Executive remuneration packages are increasingly linked to ESG targets. This trend will only grow.
This article is part of our 2021 Global Bank Review – ESG: Creating a purposeful future, an annual publication by our Global Banks Sector Group which brings together our people who live and breathe banks.
The importance of linking executive pay to ESG goals
Executive remuneration has traditionally been tied to financial benchmarks such as earnings per share and total shareholder return. ESG measures, in contrast, were largely limited to companies in the energy and extractive sectors, where the clearer link between ESG and business strategy made it easier to set quantifiable targets that could be explained to investors.
However, increasing expectations from investors, regulators, employees and the public that businesses will operate in a socially conscious way has seen ESG metrics gradually introduced into executive pay, including in the banks sector. A recent Bloomberg survey found most of the 20 major European banks responding were either working on, or already had, models linking remuneration to performance on sustainability targets. Examples include HSBC, where variable pay is linked to cutting carbon emissions and helping clients do the same, and UniCredit, where 10% of executive pay scorecard depends on ESG ratings and customer/employee satisfaction. French bank BNPP has also announced that 20% of the management team’s variable remuneration is linked to ESG benchmarks.
“The institution’s remuneration policy for all staff should be consistent with the objectives of the institution’s business and risk strategy, including environmental, social and governance risk-related objectives, corporate culture and values...”
EBA Remuneration Guidelines, 2 July 2021
Meanwhile, regulatory pressure to sync remuneration to ESG goals is growing. For example, the EU is considering including the link between executive pay to ESG as part of its taxonomy of sustainable activities. In addition, banks will need to publish information on how they factor ESG risks into remuneration, so next year’s annual reports will make interesting reading. The European Banking Authority’s guidance has also been updated this year to include a reference to ESG.
There is a similar, accelerating drive to link executive pay to ESG metrics in the US and APAC regions. A recent Deloitte review showed around 40% of Fortune 100 companies had incorporated some form of ESG yardstick into their executive incentive plans. Likewise, a recent study of 60 banks by Compensation Advisory Partners found a third of the canvassed institutions included some diversity and inclusion factors in their executive pay plans. In Australia, meanwhile, roughly 30% of executive pay in ASX-300 companies has some link to ESG performance. In Asia, there has similarly been increased interest from regulators across the region; a 2020 Willis Towers Watson survey found seven in ten companies interviewed were considering introducing ESG targets for executive incentive plans over the next three years.
What should banks consider when including ESG metrics?
“The weighting of ESG benchmarks against financial metrics remains a moot point among investors.”
Key considerations when looking at ESG benchmarks for remuneration are ensuring a clear link to strategy; that chosen metrics can be easily explained and measured; and that those areas expected to have long-term impact on sustainable value creation are identified.
Banks should also consider the timeframe over which ESG factors must be measured when assessing how social considerations can be applied to variable remuneration. For example, diversity, inclusion and well-being may be more suited to short-term remuneration while environmental goals will likely support longer-term arrangements.
How much weight should ESG metrics carry?
“Increasing expectations from investors, regulators, employees and the public that businesses will operate in a socially conscious way has seen ESG metrics gradually introduced into executive pay, including in the banks sector.”
The weighting of ESG benchmarks against financial metrics remains a moot point among investors. While many recognise the benefit of incorporating ESG into pay structures, there are differing views on how such metrics should impact pay. Most institutional investors contend that the majority of remuneration should still be based on financial metrics and that a threshold of financial performance should be achieved before an award can be made. Others argue that ESG targets should only act as a modifier to incentive outcomes, rather than providing additional reward.
Banks should also consider taking different approaches for executive pay and the wider workforce. The Bloomberg survey reported that one European bank, which ties bonuses for the wider workforce to sustainability and earnings, paid bonuses to the workforce last year despite business objectives being missed, because the bank hit its ESG targets. A great result for the workforce but one would expect investor protests if the same result applied to executive pay.
The bottom line
Expectations of linking bank remuneration to ESG are here to stay. However, the questions of what metrics are appropriate and what value should be linked to social objectives remain a moving target. Ultimately, while ESG metrics are important, the dominant focus of investors remains financial performance… for the foreseeable future. Companies need to find a way to balance such potentially conflicting aims, whilst being aware that non-financial metrics will continue to move further to the core of executive compensation packages.