Sustainability concerns have accelerated exponentially in the recent years, and even more so since the outbreak of the Covid-19 pandemic. As a consequence, stakeholders including customers, employees, shareholders, and regulators are reacting and pressuring companies to evolve and further embed sustainability in their business practices.
One best practice recognized by investors and investor-focused ratings such as ISS, MSCI, or S&P Global’s Corporate Sustainability Assessment is that of aligning progress on material ESG topics to executive remuneration to accelerate sustainability performance.
While leading companies including Apple, Danone, PepsiCo, Thales, and Volkswagen have already connected executive remuneration to ESG metrics, some companies are still reluctant to make the step. In any case, the topic of connecting ESG metrics to executive remuneration is a sensitive one given its complexities.
Arguments in favor of connecting ESG metrics to executive remuneration are that it allows to align strategic objectives, accelerate sustainability performance, and signal commitment to stakeholders. Moreover, financial and non-financial lines are blurring, spurred by integrated reporting and integrated thinking, making formal ESG performance criteria a logical next step.
Opponents claim that ESG targets cannot be properly linked to executive remuneration, as ESG targets are realistic rather than challenging, and that they are subjective and inflexible. Moreover, they could be perceived to express mistrust, therefore undermining intrinsic motivation. The same, however, could be said for financial targets.
In order to bypass the implied cons and successfully connect ESG to executive remuneration, it is essential to introduce the topic with appropriate timing, a strong strategy, and a coherent rationale behind the strategy. Several elements need to be considered in making the step to ensure the targets are based on the right KPIs and the thresholds are set properly, to ensure strategic alignment with the business priorities, as well as the company’s current performance and its ambitions.
What areas to focus on?
The most important consideration is to select the right areas to focus on. In doing so, it is important to remember that ESG topics are a subset of non-financial indicators, which concerns environmental, social and governance issues, and should not be confused with other non-financial issues such as customer satisfaction.
A materiality assessment is the appropriate starting point to identify the most relevant ESG topics, as the identified material issues relate to different risks and opportunities for the company. Which of those materialities to focus on, will depend on the company’s sustainability maturity and ambitions.
How many targets to select?
While several targets could be set for each identified selected material issue, this could quickly lead to an exaggerated, unmanageable number of objectives.
The Food & Staples Retailing industry presents two best-practice examples to resolve this challenge:
The appropriate methodology will depend on how the company can select specific KPIs, without losing sight of the broader sustainability objectives.
What kind of targets to use?
Companies can then decide to set targets based on inputs or outputs. Input KPIs are based on the resources used to yield to an outcome (e.g. share of renewable energy consumed, or number of hours spent in employee training & development), whereas output KPIs are based on the outcome itself (e.g. employee engagement or Scope 3 GHG emissions).
While input KPIs might be easier to assess, they are less powerful than output ones, as they do not focus on the result. However, output KPIs are more challenging to set given measurement difficulties: Scope 3 emissions are still challenging to collect upstream and downstream, and employee engagement might depend on the survey and on the respondents.
The kind of KPIs to be used depend on how to best measure the desired outcome. The solution may be to include a combination of input and output-based KPIs.
What to link the metrics to?
Companies are connecting ESG metrics to short-term, annual bonuses or long-term incentive plans (LTIP), and sometimes even both. What to connect the metrics to, will depend on the time horizons previously defined for the targets.
While some targets can and should be measured on the shorter term, for example those linked to occupational health & safety, some are more effective on longer-term horizons, such as those linked to reaching net-zero carbon emissions goals. This largely depends on the speed at which results can be achieved, but it is preferred to use shorter-term horizons to ensure focus is maintained.
For instance, DSM includes ESG metrics as both part of its Short-Term Incentive (STI) and its Long-Term Incentive (LTI) plans. Metrics part of the STI include sustainability solutions (Brighter Living Solutions), safety performance, and employee engagement, while metrics part of the LTI include energy efficiency improvement and the reduction of GHG emissions.
The upside of connecting ESG targets to the LTIP are that it enables companies to showcase commitment for long-term performance of the issue, and that the effects of several topics are only demonstrated on a longer-time horizon. However, the downside may be the need to revise ESG targets to align with evolving needs, and performance. Tying performance on ESG to the annual bonus is therefore more common, although it may be less effective for some topics that require setting a longer-term horizon target.
How to calibrate the targets?
The final struggle is to determine how to set thresholds and measure performance. This can be done relative to peer performance, based on ESG ratings or determined by the company itself. The appropriate methodology depends widely on the company profile, and should be selected with caution given the pros and cons of each methodology.
It is also possible to combine the methodologies. For instance, Unilever’s Sustainability Progress Index (SPI), used to determine part of the long-term incentive plan, considers both performance on ESG-ratings (e.g. achieve Leader/A ratings in five ESG ratings including DJSI and CDP) and on objectives set by the company itself (e.g. increase share of recycled plastic material in packaging, and reduce CO2 emissions from energy from factories per ton of production).
More details on the considerations to account for in connecting ESG to executive remuneration can be found in the download.
If you would like to know more on this topic, get in touch with Johana Schlotter, at firstname.lastname@example.org or call +31 6 28 02 18 80 to hear about how Finch & Beak can support you in effectively connecting ESG to your executive remuneration and accelerating your sustainability strategy.