Skip to main content
Article | Executive Pay Memo – UK

Can including ESG metrics in remuneration arrangements have a positive financial impact?

Compensation Strategy & Design|Executive Compensation|Total Rewards
N/A

By Manuel Montecelos and Manuel Cervera | June 10, 2020

We discuss how an ESG strategy could have a positive impact on your financial performance and why it is essential to include it in your performance management system.

In his influential annual letter to chief executives, Larry Fink, the CEO of BlackRock, the world´s largest money manager, said that “climate risk is investment risk”.

Last September, when millions of people took to the streets to demand action on climate change, many of them emphasised the significant and lasting impact that it will have on economic growth and prosperity. Mr Fink stated that “the evidence on climate risk is compelling investors to reassess core assumptions about modern finance”.

In his letter, Mr Fink set out BlackRock´s strategic line for forthcoming annual general meetings (AGMs) as follows: “…we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them”.

But he is not alone. Cyrus Taraporevala, chief executive of State Street Global Advisors, wrote in a letter to boards ahead of the 2020 proxy season that the asset manager will take voting action against board members at companies in major global indices that are laggards based on their ‘R-Factor’ scores and cannot articulate how they plan to improve their environmental, social and governance (‘ESG’) score. The R-Factor scoring system was launched in 2019 by State Street Global Advisors to measure company performance in business operations and governance related to financially material and sector-specific ESG issues.

According to a survey conducted in the United States by Morgan Stanley (The Economist 2017), 75% of millennials agreed that their investments could influence climate change, compared with 58% of the overall population. They are also twice as likely as investors in general to invest in companies that espouse social or environmental objectives.
Impact Investment Drivers: The increasing influence of millennial investors

Gary Retelny, chief executive of ISS, has said that the company is typically supportive of resolutions which ask for more ESG disclosure from companies, believing it is important for shareholders to know what was going on at businesses. “We are very big on long-term shareholder value. That is the lens through which we evaluate many of these things,” he said (Financial Times, 8 February 2020).

In this context, companies aware that ESG criteria are going to be a set of standards for a company’s operations that many investors will use to screen potential investments. For this reason, companies have decided to include or increase the weighted of sustainability metrics in their remuneration systems.

Investors are not only expressing their desire to invest based upon a company’s reaction to ESG, but are also specifically asking Boards to be both proactive in considering ESG in their long-term strategy and sufficiently active in implementing and disclosing progress in the short term.

89%
of investors say that the inclusion of sustainability metrics in variable pay is important in both annual and long-term incentive plans.

The Institutional Investor Survey for 2019 shared by Morrow Sodali showed that 89% of investors say that the inclusion of sustainability metrics in variable pay is important in both annual and long-term incentive plans.

A significant number of companies now set ESG measures within their incentive plans, but few give them the importance it deserves. 50% of S&P 500 companies incorporate ESG goals in their annual incentive plans, according to data compiled by Willis Towers Watson’s Global Executive Compensation Analysis Team (Figure 1).

Alt text - S&P 500 use of ESG metrics, overall prevalence and how ESG measures are incorporated into annual incentive programs
Figure 1. S&P 500 use of ESG metrics.

Source: Willis Towers Watson, Global Executive Compensation Analysis Team (GECAT)

But the key question that is being raised by companies is whether a long-term sustainable growth (ESG focus) strategy will have a positive impact on their financial results or whether it should be considered only as a temporary trend.

And this has tended to be a hard-to-find answer …until now, because:

  • Organisations that have high ratings for inclusion and diversity scores are 70% more likely to have success in new markets, and 45% of them are more likely to improve their market share (‘The Global Talent Competitiveness Index 2018’. The Center for Talent Innovation, 2018).
  • Researchers from the Peterson Institute for International Economics conducted a global survey of financial and governance data from 21,980 publicly traded firms across 91 countries. The study revealed a positive correlation between the presence of women in senior leadership and profitability - defined as gross margin and net margin (‘Why Diversity and Inclusion Matter: Financial Performance’. Catalyst, 2018).
  • 85% of CEOs of organisations which have an inclusion and diversity strategy say it has improved their bottom line (CEO Survey. Price Waterhouse Cooper, 2015).
  • Purpose-driven companies outperform the market by 42% (MarketWatch, 2019).

A global study of employee engagement conducted in 2016 by Gallup determined that 87% of employees worldwide are not engaged in their work and that companies with highly engaged workforces outperform their peers by 147% in terms of earnings per share.

But how is employee engagement linked with ESG strategy?

A study performed in 2016 by Cone Communications determined several key findings:

  • 64% of employees feel their professional and personal spheres are becoming increasingly blended.
  • 93% of employees want to work for a company that cares about them as an individual.
  • 75% of employees say their job is more fulfilling when they are provided with opportunities to make a positive impact at work.
  • 70% of employees would be more loyal to a company that helps them contribute to important issues.

According to this study, ESG investment is also a significant consideration for candidates when deciding which job to take. Responses indicated that:

  • 58% of employees consider a company’s social and environmental commitments when deciding where to work.
  • 51% of employees won´t work for a company that does not have strong social and/or environmental commitments.
  • 55% of employees would choose to work for a socially responsible company, even if the salary offered was lower.
58%
of employees consider a company’s social and environmental commitments when deciding where to work.

Beyond the perspectives of investors and employees, companies that decide to invest in ESG could see their financial results improve. Cone Communications’ corporate social responsibility (CSR) study, carried out in 2017, revealed that:

  • 87% of consumers will have a more positive image of a company that supports social or environmental issues.
  • 92% of consumers will be more likely to trust a company that supports social or environmental issues.
  • 88% of consumers will be more loyal to a company that supports social or environmental issues.
92%
of consumers will be more likely to trust a company that supports social or environmental issues.

But ESG is also about a more sensible approach to risk management

  • According to the World Economic Forum’s Global Risks Report in 2019, failure to mitigate and adapt to the impact of climate change is the number two top global risk (after weapons of mass destruction!). From the environmental point of view, companies are exposed to physical risks derived from how climate change impacts exposed populations, assets and systems (e.g. the increase in frequency, duration and severity of extreme weather events and how this impacts on infrastructure, assets and business continuity, plus the impact of slower-onset risks, such as rising sea levels). Companies are also exposed to transition risks derived from the move to a low-carbon, climate-resilient economy (which can either be reputational risk and/or increased pressure from public opinion, policy, regulators and investors, or it can be risk relating to the need to re-define business models).
  • Failure to comply with requirements relating to fair pay, equal pay, discrimination versus fairness, and transparency will also trigger risks and bring financial cost.
  • We can all recall BP’s spill back in 2010, and the impact this had on the company’s share price. Has it been able to recover? And some of the issues arising from the financial sector crisis and related scandals could have been mitigated or avoided altogether had stronger governance frameworks been in place. As it stands, though, reputational damage to the industry has yet to recover, and share prices in the industry are still affected.

The world is changing. People are changing. The speed of change is accelerating because of the impact of younger generations. Individuals want to feel that they personally contribute to society in a positive way, whether as an employee, a consumer or as an investor. The worldwide sentiment is that “we can (and must) do better”, and this is what ESG captures.

Willis Towers Watson’s view

Competition is fierce everywhere. Individuals can choose between many offers in products, services, jobs and investments. Why would they choose the non-ESG one? Could you, as a company, beat an environmentally and socially well-governed competitor just by having lower prices? How much higher would the returns you deliver need to be in order for your offering to be preferred over that of a sustainable competitor? How much would you have to reduce your margins or lower your prices to offset ESG-based competition? Wouldn’t it pay to start now and pioneer the change towards a better world within good business results? Will you be able to attract the best talent without an ESG strategy? Can you retain your employees without considering ESG factors?

No one says it will be easy, but we can work together to help you achieve your aims.

  1. Listen to your customers, to your investors and to your employees.
  2. Observe what is happening in the market and what your competitors are doing.
  3. Consider how ESG is going to add value to your organisation and build this into your strategy.
  4. Consider what can/should be done within remuneration arrangements to support your ESG approach.

For more information, please contact the authors:

Authors

Senior Director, Executive Compensation Practice Leader, Western Europe

Senior Associate – Executive Compensation, Western Europe

Contact Us