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The sustainability pay link

The Canadian Coalition for Good Governance represents Canadian investors managing $2 trillion in assets. The United Nations-supported Principles for Responsible Investment represents global investors managing $34 trillion in assets.

What do they have in common? Both believe executives should be rewarded for driving environmental, social and governance (ESG) performance that protects and creates long-term shareholder value.

The good news is that more companies are listening and acting. Unfortunately, outcomes have been mixed.

Globally, investment research firm Sustainalytics found that 16 per cent of large publicly traded companies considered ESG performance in setting executive compensation in 2012, up from 13 per cent two years earlier. In Canada, according to my own research on sustainable pay, that number is much higher, with nearly 60 per cent of companies listed on the TSX 60 providing incentives to executives who hit non-financial performance targets in 2012.

According to Corporate Knights’ Best 50 ranking, that number rocketed to 80 per cent this year (up from 56 per cent in 2010). This points to the obvious conclusion that sustainable pay incentives are becoming increasingly important in corporate Canada.

But underlying these metrics is a less compelling story.

In “Sustainable Pay,” a study I published in March 2013, it was found that only 13 per cent of the TSX 60 companies formally set annual sustainability targets for executive performance. And none of the TSX companies (and few global companies) include ESG performance in their long-term incentive plans.

Boards and their compensation committees are not setting pre-determined performance hurdles for executives to achieve, and they are overlooking the value that sustainability risk and opportunity management can bring to the corporate bottom line over time.

Also, they are failing to grasp the significance of sustainability impacts on their company or resulting from their company, as well as how sustainability will be critical to creating or protecting value over the medium term. Instead, it appears companies are largely treating sustainability performance as an after-the-fact bonus for chief executives – just another way to pay executive teams.

Another observation, particularly in Canada, is that sustainability performance metrics tied to executive pay are primarily directed at compliance, risk mitigation and value protection – not value creation. Top metrics were focused on safety and spill prevention. Few considered the opportunity side of the sustainability equation related to innovation, new products and markets, cost savings or customer acquisition. On the other hand, some global best practices see companies rewarding executives for achieving green product growth targets.

Arguably, the Canadian TSX 60 results reflect an overweighting to the extractives sector, which is necessarily concerned with compliance and risk mitigation. But how are boards rewarding proactive investments in social licence to operate and in stakeholder relations? Forward-thinking measures such as these might realize greater long-term benefits for companies and shareholders alike.

Finally, where metrics exist at all, they are nearly always backward looking. I came across few examples of forward-looking (leading) measures that assure boards their managers are placing careful investments to generate future performance results.

What explains this? We know there is a lack of agreed upon guidance for executive sustainability compensation. We also know that “pay for performance” – whether financial or non-financial performance – is a recent governance trend. The most popular performance indicators continue to be profit and executive performance goals for short-term incentives and total shareholder return for long-term incentives.

Finally, it’s clear that peer normalization plays a very strong role in determining executive compensation. The practice of engaging compensation advisors to benchmark comparable companies results in copycat pay packages.

In my experience advising companies on sustainable compensation practices, I tend to come across the following limitations or constraints:

• The human resource managers who advise board compensation committees lack experience in setting sustainable pay metrics and are not familiar with the qualities of a good sustainable pay metric;

• Companies have not identified the ESG risks or opportunities material to their performance and thus lack an understanding of how sustainability practices can enhance shareholder value protection and creation;

• As the typical corporate strategy does not include relevant sustainability performance targets, ESG is not properly positioned in the corporate balanced scorecard and thus is usually sidelined by the compensation committee.

• Boards lack an understanding of stakeholder expectations and how sustainability mega-forces will affect their company, sector, value chain and region. They are ill equipped to determine top sustainability metrics that will enhance corporate prospects going forward.

So what does the future hold?

Sustainability think tanks like Corporate Knights will continue to rank companies on their sustainable pay practices, putting pressure on company boards to enhance their ESG compensation programs. With capital markets increasingly looking for rigorous ESG value protection and creation goals, expect more compensation packages to have clear, quantified and stretching ESG targets.

At the same time, global standards and guidelines on ESG pay will emerge and compel continuous improvement. ESG pay will then join excessive pay, referred to as quantum by investors, and equitable pay (vertical pay ratios) to create a triumvirate of non-financial pay issues for boards and their advisors to address.

In other words, expect sustainable pay to be on board agendas for many years to come.

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