• The integration of ESG metrics into executive remuneration is gaining global momentum

• However, the assessment and reward of ESG matters is steeped in complexity

• We believe the best incentives align to corporate strategy and encourage long-term perspective

William Cameron

Charlie Munger

Much has been written in recent years on the shift from shareholder primacy to stakeholder capitalism. The central premise focuses on the failure of unregulated free markets to adequately create inclusive and equitable economies for all, including future generations. Indeed despite the Finance industry’s proclivity towards the quantitative, economists and market participants alike have struggled to price externalities, be they positive or negative. Indeed, as mentioned in our opening article, externalities are commonly described as market failures because the equilibrium price of the product associated with them does not accurately reflect the total societal cost. As renowned theorist Stafford Beer has written, “we cannot regulate our interaction with any aspect of reality that our model of reality does not include.” Recently there have been numerous efforts to address this problem, many of which are linked to the ESG movement. The combination of Say on Pay regulation, increasing scrutiny of executive remuneration packages by shareholders, and more recently the introduction of ESG key performance indicators (KPIs) in compensation proposals, represent one example of a potential avenue to tackling this problem. 

Type of ESG-linked pay metric adopted by companies (%) (1)

The momentum in this space is significant. Over 50% of large US corporates and 45% of UK firms now integrate ESG KPIs into remuneration, a level which has increased dramatically in the past three years. However, while aspirationally admirable, a closer look at the reality of implemented plans and a healthy dose of scepticism leads us to observe that many examples of ESG-linked remuneration add even more complexity to an already opaque situation, rather than truly incentivise executives to address externalities.

A reasonable question is to ask why we would include non-financial considerations alongside more traditional metrics in remuneration packages at all? While the competing voices vary in intensity, a comprehensive study of the research suggests there is no decisive empirical consensus on either side. Despite a range of well-researched studies, it ultimately remains unclear whether these ESG practises are positive for either the corporate bottom line or value creation, especially in the near-term. A less idealistic argument may well be that sustainability considerations have historically been deprioritised relative to growth, profitability and share price, and therefore the inclusion of more sustainability-oriented metrics provides a way to focus the minds of hereto non-compliant executives. The practical reality is that increasing regulation and ultimatums from the investment community alike provide little wiggle room or opportunity for companies to avoid including ESG KPIs in prospective remuneration packages for executives. This is a direction of travel that seems unlikely to abate in the years to come.

As boards increasingly look to distil ESG considerations into executive remuneration, the issue of complexity or multi-dimensionality looms large. Imagine a hypothetical consumer business with a design teams across the US and Europe, a manufacturing base across South East Asia, stores in all major global shopping districts, and a multi-platform digital presence.  Quite simply, how can one distil the ESG considerations inherent to that company to just a handful of metrics? While carbon reduction may seem a logical focus for oil & gas companies faced with the rising tide of energy transition – for example, Shell have recently added emissions reduction targets into their LTIPs – for many businesses such a narrow focus appears rather blunt. Furthermore, how should a firm strike the balance between measuring, setting targets, and rewarding performance for ESG inputs, versus ESG outputs? As demonstrated in the example of Sibanye-Stillwater discussed elsewhere in this quarter’s AOR, health and safety metrics are a critical consideration for mining companies. However, should remuneration focus on proactive metrics tied to training and organisational structure, and thus incentivise the avoidance of accidents before they occur, or rather take a more reactive approach which measures safety outcomes retrospectively and forfeits executive compensation in punishment for underperformance? It seems obvious the former system is conceptually preferable, but it is much harder to implement because it implicitly requires measurement of a counter-factual (i.e. how many accidents would have occurred in some hypothetical baseline scenario).

At the heart of ESG-linked remuneration is the need to include metrics that are both relevant and material, and achieve consensus on the correct methods of measurement. Implicit is the need to satisfy multiple stakeholders. But in practise, who is to judge the materiality of ethnic diversity for a hypothetical business located in a community with historically low diversity levels? Alternatively, while we can all agree as to the materiality of demographic diversity in industries such as financial services, what is the most appropriate metric by which to target, measure, and judge progress? After all, much has been written about the inability of ESG rating agencies themselves failing to agree on what best practise actually looks like. This is further complicated when proxy voting agencies such as ISS begin to adopt default positions universally, even when certain types of remuneration scheme are more appropriate for some sectors, geographies, and corporate governance structures than others.

Frameworks such as SASB’s Materiality Map provide helpful reference tools for company and industry considerations, but the question remains as to what percentage of remuneration should be allocated to ESG KPIs.  The average observed by bodies such as the UN PRI today stands at around 15% of variable pay, while some in the investment community have commented publicly that 20% feels “about right.” However, with evidence showing that non-financial targets in variable compensation have a higher payout than financial KPIs, it’s not surprising that the consensus feels rather like the wisdom of crowds.

At its worst, the introduction of ESG-linked remuneration metrics can be argued to be simply crowd-appeasement (i.e. ‘greenwashing’), or alternatively a distraction from what might really matter. For example, with the much-documented focus on carbon emissions amongst the investment community in recent years, numerous capital-lite businesses have made self-proclaimed ‘bold commitments’ to achieve net zero – a strategy encouraged by investors and index-providers alike. Conveniently, such declarations ignore the physically realities associated with their often already structurally constrained emission footprints (see our discussion of carbon intensity on page 7). Linking emissions reduction targets to pay in such cases could actually incentivise the lengthening of a decarbonisation pathway. After all, why decarbonise aggressively if you are being paid each year to hit more moderate targets over a longer period? This may sound slightly cynical, but nonetheless it does illustrate the basic behavioural importance of ensuring remuneration is linked to issues with a demonstrable connection to performance rather than/as well as social externalities. Elsewhere, labour-intensive companies seeking to include a social-oriented KPI in remuneration have tended towards demographic diversity amongst their workforce, however often ignoring alternative but relevant social considerations such as CEO-to-worker pay balance, a metric that has been deteriorating broadly across geographies like the US.

In the cases we have observed where ESG-linked remuneration looks most sensible, it is both strongly-aligned with group strategy and demonstrates prudent long-term thinking. Alcoa’s early-mover approach to tie LTIP remuneration to safety and environmental stewardship back in 2013 demonstrated a sensible recognition of maintaining license to operate as a matter spanning strategic, financial and non-financial objectives. Suncor’s prioritisation of the representation of indigenous peoples on their board, as well as targets for inclusion within management, highlights an understanding of, and commitment to the communities in which they primarily operate. Similarly, Philip Morris’ allocation of 30% of variable compensation to what they define as ‘Transformation’ – the progress they make towards smoke-free products as a percentage of total group revenues – not only reinforces group commercial strategy, but also speaks to a strategic orientation towards harm reduction that is materially incentivised at the highest levels. We have been vocally supportive of these schemes in our engagement with these companies, because their implementation is aligned with the creation of sustainable, long-term value. 

At Hosking Partners our capital cycle-led investment approach seeks neither to reflect optimism, nor pessimism towards an ideal, but rather aspires to recognise reality. We do not look to company initiatives to say the ‘right thing,’ likely reflective of the zeitgeist or latest fad to captivate commentator attention. Rather we seek values and value that we can understand. First principles thinking leads us to believe that long-term, well-aligned incentives focused on value creation tend to bear fruit for owners of businesses, not renters of stocks. However, we also recognise that executive remuneration plans appropriately considered are instructive flags as to less favourable outcomes for minority shareholders – a nod to the infamous quote by Charlie Munger above. Recognising the challenges and limitations of linking remuneration to ESG considerations, we seek not to dismiss nor discard, but rather to identify and embrace the complexity where it emerges. After all, therein lies opportunity.