The road to hell is paved with good intentions: ESG bonuses are a bad idea

Incentives have long been a focus of corporate governance, but the idea they could bolster not just governance but environmental and social goals is more recent. However, businesses in financial services and beyond are increasingly linking executive remuneration to ESG targets.

Banks including Barclays, HSBC, ING and NatWest offer CEOs bonuses linked to environmental targets, and in April, Mastercard said it would link all employee bonuses to ESG goals. According to analysis by PwC, close to half (45 percent) of the FTSE 100 have an ESG measure attached to executive pay. Even oil majors are among them, with Shell the first to link executive pay to carbon emissions in 2018.

Among insurers, however, it remains in a minority. In fact, neither Nir Kossovsky, managing director and chief executive officer of Steel City Re, the broker specialising in ESG and reputation insurances, nor Gerald Chen-Young, head of institutional consulting and advisory services group GCY Associates, say they’ve come across an insurance business doing so. And they think that’s a good thing.

Virtue is its own reward

The problem is not ESG itself, which both are committed to. Chen-Young has advised various boards on ESG issues. As he put it when speaking with Intelligent Insurer, it is not simply a fad or phase but a “movement”, comparing it to past movements such as anti-slavery, anti-child labour and universal suffrage.

“I believe ESG will be here to stay in the same way,” he said. “These are all movements that began at very grassroots levels and have now grown to become the norm. I think ESG is on a similar path.” To date, however, he’s not seen a direct correlation between executive and implementation of best practices around ESG.

“And I’m glad, because I don’t believe that alignment is the correct trajectory for this movement.”

Kossovsky agreed, citing Lucian Bebchuk, director of Harvard Law School’s Program on Corporate Governance, who has warned that ESG-based compensation could pose “significant perils” and serves executives’ interests rather than those of stakeholders.

The result was likely to be less accountability rather than more, he said. That echoes complaints by others, such as non-governmental organisations, who comment that the targets used for bonuses may do little to advance genuine ESG issues and can be irrelevant, such as attending a “town hall” meeting.

“The notion of ESG pay is noble, but its implementation produces significant challenges because of the imprecision and fluidity and the fact that metrics could be bent to adapt to a particular strategy not necessarily consistent with the noble goals of the movement,” said Kossovsky.

Companies—and their executives—can, of course, be rewarded through their stock price if they have share options or other pay linked to performance as a result of being good corporate citizens, added Chen-Young. But that’s very different from directly connecting executive compensation with ESG best practice. “That would be slightly misguided,” he said.

Horses for courses: setting the ESG agenda

The key difficulty is that there is no agreed definition of what good ESG indicators might be. “What ESG means to one company isn’t necessarily what it means to another,” said Chen-Young. “I’m not sure there is a set of metrics that can be followed that will be universally acceptable.”

The circumstances in which Kossovsky could imagine bonuses linked to ESG performance making sense illustrates the difficulties and just how unlikely it is: a situation where employees, investors, regulators, vendors, social licence holders and other stakeholders agree on what should be expected of the firm around ESG, and its management agree that these could be achieved.

“Then and only then would setting specific metrics for achievement makes sense,” he said.

Not linking remuneration to ESG goals does not mean they are ignored, however. Kossovsky suggests setting up a senior managerial function—he would call it a “reputation risk leadership committee” including senior executives from across the enterprise who have the insight into the expectations of the various constituencies, such as employees, customers, regulators, vendors, creditors, equity investors, suppliers, and activists to identify the ESG risks to the particular business.

This can then make a recommendation to the board that is specific to the company and based on an understanding of what the firm can do.

“Since that set of standards or goals is agreed through a managerial process in which the actual capabilities of the firm are recognised, the goals won’t be out of reach, nor adverse to the overall mission of the company and its principal objectives of meeting investor, regulatory and operational requirements,” Kossovsky explained.

As Chen-Young stated, it is about “alignment of interests”—not simply the financial interests of executives. “Until it becomes accepted that part of one’s fiduciary duty involves adopting ESG, we will continue to struggle to make that connection,” he said.

“The board of directors performs a fiduciary duty of oversight. If part of oversight becomes adopting ESG in some incarnation, that’s a good start,” he concluded.