Over the past few weeks, we have focused a lot on environmental and social governance (ESG) and the growing role that it is playing as a root cause of financial distress (if it is ignored) and the role that it can play as a tool to get a company out of financial distress (if it is embraced).
The most significant wakeup call came when we highlighted the fact that ESG is becoming a funding issue. Society is holding companies accountable for their actions. This does not only extend to companies that produce a product but also that company’s creditors and financers. A key question that creditors and financers ask is: is there a reasonable prospect of saving this company? In future, the answer to this question will increasingly lie in the company’s commitment to ESG. Creditors and banks are reluctant to commit funding to a company that does not take ESG seriously.
We are going to circle away from ESG for a second and then come back. One of the major issues that always gets highlighted in times of economic crisis in South Africa is the widening gap between the upper, middle and lower class. Unions spend a lot of time highlighting the fact that executives of major companies (Shoprite and Pick n Pay were victims of this in the past) receive massive paychecks while frontline workers receive a very low salary (comparatively). A similar storm is brewing when it comes to ESG. Environmentalists and social activists are questioning why the executives of certain companies receive massive paychecks while the company pays little to no attention to ESG issues.
Is it time then to benchmark executive salaries against a company’s commitment and performance of ESG issues?
The four dimensions of ESG remuneration
The selection of ESG metrics requires companies to obtain insights from their strategic and operational leadership and reflect on their purpose, underlying values and the practicalities of incorporating ESG metrics into remuneration based on their current internal processes.
PwC in collaboration with the London Business School identified four design dimensions that leaders and remuneration committees need to weigh up when deciding how to integrate ESG into remuneration structures.
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Input vs output
The PwC report points out that quantitative objectives such as reducing emissions lend themselves to output goals or external targets.
These are often based on measures of stakeholder impact and include aspects such the total amount of emissions produced employee engagement scores. Given the inherent objectivity, shareholders prefer objective output measures. But there are situations, such as strategic transformation, where input goals are also useful for addressing ESG issues that need to be measured in a more qualitative way.
The report adds that input measures or input targets are those the company uses to benchmark itself. Examples of these include developments in diversity initiatives or investments in green technology. These are measured by stakeholder outcome and not by the outcome of the measure itself.
Both input and output measures are useful insofar as they are aligned to the company’s strategy and are capable of being collected and analysed, and enable the company to communicate the data needed to support the assessment of whether the targets have been met.
Individual KPIs vs scorecards
The report points out that to effectively integrate ESG into remuneration structures, it is important to keep track of and measure progress towards ESG goals.
Sometimes an organisation will have one or two critical ESG issues that tower above others in significance, meaning that focusing on one or two KPIs may be appropriate. In other cases, an ESG issue may be multidimensional with many different objectives. In these cases, a carefully constructed and transparently disclosed scorecard may work better.
The report adds that it is important to strike a balance between ensuring the scorecard is sufficiently comprehensive to capture the range of the company’s ESG priorities and having a scorecard that is complex, and by extension unmanageable, and that fails to address the ESG issue.
Long-term incentive vs annual bonus
The PwC report points out that one of the challenges companies encounter is deciding whether the inclusion of ESG would be more effective in their short term and long term investment targets.
While environmental goals sit comfortably within the long-term investment goals, because of their long-term orientation, in that it will take several years for real progress to be observed. Certain ESG targets, such as health and safety goals and even gender pay targets, can be robustly calibrated over a single year.
The report points out that it is better to set ambitious, well-calibrated one-year targets than vague long-term ones.
Underpins vs scale targets
The report points out that in most cases, ESG metrics will work most effectively as scaled targets, with threshold and maximum performance levels.
The report adds that this is particularly the case for transformational objectives such as emissions reductions. However, some issues will have pass or fail performance standards, below which reductions in pay out are appropriate and which may serve as a gateway to an incentive pay out. Safety is such an example.
Tesla in hot water
We have already discussed how specific industries are more susceptible to ESG benchmarks than others. Mining companies, petroleum companies (Shell, BP, Engen, Exxon), and power utilities that rely on fossil fuel (which are most of the power utilities in Africa and most of Asia) are just some of the big industries that need to put ESG front and centre of their business models.
The ramifications for ignoring ESG are massive. Most of the companies within the above-mentioned industries are publicly listed companies which investment companies rely on to grow retirement savings. Can you imagine the ramifications of one of these companies being delisted? Tesla was recently excluded from the S&P 500 ESG Index because of issues including claims of racial discrimination and crashes linked to its autopilot vehicles.
Margaret Dorn, S&P Dow Jones Indices’ Head of ESG Indices for North America, told Reuters in an interview that factors contributing to Tesla’s departure from the index included Tesla’s lack of published details related to its low carbon strategy or business conduct codes.
The Reuters article points out that even though Tesla’s products help cut planet-warming emissions, its other issues and lack of disclosures relative to industry peers should raise concerns for investors looking to judge the company across environmental, social and governance (ESG) criteria. “You can’t just take a company’s mission statement at face value, you have to look at their practices across all those key dimensions,” Dorn said.
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This does raise concerns about ESG measurement and the criteria that drives the benchmark. Despite these concerns, the exclusion is a massive blow for Tesla, and a massive blow for its investors (the public). Reuters reports that Tesla has become the most valuable auto industry company by pioneering EVs and expanding into battery storage for electric grids and solar-power systems. Therefore, Tesla would be a popular stock and a drawcard of this index.
The role of the business rescue practitioner
Let’s deal with the Tesla issue first. Soon after the exclusion from the index, Elon Musk voiced his disgust about the issue over Twitter (which we all know he now owns).
Exxon is rated top ten best in world for environment, social & governance (ESG) by S&P 500, while Tesla didn’t make the list! ESG is a scam. It has been weaponized by phony social justice warriors. Fighting talk. If we look at the first part of the tweet, he does have a point. There are concerns and vociferous debates about the criteria that is used to measure ESG compliance. How can a company like Exxon be rated above Tesla? It doesn’t make sense, or does it? ESG is not about the product or service that you produce or provide, it is about the investment that companies make beyond the product or provision of their product or service. Simply put, perhaps Exxon is taking ESG more seriously than Tesla.
Justified or not, the exclusion of Tesla is more damaging to the brand than Musk realises. Publicly listed companies not only have a fiduciary duty to add value to their shareholders (creditors and lenders) but also to the public who invest in the stock to build their retirement savings. As a turnaround professional that is either leading a restructuring programme or steering a company away from financial distress, it is important that executives take ESG seriously.
Should executive pay be linked to ESG? Let’s take the Tesla example again. If Tesla was excluded from the Index because of gross ESG violations (and we are not saying that it was), the public and shareholders can take Musk to task over this issue.
Is this fair? Its kind of like having a dispute with the City of Johannesburg over an inflated electricity bill. You will be told to pay the full amount first and then raise a dispute later. Is this a fair practice? Not really; but it happens anyway. Love it or hate it.
Discretion is the better part of valour. Adhere to ESG benchmarks and then raise concerns about how it is measured. It’s is more beneficial for a company to add value to its shareholders than to be excluded from an index because you feel that ESG benchmarking is inherently flawed. This is the mantra that turnaround professionals should be encouraging their clients to follow.
The Mystery Practitioner is an industry commentator that focuses on the shifting dynamics and innovative thinking that BRPS and turnaround professionals will need to embrace in order to achieve success in their businesses.
