To Reward Well Means to Reward Sustainability

To Reward Well Means to Reward Sustainability
Only 7.4 percent of the remuneration of CEOs of Dutch listed companies depends on the company's environmental performance, according to research by Vlerick Business School. How can Supervisory directors transform current remuneration scores into a future-proof remuneration policy?

'Good remuneration' can be interpreted in two ways in 2023. The traditional meaning: good remuneration is in line with the market and appropriate to the position and responsibility resting on the shoulders of CEO and c-suite. The current meaning adds another dimension: good remuneration rewards executives who do the right thing, who take a socially responsible attitude in managing their company and who create sustainable value for people, society and the environment.

Million bonuses
How ’good’ (in both senses of the word) is the remuneration of CEOs of Dutch listed companies? The Executive Remuneration Research Centre of Vlerick Business School examined the level, structure and performance criteria of the remuneration of the top executive or CEO of a total of 74 AEX, AMX and AScX companies, based on the 2021 annual reports. First, the amount and structure of the remuneration package (see also box): the base salary of the CEOs of AEX companies averaged over one million euros in 2021, in addition to an almost equally high short-term bonus and a more than twice as high long-term incentive of over two and a half million euros (mostly in the form of shares). The remuneration of AMX and AScX CEOs, incidentally, is considerably lower.

Climate bonus still in its infancy
What is the status of linking the remuneration of the top men and top women of Dutch stock exchange funds to their efforts to do social good, to the ESG (environment, social & governance) criteria? For example, what part of the remuneration depends on environmental performance? Viewed this way, the remuneration of CEOs suddenly turns out to be a lot less ’good’: only 7.4 percent of the total remuneration awarded in 2021 is linked to it. Among companies included in the Stoxx Europe 600 stock index this is even lower at only 4 percent: a clearly worse score than that of the Dutch stock exchange funds.
The remuneration of CEOs is thus only marginally linked to the greatest social challenge facing humanity: climate change and limiting global warming to 1.5 degrees Celsius according to the Paris Agreement. We now deliberately zoom in here on the impact on the natural environment, the E of ESG. But sustainability is of course much broader and also includes the S and the G: taking social responsibility and acting according to the principles of good governance.

The unruly practice
Looking at the short-term bonus, the non-financial performance criteria (this is a broader term than ESG) are given an average weight of 35 percent in deciding the bonus. For long-term incentives, it is only one-fifth (20 percent). One would actually expect the opposite: climate goals, for example, are by definition long-term in nature. Remuneration criteria and their weighting should ideally reflect that. One possible explanation why this is not (yet) the case: unruly practice. Setting non-financial goals for the long term is perceived as difficult and is still very much under development. Perhaps Supervisory directors are also not yet sufficiently equipped to supervise ESG performance and integrate it into remuneration policy and to assess and reward executives accordingly.

'Employee bonus' most popular
Examining the non-financial criteria for the short-term incentive, employee-related KPIs are - after strategy - the most popular: 37 percent of surveyed companies make part of the cash bonus payout dependent on them. Following on this is "sustainability in a general sense," used by 32 percent of companies. However, it is unclear what exactly falls under this catch-all term (and what does not!). More transparency is thus desired. Only 14 percent of companies (or one in seven) explicitly use environmental criteria when awarding short-term bonuses (and 18 percent for long-term incentives).

Chain responsibility not yet in remuneration policy
Measuring sustainability of the supply chain as KPI has doubled compared to 2020 and can thus be called a revolutionary development in the integration of the E of ESG in CEO's remuneration policy. However, the increasing importance of chain responsibility and the sustainability performance of, for example, suppliers and customers in the field of ESG (scope 3 in climate terms)  is not yet reflected in the remuneration policy. Based on the information in the annual reports, we found that very few companies prioritize sustainability objectives in the supply chain and also reward their top management accordingly. So there is still much to be done in this regard.

The E is more than CO2
When we focus on the environmental criteria that companies link to remuneration policy, it turns out to be mainly about carbon policy: of the companies surveyed, 11 percent linked carbon emissions to the short-term bonus and 16 percent to the long-term incentive. However, this ignores the fact that the E of ESG is much broader than just carbon emissions: consider, for example, companies' impact on biodiversity. Environmental objectives such as energy and water consumption, waste management or packaging policy are also not yet or hardly integrated into remuneration policies.

Start with holistic ESG criteria
The survey does also reveal a number of inspiring examples in the field of ESG remuneration. For example, the variable pay of CEO Lard Friese of insurance company Aegon is 30 percent dependent on personal, non-financial performance. In addition, 5 percent of his bonus is linked to the number of women in senior management positions and 5 percent to the further integration of ESG into the corporate strategy. The first target can be easily quantified: by the end of 2021, women formed 34 percent of Aegon's senior management, meeting the 80 percent target. The required development of the ESG strategy was met a 100 percent, according to the annual report.
In addition to these concrete benchmarks, Aegon takes into account the level of development of its sustainability strategy. A few examples: formulating sustainability governance, selecting two top priorities (climate change and diversity) and embedding them in the  objectives and the behavior in the company, and regularly engaging with the most carbon-intensive companies in the portfolio. As mentioned, measuring and monitoring ESG criteria is still evolving: companies need time to learn to deal with them. To nevertheless tilt remuneration policies toward sustainability, Supervisory directors can first adopt holistic metrics and then flesh them out further.

Roadmap and external ratings
A second example is KPN: the telecom company uses different non-financial criteria for the short-term bonus (30 percent) and the long-term incentive (35 percent). For the former, these are customer satisfaction (measured by the Net Promoter Score) and employee engagement; for the latter, the company's reputation (monitored with external, independent data) and its (supply chain) ambition to be 100 percent circular by 2025, are considered. To achieve that goal, the company has a comprehensive roadmap, which extends to the supply industry and is guided by an internal energy - and environmental board.
A third example is STMicroelectronics. In addition to growth and margin criteria, the semiconductor manufacturer bases its remuneration policy on a self-created sustainability/CSR index: a mix of internal targets and external KPIs (performance on the Dow Jones Sustainability Index and the CDP Carbon Rating.)

Over- or underperformance?
Finally, two examples for external reporting on the development in sustainability performance and its link to remuneration. Lighting manufacturer Signify displays progress on ESG criteria not with complicated mathematical formulas, but with the simple observation of whether achieving targets is on track (on/off track). The Belgian chemical company Solvay goes a little further in transparency, indicating the percentages by which it performed better or worse than the set targets. For the One Planet strategy, it was 88 percent in 2021. The target was not met and the (rounded) percentage scores for the underlying KPI's show that this was in part due to underperformance in the areas of climate and safety.

Social expectations
The ESG performance of companies will in coming years increasingly come under the spotlight: of the compilers of the European taxonomy and sustainability indices to and including rating agencies, proxy advisory firms, NGOs, and society. How can Supervisory directors reflect those societal expectations in the remuneration policies of the CEO and other directors? It starts with the purpose and strategy and from there asking the question: what is the company's greatest positive and negative impact on society? Translate this into ESG criteria and integrate them into the assessment and remuneration policy by making the short-term bonus and long-term incentive dependent on non-financial KPI's. If the CEO's bonus is only 7.4 percent dependent on the company's environmental performance, what incentive is there for sustainable long-term value creation? It must - gradually - become more. Good remuneration, in its wide interpretation, requires a transparent, stakeholder-oriented, sustainable and future-proof remuneration policy.

This article is published in Management Scope 02 2023.