- Start date
- 26 sep 2022
- 5 days
Develop an end-to-end perspective to corporate prediction in order to best support your decision-making processes.
Incorporating ESG targets into compensation plans for CEOs and top management teams (TMTs) is a encouraging innovation for companies. Despite the fact that some studies have cast doubt on the effectiveness of these measures, and consider them nothing more than symbolic gestures, the positive outcomes are numerous and substantial. If the compensation of top executives reflects the expectations of all stakeholders, the company minimizes the short-termism of its decision-making processes, enhances corporate governance, enjoys benefits as far as image, reputation, recognition and loyalty, and attracts and retains talent. According to a recent report compiled by Willis Towers Watson, 68% of the major international listed companies adopt ESG metrics in compensation plans for their TMTs. Curiously, Italy shows the same percentage as the international sample on this score: 27 out of 40 large listed companies (again, 68%).
Data clearly show that some choices are also shared by businesses in countries around the world. First, ESG metrics are linked to short-term cash bonuses. In fact, there are very few cases of adopting ESG targets in long-term incentive packages: around 5% for companies in North America, and less than 30% for European businesses. And despite the fact that ESG is inherently a long-term undertaking, this choice makes sense. A cash bonus has much more potential impact on behaviors than long-term incentives, which usually consist of stock options in all their various forms. And the price of a company’s stock also reflects its ESG performance. Second, the overall weight on the variable component of a person’s salary is around 15% to 20% of the total of the cash bonus. Even though we’re not talking about the majority, this percentage is not symbolic; it clearly conveys a push to modify behaviors and decision-making criteria adopted by companies.
But there’s one aspect of all this that gives us pause for several reasons. Looking at 2020 data, the incentives linked to ESG metrics in which bonuses were actually paid out at or above target hit nearly 70% internationally and over 80% in Italy. This is a far higher payout compared to financial objectives, which in Italy from 2017 to 2020 were only fully achieved in 30% of the cases. These figures seem to show a sort of managerial benefit linked to ESG targets. But all this is counterintuitive in light of the current situation, in particular the state of the environment, which hasn’t appeared to improve in recent years despite the ESG bonuses that listed firms have paid their TMTs.
So it would seem that the pay-for-ESG-performance link is very weak, and unsustainable in the eyes of the world. The situation calls for intervention, and in fact certain technical aspects should be upgraded. Here are some examples where there is room for improvement: in some cases targets use qualitative metrics that are too flexible (in particular with reference to the G in ESG); KPIs are not used for material aspects (as codified by external accounting boards); there are too few environmental objectives compared to social and governance-related ones. Essential in this regard is that standard setters evolve their thinking on international accounting practices.
But companies must make two changes to their philosophy, and do so right now. The first is to acknowledge the fact that companies don’t totally grasp the science underpinning all the aspects of ESG, which are vast and complex. Not true with economic sciences, where companies represent the foremost hubs of knowledge, knowledge which is essential to target setting, which in turn in a financial context is flawless. When companies set targets for EBITDA or free cash flow or net income, they know how to estimate with exact precision the level of difficulty these objectives represent, and the overall improvement in performance the company would see. Not so for ESG targets. Viewpoints are too divergent; rating methodologies are too dissimilar and disconnected; appreciation for ESG performance is still underwhelming in financial markets. This means that companies have to delegate ESG target setting to outsiders, and fully commit to initiatives such as the Science Based Target initiative (SBTi). The point is to come up with targets that are established in an independent and conscientious way, benchmarked to the improvement that not only the company, but its stakeholders and the world expect.
Using ESG metrics in TMT compensation must be the chance for a real shift in perspective (and this is the second commitment that companies are being asked to make today), taking on the viewpoint of value generated by the company for its stakeholders and for society at large, not the other way around (value generated for the company by its stakeholders and society at large). And this, even if the value generated for stakeholders can impact the value generated for shareholders. It takes courage to embark on the path of measuring impact at a company level, in other words, determining the monetary value generated for society as a whole. But without limiting this value to single projects, and instead taking an accounting perspective that encompasses the entire company. Because no KPI, as interesting as it may be, will serve to actually modify corporate decision-making criteria based on risk/return tradeoffs.
For both these commitments, there are monetary measurements based on simple, readily available metrics. We need to translate their impact into a comprehensive corporate metric that is monetary, accounting-based, simple and available, and use this in the incentive plans for TMTs.