Dr Tom Gosling, Executive Fellow of Finance at London Business School and the European Corporate Governance Institute, shares his insights into ESG now and for the future of reward.
For the reward professional, it can be sobering and insightful to listen to the largely-objective perspectives of an academic observing industry in flux. Dr Tom Gosling has the ideal pedigree for sharing wisdom: he spent many years as a consultant on corporate governance and responsible business before shifting back into academia, where he started as a younger man with a PhD in Applied Mathematics.
His observations on the transformation of ESG (environmental, social and governance) linked to executive pay have much to add to TR2050 Members’ discussions about the future of reward. Unfortunately, his verdict isn’t positive: “I fear we are witnessing a slow-motion car crash. There could be a serious reckoning for executive pay up ahead.”
Transformation of recent years
ESG is a commitment that companies have been making for some time, but the explicit link between these targets and executive pay has exploded in the past two years. “If you go back five years it was a bit of a minority sport but now almost every single company is doing it,” Tom says.
The rush to introduce ESG targets into executive pay packages was likely caused, he explains, by the upswing in interest on the issues that ESG seeks to tackle generally. Organisations were put under pressure by investors, customers and employees to take greater responsibility for things such as their environmental footprint or sustainability.
“Linking ESG to executive pay has become a signalling mechanism. It’s a way of saying, ‘we think this is important’ and does help provide a bridge between short term actions and long-term goals.” The idea is that without the financial incentive to focus on ESG, executives may “focus too much on short term wins and profitability. The theory is that linking ESG to pay can alter that.”
Tom is unconvinced that the explicit link truly provides the positive impact it notionally intends. “I can understand the motivation, but I think it’s misguided to believe that pay can overcome a fundamental externality like the failure to put a price on the harmful effects of climate change. Executives and boards will still be driven by the fundamental economic incentives their companies face.”
He also raises concerns over the lack of transparency and the complex metrics used to assess ESG targets and performance. “If board members and investors have enough knowledge and time to thoroughly scrutinise ESG target metrics, then it could work, but most don’t. The risk is companies setting soft targets with vague metrics, resulting in higher pay-outs for executives without much tangible benefit to wider society or the environment.”
It’s this that makes Tom fear he is observing the “slow-motion car crash” and predicts the years to come could see another reckoning around executive pay: “there’s a real risk that in five years’ time we could look back and say, ‘ok we got more pay, why didn’t we get more ESG?’”
Where Tom is more positive is in the role of reward in reinforcing a strategic change within companies. “Where a CEO and board have decided on a new strategy with ESG at its core, then putting ESG targets into management bonus plans can be a great way of reinforcing the message across the organisation that things have changed. But this needs to be in the context of a wider cultural change. This is much more fruitful than thinking we can use ESG targets to direct CEOs to take actions that aren’t aligned with long-term value creation”.
The future for ESG and reward
Looking ahead beyond such drama – if indeed it comes to pass – Tom retains the academic’s pragmatism about what the future may hold for ESG and reward. “The difficulty is that we can’t accurately predict what anything will be like if we consider decades in the future,” he admits. “Look back thirty years and the changes we’ve seen until today are quite staggering.”
In the shorter term, he believes the trend for linking ESG to executive pay will continue and hopefully improve in terms of quality. “At the moment, everyone is doing it and the impact is limited and quality quite low. Ideally we would’ve focused on the companies facing the most material ESG issues and with anchor shareholders who could provide the right level of scrutiny. Instead, we’ve rushed to apply the practice everywhere, and now have to increase quality across the board.”
Tom’s recent research at London Business School, in collaboration with his old firm PwC and Cevian Capital, the activist investor, points the way forward. “First, these targets need to be meaningful, which means basing them on material ESG factors and with a decent weighting in the bonus not just few percent. Second, they need to be objective and ideally quantifiable so that external stakeholders can evaluated them and they can be assured.
“Third, the targets need to be clearly disclosed at the start of the performance period to enable shareholders and other stakeholders to engage with companies on the ambition in the targets. Fourth, there needs to be a clear explanation of how the pay targets map onto the longer term trajectory of commitments made by the company, such as Net-Zero 2050.” The research, into climate targets at large European firms, shows that targets at fewer than one in six companies currently meet these basic standards.
Over the longer term, he predicts this approach to ESG will become unnecessary as regulation and policy catches up with national and global intentions around issues such as climate change. “At the moment, companies are making voluntary ESG commitments, but as the policy environment develops, which is essential if we’re to get to net zero, we won’t need to incentivise CEOs to take these steps; they’ll be done automatically because that’s what the economic incentives in companies will point to.” Indeed, ESG should, in due course, become part of the spectrum of intangible factors that drive business success.
TR2050 is right to look ahead
Despite the uncertainty, Tom sees great value in industry leaders stepping away from their short-term objectives to consider the long-term evolution of their sectors. “Reward can be a crisis-driven industry and a lot of the work is reactive,” he says. “TR2050 provides a forum for leaders to take a step away. To start discussing the future and prepare for it as best they can. When I first heard the idea I thought it was so interesting and so important.”
“Yes, we have radical uncertainty when it comes to the future but the process of imagining what it might be like makes you more adaptable and open-minded. That will only be of benefit.”
While not a Member of TR2050 Think Tank – “there is so much going on with my academic work, I feared spreading myself too thinly” – Tom remains a close friend of the organisation and shares the insights from his research that are pertinent to our discussions around the future of reward.
He also has some advice for our Members: “reward is creaking a bit and this area definitely demands a re-think to meet the challenges that are ahead. But this generation of reward leaders are the first of their kind, they’ve come up via eclectic routes and have a real responsibility for the future of their profession and developing the next generation.
“Reward is finally getting the prominence it deserves, as are the practitioners, and the fact that they are so keen to be involved in a forum like TR2050 is very encouraging.”