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Article | Executive Pay Memo North America

Institutional investors and ESG in incentive plans: Agnostics or believers?

Governance Advisory Services |Executive Compensation|Environmental

July 30, 2020

Investors care about ESG, but what about linking environmental metrics to variable pay? An attempt to chart the uncharted in three observations.

For some time now, environmental, social and governance (ESG) metrics have been on the rise. New research by Willis Towers Watson shows that approximately half of the companies in the S&P 500 and nearly two-thirds of 400 companies in Europe’s top indices have at least one ESG metric in their incentive plans. The evolving standardization in ESG reporting, new governance codes, societal pressures and the COVID-19 pandemic are fueling the interest in ESG. It does not surprise that those European countries hit hardest by the financial crisis of 2007 – 2009 seem to be leading the way.

Investor pressure has played its part in making ESG a board-level topic. A Google search for Larry Fink‘s “sense of purpose” yields well over one million results. There are now over 3,000 signatories to the United Nations Principles for Responsible Investment (UNPRI). Investors that have signed the UNPRI account for more than $100 trillion in assets under management1. In the Harvard Business Review, Robert G. Eccles and Svetlana Klimenko note, “The impression among business leaders is that ESG just hasn’t gone mainstream in the investment community. That perception is outdated.”2 Tellingly, a client of ours was astonished when the market reacted to its new sustainability strategy with a 5% share price increase.

There’s little doubt that investors care about ESG. What the debate lacks is a clear view on institutional investors‘ practice regarding ESG in incentive plans. With responsible investment seemingly on all investors‘ minds, what about the link to variable pay?

We approach this question without a claim to comprehensiveness; instead, we have assembled observations and insights. These are not universally applicable to all institutional investors and are still evolving.3 We’ve included both asset owners and asset managers while acknowledging that the latter are much more likely to get into the details of company engagement, including issues of incentive plans.

As far as possible, we restrict the analysis to the E in ESG, as a) environmental issues, especially climate change, feature high among the systemwide ESG-related issues sovereign asset owners consider;4 and b) our consulting work indicates that E has become the center of the debate. That restriction is not always clear-cut, of course, as many investors‘ statements or guidelines do not distinguish between the environmental, social and governance categories. Some inputs, such as guidelines, are not specific to the E in ESG; others, such as engagement examples, are.

Observation 1: Advocating for ESG is mainstream; advocating for ESG metrics in incentives is less apparent.

Assessing if and to what extent investors use their influence to push companies to link ESG and compensation is difficult. Most debates take place behind closed doors, and there is a general sense that company engagement is not about dictating how a company should be run or being prescriptive about corporate strategy or policies.

A 2019 study found that for 32% (inclusion in short-term incentive plans) and 46% (inclusion in long-term incentive plans) of institutional investors, the inclusion of sustainability metrics is “very important”5 — a valuable indication, albeit one derived from an ESG-conscious sample.6 Recognizing importance, however, does not automatically mean advocating inclusion.

What about public statements? Most major institutional investors have not issued explicit guidelines regarding the linking of ESG measures to compensation. Among asset owners, there are few clear references to E metrics and incentives in voting guidelines and statements. The Government Pension Fund of Norway’s Climate Change Expectation Paper falls into this category.7 Others, like CPP Investments of Canada8 and the Japanese Government Pension Investment Fund,9 demand a long-term focus in incentive plans but leave it open as to whether this includes ESG. Among asset managers, public statements are more common.

Those that do not issue explicit guidance may take the view that as long as it is clear how ESG drives value and controls risks, it’s not needed in the incentive plan and that return measures suffice, as companies with stronger ESG practices will deliver higher returns over the long term.

Strictly based on the wording of their statements, those that do voice an opinion can be sorted into two categories:

  1. Investors that ask that “consideration” be given to ESG metrics, which include the Netherlands‘ civil pension fund ABP,10 the Investment Association (IA)11 and the Norwegian Pension Fund.12. Occasionally, these statements are phrased more strongly, such as ABP “urging” Shell to “adopt tangible [carbon] targets for the short and medium term and link them to executive remuneration.”13
  2. Investors that do not explicitly ask for “consideration” but simply articulate expectations with respect to metric design if the company should decide to incorporate ESG metrics: These include BlackRock14 and Newton.15

The picture that emerges is that investors are not on a broad scale prescriptive to companies with respect to ESG inclusion in incentives. Investor sentiment ranges from indifference to “qualified advocacy,” and it differentiates. As one of our European clients put it: “The focus of the investors is not just on financial metrics anymore, it is now on the link to the strategy. They were happy when we suggested inclusion of the greenhouse gas metric because it was linked to our strategy.”

Observation 2: Shared themes are emerging on how ESG metrics should be incorporated. Companies can derive guidance from them — within limitations.

In light of the above, it wouldn’t surprise if companies were lacking a clear view of investor demands when contemplating the idea of ESG metrics in incentives. Among the minority of institutional investors that clearly voice their opinion, however, five shared16 themes emerge. According to these, metrics should be:

  1. Linked to the strategy (Blackrock,17 IA18 )
  2. Material (BlackRock, IA)
  3. Quantifiable or measurable (BlackRock, IA, Newton19 )
  4. Auditable (BlackRock, Newton)
  5. Transparent (ABP, 20 BlackRock, Newton)

Some investors take care to safeguard the financial relevance of the metrics, implied in metric 2, more pronouncedly, for example by setting a “comply or explain” share for financial measures21 or voicing a “preference” for linking ESG goals to financial goals “so that ESG goals may not be achieved at the expense of financial success, and vice versa.” 22

The five themes illustrate the reason why we are not seeing (and are unlikely to see) all investors demanding a blanket integration of the same ESG metrics for all companies. Take climate change as an example: Eventually and indirectly all companies may be affected by it, but not all sectors and companies meet the materiality criterion.

The themes also touch upon the principal question as to whether investors are willing to accept a potential dent in short-term financial performance in return for the long-term benefits, and if so, to what extent? This is important for implementing ESG metrics in incentives, but so far it’s unclear. Paired with the more operational challenges of target setting and calibration (e.g., translating decade-long targets into incentive plan life spans or setting the performance corridor), it’s clear that introducing ESG metrics is a complex endeavor for companies.

The five themes, as an amalgamation of investors‘ stances as opposed to a joint declaration, are not an Ariadne’s thread out of the maze, but they do help steer initial thinking and increase the chances of investor support. At the same time, companies need to put in an effort to gain clarity on their investors‘ ESG views. In this respect, they are well advised to allow for more time and more dialogue with investors. With respect to the operational challenges, the key to success is sourcing input broadly — both within the organization and externally. Simply put, ESG incentive plans work best if the sustainability team and the rewards team work well together.

Observation 3: Investor sentiment differs by region. While Europe leads the way, progress is imminent in regions where one might not expect it.

Differences exist between regions with respect to the inclusion of ESG metrics, especially in the more advanced stage of European markets, and are not limited to listed companies. BlackRock‘s corporate governance guidelines, for example, explicitly mention ESG-type metrics 23only in the EMEA version of the document. The U.S. guidelines are silent on the topic. European investors also account for some of the most prominent examples of asset owners voicing their opinion on ESG metrics, such as ABP and the Pension Fund of Norway. At the same time, there is a growing trend in the U.S. as well: Linking executive compensation to “social issues, such as sustainability or social or environmental impact” was the most common type of compensation-related shareholder proposal in the U.S. last year.24 Not one proposal passed, but the average support was 24%,25 which is quite high for shareholder resolutions in the U.S.

Asia, interestingly, is also showing signs of progress. In Asia Pacific, institutional investors are exploring how they can influence companies to incorporate ESG metrics into their incentives. Such signs are less evident in Western Asia; however, four of the six founding members of the One Planet Sovereign Wealth Funds Working Group are from the fossil-funded economies of the Gulf. As the pieces gradually come together (most of the main Arab stock exchanges already publish ESG reporting guidance), Abu Dhabi, Dubai and Riyadh might soon too start debating the inclusion of ESG metrics into incentives.


For now, it seems that institutional investors are not being prescriptive or dogmatic with respect to ESG inclusion in incentives. Institutional investor sentiment on the use of ESG in executive pay ranges from indifference to “qualified advocacy.” It also differs by region. At the same time, five shared themes emerge for how companies can successfully incorporate ESG metrics. These can help steer companies‘ initial thinking and increase the chances of investor support but do not absolve companies from gaining clarity on their investors‘ ESG views.

R. Eccles and S. Klimenko, The Investor Revolution, HBR , May-June 2019
3 This paper is based on publicly disclosed information of the 30 biggest sovereign wealth funds, pension funds, US university endowment funds and asset managers, as well as informal discussions with clients and investors. Not included were proxy advisors.
4 ‘…governance issues tend to be prioritised over environmental and social ones. …[W]hile only sovereign wealth funds rank an environmental issue at the top…, all investors (except foundations) have it as a second or third issue. Climate change is the top green issue for most, followed by renewable energy.’, , State Street Global Advisors, How Sovereign Asset Owners Think About ESG, August 2019
Morrow Sodali, Institutional Investor Survey 2019,
Sample includes UNPRI signatories only
Norges Bank Investment Management, Climate Change Strategy — Expectations to Companies,   
8 CPP Investments, Proxy Voting Principles and Guidelines, February 2020
9 Government Pension Investment Fund, Annual Report 2018
10 ABP, Global Corporate Governance Framework, January 2019
11 The Investment Association Principles of Remuneration, November 2019
12 Norges Bank Investment Management, Climate Change Strategy — Expectations to Companies,
13 ABP, Annual Report 2018
14 BlackRock Investment Stewardship, Corporate governance and proxy voting guidelines for European, Middle Eastern, and African securities, January 2020
15 Assumption based on engagement with the British company Diageo in 2020; Newton Investment Management, Responsible Investment Q1 2020
16 Named by at least two institutional investors
17 BlackRock Investment Stewardship, Corporate governance and proxy voting guidelines for European, Middle Eastern, and African securities, January 2020
18 The Investment Association Principles of Remuneration, November 2019
19 Assumption based on engagement with the British company Diageo in 2020; Newton Investment Management, Responsible Investment Q1 2020
20 ABP, Global Corporate Governance Framework, January 2019; based on interpretation
21 BlackRock Investment Stewardship, Corporate governance and proxy voting guidelines for European, Middle Eastern, and African securities, January 2020
22 Assumption based on engagement with the British company Diageo in 2020; Newton Investment Management, Responsible Investment Q1 2020  
23 BlackRock Investment Stewardship, Corporate governance and proxy voting guidelines for European, Middle Eastern, and African securities, January 2020
24 Sullivan & Cromwell, 2019 Proxy Season Review Part 1 - Rule 14a-8 proposals; proposals up until July 12, 2019; submitted not just by investors
25 Sullivan & Cromwell, 2019 Proxy Season Review Part 1 - Rule 14a-8 proposals

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