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April 26, 2022updated 14 Jun 2022 1:13pm

ESG-linked pay: Investors push for more robust targets

Shareholders increasingly expect executive pay to be linked to ESG targets and are more closely scrutinising the metrics used. Climate- and diversity-related metrics are seen to make sense; third-party ratings less so.

By Joe Marsh

esg pay
Maria Nazarova-Doyle of Scottish Widows says a 20% weighting for ESG-linked pay is “about right”. (Photo courtesy of Scottish Widows)
  • Linking executive pay to ESG targets is a rising trend, as investors push portfolio companies for more clear and measurable targets.  
  • Such action is necessary, as research suggests ESG metrics linked to pay are often loosely worded and deliberately vague.  
  • Companies are coming to grips with the proportion of pay they should link to ESG targets, while third-party ratings are not favoured. 

Most asset managers and banks do not link their CEOs’ pay to ESG-related metrics, but more are set to do so, according to Capital Monitor research published this year. Investors, in turn, are increasingly expecting companies in their portfolios to incorporate environmental and/or social targets into executive remuneration and those targets to be clearly defined and measurable.  

As we enter this year’s AGM season and more companies implement sustainability targets for remuneration, there is also a growing focus on how much weight ESG metrics should be given within pay packages – just as there is on corporate climate plans.  

Remuneration-related resolutions were the most contested area of voting in Europe last year, says Kiran Vasantham, head of investor engagement for Europe and the UK at proxy services provider Georgeson. At least 10% of such resolutions were opposed by shareholders, and there was an 18% rise in shareholder dissent across seven major European markets, he tells Capital Monitor.  

Rising investor pressure  

That trend is likely to continue, with sustainability set to be a bigger focus, London-based Vasantham says. “This year, executive compensation resolutions will face more investor pressure to embrace ESG-related measurements, particularly climate change metrics. ESG metrics should be as rigorous as other financial and operational performance targets to ensure clarity and accountability.” 

Many investors – including US asset manager BlackRock – have supported quantitative ESG reporting metrics aligned with a company’s strategy and business model, Vasantham adds.

Georgeson’s latest annual global survey of asset managers, published this month, reinforces these points. Nine in ten respondents said they endorsed the concept of ESG metrics in executive compensation generally and nearly 70% would like to see a climate-related metric in executive pay (see chart below).  

They also want to see more objectively measurable and clearly stated targets – whether around human capital management, diversity or emissions – and for them to be linked to both shorter and longer-term strategy, the report says. 

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One anonymous respondent to the survey said: "The CEO will only be there six to seven years; they won’t be responsible in 2050, so they need to make a dent now. ESG metrics right now are too fungible. It’s OK having 2050 targets, but we need traction now.” 

Allianz Global Investors, a German fund house with €673bn under management, is among those setting the pace in this area. The firm announced in late February that next year it would vote against European large-cap companies that do not include ESG key performance indicators (KPIs) in their executive remuneration policies.  

Allianz Global Investors also now expects companies in the US and UK to come up with a diversity approach beyond gender. Likewise some asset owners, such as California State Teachers' Retirement System and Swedish state pension fund AP2, are working hard to reduce the gender pay gap and improve staff diversity.  

Calls for better pay analysis  

Such leadership is welcome, says Michael Hugman, director of climate finance at the Children’s Investment Fund Foundation, a British non-governmental organisation (NGO) that launched the Say on Climate initiative. 

He cites detailed analysis by As You Sow, a US-based NGO, of CEO compensation packages, including around ESG. “What you find is that there are some very loosely worded, deliberately vague qualitative metrics that are linked to the bulk of this so-called ESG pay,” Hugman says.  

Michael Hugman of the Children's Investment Fund Foundation says investors should be pushing for climate-related targets for pay. (Photo courtesy of CIFF)

“Investors need to do more of this high-quality analysis of what's really going on with these pay packages,” he adds. “They need to push companies to ensure that there is a small number of very clear, very measurable KPIs, like the Climate Action 100 benchmark for emissions reduction.  

“I'm sure most CEOs want to avoid that like the plague because they're not going to want to be held to account in that way [on cutting emissions],” Hugman says. “But if we're going to deal with climate change, that's what needs to happen.”  

Weightings and metrics 

Other key questions that companies are having to consider include: what proportion of the pay package should be linked to ESG factors and which metrics to use. The most popular weighting for ESG-linked pay in the Georgeson survey was 20%, with around eight in ten respondents picking that figure (see chart below) and Hugman also backing it.  

Similarly, Maria Nazarova-Doyle, head of pension investments and responsible investment at life and pensions firm Scottish Widows, tells Capital Monitor: “Something like 20% is about right. Below 15% is probably not enough, and above 20% you start to worry that something else important is not getting done.” 

Lloyds Banking Group, Scottish Widows’ parent company, raised its own ESG-linked pay weighting to 17.5% this year from 15% in 2021. Diversity, equity and inclusion targets account for 7.5% and climate for 10%, with the latter split between reducing operational carbon footprint (5%) and sustainable financing and investment (5%). 

“This proportion of remuneration relates to very specific goals and targets around decarbonisation and diversity,” Nazarova-Doyle adds. “But that does not mean the rest of the pay targets do not have ESG involved. We expect also to have ESG factors across the board.” 

Third-party ESG ratings a "cop-out"

Something that Nazarova-Doyle – and others, including the Georgeson survey respondents – do not favour is linking pay to third-party ESG ratings (see chart below).  

“There’s too much of a mix going on across the board [in terms of variability of ratings],” she says. “They are interesting and informative, but I would be surprised to see executive compensation widely linked to third-party rankings on ESG. I don’t think that’s the correct way to approach [ESG-linked pay]. It needs to be based on companies’ progress on operational decarbonisation, diversity et cetera.” 

Paul Lee, head of stewardship and sustainable investment strategy at investment consultancy Redington, supports this view. “The variability of third-party ratings raises some concerns,” he tells Capital Monitor, reflecting scepticism shown by others, including big institutional investors such as Japanese insurer Nippon Life.

“To my mind, [using them] seems like a cop-out: remuneration committees need to be robust in their assessments of executive pay, in relation to ESG metrics and all others,” London-based Lee says. “If they aren’t and cannot provide clear justifications for their decisions – and especially if their decisions seem inappropriate – the committees should be held to account for poor decision-making. 

“I think we’re seeing more investors willing to reflect this in their votes on individuals as well as their votes on remuneration reports,” he adds. 

Early warning

But they recognise that it is early days for ESG-linked pay, indicates the Georgeson report. Hence, it adds, while asset managers are raising their focus on this area, most have not been actively voting against companies with poor ESG metrics or metrics they struggled to understand.  

Nonetheless, the increased opposition to votes on remuneration is a warning for companies to focus on shareholder engagement and education, particularly during the off-season, Vasantham says. “It is especially important to keep investors apprised of the progress of various ESG initiatives, such as reducing greenhouse gas emissions, and new challenges and mitigating factors that may cause misalignment or a change in criteria.” 

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