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Linking Executive Remuneration and Incentives to ESG: Are We Asking the Right Question?


Expert insights from Dr Margaret Cullen, Founder and Principal, Think Governance Ltd., and Board Assessor, IoD Ireland. This blog has been written exclusively for IoD Ireland members.

In my last article (‘Keeping Governance Front and Centre: Don’t Put the Cart Before the Horse in Considering ESG’ , June 2020) for the Institute of Directors in Ireland on ESG, I wrote about the importance of keeping the “G”, governance, front and centre and of the danger of narrowly defining G. I wrote: “In interpreting ‘G’ there is a strong tendency to focus on governance form as proxies for governance effectiveness: e.g. independent non-executive director (INED) majority on the board; ‘appropriate’ gender and cultural diversity on the board; separation of the roles of chair and CEO; and remuneration structures that demonstrate alignment between executive pay and shareholder value creation.” In this article, I want to pick up the discussion with a focus on executive remuneration and incentives, institutional investor say on pay and the move to integrating ESG into the remuneration mix. 

Agency Theory

Agency theory has long dominated the corporate governance literature and influenced so much of regulatory policy and governance best practice guidance. In simple terms, agency theory identifies and applies solutions or mechanisms to solve the agency problem. The agency problem arises from the separation of company ownership and control. As far back as 1776, Adam Smith observed that: “The directors of companies, being managers of other people’s money, cannot be expected to watch over it with the same vigilance with which they watch over their own [1].” Agency theory looks at corporate governance practices and behaviours through the lens of the agency problem and perceives the governance relationship as a contract between shareholder (the principal) and directors (the agent). The conceptual underpinning of corporate governance codes around the world and the demands of company law for checks and balances is the need to respond to the agency problem. We have become accustomed to governance mechanisms that seek to address the problem such as independent board structures and the separation of the role of chair and CEO. The remuneration of executive directors as a mechanism to align the interests of managers with the interests of shareholders, long promoted by agency theorists, emerged in the US in the 1990s and quickly spread to Europe. The concept of variable pay, and particularly long-term incentive plans (LTIPs) as a mechanism to incentivise managers to maximise shareholder wealth was born and the rest, as they say, is history. 

Shareholders Rights Directive

Related to executive remuneration as a governance mechanism is the concept of investor say on pay, both binding and non-binding. The Shareholders Rights Directive (Directive (EU) 2017/828) (“SRD II”), for example, seeks to encourage long-term stewardship and a move away from an emphasis on short-term performance. To this end, asset managers will now have to make certain disclosures publicly outlining how they engage with investee companies. SRD II will give shareholders two annual general meeting (‘AGM’) votes in relation to director pay arrangements: Remuneration Policy (“Your licence to pay”): At least every four years, companies will be required to put a comprehensive policy on all elements of compensation for executives for shareholder approval. Once approved, pay arrangements must be operated in line with this policy, until a new one is approved.
Remuneration Report (“What happened in the year”): Every year shareholders will vote on the Remuneration Report, which will describe how executive pay arrangements were governed in the company. For example, the report will include details of performance achieved and how short- and long-term incentive outcomes were aligned with this.

Principles of Renumeration

The Investment Association’s (IA) Principles of Remuneration is a useful proxy for investor (asset owner/asset manager) expectation in this space. The IA maintains a public register, which is the world’s first register tracking companies in the UK FTSE All Share that have received significant opposition by shareholders to a resolution (written statements by a company’s board of directors detailing a binding corporate action), or any resolution withdrawn before a shareholder vote. It identifies which companies are acknowledging shareholder dissent and how they are addressing their shareholders’ concerns. The UK Corporate Governance Code (2018) requires an update statement from companies within six months of the shareholder meeting.  

ESG Criteria

Executive pay awards have traditionally focused on financial metrics, such as relative total share return, earnings per share, share price performance or revenue growth. The level of capital flowing into funds that incorporate ESG criteria have grown considerably over the last few years so what was once an issue on the fringes of investment is becoming part of the material financial analysis of a company’s value. Not surprisingly, attention has now turned towards ESG-linked pay and the role it can play in incentivising and rewarding ESG performance by companies and their executives. The inclusion of non-traditional metrics for pay comes as investors, politicians and the wider public pile pressure on companies to consider their wider societal impact, particularly since the pandemic started and the Black Lives Matters protests last year. In its Remuneration Principles for 2021, the IA asks remuneration committees to consider including strategic or non-financial performance criteria in variable remuneration, for example, related to ESG objectives. Per the guidance, ESG measures should be material to the business and quantifiable. In each case, the link to strategy and method of performance measurement should be clearly explained. The IA note that the impact of ESG risks on long-term value of companies is becoming increasing apparent with companies incorporating management of material ESG risks and opportunities into their strategies. The IA consider it is appropriate for the remuneration committee in these cases to consider the management of these material ESG risks as performance conditions in the company’s variable remuneration, clearly linked to the implementation of the company’s strategy.

The UN Principles for Responsible Investing (PRI) [2] have long considered that ESG-linked pay can be an important tool to drive value and better sustainability performance. In its 2016 paper, ‘Linking ESG into Executive Pay’ [3],  it notes that “linking environmental, social and governance (ESG) performance to pay can help hold executive management to account for the delivery of sustainable business goals”. In a recently published paper [4] , the PRI examines the academic evidence around ESG-linked pay and the role it can play in incentivising and rewarding ESG performance, gathering insights from a literature review conducted by academic researchers. The studies examined as a part of this review, according to the paper, signalled strongly that ESG-linked pay is indeed value-enhancing for companies. The PRI expect to see more examples of ESG-linked pay where companies are looking to prove a point around their commitment to sustainability. This could be companies that already have a strategic focus on sustainability, i.e. those that have good records of ESG performance and are incentivising further improvements by tying their executive rewards to these factors. This could also be companies that are embedding ESG-linked pay for signalling ESG commitment, i.e. those that want to be perceived as sustainable because the industries in which they operate are vulnerable to stakeholder pressure or regulatory changes.

Executive Renumeration as A Governance Mechanism

In my classes, I have long since challenged the preponderance of executive remuneration as a governance mechanism and, particularly, the emphasis on the need to incentivise the behaviours and/or the outcomes we want from management. Drawing on academic research in the organisational psychology and behavioural literature, I have encouraged students to consider the unintended consequences of such structures and challenged them to reflect on their necessity. As regards unintended consequences, we have plenty of evidence. The surge in stock option schemes in the 1990s in the US led to a proportionate surge in restatements of annual accounts by listed companies in the US (Winter 2010 ) [5]. The 2007-08 financial crisis focused attention on cash bonuses and the asymmetry between risk and reward engrained in cash bonus and long-term incentives schemes. Turning to whether incentives are necessary, Fehr and Gachter [6] (2000) have argued that without explicit incentives, agents perceive their contracts to contain an implicit obligation to provide efforts based on social norms of cooperation and reciprocity. They argue that once an explicit incentive is introduced the perception may shift to the understanding that effort is only required because of, and according to, the incentive, and the social norms as a basis for providing effort are forgotten. 

Cuevas - Rodriques et al, [7] (2012) , offer insights to managers about how intrinsic incentives may provide an alternative mechanism of control over agents’ behaviour to extrinsic behaviour prescribed by agency theory. They argue that intrinsic incentives of (i) personal satisfaction and (ii) identification with organisational objects combined with (iii) implicit social obligations and reciprocity may, under certain circumstances, provide stronger restraints on agent opportunism, if it exists, than the use of traditional extrinsic rewards in the form of incentive alignment.

The PRI’s recent paper prompted me to further reflect on this literature and whether professional bodies, NGOs and/or governance guidance is asking the right exam question when it comes to executive pay and environmental and social aspects. We all appreciate the importance of quality leadership within an organisation. I argued in my last article for IoD Ireland that the task of establishing core values such as what a company stands for, and doing this in a manner that takes into account concerns across and within heterogenous stakeholder groups, is the governance challenge.  

Modern day boards and executive management must be capable of managing multiple masters and proving that value and values are not mutually exclusive. We are so beyond the perception of the governance relationship as a contract between shareholders and executive directors. Alongside the Paris Agreement sits the UN’s Agenda 2030, at the heart of which sits 17 Sustainable Development Goals (SDGs) which lay out a path to end extreme poverty, fight inequality and injustice, and protect the planet. If we need to incentivise company leaders or “hold executive management to account” to direct companies towards achievement of the 17 SDGs, are these the right leaders to effect the enormous sea change needed. In addition, given the socio-economic divides that exist in our world, surely the inequalities exposed by the pandemic and the volume of public money used to protect large businesses could strengthen the argument for measures to contain top pay and re-balance extreme income differences. According to recent research by the High Pay Centre in the UK [8], the median FTSE 100 CEO took home £2.69 million in 2020. This is the lowest level of median pay since 2009, and is a reduction of 17% from the median FTSE 100 CEO pay in FYE 2019, which stood at £3.25 million. 

This reduction, according to the report can be related to the reduction in variable pay arising from the pandemic. Notwithstanding the reduction, the median CEO pay of £2.69 million is 86 times the median earnings of a UK full-time worker in 2020 (£31,461). In 1995, this multiple was 45, reflecting the upward trajectory in CEO quantum related to executive remuneration and specifically variable pay as a governance mechanism. (The highest earning CEO made £15.45 million in 2020!) The High Pay Centre argues that these are still very generous rewards for individuals who have already made millions of pounds over the course of their careers, at a time when, in general, government support for the economy has probably been more important to the survival and success of the UK’s biggest companies than the decisions of their executives. 

It is for these reasons that I find the emphasis on linking executive pay and ESG outcomes somewhat contradictory. Surely what we need from company leaders now more than ever is an implicit obligation to provide environmental and social efforts based on the social norms of cooperation and reciprocity that Fehr and Gachter (2000) refer to as well as more emphasis on narrowing the socio-economic divides? Maybe we need a new exam question in this space? 


1. Adam Smith, 1776, The Wealth of Nations (abridged) 
2. UN Principles for Responsible Investing
3. https://www.unpri.org/download?ac=1798 
4. https://www.unpri.org/executive-pay/esg-linked-pay-what-does-the-research-say/7863.article 
5. Winter, 2010,  DSF Policy Paper No.5, Corporate Governance Going Astray
6.Fehr, Ernst, and Simon Gächter, 2000, Cooperation and Punishment in Public Goods Experiments, American Economic Review
7. Cuevas - Rodriques et al, 2012, Has Agency Theory Run its Course?: Making the Theory more Flexible to Inform the Management of Reward Systems, Corporate Governance: An International Review
8. https://highpaycentre.org/ceo-pay-survey-2021-median-ftse-100-ceo-now-paid-2-69-million/