Firms that peg CEOs’ pay to ESG goals must be clear how it fits with their strategy

SHOULD a chief executive’s salary be bumped up if the company reduces its carbon emissions or improves on the gender diversity of its board? More companies are mulling this question – whether to tie their leadership’s salaries to environmental, social and governance (ESG) outcomes.

The answer isn’t just a simple yes or no, but involves a big “why” and “how”. Companies that choose to adopt “ESG-linked salaries” should focus not just on the act itself, but also examine how the practice fits into their broader strategy, and whether target fulfilment can be verified.

Poorly implemented ESG-linked pay is arguably worse than not even adopting the measure. Companies run the risk of having conflicting objectives, or even being accused of greenwashing.

ESG-linked salaries are generally on the rise in the region. In the Asia-Pacific, the proportion of companies that include ESG metrics in executive incentive plans rose to 77 per cent in 2023, from 63 per cent the year before, a recent study by financial-services company WTW found.

In Singapore, around 93 per cent of the 30 companies studied adopted the practice. The 30 companies included blue-chip listed companies such as Keppel and Singtel.

However, a separate study suggests that some Singapore companies tried, and then gave up the practice. The study noted a fall in the number of companies that linked their top executives’ remuneration to sustainability performance: The figure was 26 per cent in 2021, and 16 per cent in 2023, going by the latest edition of the Sustainability Reporting Review.

Identifying the right targets for ESG-linked salaries is a hurdle. Professor Lawrence Loh of the National University of Singapore (NUS), who helmed the review, said: “The key problem is measurement, as what is measurable may not be what is important. There is also a challenge in getting accurate data.”

Investors are also sceptical, and suspect that companies might incorporate meaningless, easy-to-hit ESG metrics – as a form of greenwashing, or worse, to enrich executive bonuses.

“In some cases, this is seen as a way of making it easier for executives to get some compensation,” said Shai Ganu, global leader for executive compensation and board advisory at WTW.

“A lot of compensation tends to be on hard financial measures, for which there is a perception that you have to work very hard. There may be some sceptics who view this as: ‘Are you just setting a soft target, making it easier to achieve these goals?’” he noted.

Ganu advises boards to spend “a lot of time and rigour” on setting their ESG targets, to the same extent that they would for financial targets. “You shouldn’t make these gimmick KPIs,” he said, in reference to key performance indicators.

The method to achieve the targets is also just as important as the fulfilment of the targets, said Koh Ping-Sheng, professor of accounting and management control at ESSEC Business School, Asia-Pacific.

For instance, if companies were to abruptly shift away from high-emissions suppliers without helping them to make the transition, it could have a negative social impact on the livelihoods of workers at the supplier – impacting the “S” in ESG.

“ESG compensation matrices may cause CEOs to focus on quantitative metrics at the expense of qualitative considerations. This can lead to them hitting the targets, but missing the point of having an ESG strategy in the first place,” explained Prof Koh.

Companies should also be mindful that more targets may not necessarily be better. They should infuse carefully-chosen targets into the corporate strategy, rather than fall into a mindset of “financial targets versus ESG targets”, he added.

Better disclosures

After careful implementation of ESG-linked salaries, companies need to communicate them well to investors. Many still fall short in doing so, noted Prof Loh.

“I think many companies are merely stating that there are linkages without specifying the details. There is a need for better disclosure of the precise breakdown in the governance portion of the annual report,” he said.

Echoing this sentiment, Prof Koh noted that it takes a “deep dive” into a company’s corporate reports to even find out if it is adopting the practice. “There is a general lack of transparency and wide variation in the disclosure of ESG-linked pay, and the underlying ESG matrices used,” he added.

He cited Singtel as a company that spells out the weightage of ESG-related KPIs and the issues taken into consideration – such as diversity and inclusion, ethical business practices, and data and customer privacy. Many others, however, do not offer such details.

To be sure, companies should not be expected to disclose their leadership’s compensation package in such granularity that it would impede competitiveness.

But at least disclosing the general metrics used would signal to investors that a company is serious about its ESG commitments, and not just engaging in “window-dressing”. It could also appeal to more ESG-minded institutional investors.

Industry watchers advise companies to approach this opportunity – but carefully. In a 2022 report, Professor Mak Yuen Teen of NUS noted: “Although linking ESG metrics to executive pay can be useful, it may also be counterproductive if not done well and end up boosting executives’ pay or shielding them from poor performance.”

He added: “Companies seeking to link ESG to remuneration policies should thus ensure that ESG integration is done hand-in-hand with the strategies, policies and practices of the business.”

Conversations about leadership salaries are understandably tricky, and ESG metrics add another layer of complexity. Each company will have to figure out for itself the “why” and “how” of ESG-linked pay.