Environmental, social and governance (ESG) performance is going to weigh more heavily in executive pay at more and more companies. This is a good development, but there are pitfalls. If such ESG indicators do not properly reflect the real value that a company creates in the long term, there is a risk of 'boilerplate' indicators.
CEO pay used to be based mainly on the extent to which they had achieved their financial performance. This has been increasingly supplemented with non-financial indicators, such as customer satisfaction and employee engagement. In recent years, we have seen the emergence of ESG indicators in CEO compensation packages, and that is a good thing. Although the results of PwC's 25th CEO Survey show that they still lag far behind more traditional non-financial indicators.
The emergence of ESG indicators in executive pay is in line with the Dutch code for corporate governance. This code states that executive pay must focus on the long-term value creation of the company. Moreover, the outside world (the stakeholders) is asking for it. ESG criteria in remuneration, for example, can be the litmus test for financial supervisors who must assess whether banks and insurers take climate change seriously. It is a very concrete way of closing the gap between 'doing' and 'saying' just for a critical audience.
Setting the right criteria and targets in executive pay, however, has its pitfalls. Remuneration committees that do not do this properly run the risk of assessing their CEO on so-called boilerplate indicators: 'standard indicators' that do well in an annual report or other external communication, but it is very doubtful whether they contribute to the desired long-term value creation. For ESG indicators in particular, the relevance is strongly related to the mission, values and business strategy of the company. A boilerplate approach is therefore not suitable and active communication with stakeholders will be necessary.
One of the main pitfalls is reward criteria that do not follow the strategy. An example is a CEO of a bank who is assessed on reducing the carbon footprint of this bank. While the biggest impact on reducing emissions can be achieved by changing the policy for financing companies that emit a lot of greenhouse gases. This doesn't mean that this bank should not strive to reduce carbon emissions. On the contrary, everyone should contribute to this, but the question is then whether this belongs in the business operations or is actually part of the strategy.
Another example is a CEO who is judged on the diversity on the board of directors, while the strategy is aimed at creating an inclusive culture in the organization. In this case the reward criterion distracts from the objective. In other words: objective met, but point missed.
With ESG indicators comes the complicating factor that there is a 'timing disconnect'. The word long-term value creation already says that companies do not achieve their ESG goals overnight. So indicators always relate to the path to the end goal. This applies not only to climate change and environmental pollution, but also to social goals.
A company that wants more women in senior and middle management must implement a good diversity policy in which women are given room to grow. That's where the performance criteria should be. Putting temporarily all energy into recruiting women from the labor market so that the CEO achieves the target is not long-term value creation without a corresponding policy to ensure that these women remain.
There must be a balance between financial and non-financial indicators. In an ideal world, the financial result is entirely dependent on ESG performance, but we do not yet live in that ideal world. ESG performance in this transition period is often still dependent on financial performance; especially since companies need some room in their financial performance to invest in ESG. In the recent past, we have seen examples of CEOs who performed fantastically on ESG, but ended up being pressured by shareholders due to disappointing financial performance.
Long-term value creation is different for every company. Each company (or industry) will answer the question where the most positive impact can be made for a broad group of stakeholders differently. There is no such thing as 'one size fits all'. So this also applies to criteria in executive compensation. ESG indicators, like financial indicators, must be achievable and measurable while being meaningful and challenging. Boilerplate indicators are not.
ESG objectives are not yet as well represented in the strategy of companies as objectives that are closer to day-to-day operations. The same applies to performance targets in CEO remuneration packages.
Most Dutch CEOs who participated in the 25th CEO Survey have included goals related to customer satisfaction, employee engagement and digitalization in their long-term strategy. These are goals that are linked to day-to-day business performance. Goals related to environmental, social and governance (ESG) are less well included in long-term strategy and also less included in compensation packages.