Executive briefing – March 2021

Environmental, Social and Governance (“ESG”) measures and their increasing use in incentive plans

Aside from COVID-19, the start of 2021 has seen a keen focus on ESG matters from investors, proxy agencies and society at large. The continued push from stakeholders for better reporting on ESG factors has begun to influence incentive design so that we are now seeing a progression in the use of ESG performance measures in annual bonuses and, to a lesser extent, LTIs.

To date ESG has often been captured and assessed under the umbrella of personal or strategic objectives. These have often involved subjective assessments of performance in the round. However, we are seeing more examples of ESG measures now featuring as distinct, discrete measures usually in the annual bonus in the first instance. In our experience, companies wish to build up a track record of setting and monitoring progress on an annual basis before committing to longer-term performance targets in an LTI. However, we are already seeing this migrate into their use in LTIs and we expect this to increase over time as companies become more comfortable with setting longer-term targets.

Whilst the definition of what counts as an ESG measure is open to some interpretation, our analysis shows that around 40% of FTSE 350 companies have one or more specific ESG measures in their annual bonus, with the median weighting being 20% of the total award. For long-term incentives, the use is only around 15% of FTSE 350 companies with the median weighting being 25% of the total award. We expect prevalence to have increased by the end of the 2021 AGM season. It is also worth noting that a number of new restricted share plans are including an ESG consideration as part of a general underpin.

Some shareholders still view the use of ESG measures with some scepticism, on the basis that historically non-financial measures have paid out at higher levels than financial measures. For this reason, ESG measures will still only represent a minority of the overall incentive potential. As ever, some correlation with financial performance is still expected to justify any payout and Remuneration Committees will be expected to ensure overall outcomes reflect the wider stakeholder experience.

Whilst the push for greater accountability on ESG measures seems unstoppable, there are a number of issues to consider:

Standard-setting and targets

• ESG measures may seem easy to set targets for in contrast to financial measures.  However, the time horizons envisaged do not always align with the standard annual or even three- to five-year cycles that are almost universal in incentive schemes.  Further, given their ‘strategic’ nature, ESG measures may not help institutional investors in their quest to simplify executive pay or for the targets used for pay determination to be more transparent.
• For some ESG measures, it may be difficult to distinguish between average, good and great levels of performance and, therefore, setting a typical target range becomes difficult. A danger with any new measures is that there is not a full understanding by all parties of the assessment criteria and/or any limitations on the reporting data. If this is not identified until the final assessment, it can undermine the integrity of the measure. A clear record of the assumptions underpinning the targets and the data which will used to judge performance can help to avoid any ambiguity.
• Institutional investors and proxy agencies are developing their own tailored systems to evaluate ESG performance which creates a myriad of sources of data to support benchmarking.  Companies will struggle to meet all these different standards.  Corporate ESG activity may also become ‘bureaucratised’ and there is a risk of ‘box ticking’ to keep up with the performance ratings. In our view, the starting point should always be to identify the Board’s specific priorities rather than what is fashionable at peers.

Unintended consequences

• An overly-formulaic approach could dissuade leadership teams from agreeing to the aspirational goals and targets which stakeholders expect.  The use of good judgement and discretion by the Remuneration Committee could serve as the counter to this (and corporate culture might too) but the use of discretion goes against the prevailing tide as far as shareholders are concerned.  This should be resisted as the unintended consequence could be that ESG ambitions and outcomes are reduced rather than advanced.
• Using too many measures, each with a relatively low weighting, risks diluting the incentive impact of the annual bonus. Measures which are authentic to the business, reflect the culture and the strategy are more likely to have the desired impact on behaviours and drive real performance outcomes.

Consultation on the government’s proposals to restore trust in audit and corporate governance

On 18 March, the Business Secretary announced a consultation into a major overhaul for the UK audit regime. The consultation covers wide-ranging reforms to the audit and corporate governance regime, targeting the UK’s largest businesses.

Strengthening clawback and malus provisions

Part of the White Paper sets out proposals to strengthen malus and clawback provisions within executive directors’ remuneration arrangements. This would be enforced via changes to the UK Corporate Governance Code (the “Code”) which would require, on a comply or explain basis, a minimum two-year clawback period covering at least:

• serious misconduct,
• material misstatement of results or an error in performance calculations
• failures of internal controls and risk management.

This would represent a tightening of the Code which currently says remuneration polices should include recovery and withholding provisions but does not specify how these should be applied.

Whilst not in the consultation paper itself, the accompanying press release suggests the Code will require these clawback and malus provisions to be written into directors’ contracts (i.e. rather than just enforced through bonus plan rules and letters as is more often the case currently) although we wonder if this is simply loose terminology as they do not need to be in service agreements to be enforceable.  

New corporate reporting

The press release also promotes greater transparency about the state of the company’s finances and its ability to pay dividends and bonuses. The use of “Resilience Statements” which build on existing going concern and viability statements are proposed initially for premium listed companies but would be extended to other public interest entities in due course. Various methods are proposed to ensure directors are directly accountable for decisions on dividends, one of which includes an explicit statement that the dividend proposed would not threaten the solvency of the company over the next two years. The specific reference to bonuses is not repeated in the actual consultation paper where the focus is solely on preventing dividend distributions when a company could be facing insolvency. 

The new regulator the Audit, Reporting and Governance Authority’s (ARGA) will be tasked with the responsibility for the realisation test which defines realised profits and losses which can be used to determine how much of accumulated reserves can be considered for distribution.

The link to the consultation paper is set out below. Responses are required by 8 July 2021.

https://www.gov.uk/government/consultations/restoring-trust-in-audit-and-corporate-governance-proposals-on-reforms

Pensions and Lifetime Savings Association (“PLSA”) Stewardship and Voting Guidelines 2020

On 10 March, the PLSA published its 2021 stewardship and voting guidelines (full guidelines https://www.plsa.co.uk/Portals/0/Documents/Policy-Documents/2021/PLSA-Stewardship-and-Voting-Guidelines-2021.pdf). These guidelines are often used as reference for pension trustees when considering how to exercise their vote.

There are relatively few changes from the 2020 version but the items of interest from a remuneration perspective are:

• Remuneration committees should consider how the company has been affected by the coronavirus, the level of financial support accepted from government, and how this might affect the perception of remuneration among stakeholders.
• Investors should consider voting against the Remuneration Policy if:
  • There are no plans to align senior executive remuneration to performance against relevant sustainability metrics within a reasonable timeframe
  • The business has operations which are highly carbon intensive and has not included at least one climate-related metric in the calculation of executive incentives. The metrics also should not be contradictory.

If you wish to discuss anything arising from this briefing, please ask your usual contact at FIT or call us on 020 7034 1111 or email us at Info@fit-rem.com. 

This paper is intended to be a summary of key issues but is not comprehensive and does not constitute advice. No legal responsibility is accepted as a result of reliance on the contents of this paper.

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