Q&A | ESG-Linked Compensation: Getting Started, Common Metrics, and the Role of Banks

Posted on July 14, 2022

Upasna Handa
Upasna Handa
Senior Associate, Product Commercialization for Second-Party Opinions
Morningstar Sustainalytics
Morningstar Sustainalytics
In part 1 of our Q&A with Sustainalytics’ Upasna Handa, Senior Associate, Product Commercialization for Second-Party Opinions, we covered why it is important for companies to tie their executives’ compensation to ESG metrics and what is motivating them to go down this path.

In this second part, we get into specifics about how companies initiate this process, the kind of metrics that are most widely used, and how companies initiate the process of tying executive compensation to ESG performance.  

Sustainalytics: What specific metrics are companies using to align executive compensation to ESG performance? 

Upasna Handa: There are some common themes that companies are exploring ​to align executive compensation with ESG priorities.

When it comes to the environment, for example, some of the most used metrics include reducing CO2 emissions by a predetermined date; achieving net carbon neutral emissions across a company’s global footprint; linking a percentage of bonuses to non-financial metrics, such as carbon dioxide reduction; cutting electricity consumption in buildings; and switching to 100% renewable energy on a specific timeline.

As far as metrics related to social and governance factors are concerned, these include diversity, equity, and inclusion targets; for example, increasing representation in managerial roles of women, Black, Latin, Indigenous, and multiracial employees or increasing the diversity of candidates in the promotion pipeline.

SUST: How do companies start this process?

UH: Despite the growth in ESG-based incentive plans, many companies are still looking at how to adopt this executive compensation structure. Key challenges include clearly articulating MEIs, ensuring the board understands them, deciding on appropriate key performance indicators (KPIs), and measuring the success of ESG programs based on those metrics.1 Senior executives are at the center of identifying material ESG risks to the business and devising plans to manage that risk effectively.

To start, companies must communicate the nature of their business and sub-sector to help all stakeholders understand the ESG issues that have a meaningful impact on their business. Any KPIs selected must speak to material and relevant ESG issues and the related sustainability targets. They must represent significant improvements over the organization’s past performance and be comparable to external benchmarks available from science-based methodologies, as well as peer performance.2  Finally, companies must measure and disclose the targets in a meaningful way to ensure transparency and accountability for non-achievement.

SUST: Are financial institutions implementing ESG-linked compensation differently than other types of corporations?

UH: The themes for executive compensation program targets are similar for financial institutions and other corporations. However, banks’ ESG risk exposure comes mainly from the businesses they finance and enable through their lending and/or underwriting activities rather than their operations. 

SUST: How are financial institutions using ESG metrics to reduce negative impacts in their portfolios and among their clients?

UH: Banks and other financial institutions can enhance their lending portfolios by including ESG as a mainstream component in their sustainability strategy. Responsible lending sends a strong signal among the corporate sector looking to access capital. One of the ways this can happen is when banks prioritize loans and other lending instruments for companies with sustainability and ESG as a strategic commitment.  

To ensure that banks’ executive management is accountable, they can utilize sustainability-linked compensation as a KPI. Many banks already have ESG-based targets for themselves and for their clients. For example, at HSBC, executive directors need to cut the bank’s carbon emissions and help clients do the same. If they don’t reach their targets, their variable pay packages will be impacted.  

UBS and Deutsche Bank provide good examples of KPIs that aim to reduce the negative impacts of their lending portfolios.3 UBS, for example, aims to reduce absolute financed emissions associated with loans to fossil fuel companies by 71%. It also wants to reduce emissions intensity associated with loans to power generation companies by 49%, commercial real estate lending by 44%, and its general real estate lending portfolio by 42%.4 

As for Deutsche Bank, its KPIs are focused on reductions in the bank’s power consumption in its buildings, on the way to 100% renewable sources of energy by 2025 and increasing in its volume of sustainable financing and portfolio of ESG investments under management to over 200 billion euros by the end of 2025.5 

Additionally, financial institutions such as Allianz Global Investors and Cevian Capital are calling upon European public companies to start, or accelerate, the development of such ESG targets for integration into compensation plans to be put to shareholder vote at AGMs in 2022.6


For more insights on the state of ESG pay-links, why companies are introducing ESG-linked compensation, and how to get started, download our ebook,  ESG Accountability: Tying ESG Performance to Executive Compensation.


 

References

Willis Towers Watson. 2021. "ESG and Executive Compensation: Hearing from board members globally." July 12, 2022. https://www.wtwco.com/-/media/WTW/Insights/2021/04/ESG-and-Executive-Compensation-Report-2021.pdf?modified=20210419083740.

2 Sustainalytics Proprietary Data.

3 Segal, Mark. 2022. "UBS Ties Compensation of Top Execs to Sustainability Performance." ESG Today. July 12, 2022. https://www.esgtoday.com/ubs-ties-compensation-of-top-execs-to-sustainability-performance/

4 Reuters Staff. 2020. "Deutsche Bank to link management pay to sustainability targets." July 12, 2022. https://www.reuters.com/article/deutsche-bank-esg-change-suite/deutsche-bank-to-link-management-pay-to-sustainability-targets-idUSKBN28I08N

5 Bindman, Polly. 2022. "How banks link ESG to CEO bonus pay." Capital Monitor. July 12, 2022. https://capitalmonitor.ai/institution/banks/how-banks-link-esg-to-ceo-bonus-pay/

6 Bradford, Hazel. 2022. "Allianz Global Investors to push for executive pay-ESG link." Pensions & Investments. July 12, 2022. https://www.pionline.com/esg/allianz-global-investors-push-executive-pay-esg-link.


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