Fears of an ESG misselling scandal as ESG bonuses surge

ESG is not a socialist ideal. Instead, ESG advocates talk about it as a way to maintain profits in the long term. ESG itself does not explicitly say high pay awards are incompatible with its ideas, but then again, public perception is everything.

Who says so? Why ESG advocates pin much of their faith on the idea that the customer, still smarting over the inequities of the banking crisis of 2008 and worrying about climate change, demand that the goods and services they purchase come from ethically sound businesses. 

SEE ALSO: → ESG and making a profit?

They insist that the millennial generation, in particular, scarred by Covid and lockdowns, want more than money from their work; they want a sense of purpose too. And so, at a time of labour shortages, applying ESG principles is an effective way of attracting staff.

There is nothing wrong with companies paying out bonuses for adherence to ESG, but such a policy is not without risk, especially if ESG related bonuses are deemed excessive.

So, that’s one risk related to ESG — ESG relates bonuses becoming linked with greed.

And here is another risk. The Financial Inclusions Centre has warned of the dangers of an ESG misselling scandal as money is pumped into funds branded as ESG, even though many of the agencies that provide ESG ratings are unregulated.

The legacy of 2008 

“Before 2008, I had never heard a client mention ESG,” says Hiroki Sampei

Head of Engagement, Japan at Fidelity International. He said: “ESG awareness is an enduring legacy of the global financial crisis.” 

And most of us can relate to that. We know bankers enjoyed massive bonuses in the lead-up to 2008, and banking greed was associated with a crisis that brought the global economy to its knees.

It is not that bonuses are bad per se, but there is an association in the public’s consciousness between bonuses, greed and unethical behaviour.

There is also a link, in public perception, between bonuses and short-term thinking, the antithesis of the ESG rationale.

ESG and bonuses

According to Institutional Shareholder Services ESG, executive pay related to corporate responsibility rose to 20 per cent of total pay at Russell 3000 companies in 2021 from seven per cent in 2018.

The FT cited Apple, Disney and Starbucks as examples of companies that have added environmental and workplace targets to pay awards for senior management.

There are dangers in this approach.

As PwC stated: “Including ESG metrics in executive pay packages is a tangible way to close the say-do gap for a sceptical audience, but is not without its challenges.”

PwC warned that ESG bonuses could:

• Hit the target but miss the point, for example, “a bank that focuses on reducing its own carbon footprint when the biggest effect it could have on reducing emissions is through changing its approach to financing companies that emit carbon.”
• Distort incentives
• And the risk in calibration where companies set targets they know they can meet.

According to a paper by Uri Gneezy, Stephan Meier, and Pedro Rey-Biel, incentivising pro-social goals can undermine pro-social motivation and trust.

And a famous TED talk from Dan Pink gave a compelling outline of why financial inventive are often counter-productive in encouraging people to work effectively.

The FT stated: “ESG pay provisions tend to be vague, and asset managers expressed concerns that if ESG pay replaces bonus targets tied to share price performance, then executives could be insulating bonuses during a turbulent stock market this year.”

PwC stated: “There’s often an idea that ESG targets in pay can be used to direct CEOs to undertake activities that benefit society, which they wouldn’t undertake without the incentive. This misunderstands how board governance works. Pay follows strategy; it doesn’t drive strategy.”

But it added: “Once ESG factors are integrated into the strategy, linking them to pay can be a natural next step, particularly as a tool for mobilising the organisation behind a new set of priorities.”

Misselling risk

And from executive bonuses, we move to ESG funds.

Mick McAteer, founder and co-director of the Financial Inclusions Centre, told Financial News that “we are very concerned about the influx of money going into funds branded as ESG.

He added that poor understanding of ESG funds and scores by investors could lead to a “misselling scandal.”

Misselling and bonuses 

A superficial analysis might suggest an ESG investment risk associated with poorly defined and regulated ESG standards is unrelated to executive pay linked to meeting ESG targets at companies.

But in the eyes of the public, there is a relationship.

The Financial Inclusions Centre raised the spectre of green-washing ESG funds, while critics of bonus culture worry about bonus incentives encouraging companies to apply green-washing.

Just as ESG funds could use ambiguity over ESG standards to invest in companies that are ESG friendly by the letter but not by spirit, so might a corporate culture applying bonuses to ESG hide behind poorly regulated ESG scoring systems.

The ESG industry must be seen to deliver in spirit and not hide behind ambiguity to present a company as meeting ESG standards when it clearly doesn’t by the standards of common sense applied by the public.

Bonuses for meeting ESG targets providing they adhere to a carefully planned strategy are at a reasonable level, and transparent are not necessarily negative.

But there is dangerous ground here. ESG itself must comply with the spirit of ESG. And there is a risk in the public’s psyche of amalgamating a misselling scandal with ESG related bonuses to company executives. So ESG must rise above even a hint of impropriety.