Executive remuneration and ESG

United KingdomScotland

Environmental, social and governance (ESG) considerations are top of the agenda for many companies today. While ESG seeps into all aspects of business, executive remuneration is one of the areas that is beginning to address ESG concerns. Recent research found that three in five FTSE 100 executive bonus plans now have an ESG component, and with the adoption of ‘E’ and ‘S’ metrics in executive pay decisions globally doubling in recent years, the drive towards integrating ESG issues within executive remuneration is certainly not going to slow down any time soon.

This Law-Now is the seventh in our executive remuneration series, exploring why UK companies might think about linking executive remuneration with ESG and how they might set about doing this.

Why link executive remuneration with ESG?

We have identified five key reasons why UK companies should consider linking executive remuneration with ESG considerations.

1. Disclosure obligations

UK-listed companies are well-used to financial reporting and in recent years there has been an increased focus on remuneration-related disclosures with the Companies (Directors’ Remuneration Policy and Directors’ Remuneration Report) Regulations 2019 requiring them to report annually on board remuneration. This increased focus on remuneration-related disclosures has been coupled with an increase in ESG-related disclosure requirements. For example, a company with a UK premium listing is required to include a statement in its annual report on the extent to which the disclosures therein, including remuneration disclosures, are consistent with the recommendations of the Taskforce for Climate-related Financial Disclosures (LR 9.8.6R(8) of the FCA Handbook). Additionally, when considering and reporting on remuneration (among other things) a signatory to the UK Stewardship Guide is required to systematically integrate stewardship and investment, including material environmental, social and governance issues, and climate change, to fulfil its responsibilities.

2. Sustainability requirements

Looking specifically at sustainability requirements, the UK Corporate Governance Code is clear that sustainability should be meaningfully addressed by requiring the remuneration policies and practices of companies with a premium listing, whether incorporated in the UK or elsewhere, to be designed to support strategy and to promote long-term sustainable success (Principle P of the UK Corporate Governance Code). Additionally, under the Sustainable Finance Disclosure Regulation (SFDR) some financial institutions must also ensure that their remuneration policies promote effective management of sustainability risks, and, while the SFDR has not been adopted into UK law post-Brexit, it could still be relevant for financial institutions operating throughout the EU, while other companies may choose to use it as a guide for determining their disclosures. Finally, the purpose, beliefs, strategy and culture of signatories to the UK Stewardship Guide are intended to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society.

3. Transparency requirements

On the governance side, transparency requirements are pushing UK companies to be mindful of ESG when dealing with executive remuneration. The UK Corporate Governance Code obliges a company with a premium listing to establish formal and transparent procedures for developing remuneration policies and determining remuneration. Directors of such companies must also exercise independent judgement and discretion when authorising remuneration outcomes, taking account of company and individual performance, and wider circumstances.

4. Shareholder engagement

Perhaps one of the most compelling reasons to think about connecting executive remuneration with ESG measures is growing shareholder interest in ESG outcomes and shareholder engagement in remuneration. A recent survey found that 77% of British investors are likely to consider investing ethically and, globally, a 2021 report found that 88% of investors subject ESG to the same level of scrutiny as operational and financial matters. ESG is clearly a high priority for the majority of investors, and with annual reports on remuneration for UK-listed companies being subject to an annual advisory shareholder vote (s.439 Companies Act 2006) and there being a binding shareholder vote on remuneration policies every three years (s.439A Companies Act 2006), it is vital that executive remuneration reflects shareholders’ ESG priorities.

5. Public recommendations and strategies

Lastly, public recommendations and strategies may drive a UK company into tying together executive remuneration and ESG. The Investment Association’s Principles of Remuneration state that remuneration committees should consider including strategic or non-financial performance criteria in variable remuneration, for example relating to ESG objectives, and that they should be material to the business and quantifiable. The FCA’s current strategy also includes developing a policy approach to ESG remuneration within regulated firms.

How to link executive remuneration to ESG?

One of the most challenging aspects of linking remuneration to ESG objectives is setting objectives that are sufficiently clear, precise and measurable as to deliver the outcome that is sought by boards and investors. One of the most prevalent ways of doing this is to set ESG-KPIs that can be used as standalone targets for executive remuneration (much like financial targets), or as discretionary objectives for the remuneration committee to consider when quantifying executive remuneration.

ESG-KPIs tend to vary depending on the sector the company operates in. For example, financial services companies might focus on progress towards green financing commitments, whereas construction companies might focus on occupational health and safety. Nevertheless, there is plenty of choice for companies looking to implement KPIs in respect of each of the ‘E’, ‘S’ and ‘G’ components. In the ‘E’ sphere, typical KPIs include reducing carbon emissions, increasing the use of renewable energy, achieving net zero targets, or reducing food waste. Common ‘S’ KPIs relate to investing in communities, increasing leadership diversity, improving occupational health and safety and accessibility, staff education and training, and data privacy. ‘G’ KPIs are less common, but they are still important. These could relate to compliance, prevention of corruption and bribery, reporting and communication, or risk management. There are also KPIs that combine all aspects of ESG such as sustainable production and supply chains and responsible sourcing.

Future Perspectives

Looking ahead, strong public demand will require companies to be seen to be addressing ESG issues and demonstrating real progress. Many will need to look at their remuneration policies and practices through an ESG lens and, with ESG increasingly covering all aspects of business and regulation, linking executive remuneration to ESG considerations will be a “must have” for any company wishing to engage with ESG proactively and to promote itself as having done so.