Global businesses have reached a sustainability inflection point. The expectations of stakeholders and the heightened scrutiny of investors put organizations under pressure to express their social roles more clearly, prioritizing environmental and social objectives within their strategies. of the business, and demonstrate progress to stakeholders. We know too that employees prioritize their employment decisions based on the organization’s purpose, culture, ESG goals, and diversity, equity and inclusion (DEI) priorities. Yet for the most part, corporations neglect a powerful lever for advancing their sustainability agendas: executive compensation.
A gap has opened between pay and purpose in most executive suites. Most top teams are motivated against short-term financial performance, which is different from organizational purpose statements that often reflect aspirational long-term financial and non-financial goals. This creates a disconnect between an organization’s purpose (its contribution to society) and executive pay (what kind of “performance” is rewarded). By realigning these two factors, corporations have the opportunity to transform executive compensation from a reputational risk factor to a change factor.
Research SHOWS that organizations that adopt a long-term incentive approach for their executives show more “long-termist” behavior, such as investing in innovation and stakeholder relations. But while the effectiveness of tying incentives to long-term results is well established, many organizations still drag their feet and fail to include such incentives in their executive’s pay packets.
There are many reasons for this. The bottom line is that in the current global economic and geopolitical climate, business leaders must deal with urgent disruptive forces while focusing on short-term financial metric performance. In some cases, “keeping the ship afloat” is the primary focus. But there are other challenges, too, including:
- ESG regulation is fragmented and evolving, with many rules yet to be finalized and robust ESG metrics to be implemented.
- ESG data collection methods are not standardized.
- Target setting and calibration methods are often untested, and best practices are still scarce.
But even if it is complicated, the transition to a sustainable economy is an inevitable process. With so much pending legislation and increased reporting requirements, organizations have no choice but to comply. They can choose to be reactive to these changes or be a front runner. Inertia has its own risks as well.
Combining research from Foundation of Reward Value with EY’s Total Reward advisory experience, we’ve identified five questions that can serve as a helpful starting point for companies to create sustainable compensation programs.
What is the goal?
What is the organization trying to achieve with its compensation plan? How do these goals link to corporate purpose and strategy?
The plan should go beyond the usual “attract and retain the right people” objective. This should be a catalyst for positive change in the organization and for its stakeholders.
It is important that this goal is clearly defined because it will inform all the following compensation plan design options, against which the variable salary plan will be evaluated – especially where ESG metrics will be have a material effect over a relevant time horizon.
What metrics matter?
Next, organizations need to know which ESG metrics are important – and which are not. What topics does the organization invite its stakeholders to measure its progress? What financial, social, and environmental impact is expected to be made by prioritizing these topics?
For example, reducing greenhouse gas (GHG) emissions is positive and potentially on everyone’s agenda. But if you are in the financial services industry, reducing GHG emissions in your own premises will have a limited impact, while reducing emissions related to your investment and/or loan portfolios will be much more effect. Such materiality is an important issue for the relationship between ESG and business performance.
Santander includes this method in an incentive (short and long term) method. It measures its role as a financial institution to society by the level of green finance raised and facilitated through the bank’s loan portfolio, and the decarbonization of its investment portfolio. The deferred share of the bank’s executive director and senior management incentive scheme is dependent on the achievement of this sustainable financial behavior.
British supermarket giant Tesco introduced a new compensation plan in 2022 that illustrates another way to incorporate materiality. As part of its performance share plan, the supermarket chain includes food waste reduction in its long-term incentive scheme for its executives. This approach is complemented by other ESG measures, such as carbon reduction and leadership team diversity.
How do you evaluate incentives and over what period of time?
Once the materiality is assessed, it is important to determine the priorities – or the weight – of the measures of the incentive method to drive the right behaviors.
While organizations are paying more attention to ESG topics as compensation, the weight allocated to these metrics is often not enough to make a difference. If an executive’s compensation is linked to a broad basket of financial and non-financial measures (including ESG), they are less likely to have an impact on the executive’s behavior. Either attention may be diluted and spread across multiple factors, or attention may not be given at all because the payoff effect is small. In most incentive schemes, non-financial metrics are usually a basket of topics and the total weight allocated is usually less than 5% of the total compensation, and therefore has little impact on decision making.
To make an impact, compensation plans must be tied to clear KPIs and be financially meaningful to participants. Mars’ long-term incentive plan promotes this approach by linking pay to clear goals that cover four “quadrants of performance” (financial results, quality growth, positive impact on society and being a trusted partner). The two non-traditional metrics each have a weight of 20% and consist of GHG emission targets for 2025 (and beyond) in all ranges and a social reputation measure monitored by besides measuring the ratings of the Mars corporation as a reliable partner that responds to stakeholder interests (employees, supply. chain, customers, and society in general.). As long-term-minded investors, Mars sees these non-traditional measures as clear objectives for shareholders.
“It’s important that leaders are clear on what’s important and understand the role they need to play in achieving traditional financial metrics and non-traditional metrics,” said Andy Pharoah, the vice-president. of global corporate affairs and sustainability of Mars. “At Mars, the growth of the cost of GHG emissions is not seen as a success so the shareholder’s goals include specific continuations that are integrated into the business strategy and the three-year, approved by the board, integrated plans to create value.These goals drive a significant portion of compensation and give our leaders a clear definition of success.
What are the targets?
For incentive purposes, sustainability KPIs must be measured and usually set with reference to external standards or international agreements (such as the Paris Agreement). As regulations and standards continue to evolve, so do the ESG metrics chosen. Boards therefore need to ensure that they are measuring what is important and allow for changes in bias where necessary.
Once the metrics to be used have been decided, it is important to quantify and calibrate the target level of performance for each KPI selected – for example, the reduction of GHGs by “X” percent in “Y” years . Consider using relative targets to allow sector comparisons. In another way to check the internal efficiency for example of your GHG emissions, it is good to make a measure that depends on the level of sales or production. Lower emissions due to lower production do not measure up to improvements in energy efficiency for example.
Incentives are reliable and effective if they are given for achieving results that are beyond what can be achieved without executive intervention. To realize change, it is important that the targets are “stretchy” enough and not small. Linking wages to targets set in accordance with Science Based Targets initiative (SBTi) already established a strong level of credibility and stretch.
How will you show progress?
With ESG metrics in place to drive executive focus, disciplined disclosure practices play an important role in providing visibility into the progress being made. The goal is to offer investors, customers, employees, and other stakeholders a transparent and accessible communication of the joint efforts made by an organization to promote sustainability.
Targets linked to remuneration should be audited and disclosed in accordance, where possible, with existing disclosure standards. Audited targets increase the credibility of the measures and with them the reliability of the remuneration procedure. In addition, with the application of existing disclosure standards, remuneration disclosure will be transparent and comparable. To use, for example, the Global Reporting Initiative standards on emissions, performance based on the number of subsequent years can be effectively monitored and clearly linked to executive remuneration pay-outs. On the other hand, the monetized effects analyzed in accordance with ISO certified VBA impact assessments will also be audited and effectively linked to remuneration.
There is a compelling business case for boards and executives to accelerate the transition to a sustainable and resilient economy by aligning their organization’s sustainability priorities with their executive compensation KPIs and management frameworks. Considering the five questions posed above can be a starting point on a path to creating a sustainable compensation framework for organizations that serve as a cause of positive change.
