Building a Portfolio

Can Linking Executive Compensation to ESG Drive Sustainability?

With environmental, social, and governance (ESG) issues increasingly viewed as material contributors to shareholder value, there is growing support for factoring performance on ESG measures into CEO compensation. Advocates hope that tying ESG scores to executive pay might better promote sustainable company performance and result in meaningful progress on critical issues like income inequality and climate change.

CEO Pay and ESG: Shifting Trends

The corporate world has been under pressure from shareholders and policymakers to link CEO compensation to corporate performance. However, moves to align pay with stock price performance have often resulted in ever bigger payouts over time, especially during periods of strong stock market returns. The debate has steadily turned to the role ESG criteria should play in aligning CEO compensation with shareholder value, given the evidence that positive ESG scores may bode well for stockholders. A study by risk management and analytics provider Axioma found that portfolios skewed toward companies with better ESG scores often outperformed their benchmarks in a range between 81 and 243 basis points over four years ending in March 2018.

There are numerous examples of the significant liabilities that firms can incur as a result of ESG-related shortcomings. Historically, when CEO compensation has been linked to ESG, it has primarily focused on factors that reduce risk. For instance, the energy and manufacturing sectors have used safety as a key metric for many years.

Relatively new is the trend of linking CEO compensation to metrics that proactively drive sustainability. Last year, consumer products company Clorox became one of the few firms to link such ESG goals to the compensation of its CEO and CFO, outlining plans to cut its greenhouse gas emissions and make its packaging more environmentally friendly, with the overarching aim of achieving “profitable, sustainable and responsible growth.”

Other proponents point to flaws in the reigning alternative of linking CEO pay to purely financial metrics, which can result in pay gaps that represent a social injustice and can erode trust in business more broadly. Aligning pay with ESG could help drive more inclusive growth.

A key challenge for many firms will be to ensure that the ESG goals linked to executive pay are closely aligned to long-term profitability and shareholder value.

The Challenge of Aligning CEO Pay with ESG

As ESG is a broad topic, a key challenge for many firms will be to ensure that the ESG goals linked to executive pay are closely aligned to long-term profitability and shareholder value. Added to that is the challenge of securing consensus on how to measure ESG, with no universal standard in place.

There is continued controversy over CEO pay issues thanks to the huge remuneration gap between CEOs and workers as well as the sheer size of some CEOs’ earnings. Given the sensitivity of the subject, it will be important for firms to clearly demonstrate that aligning compensation to ESG factors is adding value for shareholders. CEO compensation must still pass the scrutiny of the annual say on pay vote, so it will be vital to show that the derived pay packages have been clearly linked to business performance.

It follows that the ESG metrics chosen as inputs in setting CEO pay must be directly relevant to the company’s activities. Firms must ask which ESG factors are material in driving value for their shareholders, with a view on the long term as well as the near term.

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