Sustainable Investment in China | ESG and Executive Pay: The Missing Link

By James Gifford, Executive Director, PRI

The recent focus by investors, policymakers and the media on executive remuneration has demonstrated the challenges in assessing complex pay packages and corporate performance. It’s clear that existing remuneration plans for senior executives do not necessarily promote sustainable value creation for their companies, and the consequences of inappropriately designed and misaligned remuneration policies in recent years have been severe for investors and the market as a whole.

There is growing awareness that misaligned incentives are a key obstacle to creating a sustainable financial system, and investors have a crucial role to play in rectifying many of these deficiencies. However, the policy and public debate has so far largely overlooked the extent to which companies should consider linking remuneration criteria to strategic performance indicators relating to broader ESG and sustainability issues, and whether investors need to send stronger signals to companies of their desire to see this happen.

With this in mind, the PRI and UN Global Compact Lead have facilitated a project between a group of five companies and 11 institutional investors to create a set of overarching principles outlining how companies should link ESG metrics to executive pay, and have recently published a new guidance paper* in order to help investors begin a dialogue with managers on these issues.

The group set out with a shared belief that existing remuneration plans for senior executives do not necessarily promote sustainable value creation for their companies. While emerging practices are taking shape, and there remains no universally agreed guidance on how to link ESG metrics to executive pay, the consensus is clear: including ESG issues within executive management goals and incentive schemes is an important factor in the creation and protection of long-term shareholder value. And companies should focus on identifying and integrating ESG metrics that are generally forward looking, clear, attainable, replicable, comparable and time-bound.

Considering the influence of ESG factors on corporate performance and reputation, ideally all companies would link executive compensation to key ESG metrics. However, companies from different sectors and industries are affected by particular market forces in different ways, and face varying degrees of materiality for particular ESG issues. Like traditional financial and operational measures of performance, board level oversight appears to be a key factor in ensuring ESG metrics are both relevant and embedded in a company’s broader strategy. There are signs that some boards have started exploring different ways for integrating ESG factors in incentive mechanisms for senior management, but this is not the case for the vast majority of companies today. Investors that participated in the project considered it crucial that boards consistently discuss and monitor the selection, design and verification of ESG metrics and goals to be linked to executive compensation, as they would for any other measure of performance.

Today's unfolding sustainability challenges present both risks and opportunities for companies and increasingly, investors are likely to engage with boards to seek assurances that managers are suitably incentivised and rewarded for their ability to position the company to overcome these. Ensuring ESG issues make up a meaningful component of overall remuneration will give investors confidence that parties throughout the investment chain, including the managers of the companies in which they invest, are acting in their long-term interests.

*PRI - Integrating ESG issues into Executive Pay