ESG Executive Compensation: Tying ESG Metrics to CEO Pay

Find out about the pros and cons of including ESG metrics in executive pay

Only got a minute?

Head to our 60-second takeaways

Background to ESG and executive pay

Over the past few decades, there has been a heightened awareness of environmental and social challenges. As a result, stakeholders have been pushing companies to take a more holistic and responsible approach to their operations. This shift has led companies to tie ESG to executive compensation. In fact, one study showed that 77% of major companies across North America and Europe in 2023 include ESG metrics in their executive incentive plans.

Short-term financial gains

Companies are recognising that a focus solely on short-term financial gains can lead to unsustainable practices and increased risk of issues such as:

regulatory fines
legal liabilities
supply chain disruptions, and
reputational damage.

By integrating ESG metrics into executive pay, companies are motivated to manage these risks more effectively.

Plus, institutional investors and asset managers are increasingly basing their investment decisions on ESG factors. Aligning executive compensation with ESG goals can signal to investors and employees that a company is committed to sustainable practices.

Not to mention, consumers and the general public are becoming more conscious of the social and environmental impact of their purchasing decisions. Companies that prioritise ESG can enhance their reputation, attract socially responsible consumers, and mitigate reputational risks.

Including ESG metrics in executive compensation

Europe is currently the global leader in tying ESG to executive compensation. The fact that the Securities and Exchange Commission (SEC) has adopted amendments to its rules, requiring companies to disclose the relationship between executive compensation and financial performance, is expected to fast-track this trend.

The SEC is also reviewing further regulatory changes that would require advisers to include ESG factors and strategies in fund prospectuses, annual summaries and brochures. The advice is therefore for companies and fund advisors to review their compliance programs regarding investor disclosures as well as their ESG practices and policies.

Examples of non-financial ESG metrics

Some examples of common non-financial ESG metrics include:

Employee or customer safety
Water consumption
Carbon footprint
Data security and privacy
Sustainable sourcing
Energy efficiency
Workforce diversity, equity & inclusion

Pros & cons of tying ESG performance to executive pay

PwC’s 2021 global investor survey shows that:

Two thirds of investors believe that ESG performance measures and targets should be included in executive pay.
86% of investors believe that ESG measures help to ensure managers focus on non-financial factors that drive long-term shareholder value.

While tying ESG metrics to executive pay certainly seems like an attractive proposition from an investment perspective, there are pros and cons.

Pros of tying ESG performance to executive pay

Alignment with long-term sustainability

Linking executive compensation to ESG performance can encourage a focus on long-term sustainability rather than short-term financial gains. This can promote responsible decision-making that considers the impact of the company on various stakeholders and the environment.

Stakeholder value creation

ESG metrics can incentivise executives to create value for a broader range of stakeholders, including employees, customers, communities, and the environment, rather than just shareholders.

Risk management

Incorporating ESG metrics can encourage executives to proactively manage ESG-related risks, such as environmental liabilities, regulatory compliance, and reputational risks. This can lead to better risk mitigation and improved resilience.

Enhanced reputation

Demonstrating a commitment to ESG performance through executive compensation can enhance the company's reputation and brand image, attracting socially conscious investors and customers.

Innovation and efficiency

ESG metrics can drive innovation and operational efficiency as executives seek to implement sustainable practices, reduce resource consumption, and optimise processes.

Cons of tying ESG performance to executive pay

Complexity and measurement challenges

ESG metrics can be complex to define and measure accurately, leading to potential disputes over performance targets and results.

Unintended consequences

Incentivising specific ESG metrics could lead to unintended consequences, such as "gaming the system" or neglecting important aspects of ESG that are not directly linked to compensation.

Difficulty in comparability

Different companies may have varying ESG priorities and performance metrics, making it challenging to compare executive compensation across organisations.

Risk of greenwashing

Risk of greenwashing: There is a risk that executives may focus on superficial changes to meet ESG metrics without making substantial improvements to the company's actual sustainability practices, i.e. greenwashing.

Potential for resentment

If ESG metrics lead to significant changes in executive compensation, it could potentially lead to resentment or dissatisfaction among executives who believe their compensation has been unfairly impacted.

Market competitiveness

Companies might face challenges in attracting and retaining top executive talent if ESG metrics are not competitive with compensation practices in the industry.

Conclusion

Linking ESG metrics to executive pay can be a positive step for companies, provided it is carefully designed and implemented. It aligns executive incentives with broader societal and environmental goals, encouraging responsible and sustainable business practices. Target-setting poses a particular challenge and there are likely to be other hurdles to overcome in the next few years. For now though, ESG in executive pay is becoming more and more common, and it’s seen by many as a step in the right direction for society as a whole.