The Many Questions of Tying ESG To Executive Compensation

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In the last few years, companies have strengthened their commitments to ESG and CSR. This is evident in research carried out by the Governance & Accountability Institute, which highlights that as many as 85% of S&P 500 companies published reports on sustainability, CSR and ESG performance in 2017. In contrast only 20% did so as recently as 2011.

This strengthening commitment is being driven by increased pressure from diverse stakeholder groups such as special interest groups, regulators, employees and the general public. Aware of these trends, investors are increasingly constructing portfolios that emphasize the importance of ESG and CSR concerns for the long-term financial performance of their portfolios. For instance, recent figures reveal that approximately $22.9 trillion of assets under management worldwide now incorporate ESG focused investments.

Boards should take note. According to Goldman Sachs, these trends will increasingly make “ESG more relevant to shareholders as companies articulate the ties to operational and financial performance.” The potential positive impact of such ties are demonstrated in a recent academic paper titled: ‘Shareholder Activism and Equity Price Reactions’ in Economics Letters, which shows that CSR performance can impact stock returns and risk. In response, a number of companies have started to embed CSR more deeply within their firms,’ by tying executive pay to specific ESG and CSR targets.

Royal Dutch Shell, responding to pressure from investors, has just announced plans to tie executive pay to three-to-five-year targets for net carbon footprints from 2020. As the world’s second largest oil company, this move will certainly set an important industry precedent and encourage other industry players to follow suit.

More generally, the incorporation of ESG and CSR as targets within executive compensation contracts is a particularly interesting development, not least because traditional views of ‘optimal’ executive compensation contracts are that they should help align incentives of executives/managers with outside shareholders. This traditional view says little about other stakeholders, yet a key message to corporate boards is that focusing on other key stakeholder groups (beyond shareholders) and outlining strength of commitment through targets linked to executive pay, need not conflict with firm value objectives.

While positive long-term value implications of firms’ ESG commitments are perhaps easiest to discern in the energy sector, they are present in other industries, such as finance, pharma and others. The increasing value relevance of CSR and ESG activities give firms’ strong incentives to prioritize such objectives, and to an extent serves to nullify a classic debate relating to whether firms should prioritize ESG and CSR objectives simply because they have a fiduciary duty to society do so.

For these initiatives to be effective they need to be substantive. ESG targets need not exclusively focus on firms’ environmental footprints. For example, executive compensation contracts could incorporate targets relating to employee welfare. As a key stakeholder, prioritizing employees can have numerous positive benefits that can enhance performance, commitment and loyalty. This could help strengthen a firm’s external reputation and lead to increased sales, customer satisfaction and brand loyalty amongst other benefits.

Should executive compensation contracts embed targets pertaining to employee welfare as well as environmental concerns then? Hugh Welsh, General Counsel, Secretary and President at DSM North America, a global science-based company, thinks so. In his company, 50 percent of short and long-term compensation are tied to explicit targets relating to sustainability, including energy reduction and employee engagement. He argues that “if multinational corporations are sincere about sustainability, then they must link compensation for the senior executives directly to meeting goals such as cutting carbon emissions, and lowering water and energy use. Otherwise those targets will always be far down the list of executives’ priorities – if even on the list.”

So while companies such as Shell should be commended for taking active steps to link executive pay to ESG and CSR targets, there are a number of important considerations that need to be addressed carefully going forward by boards and other stakeholders. For instance, what specific ESG targets should be emphasized and over what timelines? Who should determine these targets? For instance, should they be left exclusively to compensation committees? Or should other stakeholders including regulators, non-executive employees and the general public, be given greater say?

The answers to these questions will likely vary by geography and industry, since, for example, the activities of certain industries such as the energy sector and financial sector are of greater interest to society and the general population since their operations tend to have greater wider impact. Shareholders pressure on executives to deliver share price related performance targets can create a culture that puts safety and ESG concerns second to corporate profits.

Finally, compensation committees may also wish to consider the extent of executives underlying commitment to ESG based on previous career and life experiences and tailor compensation contracts accordingly. New research by business school researchers at the Universities of Kent, Edinburgh and Bangor in the UK, highlights that executives may respond to the same compensation contract incentives differently based on, for example, their specific career experiences. This may imply that executives who lack a past focus on ESG and CSR may need greater pay based incentives to actively work towards specific ESG targets.