Sustainability – yes or no? Though often wrongly mistaken for an empty marketing concept, sustainability has almost become a licence-to-operate for both national and international players. In fact, given the recent developments such as the formulation of the Sustainable Development Goals (SDGs) or the United Nations-backed Principles for Responsible Investing (PRI) there is no escaping any more. Also in Switzerland, the topic is increasingly receiving attention with the Federal Council announcing that sustainability should be included in the concept of fiduciary duty.
Besides governmental agencies and non-profit organizations, investors are also taking action. In fact, it is estimated that around every fifth dollar under professional management is invested following sustainable and responsible strategies with an increasing number of financial institutions introducing sustainability requirements to their investment processes. The impact of investments on, for example, the environmental footprint is increasingly being monitored. Indeed, doing “good” pays off and academic research shows that such strategies result in better riskadjusted financial performance than traditional ones.
In that respect, certain players are making bold moves. For instance, Norway’s USD 960 billion sovereign wealth fund will request the banks, in which it has invested, to disclose how their lending contributes to the reduction of greenhouse gas emissions. In the UK, the Environmental Audit Committee has requested the 25 biggest pension funds to publicly disclose how they manage climatechange risk of pension savings. In Switzerland, major player Swiss Re recently announced its decision to shift its CHF 120bn investment portfolio to benchmarks that systematically integrate ESG criteria.
One answer lies in appropriate compensation systems. If designed and calibrated properly, incentive systems can serve as a catalyst to drive a company’s ESG agenda and support corporate efforts. In 2012, the PRI, an international investors network and leading proponent of responsible investments, published a first guidance on the integration of ESG in executive compensation plans.
Though since then some development has occurred, practical advice on how to link ESG performance to variable pay is still lacking. As an attempt to fill this gap and better structure the discussion around it, HCM has built on the PRI recommendations and developed a 5-step approach on how to integrate ESG considerations in compensation systems.
HCM’s research using its proprietary database shows that there is a significant momentum regarding the integration of ESG factors in executive compensation. In fact, the number of companies disclosing specific ESG criteria in how they pay their executives increased from one third to one half from 2012 to 2016 (see figure 1)
Switzerland is, however, slightly lagging behind with only 40 percent of the companies in the blue chip Swiss market index (SMI) disclosing such links.
One important aspect to keep in mind is that company size4 correlates to a large extent with the considerations given to sustainability performance. In our global sample, this is partially reflected as only global companies of a certain size are represented.5 For Switzerland, the depth of the database provides more thorough evidence of the size effects: While 40 percent of the SMI companies disclosed sustainability criteria, only 15 percent of the SMIM companies did so.6 Market practice on how these companies integrate ESG in compensation, however, is diverging.
Building on the PRI recommendations, HCM developed its own approach to reflect ESG in compensation systems to structure discussions and support decision-making on key design aspects. This approach consists in five distinctive steps as shown in figure 2. The first step addresses participants’ eligibility to compensation plans.
Secondly, the mechanics of how ESG factors impact compensation need to be outlined. Thirdly, ESG performance indicators can be selected with the key aspects to consider being the type and number of ESG criteria. Next, the level and way to measure ESG performance is to be addressed. Finally, a robust governance structure around ESG-related compensation decisions needs to be put in place.
