Executive compensation should be linked to ESG

The traditional microeconomic view postulates that the objective of a commercial business organisation is to maximise profit. Considering this, business leaders must determine how they would prefer to run their organisations. 

As many businesses grew over time, their need for capital growth prompted them to mobilise funds from multiple shareholders. Accordingly, business organisations revised their objective to another one-point narrative – maximising shareholders' value. For most such organisations, the compensation structure for their business leaders, such as CEOs, was also aligned to this objective.

Several business leaders have developed their business strategies and plans around this objective. At the rudimentary level, the basic objectives such as maximising revenue by increasing the number of units sold and minimising cost by cutting down wherever possible, remain relevant over the years. To accomplish these objectives, many business leaders ended up losing their focus on the broader impact of their business activities.  

Let's imagine, some types of food and drinks manufactured by certain organisations may be harmful to health. While it would be better to focus on trustworthy research to ascertain whether the product is truly harmful or not, quite often the focus shifts away from such research and concentrates more on advertising campaigns and promotions to maximise the shareholder value.

Similarly, the production processes for certain products may expel hazardous waste into the environment. This waste can comprise the solid waste that takes thousands of years to be broken down by the environment. It can also be liquid waste that would affect the flora and fauna around various water bodies or gaseous waste that would negatively impact the atmosphere. Overall, such activities would adversely affect most living beings in the world. 

While it makes perfect sense to install suitable technology for the effective management of such wasteful materials for the common good, the quest for maximising profit may shift the focus away from such issues. Instead, the focus shifts towards doing just enough to obtain regulatory compliance certificates.  

Illustration: TBS

For several decades, activists and other stakeholders have been highlighting the side effects of such a one-point objective. Moreover, business organisations have initiated to change themselves by incorporating many activities within their programmes. 

To begin with, many organisations started addressing the need for employee safety in their workplaces, energy conservation, and various community services. Such programmes were augmented by adopting corporate social responsibility (CSR). 

Many countries have enacted laws to mandate commercial organisations to spend a part of their profits towards recognising CSR programmes. In Bangladesh, although CSR activities are not mandatory by law, several organisations run these programmes regardless, for several years now.

With constantly changing stakeholder demands, it is essential to address the overall environmental and social needs with the right kind of governance (ESG). ESG metrics need to be standardised for investors, customers, employees, regulators, and other stakeholders in business organisations. 

The World Economic Forum (WEF), in coordination with the Big Four accounting firms, published a guideline on internationally agreed metrics for tracking and publishing short-term and long-term ESG goals. While stakeholders have been demanding more transparency, such metrics will help everyone to monitor business activities and performances through a common lens.  

However, just incorporating additional metrics to monitor business performance will not be sufficient. The objective of a business organisation needs to evolve continuously as well. The stakeholders today, including the new-generation employees, prefer to get associated with the organisations that are driven by a purpose – and not necessarily only with a profit motive. 

Business leaders, including the CEO and board members, need to educate themselves about these upcoming realities. They must learn ESG, its broader impact, and devise how to reconfigure their business strategies to serve the purpose. 

Along with this, the executive compensation also requires a complete overhaul. If business leaders continue to get rewarded according to the conventional definitions of successful businesses, the ESG needs are unlikely to get addressed over time. Therefore, the entire compensation package should be assessed and recalibrated with respect to the ESG goals. To facilitate this, compensation components that are no longer relevant should be removed, and other applicable components should be incorporated.  

An executive compensation structure aligns with several internal and external targets. Such targets must include metrics such as diversity and inclusion in the workforce at every level. Similarly, there must be a good degree of focus towards the adoption of green tech and climate tech for facilitating environmental sustainability.  

Many organisations have already pledged their net-zero commitments, i.e., achieving a balance between the greenhouse gases produced and removal from the atmosphere. Reaching net-zero is pegged with multiple short-term and medium-term goals towards achieving this balance. Consequently, the executive compensation should also be aligned with these short-term and medium-term goals for each year. 

Though organisations will require new policies, practises, and technologies to achieve net-zero, business leaders must also walk the talk. For example, CEOs must proportionally cut down their travel miles and conduct more digital collaboration and communication to reduce their personal carbon footprint.

A significant amount of compensation for business leaders is realised through variable components such as annual bonuses and long-term incentives. The formulas to derive such components must be reviewed and appropriately weighted towards ESG goals. 

Finally, organisations must develop robust and trustworthy systems. Appropriate processes must be inculcated to regularly collect, analyse, and transparently communicate data to the stakeholders. Suitable technology should be commissioned to assure the stakeholders about the authenticity and transparency of business leaders' performance towards meeting ESG goals.

The author is a partner at PwC.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.