A recent study by PwC and the Leadership Institute at London Business School demonstrates the extent to which ESG targets have become prevalent in pay plans around the world. In a survey of over 600 senior leaders globally, we found that 77% already have ESG targets in their incentives.
In most cases, this was in the annual bonus, although around half of senior leaders globally say they now have ESG targets in their long-term incentive plan (LTIP). The typical weighting among companies that have such targets is currently 10% to 15% of the incentive, which senior leaders think is about right. But investors want to push it higher, to between 15% and 20% on average.
So the momentum towards linking pay to ESG seems universal and unstoppable, but the question remains: how to do it well. Our study explores what investors and senior leaders hope to achieve by linking pay to ESG, how they go about it in practice, the risks and difficulties to be managed, and how to create the link in an effective and sustainable way.
Creating focus on the right things
Over 85% of investors and senior leaders agreed on the three main motivations for linking pay to ESG.
First, on the whole, investors and senior leaders believe that a focus on the right ESG factors supports long-term shareholder value creation. But investments in ESG can conflict with profit maximisation in the short term. Investors and senior leaders believe that incorporating ESG targets into pay can therefore help to ensure appropriate focus on non-financial factors that drive long-term shareholder value.
Second, the role of pay in signalling intent is important. Many participants in our study reported that the focus on ESG is being supercharged by younger generations, who are proactively asking their employers (and prospective employers) what they are doing in the area. Linking pay to ESG—“putting your money where your mouth is”—can be a powerful way of signalling intent to stakeholders inside and outside the company.
Third, many organisations are committing to long-term ESG goals, particularly net-zero goals in the battle against climate change. The process of setting pay targets imposes a discipline to translate these longer-term aspirations into tangible short-term goals over one to three years.
AllianzGI and Cevian Capital are two major investors who have publicly supported this view, stating: “The inclusion of climate metrics into remuneration requires a strategic discussion between board and management, which will be valuable in itself, as it forces companies to determine their immediate priorities.”
What to target?
Differences in view between investors and senior leaders emerge when considering which ESG targets to focus on. Most senior leaders prioritise factors relating to employees: health and safety, and employee satisfaction. By contrast, investors focus on decarbonisation and environmental goals.
In part, this reflects different perspectives. Senior leaders are focused on maximising value in their company and employees are a group of stakeholders that is intimately linked to value creation. For many companies, environmental impact may not be the most material ESG factor. By contrast, investors managing highly diversified portfolios have a greater concern for so-called “systemic risks” across the market and are coming under pressure from asset owner clients to take action, particularly on the environment.
Evolving governance
Board governance over ESG target setting and assessment needs to be developed. In many companies a sustainability committee will take responsibility for scrutinising, monitoring, and measuring achievement of the ESG strategy and goals. They will need to have an appropriate input into the remuneration committee discussion at key points in the remuneration process, particularly the setting and assessment of targets. The governance needs to be synchronised so that the remuneration committee retains independent oversight of—and ultimate decision making in relation to—remuneration, but with appropriate input in relation to ESG from other committees on the board.
Doing it well
Through our study, we identified five important lessons if pay is to support the integration of ESG strategies into the day-to-day operation of the business.
1. Tell the story, linking to strategy. Employees and other stakeholders need to understand how ESG goals link to the company’s strategy and priorities. Without this alignment, goals will lack credibility.
2. Lead with culture, support with pay. It is culture, not pay, that drives sustainable behaviour in support of ESG strategies. Pay must be seen as the enabler of culture, not the sole driver of it.
3. Engage, communicate, empower. Engaging employees in development of the ESG strategy increases ownership of the goals. Employees need to understand how they can influence ESG goals and must be given the tools and freedom required to do so.
4. Build capability and collaboration. Integrating ESG into pay requires close collaboration between HR and sustainability functions—and it might also require new capabilities in both. Governance oversight of target setting and measurement might need to evolve to enable appropriate input from sustainability committees into the remuneration process.
5. Maintain a focus on value. Good ESG performance can’t be an excuse for not creating value. The best organisations capture the symbiosis between ESG and long-term financial performance specific to their company, and pay arrangements need to reflect that.
There is continuing debate about the extent to which ESG and long-term value are aligned. But what is clear is that it is difficult for a business to be sustainably successful without treating its stakeholders and the environment with respect. And, equally so, without creating long-term value for its shareholders.
The linkage of ESG to pay must reflect both.
Tom Gosling is executive fellow at London Business School. Phillippa O’Connor is partner at PwC, leading its national reward and employment practice. She also leads on the people aspects of ESG for the firm.