The inclusion of ESG targets into executive pay may be happening at high speed but it comes with a warning: it may prove “no panacea” and produce “unintended consequences”.

A new study from London Business School and PwC finds that 45% of the FTSE 100 include an ESG target in their annual bonuses or long-term incentive plans (LTIPs), or both, for executives.

The research also revealed that 37% use an ESG target in the annual bonus, with an average weighting of 15%; almost a fifth of the UK’s largest listed companies use ESG in LTIPs, with an average weighting of 16%.

“New” ESG measures are becoming more popular. Companies have used long-standing metrics such as health and safety, risk and employee engagement for some time. But the report says 28% of companies use relatively novel measures concerned with climate change, sustainability and diversity.

‘Practical difficulties’ in linking ESG to pay

That all indicates that ESG has firmly lodged itself in the executive pay process. But the report suggests remuneration committees should also be taking care.

According to Tom Gosling, executive fellow at London Business School’s Centre for Corporate Governance, ESG measures do not always produce the right results. “The increased focus on integrating ESG considerations into company strategy and operations is welcome. But this doesn’t mean we should automatically include ESG targets in pay. There are lots of practical difficulties—and scope for unintended consequences—in linking pay to ESG.

“And there’s a risk that more ESG targets simply results in more pay, due to the difficulty of knowing how stretching these targets are.”

The report says that pay deals are already complicated, and adding ESG targets may bring about unwanted results. This may include “hitting the target but missing the point”; creating a distraction from other important issues, and challenges in “measurement and calibration”.

ESG targets may also undermine shareholder value, which would need careful explanation from a board and a clear justification.

The paper concludes that boards could consider options other than ESG remuneration targets. This might be “simplifying and lengthening” time periods for pay, while a public commitment to ESG goals and robust reporting on progress might create the same intensity of ESG accountability.

Investor focus on ESG

There have been other recent observations of the link between pay and ESG. Last month, Institutional Shareholder Services (ISS) revealed research showing that the use of ESG pay incentives had more than doubled globally over the past two years. Casey Lea, an ESG expert at ISS, said they were now a “critical issue”.

“This rapid increase in adoption means investors must be mindful of not just who is adopting these incentives but also what type of metrics are being used, how important they are in driving executive pay, and the performance period on which they are measured,” Lea said.

Some investors are taking the issue seriously. This month Swedish investment manager Cevian said it would use its vote at AGMs to highlight companies that fail to incorporate ESG measures into executive pay arrangements.

Numerous investors have cited ESG reasons for examining executive deals in light of companies taking money during the pandemic for furloughed staff.

Pay remains a sensitive issue. The new report concludes that while ESG targets may help, they also come fraught with difficulty.

“Incorporating ESG targets into executive pay can play a role in helping some businesses be a force for good in addressing the immense challenges we face today. But adding ESG to pay is not a simple equation. The answer is not always what we expect, and the risks of getting it wrong are substantial,” the report says.

“Paying for good while paying well is a hard thing to do.”