Remuneration Policies Need Rethinking
While many companies are committed to long-term social goals, they still judge their directors on short-term results. As such, CEOs are insufficiently encouraged to make the correct decisions that are good for people and the environment. In fact, leaders with a personal drive to do sustainable business can become demotivated by short-term bonuses. Ultimately, this inhibits the transition to a more sustainable society. Frederic Barge, founder of non-profit research firm Reward Value, therefore argues in favor of a new remuneration model. ‘Financial incentives that better align with the sustainability strategy can be a catalyst for ESG policy.’
The key question for directors and Supervisory Board members is: How do you do it? How do you link directors’ salaries to ESG goals? Reward Value wants to help Boards gain new methodologies and science based information in order to convince stakeholders that things should be done differently. To this end, the institute collaborates with Dutch and foreign universities and business schools.
On a warm September afternoon at Amsterdam's Arena Hotel, several Supervisory Board members from listed and non-listed companies were invited for an update on the latest information and ideas and how they can progress. According to Barge, the current remuneration system has two bottlenecks. Directors are evaluated based on a company's performance information, but the impact on people and the environment should also be a factor. So far, aspects such as the use of fossil resources and poor working conditions have not been factored in. The second problem is the time horizon. Many bonuses are paid out after three to five years, while sustainability ambitions are often only realized after a longer period.
Transparent discussions in the boardroom
According to Reward Value, companies need to begin monetarizing the positive or negative impact of their business on society. A rising number of companies are already doing that. In 2019, several multinationals including BASF, SAP, Bosch and Kering joined forces to form the Value Balancing Alliance (VBA). This network has since been joined by companies like L’Oréal, Michelin, Novartis and Roche. Together with international universities, the big four accounting firms, the Organisation for Economic Co-operation and Development (OECD) and other stakeholders, the network developed a standard for measuring human, social, financial and environmental value. ‘But it is more than that,’ argues Mario Abela, Professor of Accountancy affiliated with the VBA. ‘These companies also use the information in their business operations. Moreover, they are able to identify the KPIs that really matter. By viewing business strategy from a financial, environmental and social perspective, discussions in the boardroom become more transparent.’ Barge says this is vital: ‘Only once you are aware of the full impact of your organization based on financial and non-financial figures can you realize long-term value creation and link that to your remuneration policy.’
A long-term vision carries weight
An experiment conducted among 3,000 respondents (MBA students and comparable respondents) by SEO Economic Research commissioned by Reward Value has shown that financial incentives help increase a company's sustainability performance. ‘Not only does remuneration play a role – the director’s personality and the shareholders’ ambitions also matter,’ said Bas ter Weel, Director of SEO Economic Research and Professor of Economics at University of Amsterdam. ‘The gain is greatest if the CEO considers sustainability an important theme, if the remuneration stimulates cleaner and sustainable choices and if shareholders endorse a socially responsible strategy.’
The latter factor weighs especially heavily. The survey found that the surveyed participants invest 27% more in the long run if shareholders have a long-term vision. For ESG-based variable remuneration, that percentage is 14.5%, compared with 3.5% for CEO personality. The total effect of financial incentives, CEO preferences and shareholder ambition amounts to 40% higher investments in cleaner production. Reward Value will also conduct the experiment in groups and in-company in order to also identify the effect of Board dynamics and organizational culture.
Environmental KPIs are still scarce
‘Companies are already linking ESG criteria to directors’ salaries, but those are still mainly short-term incentives,’ says Xavier Baeten, Professor of Remuneration & Sustainability at Vlerick Business School. ‘In around 60% of listed companies in Europe, the short-term incentive partly depends on ESG indicators. Only 27% have long-term incentives that depend on one or more ESG indicators. One explanation could be that companies still find it difficult to establish longer-term ESG KPIs.’ Baeten notes that environmental performance is still hardly formulated as a KPI. ‘Only 9% of companies say they do this, although we do see rapid evolution here.’ According to Baeten, the following is also noteworthy: ‘According to our research, the inclusion of sustainability criteria does not result in higher sustainability performance. This may have something to do with the immature way in which KPIs are still set. They should be set based on an explicit sustainability strategy in which priorities are defined and underpinned by a good measurement system. That’s still happening very rarely.’
Structure of the remuneration package
Baeten cites other noteworthy statistics: ‘When a company starts formulating ESG as a KPI, it takes at least three years before it affects the company's sustainability results.’ And: A Sustainability Committee that advises the Board has a positive impact. ‘It is probably because that kind of committee accumulates a lot of knowledge and can therefore select ESG criteria that have real impact.’
A study of the effect of the various remuneration methods also resulted in interesting findings. For the purposes of the study, Baeten followed 800 companies for a period of seven years. The Professor concludes that salary does not influence sustainability performance. ‘A significantly higher salary does not result in more sustainable decisions. On the other hand, the structure and underlying KPIs of the remuneration package do matter. Awarding a share package dependent on the long term results of the company has a positive impact on the sustainability results, but the size of the reward should not be too large.’
Stay in control of remuneration policies
Barge notes that Supervisory Board members are divided when it comes to remuneration policy. On the one hand, there is increasing sustainability legislation across Europe, which calls for firm ambitions. In addition, there is constant pressure to meet the multitude of compliance regulations. On the other hand, there is growing unease among stakeholders concerning the size of directors’ bonuses. ‘We need to make these – often emotional – discussions more about substance. Variable remuneration helps companies become more sustainable more quickly, which benefits society as a whole.’ Barge calls on Supervisory Board members to be especially vocal about which aspects they are lacking in order to convince stakeholders that the remuneration system needs to be shaken up. ‘Sooner or later, linking remuneration to sustainability goals will be mandatory. You would do better to have control over this development and take the initiative now.’
During the discussion, one Supervisory Board member lamented that companies are weighed down by the plethora of regulations in ‘today's accounting world’. Society is rapidly changing and the business world has to respond with linear, controlled, responsible measures. ‘That doesn't fit anymore. We have many internal discussions about the role of the Board, governance and how we interpret it. Directors and regulators are appointed based on their knowledge of financial, legal and business knowledge, but that is no longer enough. We do not know about everything anymore. We try to keep up through expertise teams that update us on cybersecurity, artificial intelligence, diversity, tech and innovation. But maybe we need a completely different Board. We need to rethink our purpose, which people with what knowledge and attributes align with that and how we compensate them.’
Start with a trial run
Back to the question of how to begin modernizing remuneration policies. Barge lists a number of steps. Establish the purpose and your sustainable ambitions. Ask yourself which sustainable resolutions are really going to make an impact. What is tangible? You also need to carefully consider the extent to which you are going to factor ESG criteria into the remuneration package. Will it encourage more sustainable behavior? Do not make the time frame too short. Make sure the goals you formulate are not too easy – they need to be sufficiently challenging.
Many companies want to do this but do not know how to get started. Barge's advice is: ‘Start with a trial run. Draw up a separate policy alongside the existing remuneration policy. This will allow you to accumulate knowledge and insights, that help to formulate a more sustainable reward policy in the future.’
This article was published in Management Scope 08 2022.