Is Tying Executives' Pay to ESG Performance Effective?

Is Tying Executives' Pay to ESG Performance Effective?

Offering financial incentives to achieve certain goals has long been a standard business practice, but applying the concept to sustainability performance is relatively new.

The Carbon Disclosures Project's 2008 report on the S&P 500 found that 29 percent of the companies that responded to the CDP survey had begun building environmental responsibility and climate awareness into executive incentives.

While the idea appeals to stakeholders, it presents several challenges to businesses.

"Companies are struggling with how to do this effectively to meet the needs of their stakeholders," said Jennifer Coulson, manager of corporate engagement for NEI Investments. Coulson moderated a panel discussion this week on linking executive compensation to corporate environmental, social and governance performance at the annual Ceres Conference, which was held in Oakland.

The discussion included Robert McCormick, chief policy officer for Glass Lewis, a prominent independent proxy advisory service that compiled a report on executive compensation and sustainability in 2010 called "Greening the Green."

"Any compensation metric is only as good as how it is used," said McCormick. The Glass Lewis studied compensation plans at publicly traded companies in the United States, United Kingdom, Australia, France, Germany and the Netherlands and found a lot of room for improvement.

The Glass Lewis review of long- and short-term compensation plans, as described by companies in standard regulatory findings, also determined that 29 percent of the firms disclosed a link between compensation and sustainability. Then the company went a step further in analyzing the disclosures by assessing the quality of those links.

Glass Lewis deemed 40 percent of the links as being "weak," meaning there was no specific percentage of compensation tagged to sustainability, although the compensation committee asserted that metrics related to sustainability are considered in determining executive compensation. Twenty-nine percent fell into the "medium" category, which covered firms that bundle sustainability metrics with others and disclose what percentage that group of metrics has in compensation calculations. Just under a third of the links, 31 percent, were considered "strong" for disclosing the percentage of the executive compensation that is linked to sustainability.

Glass Lewis' "Greening the Green" report included a case study of Intel, whose employee compensation plan is described on its website and in its corporate responsibility report, but not disclosed in its corporate filings.

Intel has factored achievement of environmental sustainability goals into its employee bonus program since 2008. The firm also ties ESG issues to compensation for senior executives. "Intel has had metrics for environmental progress since the 90s -- but they did not necessarily relate to the individual employee," said Michael Jacobson, director of corporate responsibility for Intel, who also participated in the Ceres panel.

The company considered how to make sustainability matter to all employees and decided "the answer is to tie it to pay," Jacobson said. The key to the success of such programs is to engrain sustainability and corporate social responsibility values into core of the company values and its mission, "and make compensation reflect it," he said.

Problems occur, however, when the metrics that are considered fail to capture the entire risk that companies have to mitigate, and when the criteria for rewards either do not set the bar high enough, or don't consider that a single catastrophic event can negate any other progress a firm has made in the areas of sustainability and ESG, according to the panel, which included Sandy Taft, the director of U.S. climate change policy at National Grid, and Scott Zdrazil, first vice president and director of corporate governance at Amalgamated Bank.

The panel pointed to Transocean Ltd.'s bonuses for executives within a year of the Deepwater Horizon disaster that left 11 dead and created a massive oil spill in the Gulf of Mexico. In a securities filing in April, Transocean called 2010 "its best year in safety performance," leading to renewed criticism of the firm.

Zdrazil, whose firm is an advocate of sound pay-for-performance programs, said essential questions for companies in tying compensation to sustainability and ESG issues include "What are you really rewarding?"

"Are you really saying, 'Congratulations, you got the job and if you don't violate the law you get your bonus?" he asked. And if so, he added, "Why are you rewarding executives for meeting minimal ethical and legal requirements?"

In another Ceres panel, Jonas Kron, vice president and deputy director of social research and advocacy for Trillium Investment, counted ill-considered CEO compensation plans among key risks for investors.

He drew an analogy to the incentive that reversed soaring mortality rates among the convicts England transported to Australia in the 18th century. Initially, ship captains were paid for each prisoner who boarded their vessels. The result was the ships were packed with as many convicts that could be jammed aboard and a third of them or more died. "This was the CSR scandal of that time," Kron said. Until captains were paid only for the transportees who walked off the ships, the convicts continued to die in droves.

In today's business world, Kron said, "we have to figure out how to pay the captains of these ships to be sustainable. If we give them short-term incentives, we're going to get short-term results."

Image CC licensed by Alex Proimos.