As ESG and climate-related metrics become increasingly entwined in executives’ pay incentives, Calum Davies, Member Manager at Chapter Zero, shares insights from chairs of sustainability committees on the importance of better engagement and alignment with the remuneration committee.
The UK’s leading businesses are increasingly linking ESG and climate-related targets to the pay and incentives received by their executives.
According to recent findings, 70% of FTSE 100 companies incorporate some level of ESG metrics into their annual bonus plans, and around 30% build them into their longer-term incentives. These figures are increasing year on year. The findings also show that ESG-linked targets account for between 10% and 20% of overall variable remuneration, indicating that ESG targets are starting to have more substantial weight in executive remuneration, with room to increase in importance.
As this important subject rises up the agenda, a group of Sustainability Committee Chairs in the Chapter Zero community recently shared their learnings and challenges around ESG in remuneration, and how they have been collaborating with the remuneration committee to ensure ESG targets are more effectively aligned with executive pay.
1. The challenge of setting robust targets
A key challenge for sustainability and remuneration committees is choosing and calibrating robust targets for their remuneration plans.
For meaningful change to happen around sustainability and climate, targets need to apply the same robustness and methodologies as financial targets. Given how critical climate change is, targets should be bold enough to be stretching, yet achievable. The targets should also be material and aligned with the company’s broader sustainability plans.
Committee chairs need to collaborate to decide whether to focus on a few select metrics, such as net-zero commitments, or take a multi-dimensional approach that includes social metrics, Scope 3 emissions and more. Taking a broader approach could be a more effective way to accelerate top-down cultural change. It’s also important to consider whether targets are based on internal or external benchmarks and which targets require third party verification.
Clearly linking targets to a business’s strategy and purpose, while meticulously collecting and analysing data on the company’s ESG metrics can help satisfy shareholders that pay-outs are warranted.
2. Investor expectations are evolving
One of the external drivers for more inclusion of ESG targets in executive pay is of course the rising level of support from investors, who are requesting more transparency and pressing for reward that is focused on progress relating specifically to the company’s net zero strategy.
There’s a common desire among the investment community for targets to be strategically aligned, quantifiable, and material to the business. Poorly defined goals could bring the risk of accusations of greenwashing and create scenarios where executives receive pay-outs even when financial targets are missed. It is important to effectively communicate the alignment of short-term (1-3 years) targets with longer-term (5-10+ years) net zero commitments.
At the same time, today’s investors emphasise striking the right balance – and not weighting climate targets too heavily at the expense of other important performance indicators. All aspects of ESG must be given consideration in establishing the most appropriate targets for executive remuneration.
3. Short-term vs. long-term incentives
Sustainability and remuneration committees should work together to establish whether short or long-term targets are most effective. Some ESG goals, such as improving diversity, sit well within an annual bonus because they can be delivered in a single year. Others, such as environmental ambitions around Scope 1 and 2 – and increasingly Scope 3 – emissions can suit longer-term targets.
The challenge with longer incentives is that priorities inevitably change. It’s a huge undertaking to set specific and meaningful long-term targets that are not financial, so there should be a strategic, compelling and competitive reason for doing so and this should be reviewed on a regular basis.
The benefit of linking goals to an annual bonus is that they can be flexed year on year, as social values or stakeholder expectations evolve. Some committee chairs believe well-defined short-term targets are more effective than nebulous long-term goals.
4. Aligning sustainability and remuneration committees
With robust sustainability strategies being long proven to positively impact organisational success and shareholder value, there is a real need for strong collaboration between the sustainability and remuneration committees.
This means that more thorough discussions occur, the latest and best data is considered, and boards reach a better perspective on whether ESG targets are right for that moment in time – and are suitably stretching.
As a result of cross-committee collaboration, targets are likely to be clearer and better positioned to be measured effectively. Should sustainability priorities change, the remuneration committee can respond immediately and ensure executives aren’t working towards outdated goals. Expectations will only grow, especially given the increase in the different regulatory bodies working together, and the two committees must collaborate to be ready for this.
With stronger engagement with the remuneration committee, sustainability committees can make their case for ESG metrics being less marginal. They also have a stronger voice in the organisation when ESG-related events occur, and can ensure that any resulting reputational damage is reflected in executives’ remuneration.
5. Keeping sight of the bigger picture
The most effective ESG strategies are those that are embedded in the ‘DNA’ of the business and its strategy. A well-defined purpose that embraces goals that are broader than shareholder value can transform strategies and lead to positive action.
In this regard, ESG targets in remuneration can be much easier to implement when there’s a clear resonance between the metrics used and the wider company strategy.
In particular, committees should aim to demonstrate how ESG targets directly relate to financial performance, such as through improved operational efficiency or cost savings. This holistic approach can achieve faster buy-in from stakeholders and ultimately lead to important behaviour and cultural change.
6. The future of ESG targets in remuneration
As customers, employees and investors increasingly look to businesses to be accountable for their impact on society and the environment, the presence of ESG goals in executive pay will likely increase.
However, this trend could be undermined, because some businesses are moving away from setting performance-based incentives for those further down the organisation. One way to move the dial on this is to incorporate sustainability metrics in all employee share programmes.
Sustainability and remuneration committees should be bold about setting rigorous, data-led targets for company executives. Targets should also be communicated well to the executive team, including the clear benefits and opportunities associated with achieving these goals. This is the way forward to ensure modern businesses meet challenging environmental targets, while remaining competitive, relevant to their customers and commercially successful.
If you are a Sustainability Committee Chair or member and would like to share your experience with others, Chapter Zero offers a range of events, roundtable discussions and workshops that help NEDs address climate change in their boardrooms.
Read more about becoming a member of Chapter ZeroHere
Written by Calum Davies, Member Manager at Chapter Zero