocated to these metrics is often insufficient to make a difference. If an executive’s compensation is linked to a broad basket of financial and non-financial measures (including ESG), the likelihood that they will have an impact on executive behavior will be small. Either the attention will be diluted and spread out over too many factors, or attention isn’t given at all as the impact on compensation is minimal. In most incentive schemes, non-financial metrics are often a basket of topics and the aggregate weighting allocated is often less than 5% of total compensation, and as such has little impact on decision-making.
To make an impact, compensation plans need to be tied to clear KPIs and be financially meaningful to participants. Mars’ long-term incentive plan highlights this approach by linking pay to clear objectives covering four “quadrants of performance” (financial results, quality growth, positive societal impact and being a trusted partner). The two non traditional metrics are each weighted 20% and are comprised of GHG emission targets for 2025 (and beyond) on all scopes and an externally monitored societal reputation metric measuring Mars’ corporate ratings as a trusted partner that addresses stakeholder interests (employees, supply chain, customers, and society at large.). Because of it’s long-term-minded investors, Mars sees these non-traditional measures as clear shareholder objectives.
“It’s crucial that leaders are clear on what is important and understand the role they have to play in achieving both traditional financial metrics and non-traditional metrics,” said Andy Pharoah, Mars’ global vice-president of corporate affairs and sustainability. “At Mars, growth at the expense of GHG emissions is not seen as a success which is why the shareholder objectives include specific sustainability ones which are integrated in the business strategy and the three yearly, board-approved, integrated value-creation plans. These objectives drive a significant component of remuneration and gives our leaders a clear definition of success.”
What are the targets?
For incentivization purposes, sustainability KPIs must be measurable and typically set with reference to external standards or international treaties (like the Paris Agreement). As regulations and standards continue to evolve, so too will the ESG metrics that are selected. Boards therefore need to make sure that they measure what matters and allow for discretionary adjustments where needed.
Having decided the metrics to be used, it’s critical to quantify and calibrate target performance levels for each KPI selected – for instance, reduction of GHGs by “X” percent over “Y” years. Consider using relative targets to allow for sector comparison. Alternatively to assess the internal efficiency of for instance your GHG emissions, it is sound to make the measure dependent on the level of sales or production. Lower emissions due to lower production does not measure progress on energy efficiency for instance.
Incentives are credible and effective when they’re given for achieving results beyond those that would have been achieved without executive intervention. To realize change, it is important that targets are sufficiently “stretched” and not trivial. Linking remuneration to targets set in accordance with the Science Based Targets initiative (SBTi) are already establishing a strong level of credibility and stretch.
How will you show progress?
With ESG metrics in place to incentivize executive focus, disciplined disclosure practices play a vital role in providing visibility on the progress being made. The goal should be to offer investors, customers, employees, and a range of other stakeholders a transparent and accessible articulation of the coordinated efforts an organization has made to improve sustainability.
Remuneration linked targets should be auditable and be disclosed following, where possible, the existing disclosure standards. Audited targets increase the credibility of the measures and therewith the trustworthiness of the remuneration scheme. Furthermore, in using existing disclosure standards, the remuneration disclosure will become transparent and comparable. In using, for example, the Global Reporting Initiative standards on emissions, volume-based performance over subsequent years can be effectively monitored and clearly linked to pay-outs of executive remuneration. Alternatively, monetized impacts analyzed in accordance with the ISO certified VBA impact assessments are also auditable and can effectively be linked to remuneration.
There is a compelling business case for boards and executives to accelerate the transition to a sustainable and regenerative economy by aligning their organization’s sustainability priorities with their executive compensation KPIs and governance frameworks. Considering the five questions posed above can be a starting point on a path to creating a sustainable compensation framework for organizations that serves as a catalyst for positive change.
Authors: Frederic Barge, Martha Cook, Katherina Savage.
Source: https://hbr.org/2023/02/linking-executive-pay-to-sustainability-goals
