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By linking executive pay to transparent and measurable ESG factors, companies can show they take ESG issues seriously. Nina Röhrbein reports on work being done in this area

While the issue of executive remuneration has sparked much debate and many shareholder revolts this year, little thought has been given to integration of environmental, social and governance (ESG) factors into corporate pay.

But the UN-backed Principles for Responsible Investment (PRI) has recently produced a report on how to link those factors to executive pay.

“A lot of work has been published on executive remuneration generally but relatively little research has been done specifically on integrating ESG factors into executive pay,” says Rob Lake, director of responsible investment at the PRI. “Integrating relevant ESG factors into executive remuneration is, in a way, the next frontier for thinking about how companies can take ESG factors seriously and how investors can play a part in that.”

For the project behind the report, a group of 11 PRI signatories co-operated with a number of companies through the UN Global Compact LEAD platform to identify the most significant ESG factors behind companies’ long-term financial performance and to discuss how those factors could be tied into the way the companies structure their executive remuneration. A third area of discussion focused on the provision of high-quality disclosure of such practices.

“For the overwhelming majority of companies there are indeed ESG factors that are crucial to long-term financial performance, and if they are that significant it makes sense to find a way to focus senior management’s attention on delivering those objectives by linking executive pay to those relevant factors in an appropriate way,” says Lake.

Investors have become aware that some companies have not done anything to link ESG factors to executive pay, or have done it in ways that have not been helpful – by, for example, linking executive pay to sustainability indices, such as the Dow Jones Sustainability index.

“Investors in the group generally do not favour this approach because it does not home in on the specific ESG factors that are relevant to the individual company,” he says. “A company needs to look at the ESG indicators that are most relevant to its success and long-term performance.”

Recognising the ESG factors that affect long-term financial performance is more obvious in some sectors than in others. Big energy users such as utilities easily ascertain that reducing greenhouse gas emissions leads to reduced energy use and lower costs.

“But in order to reduce energy use they probably have to invest in new plant and equipment, meaning they might not necessarily see the benefits for a few years,” says Lake. “They need to allow for a longer timescale before reaping the benefits.”

Other examples of ESG factors include customer satisfaction for companies in the service industry and accident rates in the mining sector. But they need to be measurable. “Investors need to be able to see exactly what executives are rewarded for, which is why ESG factors need to be verifiable,” says Lake. “It should not be an exercise in reputation management for the company because there has been criticism of executive pay. There is no single standard set of ESG factors that is relevant for all companies. It is about each company working out what makes the most sense for its business.”

As there is no standard way of measuring certain factors such as, for example, customer satisfaction or employee engagement, companies need to be transparent and able to explain exactly how the selected metric works.

“When a company is subjected to scrutiny about a metric and it turns out that it is entirely subjective without any methodology behind it, it is unsatisfactory to investors,” says Lake.

In the financial services sector, the focus is on risk management, although the classic issues that are being discussed now concern executive pay, ensuring that executives do not get bonuses for short-term, risk-taking behaviour that causes problems in the longer term through claw-backs and other mechanisms.

Transparency of the remuneration structure will give investors the evidence they need of alignment with business strategy and shareholder value.

One of the examples mentioned in the report is the Dutch chemical company DSM. In 2010, it redesigned its remuneration policy to ensure further alignment with corporate strategy and values, and today executive pay at DSM is equally composed of fixed salary and variable remuneration. The short-term incentive scheme accounts for half of variable remuneration, while the long-term incentive scheme makes up the other half.

DSM links not just short-term cash bonuses to greenhouse gas emission reductions but also the vesting of long-term share base incentive pay. It links 50% of the vesting of long-term share awards, which is usually done after three years. Shares are conditional on performance. Executives receive shares after three years, provided that certain financial targets as well as emission reduction targets have been achieved.

In addition, DSM has also set a number of clear sustainability targets for 2015, relating to innovation and operations, energy efficiency, greenhouse gas emissions, employee engagement, diversity, and receiving a top ranking at the Dow Jones Sustainability index.

Most companies that currently link compensation to ESG factors do so through short-term incentives, which are usually based on factors such as individual performance, annual or quarterly goal completion and short-term financial performance, and often leave room for a variety of metrics on which executives can be rewarded. Conversely, long-term incentives are usually tied to fewer, often financial metrics, such as a company’s total shareholder return or earnings per share. However, according to the PRI, ESG metrics would be particularly suited as proxies for a company’s long-term success.

Like many other remuneration advocates, the PRI did not focus on the outright amount people were paid in the project.

“Executives deserve to be rewarded if they deliver what is good for the company in the long-term interests of shareholders,” says Lake. “The focus that companies sometimes have on very short-term performance is not necessarily in their or their shareholders’ longer-term interests. Academic research shows that companies forego investment opportunities that would deliver long-term returns purely in order to hit short-term performance targets. Companies and senior executives needs to refocus their attention on longer-term drivers of value and performance and ESG targets are often linked to those longer-term factors.”

In fact, the dialogue that the PRI is conducting is part of an effort to slowly shift the timescale from short to long term by demonstrating to companies that investors are interested in these longer-term performance-driving factors.

“The market overwhelmingly is still too focused on short-term performance,” says Lake. “Companies sometimes respond rationally to short-term signals that they get from investors and there may be good reasons for investors to focus on short-term performance, particularly in the current environment, and for companies to think in the same way. We need a new, shared understanding of the relevance of thinking in terms of longer-term performance. It has to be collaboration and a dialogue across the whole of the investment chain, which is why we try to create a dialogue between companies and this group of investors.”

While the focus is primarily on remuneration of the board on which investors have a right to vote, Lake acknowledges that the way remuneration-linked incentives work at lower levels in the company is also of relevance to investors.

“To ensure that everyone in the company is focused on the right objectives, it makes a lot of sense for companies to introduce appropriate links to ESG at other levels down into the system as well,” says Lake.

To take the practical implementation forward, individual PRI signatories will continue their discussions with the companies they hold on the basis of the PRI guidance document. The PRI, meanwhile, is starting a new project with companies within the UN Global Compact on the integration of a range of other ESG factors that are relevant to their business, not just executive pay.

The paper ‘Integrating ESG issues into executive pay’ can be found at www.unpri.org (bit.ly/P9ygTJ).

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