The use and conundrum of ESG performance conditions in executive remuneration

There has been an increasing focus on environmental, social and governance (ESG), particularly the environmental performance of companies, over the last decade. This has been encouraged by investors operating ethical funds, where one of the attractions for participants is that the investments made advance ESG objectives.

Given these specialist funds, and an interest of investors generally, ESG has become a relevant key performance indicator for all companies. 

Another consequence of this is the inclusion of ESG measures in executive director incentives – primarily long-term incentives but in some cases bonus plans, too. This assumes that if you want companies to deliver objectives, it is appropriate to incentivise this.  

It is difficult to disagree in principle with the argument and resulting use of ESG performance conditions for incentives, particularly environmental targets. However, there are some important considerations when doing so – not least that setting and measuring environmental objectives can be challenging.

For some environmental challenges faced by companies, ultimately resolving them can result in a deterioration during the investment and change process. Companies must consider whether it is appropriate to effectively punish executives for short-term reductions in performance if they are essential to longer-term satisfaction of ESG goals.

Historically, companies have struggled to justify the payment of incentives for poorer outcomes than previous years. However, environmental objectives often don’t follow the rules of linear performance used when setting financial based performance measures such as EPS.

The difficultly measuring the partial satisfaction of environmental objectives during the journey to their achievement is one factor that has given rise to the use of third-party environmental audits. Even so, the complexity of meeting some of these objectives, and the comparatively new area of auditing them, means it is likely to take some time for all factors affecting the outcomes to be understood and reliably measured.

Consequently, performance payments during the journey, rather than at the endpoint, results in reputational risk for companies should performance subsequently deteriorate. It is hard to avoid, however, given that the standard performance period for a long-term incentive plan is three years, and the complete satisfaction of the objective could be ten years or more. There is always a danger of paying out for inappropriate performance where the reward cycle does not align with the period required to satisfy the objective and there is a risk of it not being met.

This is not a new issue. The financial services sector has historically had problems with rewards for performance being paid over a shorter periods than the risk period attached to that performance. This often resulted in payments that were inappropriate set against the long-term performance delivered.  

ESG performance payments inevitably run a similar risk.

There is little attraction to increasing the length of performance periods beyond the current three years, given that the average CEO’s tenure often is no more than five years. Simply extending performance periods for ESG based incentives is unlikely to be the answer.

However, one way ESG measures could be used is as a longer term underpin on shares held to meet minimum shareholding requirements during employment and increasingly for a period post-cessation. These measures could operate as part of malus and clawback provisions.

The disadvantage of this approach is that there is no direct link to the payment of incentives and the meeting of ESG targets. Even so, it could be argued that this approach may be more effective in achieving ESG objectives than existing ESG incentives, because every decision made by management will be considered in the context of its long-term ESG impact.

This would be a significant change of approach. Forfeiting earned shares for failing to meet ESG targets is very different to being paid for achieving them. Moreover, remuneration committees may consider that failure to meet ESG objectives, or a non-linear satisfaction, is not a reason to forfeit shares if the overall holistic journey has been positive. 
If they have that discretion, however, it could prove an effective approach. Certainly, it may be easier for a remuneration committee to make such a decision than justify payments based on very uncertain measures of performance.

Several ESG issues in the past have taken many years to come to light, with their impacts being felt over an even longer period. Using ESG as a longer-term general underpin mirrors this and could help align incentives with the long- term horizon these issues require.