Remuneration and the E in ESG – does Australia need to play catch-up?

ESG has climbed up the Australian corporate agenda in recent years, amidst growing stakeholder pressure and increased recognition that an effective ESG strategy is important to the generation of sustainable, long-term value for shareholders.

With the spotlight firmly being placed on the big “E” in ESG in 2021 (driven in part by COP26), it comes as no surprise that the link between executive pay and climate-related considerations is front-of-mind for Remuneration Committees, particularly in traditionally high-emitting industries (such as resources, materials, industrials, energy and utilities).

While we have observed an increased use of “E” incentive measures amongst ASX companies with carbon-intensive operations, the growing number of companies in other industries making net-zero commitments raises a broader question: should businesses outside of traditionally high-emitting industries consider incorporating climate-related measures into their incentive programs?

This article explores the current state of play in Australia compared to the UK and US and key considerations for Remuneration Committees looking at the introduction of climate-related measures.

The state of play in Australia

The use of “E” incentive measures remains relatively low in Australia by international standards, with examples outside of traditionally carbon-intensive industries far and few between.

This is despite KPMG’s 2021 Australia CEO Outlook survey identifying climate change as one of the three most significant threats to growth (alongside supply chain issues and cyber security) and a recent ACSI study showing that almost 25 percent of the ASX200 have now made net zero or carbon emission reduction commitments (including companies within financial services, technology / financial technology, property, consumer discretionary and telecommunications).

Rare examples of companies with climate-related incentive measures in broader industries include:

  • NAB and QBE who incorporated climate considerations into their FY21 short-term incentive (STI) programs; and
  • Insignia Financial (previously IOOF) who has a “building a better tomorrow” measure under its FY22 long-term equity plan (linked to the company becoming net zero) and Goodman Group who has adopted an ESG LTI modifier for FY22.

In contrast to overseas markets, it is also more common in Australia for environmental metrics to be incorporated into the STI, as against long-term incentive (LTI) plans which typically account for a larger portion of executive remuneration packages. In addition to Goodman Group and Insignia Financial (noted above), only a handful of companies have adopted climate-related metrics under their LTI plans (including AGL, Fortescue Metals, South32, Northern Star and Incitec Pivot) and not completely without scrutiny from proxy advisors.

The overseas landscape

In contrast, the UK market is leaps and bounds ahead of Australia when it comes to tying remuneration to the big “E”, with FTSE100 companies outside of traditionally high-emitting industries using climate-related measures (including under their LTI plans) either as stand-alone metrics or as part of an ESG component.

For example, reflecting the focus on sustainable investing and financing, some of the UK’s big banks have incorporated environmental measures into their incentive programs as follows:

  • 20 percent of Barclays’ 2021 annual bonus was tied to strategic measures (which included targets relating to green financing, near-term financing emissions targets, reduction in carbon footprint and increased use of renewable energy) and 10% of its 2021 LTI is subject to a “climate” measure which will focus on progress towards Barclays’ ambition of being net zero by 2050;
  • 25 percent of HSBC’s 2021 LTI is tested against an “environment and sustainability” component (which includes carbon reduction and sustainable finance and investment); and
  • 5 percent of Lloyd’s Bank’s 2021 STI was tied to reducing operational carbon emissions.

Similar measures are observed in the UK in other industries including consumer discretionary (e.g. Unilever), media (e.g. RELX) and support services (e.g. Ashteed Group). There is also a growing trend in the US of companies utilising environmental incentive measures including in technology (e.g. Microsoft and Paypal) and consumer staples (e.g. Pepsi).

Interested in adopting “E” incentive measures – what should Remuneration Committees be thinking about?

Key considerations for Remuneration Committees

Given the international landscape and growing stakeholder pressure, we do expect to see more Australian companies in broader industries consider adopting environmental incentive measures where material to their long-term strategic priorities.

However, it is important for Remuneration Committees to avoid simply jumping on the band-wagon and adopting “E” incentive measures to give external stakeholders a “bite”, without giving careful thought to some key considerations (particularly in respect of LTI measures). These considerations include:

Choosing the right metric/s

In selecting measure/s and to support palatability externally, Remuneration Committees should ask themselves – is the metric transparent and clearly quantifiable (i.e. can we set clear and stretching targets) and can it be linked back to the long-term corporate plan / broader ESG strategy? While the current absence of any global agreement on harmonised ESG disclosures presents a challenge for selecting transparent measures. This will soon change with the development of the IFRS Sustainability Disclosure Standards which will provide a global baseline. Boards can also look to examples in the UK and US to support decision-making.

Developing an effective external communication and engagement strategy

While some external stakeholders have historically had a preference for traditional financial metrics, investors and some major proxy advisors are increasingly receptive to the introduction of ESG measures under LTI plans where accompanied by a compelling story. For example, in Australia, CGI Glass Lewis has indicated it will support non-financial measures in the LTI with up to a 25 percent weighting (including environmental measures). In addition to carefully considering the weighting of any “E” metrics (see below), Remuneration Committees should ask themselves – can we effectively articulate our ESG story to external stakeholders and explain why this climate-related measure / commitment is important to that story and long-term value creation for our shareholders?

Materiality

Many of the measures we are seeing introduced into STI and LTI plans in Australia and overseas have a relatively low weighting – typically 10-25 percent. While materiality reflects the importance of the chosen climate metric and a low percentage rating may not convey the importance, a key question for Remuneration Committees will be – does the weighting on this measure strike an appropriate balance between garnering external support whilst ensuring executives are committed to the outcome relative to other strategic objectives?

There is little doubt that the incorporation of climate-related measures into incentive plans in Australia will be something to watch over the next few years.

Thanks to Samu Elleperuma for assistance in research and writing.

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