Asia Pacific joins the ESG incentives trend

Integrating Environmental, Social and Governance (ESG) metrics is the topic of the hour for Remuneration Committees in Europe and North America, perhaps trumped only by mastering the impact of the pandemic. It seemed not a week passed in this year’s AGM season without companies announcing new or increased ESG components in their executive pay frameworks — BMW² and Siemens³ are only two well-publicised examples.

Compensation professionals in Asia Pacific (AP), however, do not have many examples, let alone market studies, available for reference. The general impression is that AP organisations find themselves, at best, at the fringes of arguably the biggest trend in incentive plan design. We set out to put this perception to the test and to help AP companies with preliminary market observations and ‘best practice’ lessons.

Findings are preliminary as they are based on the disclosure of only a small sample of listed firms in select markets (typically the ten biggest companies by market cap), supplemented with consulting experience. The AP-wide observations in this paper, in a region whose executive compensation practices are as diverse as its cultural traditions, should be understood as reflections of a broad trend. They do not apply equally to each country.

Drivers of ESG incorporation: while there’s progress, investors and regulators do not (yet) demand a link to executive compensation

We have identified several drivers of ESG integration in our work in Europe. These drivers do not necessarily directly lead to more ESG metrics in incentive plans, but they do contribute to companies’ reflecting ESG in their strategy and operations. How does AP fare against these drivers?

1. Investor focus: AP-based signatories to the United Nations Principles of Responsible Investment (UNPRI) have tripled in the last five years⁴ — the list includes some of the biggest sovereign funds in the region (for instance, GPIF of Japan). Asian investors have also signed up to more specialist action groups, for example Climate Action 100+, albeit in limited numbers. Despite these signs of interest, public statements on ESG and incentives are very rare. However, some investors are currently exploring how they can influence companies to incorporate ESG metrics into their incentives.
2. Regulatory pressure: progress is evident in general ESG reporting for listed entities: ESG reporting is now mandated for companies listed on the Hong Kong Stock Exchange and there are disclosure and reporting requirements, recommendations or guidelines of varying degrees in Indonesia, Thailand, the Philippines, Vietnam and many more countries. However, there are no known examples of corporate governance codes recommending, yet alone laws requiring, the inclusion of ESG metrics in incentive plans. The sole exception is the China Banking and Insurance Regulatory Commission (CBIRC)’s requiring “customer” focused metrics in incentive plans for certain senior executives.
3. Societal and customer pressure: compared to other regions, companies in Asia Pacific face less pressure from the broader society to address ESG matters. It is hard to imagine, for instance, that a major company in AP would offer a Supervisory Board position to a 23-year old climate activist — as Siemens did earlier this year. To stay with the environmental example, compared to the at times vast demonstrations in European cities, the impact of the Fridays for Future movement was sporadic in most of the AP region. Consumer sensitivities to ESG questions are developing, but probably not yet comparable to Europe. As ING recently put it: ‘Western consumers – and those in some Asian markets – now care about provenance …’.⁵

In sum, AP certainly is no stranger to ESG, and the topic’s importance is accelerating. However, the debate thus far lacks the breadth and constancy it has in other regions. From a compensation perspective, there are few public investor demands or regulatory pressures to include ESG metrics into incentive plans.

Market practice ESG integration into incentive plans

Part 1: Three stages of maturity in AP

Market practice is a valuable guidepost for HR professionals in most incentive design decisions, but even more so in areas like ESG where there is less experience. The stages of development in selected markets, illustrated below, help companies answer the ever-present question ‘how do we compare against the market?’.

1. 01

   Leaders

   Prevalence of ESG metrics is high (at least majority practice of the sample studied) plus, there are confirmed examples of:

   • ‘Sustainable’ as opposed to just ‘operational’ ESG metrics (e.g. environmental metrics, I&D); and
   • Metrics in the LTIP (not just the STIP); and
   • Weighted metrics (not just ‘a line in the BSC’).

   Countries and observations

   • Australia: tying ESG metrics to compensation is quite common, regardless of sector, and occurs mostly through the short-term incentive plan (STIP) and here predominantly through individual objectives. However, a few companies include ESG metrics as a weighted component in the long-term incentive plan (LTIP). The average combined weighting of ESG metrics in STIP or LTIP (~20% to 25%) is aligned with other regions. Common STIP metrics include safety, NPS and employee engagement. (Gender) diversity is also used. LTIP examples include employee engagement and reputation.
   • Singapore: despite the uncertainties caused by limited disclosure, Singaporean practices seem comparable to Australian practices. Similarities include high prevalence, the strong preference for incorporating ESG via the STIP and the presence of prominent examples of LTIP integration. Common STIP metrics include employee engagement, customer feedback and diversity. Several companies use environmental/sustainability metrics.

2. 02

   Midfield

   Companies use ESG metrics, but the criteria for ‘leaders’ are only partially met.

   Countries and observations

   • Japan: ESG performance metrics have gained some traction over the past few years but remain relatively uncommon. ESG metrics can be found in both STI and LTI plans although companies rarely include them in both. CO₂ reduction is a relatively common environmental metric. A handful of companies use indices (e.g., the Dow Jones Sustainability Index) to measure their sustainability performance.
   • Hong Kong: using ESG metrics within reward structures is relatively common but not standard practice. ESG metrics are typically linked to STI plans. Many of the bigger companies analysed use metrics related to the environment, such as CO₂ reduction, and there are several cases of sustainability measures (such as safety and customer satisfaction) in STI plans.
   • Thailand: while a fair number of companies incorporate ESG into their incentives, it’s far from being standard practice. ESG metrics are only found in annual incentive plans and are largely limited to customer and people development metrics.
   • China: state-owned enterprises tend to include ESG metrics within their STI balanced scorecard. Linkages in the LTIP are rare. Metrics used depend on the respective industry but include social responsibility, safety and environmental metrics. Some internet companies include “value” in the assessment of their executives, allowing for incidents that have a profound negative impact on society to be reflected. It is relatively common for non state-owned enterprises in industries such as energy, manufacturing, chemicals or construction to have ESG metrics in their STI balanced scorecard.

3. 03

   Laggards

   ESG metrics are rarely/not at all incorporated into incentive plans.

   Countries and observations

   • Taiwan: it is uncommon for companies to tie ESG metrics to incentive plans, despite the local investment community’s placing importance on ESG and relatively detailed ESG reporting.
   • India: our consulting experience tells us that ESG targets are generally not found in executive incentive plans. At times, they are included in the objectives of the CSR department’s management cadre. This is despite the fact that government rules require companies above a certain size⁶ to spend at least 2% of their profit on CSR activities and ESG/CSR activities are well disclosed.

   AP as a whole lags behind other parts of the world when it comes to prevalence of ESG metrics.

   While the three categories are somewhat permeable, there is little doubt that the level of maturity varies vastly across the region and that, if we take AP as a whole the region lags behind other parts of the world. At the same time, the “Leader” countries in AP are not far behind their peers in other regions when it comes to ESG prevalence, using both the STIP and to a lesser degree the LTIP as the integration vehicle, the weighting of combined ESG metrics, and the use of ‘sustainable’ metrics. It is noteworthy and encouraging that environmental metrics can be found in a number of markets considering that the region is particularly prone to the negative effects of climate change.⁷

Part 2: Six ‘best practice’ lessons learnt

The accelerating ESG debate, combined with the fact that ESG integration is in its infancy in some countries, suggests that many companies in AP will concern themselves with ESG and incentive plans sooner or later. In preparation of these discussions, we have identified six key learnings from companies that have successfully mastered this challenge.

Crucially, these learnings apply regardless of whether the company plans to have the ESG in the short-term (medium impact) or the long-term incentive plan (high impact). They answer the question ‘if we decide to introduce ESG metrics, how should we go about it?’

1. Start with the strategy: ESG needs to be part of the business strategy to make incentives work.
2. Involve the right stakeholders: success starts with engaging stakeholders outside of the rewards team (such as the sustainability team, if it exists, executives, or board of directors). Workshops are the tried and tested tool for the ESG incentive design process and a beneficial learning experiences for all parties.
3. Focus on KPI selection, setting and measurement: selection and target setting are often more difficult than with traditional financial metrics: ‘how to break down often decade-long targets into incentive plan timeframes?’; ‘how to maintain line-of-sight for participants?’; ‘what are acceptable levels of performance?’ – the difficulties are manifold. With respect to target setting, our clients have employed the following solutions: using discretion, making time the variable rather than level of performance (i.e., bonus for early target achievement) and deliberately wide performance ranges.
4. Be bold and accept uncertainty: measures may need to evolve more frequently (including definitions, measurement, targets) and at first introduction, companies will probably need to accept a certain level of uncertainty.
5. Keep an eye on market practice: market practice should be monitored as it continues to evolve in this space. This also includes market practice from Europe and the U.S. as these regions have more experience with ESG and can provide valuable lessons.
6. Manage the change: the introduction of a new metric requires communication with plan participants and vocal support from top leaders – our clients tell us that this is especially true for ESG metrics. But it should be easily manageable if the new metrics support the corporate strategy, have stakeholder buy-in, are flexible, and are mindful of peer practice (in other words – see the list above!).

In AP, integrating ESG metrics into incentive plans is less common and less advanced than in other parts of the world. However, there are countries in the region, namely Singapore and Australia, that have already come a long way and can serve as models for other markets. Others, like Japan, are in close pursuit. This observation also holds at the company level. In other words, ESG incentives are very much an AP topic.

At the same time, there still is a long way to go for most companies. We believe that many will set out during the next two years. In charting the path of introducing ESG metrics into their incentive plans, these companies are well advised to heed our six ‘best practice’ lessons to avoid the pitfalls of a complex endeavour.

Footnotes

¹ John Heywood

² Vanessa Dezem, BMW climate strategy may influence manager compensation, July 2020 (https://www.bloomberg.com/news/articles/2020-07-26/bmw-climate-strategy-to-influence-manager-compensation-fas-says)

³ https://press.siemens.com/global/en/pressrelease/siemens-strengthen-responsibility-and-sustainability-new-managing-board-compensation

⁴‘ From 104 to 303’, Anna Fedorova, Interest in ESG investing grows in Asia, July 2020 (https://esgclarity.com/interest-in-esg-investing-grows-in-asia)

⁵ https://www.ingwb.com/themes/sustainable-finance-articles/why-sustainability-is-asias-future

⁶ https://www.mca.gov.in/SearchableActs/Section135.htm

⁷ https://www.asia-pacific.undp.org/content/rbap/en/home/presscenter/articles/2019/climate-change-in-asia-and-the-pacific.html

Author

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Johnathon Brown

Consultant, Executive Compensation & Board Advisory

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