Does linking ESG performance to bonuses actually work?

Linking executive pay to ESG targets is gaining traction across corporate America — but does it work? Here’s the AXA IM perspective:

As ESG becomes more popular among American investors, another trend also rises — financial incentives for CEOs to meet ESG goals. Linking ESG performance to pay can give companies the push they need to implement and sustain an ESG strategy, but opaque ESG criteria can be misused and do more harm than good. What’s the bottom line? Let’s dig in. 

Inside the ESG-linked pay trend

The most recent data estimates ESG targets can determine¹ of an executive’s incentive pay, primarily paid through bonuses. This practice is more common in Europe than in the United States. European companies have been producing sustainability reports for several years due to increased pressure from local governments and European regulators. Likely, European policymakers may soon mandate the adoption of climate-related metrics into executive pay.

This isn’t to say that American investors are out of touch with the importance of linking ESG strategy to executive compensation, however. Sixty-nine percent of U.S. institutional investors² place more trust in a company that connects ESG performance to executive pay, a 17 percent year-over-year increase. In 2021, 25 percent of all U.S. companies³ featured some form of an environmental or social metric within their executive incentive pay plans — up from 16 percent in 2019. In 2020, around 53 percent of S&P 100 companies in the U.S. included ESG criteria in executive pay packages, which appears to have impacted the pay practices for smaller companies, given that 25 percent of all U.S. companies incorporated such targets in 2021. These statistics suggest that U.S. interest in ESG incentives is evolving to match the preferences of global investors. 

Although ESG-linked pay is gaining traction in the U.S., widespread adoption still isn’t a sure thing. Notably, the recent Supreme Court ruling limiting the Environmental Protection Agency’s ability to fight climate change only heightens current stakeholder tensions and could potentially halt any encouraging ESG progress the U.S. market has made in recent years.

The pros and cons of ESG-linked pay

Across the board, ESG-linked remuneration policies incentivize management teams to build ESG objectives into corporate strategies. For companies that already have an established sustainability strategy with targets and timelines, ESG-linked pay can give executives or stakeholders the push they need to monitor the achievement of key objectives. Linking ESG performance to executive pay can also inspire executives and stakeholders to take a more active role in fighting climate change, furthering social equality, and adapting corporate structures to reflect these initiatives as priorities for the organization.

However, there remains the distinct possibility of firms hitting ESG targets while missing the larger point. Since linking executive pay to ESG performance is a relatively new trend, some companies may only implement it as a way to “check off boxes” and please eco-conscious investors. Also, recent research indicates that corporations pay 10 to 15 percent higher⁴ for targets they are more likely to hit. Sustainability goals can be miscast as a license to justify discretionary payout packages, rewarding executives for taking actions that fail to drive any stakeholder value. The best way to drive real change is to include relevant, verifiable, and material ESG elements into all remuneration policies, a crucial part of our work at AXA IM.

The AXA IM perspective

At AXA IM, we believe that — when executed thoughtfully — linking ESG performance to executive pay can be a win for all parties involved. Including appropriate ESG criteria in executive pay signals a commitment to ESG strategy. Once potential investors see these actions' positive effects, they may be more inclined to invest.

The following guidelines can help companies keep ESG-linked pay policies ethical, sustainable, and effective:

• Focus on tangible and measurable ESG criteria that are relevant to corporate activities and objectives
• Integrate ESG criteria in short- or long-term remuneration with short-term ESG objectives in the STI and longer-term ESG objectives in the LTI
• Periodically realign incentives to reflect evolving investor expectations and changes in investors’ desired outcomes.

Any metrics referenced should appropriately measure a company’s activities and business within its specific sector to optimize the benefits. For an oil and gas company, for example, relevant benchmarks might include reducing GHG emissions or a reallocation of CAPEX to more environmentally-friendly energies. On the other hand, a bank might commit to an increase in social action or green loans to finance net zero buildings as part of its ESG strategy. By aligning incentives, ESG-linked pay can have a positive incentive effect on corporate ESG strategy.

Sustainability should be everyone’s top priority. If linking ESG performance to executive pay helps us move the needle, it’s our duty as investors to make this practice as transparent and ethical as possible. Contact our team of experts today to learn more about how AXA IM’s voting policies support our mission.