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Balancing Executive Pay and Corporate Sustainability

The economic downturn has put executive pay in the shareholder spotlight, with investors increasingly demanding that executive compensation be linked to corporate performance. So far, however, the ongoing policy and public debate has largely overlooked the extent to which companies should consider linking remuneration not just to financial performance but also to specific environmental, social and governance (ESG) metrics and whether investors need to send stronger signals to management to make this happen.

With responsible investment gaining media coverage, companies will be well aware of the importance of addressing their ESG risk.

Studies show that capital is likely to flow into companies that can demonstrate transparency, compliance with bribery legislation, management of environmental risk and other factors. We also know what happens when CEOs are seen to be running afoul of governance issues. There are the massive costs associated with BP’s failure to address adequately environmental, health and safety risks in connection with the disastrous Gulf of Mexico oil spill. Similarly, weak leadership at South African mining giant Lonmin has led to the breakdown of employee relations, with the strike earlier this year slashing its earnings, on top of the massive strikes two years prior that made international news.

Back in 2012, during the so-called Shareholder Spring, when shareholders began to question excessive executive pay, the Principles for Responsible Investment (PRI), a United Nations–supported group of institutional investors that has committed to sustainability measures, developed some guidance for integrating ESG issues into executive remuneration decisions. These included: adopting a clear process for identifying the appropriate ESG metrics to be linked to pay; linking those metrics to reward systems so that they form a meaningful component of the overall remuneration framework; and disclosing the rationale, method and challenges presented by the incorporation of ESG metrics into executive pay clearly and concisely.

New research from PRI covering the mining, energy and utilities sectors, to be released September 25 at PRI’s annual conference in Montreal, shows some interesting statistics. A review of public filings for 84 companies in these sectors revealed that 83 percent of them incorporate some type of ESG issue into compensation decisions, as it is a growing trend in these industries. From a regional standpoint, Australia is clearly leading the way, followed by North America and Europe.

Yet whereas almost all companies incorporated ESG issues in short-term compensation plans, just 16 percent of companies tied these issues to long-term incentives.

Other key findings indicate that safety is by far the most prevalent ESG issue employed by companies in the mining, energy and utilities industries, whereas in those sectors, climate change is the least prevalent. Other metrics cover environmental issues such as pollution or water use, governance factors such as board composition and diversity and social metrics such as labor and community relations.

Finally, looking at compensation plans overall, approximately 25 percent of the 84 companies reviewed allow for board discretion in the determination of remuneration awards, although more than half have clawback provisions.

The study shows that there remains significant work to be done in developing long-term and rigorous approaches to providing incentives for ESG performance through executive pay. It also shows that the performance metrics used are often opaque or ill-defined.

Certainly, there are challenges to doing this, including the lack of a universal standard of reference for boards, top management and remuneration consultants to assess relevant ESG risks and opportunities. There is also the concern of creating executive incentives in isolation, without promoting a holistic approach toward sustainable performance. And there is the potential for different performance factors to compete with one another within compensation packages and remuneration reports that are already lengthy and difficult to read.

Today’s complex sustainability challenges present both risks and opportunities for companies. Our preliminary research suggests the mining, energy and utilities sectors are ahead of the curve, as they are already linking their organizational ESG strategy with individual performance.

But investors need to engage in a wider dialogue with these companies to ensure that ESG issues constitute a meaningful component of overall remuneration and that incentives are being aligned with long-term strategic plans to ensure that senior management is held accountable for sustainable performance and the delivery of continued shareholder value and so that investors are confident that stakeholders across the investment chain are taking a long-term view.

Companies must also develop ESG criteria that are relevant for their businesses and use more robust metrics that capture a long-term view of ESG issues and regularly communicate these processes to the wider stakeholder community, including investors. Transparency is critical, as investors are more likely to engage with boards that ensure senior management is suitably rewarded for their ability to position the company to meet sustainability challenges.

Fiona Reynolds, based in London, is the managing director of the Principles for Responsible Investment.