ESG Compliance (2): Sustainable remuneration as a factor for sustainable business.

 Which ESG incentive options exist for board members and managing directors?

ESG Compliance (2): Sustainable remuneration as a factor for sustainable business.

Environmental aspects, social responsibility and supervisory structure issues (ESG: Environment – Social – Governance) continue to become increasingly important for corporate governance. Linking the remuneration of board members and managing directors to ESG criteria sends a powerful message to both employees and investors. What has to be considered?

According to a current study by the HR consulting company, Lurse, many companies have already incorporated environment, social and governance (ESG) aspects into their company management and remuneration systems. As we have already reported, this reflects the new requirements imposed by investors and supervisory authorities along with increasing regulatory pressure: Current examples include the proposals for the following EU directives: the Corporate Sustainability Reporting Directive (CSRD), the Corporate Sustainability Due Diligence Directive as well as the German Corporate Governance Code, which entered into force in June.

A strong signal for stakeholders

Nevertheless, this development has not yet been fully integrated into the remuneration of top managers: Although a survey conducted by the investment company Union Investment together with the Sustainable Governance Lab at the University of Giessen, Germany, found that almost all DAX 40 companies have included sustainability targets in their management board remuneration, the Lurse survey determined that only 47% of the companies surveyed stated that sustainability criteria are relevant when assessing the remuneration of managing directors and the board of management. These factors do not play any role at all for more than one third of the companies. However, ESG criteria for top management remuneration send a strong signal to all stakeholders – beginning with activist shareholders and institutional investors to the workforce along with potential employees. In addition, there are numerous ways of linking the remuneration of management board members in managing directors to the company’s ESG performance and to the transformation of business models.

Extensive freedom

Currently, there are neither legal regulations nor specific requirements from investors and share voting consultants concerning ESG-oriented remuneration models. Nevertheless, one thing is certain in view of the Act Implementing the Second Shareholders’ Rights Directive (ARUG II): The executive board remuneration structure at stock companies must be oriented on the company’s sustainable and long-term development. This creates extensive freedom. Which guidelines can supervisory boards and HR follow when implementing ESG incentives?

  1. Congruence of the ESG program and sustainable incentives
    The first step consists of ensuring that the structure of board and executive remuneration does not contradict the company’s ESG program by linking ESG incentives to the sustainability strategy and its implementation. To guarantee transparency for investors, the criteria for ESG incentives for the top management need to be specific, measurable, appropriate, realistic and time-bound, similar to the target agreements for employees in accordance with the SMART method.
  2. Selecting sustainability targets and criteria
    With regard to environmental aspects, this can consist of specific CO2 reduction targets for production facilities, a real estate portfolio or an investment portfolio within a defined period of time. Specifications governing the recycling capabilities of the product portfolio or on the proportion of renewable energies within the total energy consumption are also conceivable options.
    When considering social aspects, remuneration can be based on specific requirements regarding diversity or inclusion, health protection and occupational safety, as well as further training for employees.
    Criteria concerning governance or good corporate management can include preventing corruption and bribery or the efficiency of compliance and risk management, for example. These criteria can be measured on the basis of key performance indicators (KPIs) such as the number of training courses and participation rates or inquiries regarding compliance topics which serve as evidence of employee awareness. In contrast, remuneration incentives for implementing new legal requirements such as the Supply Chain Act make less sense when the company is obliged to comply with these in any case.
    Sustainability criteria can also be based on a rating for debt capital providers. However, define individual KPIs may be the better approach depending on how well a company is positioned. Although this may involve a significant amount of work, the scope of rating may be too extensive when it comes to sustainability progress. Remuneration incentives can also be linked to certifications such as sustainable supply chain management. The following examples also point towards possible ESG criteria:
    The German Sustainability Code or the focal topics published by the Sustainability Accounting Standards Board. It is also important to bear in mind the recommendations issued by institutional investors and share voting consultants.
  3. Prevent duplicated work from parallel structures
    To prevent duplicated work arising from parallel structures, the sustainable incentives need to be coordinated with the content of non-financial reporting pursuant to Section 289b and Section 289d of the German Commercial Code (HGB). In future, they will also have to be aligned with the non-financial reporting pursuant to the Corporate Sustainability Reporting Directive. Performance criteria and measurement systems from existing sustainability reporting systems can frequently be used for ESG incentives.
  4. STI or LTI. Which is the better option for remuneration?
    ESG incentives are primarily anchored in the variable remuneration. This complies with the German Corporate Governance Code (DCGK): The code states that stock companies need to address sustainability aspects when they select financial and non-financial criteria for assessing variable remuneration. The decision regarding the specifically suitable ESG incentives for board members or managing directors needs to consider questions such as: How are ESG criteria weighted in comparison to financial criteria? Are sustainability targets additively linked to financial targets such as profit figures? Or do they influence other non-financial criteria as a multiplier that increases or decreases the variable remuneration? Are the sustainability targets anchored in short-term incentives (STI) or in long-term incentives (LTI)? It is important to note that the latter is preferred by some investors.

It is already clear that ESG criteria will continue to play an increasing role in the remuneration of management board members and that these are also becoming increasingly important for SMEs – even if only with a view towards access to financing. During times of crisis, stakeholder trust becomes vital for companies. Accordingly, ESG-oriented remuneration for the board and management has an even more powerful impact on investors, lenders and employees. Transparency regarding how the sustainable criteria are integrated into the remuneration is the top priority. Companies have extensive freedom regarding ESG incentives for the top management. Although companies have only just begun implementing these, suitable instruments are already available to precisely tailor the incentives to the company.