ESG Focus: ESG-Linked Remuneration Now In Focus

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ESG Focus: ESG-linked remuneration rules reporting season

There was plenty of action on the social and governance fronts this FY23 reporting season, including a heightened focus on sustainability-linked remuneration and other governance incentives.

-Applying the marginal gains theory
-ESG-linked remuneration – analysts keep the score
-Fatalities rise as wages soar
-Indigenous engagement gets plenty of attention
-Companies fight Same Job-Same Pay bill
-Modern slavery in too-hard basket so legislation threatened
-Cybercrime threats rising

By Sarah Mills

ESG Reporting season is beginning to feel increasingly like Christmas – where we all get to find out who’s been naughty or nice.

But there’s much more going on with ESG reporting than just naming and shaming. 

It’s all about sustainability and safeguarding trillions of shareholder dollars in a period of rapid change.

Steven Bartlett, author of the recently published Diary of a CEO, devotes one chapter to the “Leverage of the Power of Progress”, which highlights the benefits of ESG reporting and measuring of multiple metrics for companies.

After interviewing Sir David Brailsford, a man considered to be the mastermind of the “marginal gains” theory, Bartlett goes on to detail Brailsford’s application of this approach to the British cycling team, “which was widely regarded as the laughing stock of the sport”.

Brailsford advised the team to stop thinking about major steps forward and instead to focus on all the little easy things that can be improved – everything from using antibacterial hand gel to reduce infection, changing pillows to improve sleep, and wind tunnel testing of suits.

The result: in five years the British Cycling team won 57% of all road and track cycling gold medals at the 2008 Beijing Olympics and further outdid themselves at the London Olympics – and let’s not forget a Tour De France victory, making it one of the most successful cycling teams in history.

With this in mind, the dazzling array of social and governance data sets included in the FY23 reporting season might be considered an encouraging sign – many metrics on a variety data points, all chosen as areas of improvement. 

And their number and strategic relevance are likely to rise sharply as companies get their bearings, with the ones that do this the best, aligning their metrics to support their strategies, likely to emerge triumphant.

All data sets, from emissions, to cyber, to safety, are basically subsets of governance, so it makes sense to lead with remuneration for the Social and Governance side of reporting season, given it provides strong context for the many disparate figures on show.

Main Social And Governance Themes This Season

While hanging this story on the coat-hanger of remuneration, this section also includes a summary of the key social themes to emerge from the FY23 reporting season to be addressed in more detail in part two of this story.

In summary, labour shortages proved a highlight, especially given the prevalence of safety-linked ESG remuneration.

Analysts attributed rising fatalities and mixed injury performances to the difficulty in recruiting skilled and semi-skilled labour. 

Many also viewed the intense competition in the market as a lens to determine the ability of certain companies to attract not only primary skills, but management skills.

While it’s early days yet, the FY23 annual results reveal nearly every ASX100 company is reporting on safety. 

Not only are most ASX majors reporting on safety, but the majority are also linking safety to remuneration.

After safety, the indigenous theme proved very popular among companies, a plethora adopting Reconciliation Action Plans, most likely because it generally represents “low hanging fruit” given the cost to companies (save perhaps for primary producers) is relatively low given the size of the indigenous population.

Not so equal pay, which received considerable push-back.

The Same Job-Same Pay bill, which plays heavily into the gender equality theme, caused a stir, BHP Group ((BHP)) conservatively estimating its introduction will cost it $1.3bn, hitting dividends, figures questioned by the government. 

Outside of the proposed legislation, not much relating to gender caught analysts’ eyes, although more companies are reporting on the issue, and more women continued to be appointed to leadership positions, this representing relatively inexpensive and low-hanging fruit for the gender issue.

Modern slavery remained a highlight – mainly because of the lack of attention paid to it by corporate Australia.

The Attorney General proposed in May to eliminate “bare minimum” modern slavery reporting after a review of modern slavery statements revealed the vast majority had adopted a minimum approach to compliance, rendering the statement incompatible with current legislation.

The other major high-profile and expensive governance theme was cybercrime, with several ASX-listed companies reporting some shockers. 

This article focuses on governance – specifically the performance of companies in linking remuneration to ESG factors during the FY23 reporting season, and cybercrime reporting in FY23. 

A second instalment on social and governance reporting takes a deeper dive into the season’s key Social themes: safety and reconciliation plans, as well as developments in modern slavery and gender diversity.

Again, Jarden and Macquarie analysts provide the fundamental data drawn from annual reports that underpin the observations in this story.

For reference going forward, the two main safety metrics for reporting this season included:

-Total Total Recordable Injury Frequency Rate (TRIFR) 

-Lost Time Injury Frequency Rate (LTIFR)

Remuneration King Pin of Reporting Season

Remuneration linkage is critical to incentivise change, particularly in big, slow companies facing an onslaught of change, and boards and directors are becoming increasingly aware of their importance.

Fortescue Metals ((FMG)) has understood this from the start and its Fortescue Future Industries executives are very clearly incentivised towards change and innovation.

For example, Fortescue was the only company to include a requirement (linked to remuneration) that decarbonisation projects enter Final Investment Decision phase supported by funding – and it had three such projects on the go. 

If Brailsford’s theory of marginal gains is to prove correct, then Fortescue Metals’ odds of beating the competition should be on an upward trajectory.

The main metrics used to set remuneration in FY23 included: culture, employee engagement, health and safety, environment, sustainability, net zero transition, etc.

A shift was also evidenced in analysts’ approaches to board and management remuneration in FY23.

In previous years, the analysts focussed largely on the rejection of remuneration packages and the numbers of those reporting mainly on safety metrics (and emissions).

This year, analysts drilled down to developments in ESG-linked remuneration packages, which were numerous, listing incentives and turning their focus to the introduction of leading safety indicators over traditional lagging indicators such as TRIFR and LTIR, and the strategic incorporation of social themes.

Not only did more major companies report on social scores (and emissions), but more companies joined the ranks of those linking short-term and long-term incentives (STIs and LTIs) to executive remuneration.

Social metrics scored more heavily in remuneration than environmental scores, possibly given it is relatively inexpensive, and easier to control. Also, for many companies, emissions are less material.

Macquarie Breaks Down ASX300

On the remuneration front, Macquarie reports that 14 companies introduced ESG-focused metrics into their management scorecards and executive remuneration, taking the ASX300 total to 71%, with 212 chiefs having tied variable remuneration to ESG, up from 191 the previous August.

These included APA Group ((APA)), Breville Group ((BRG)), Challenger ((CGF)), Chorus ((CNU)), Gwalia Resources ((GWA)), HealthCo Healthcare and Wellness REIT ((HCW)), Insurance Australia Group ((IAG)), Kelsian Group ((KLS)), nib Holdings ((NHF)), NextDC ((NXT)), Region Group ((RGN)), Sandfire Resources ((SFR)) and Silverlake Resources ((SLR)).

The broker says the vast majority of ASX300 linked remuneration to STIs but 29 were linked to long term incentives, up from 15 in 2022. 

Long-term incentives are generally viewed less favourably unless paired with short-term incentives. Including both points to a more strategic approach. 

Speaking of strategy, Breville announced its sustainability agenda (including environment) as one of its five strategic priorities and allocated it an overall 20% weighting of executive remuneration.

Jarden examines the S&P/ASX100 and finds 83% of companies included at least one ESG metric in their STI framework.

Macquarie says LTI-linkers included 29Metals ((29M)), Aristocrat Leisure ((ALL)), AMP ((AMP)), Bendigo & Adelaide Bank ((BEN)), Bellevue Gold ((BGL)), Breville Group, Commonwealth Bank of Australia ((CBA)), Challenger, Coronado Global Resources ((CRN)), Cleanaway Waste Management ((CWY)), Dexus ((DXS)), Endeavour Group ((EDV)), Goodman Group ((GMG)), Grange Resources ((GRR)), G.U.D. Holdings ((GUD)), Insignia Financial ((IFL)), James Hardie Industries ((JHX)), Liontown Resources ((LTR)), New Hope Corp ((NHC)), Northern Star Resources ((NST)), Perenti ((PRN)), Sandfire Resources, Tietto Minerals ((TIE)), TPG Telecom ((TPG)), Unibail-Rodamco Westfield ((URW)), Virgin Money ((VUK)), Wesfarmers ((WES)) and Woolworths ((WOW)).

Companies also tinkered with remuneration and weightings. 

On the social front, Challenger’s LTIs ascribed a 25% weighting to culture, including risk culture, engagement scores and specific culture-related questions from engagement surveys.

Transurban ((TLC)) upped its People and Culture weighting to 15% from 10%. And Challenger announced it was linking ESG to lng-term incentives in FY24.

Jarden Drills Down To Quality Of Metrics

Jarden observes 75% of S&P500 companies have disclosed that ESG metrics contributed to executives’ pay in 2022, up from 66% in 2021. 

More than half of these related to diversity and inclusion and included environmental metrics as part of bonuses, up from 25% in 2020. 

After examining the ASX100, the broker finds the main metrics included in STIs included: people (59%), safety (43%), customer (31%) decarbonisation (27%) and broad ESG (24%). 

Other metrics included cyber, leadership in ESG, ESG and reputation. The broker found “customer” had the highest ESG average weighting.

When it came to long-term incentives, 15% of companies had at least one ESG metric and the average percentage of ESG included within the LTI is 18%. Decarbonisation was the most common LTI ESG weighting at 15%, following by sustainability 4%, customer 3% and reputation 3%.

Given their wide adoption, Jarden attempts to evaluate the quality of ESG metrics adopted by companies and finds a “surprising” lack of transparency as to how 46% of these targets were to be achieved, leaving considerable room for gaming.

Gateways, Scorecards And Weightings

A gateway approach to building remuneration incentives is favoured by most analysts and investors. 

This approach demands a satisfactory risk-management score as a pre-requisite to receiving an STI.

They usually include metric gateways – the minimum hurdle on a specific metric to be achieved for directors to receive that percentage of their remuneration. 

Metric gateways are viewed positively, given it they set clear targets, with STI gateways preferred. 

Among 36 of the ASX100 to report gateways, Jarden observed a mix of safety gates, fatality gates, significant incident gates, financial gates and executive behavioural gates – all mostly STIs.

For example, BHP, Fortescue Metals, Newcrest Mining ((NCM)), Rio Tinto ((RIO)) and Santos ((STO)) have all set fatality and severe incident gateways.

Among companies with best practice scorecards including percentage allocations and targets (i.e. percentage of remuneration linked to targets), Jarden observes Coles ((COL)) and Fortescue Metals lead the pack followed by Northern Star Resources, Rio Tinto, Telstra ((TLS)) and Woolworths ((WOW)).

BHP set a clear target linked to remuneration to improve female participation by 3%.

Red Flags In ESG Remuneration Structures

When rounding up remuneration red flags, Jarden warns investors that companies should be setting clear and reasonable TRIFR thresholds, including maximums and stretch targets. 

In particular, TRIFRs should not be too high to making vesting over-achievable. 

We discuss this issue in our second article on social and governance investing to be titled “Day Of The TRIFRs”.

Jarden also warns that linking remuneration based on employee engagement surveys is questionable and prefers retention, attrition, gender pay gaps and internal promotions.

At the moment, 71% of companies reporting a people component used a survey which ended up being the highest for average metric weight, observes Jarden.

IAG was one of these – its only ESG component was engagement and worth 10% of STI. 

Similarly, Westpac ((WBC)) uses an Organisation Health Index Score as part of the People and Culture aspect of their STI, with no details on how this compares with peers, observes Jarden.

Jarden says investors also need to beware statements of “progress” or rewarding directors for vague improvement rather than disclosing performance against targets. 

And Now For The Wooden Spoon Awards

Allkem ((AKE)) proved a contender in this respect for Jarden’s FY23 Wooden Spoon Award.

Revealing itself to be a master of drivel, the company awarded a remuneration weight of 15% for “Progress in the development of the management structure and organisational culture to deliver the company’s aspirations”. 

CSL ((CSL)) and National Australia Bank ((NAB)) joined Allkem in the contender ranks, including rewards for “progress on Diversity and Inclusion” without setting targets that Jarden considered to be meaningful. 

On the TRIFR front, IGO ((IGO)) gains a flag for setting a stretch target of 14.9% (most companies reporting on this metric are half that). 

Not only was this figure much higher than peers, it was higher than the company’s previous year’s TRIFR, suggesting the company is setting the target to make remuneration achievable depending on market variables, rather than setting genuine targets.

When it comes to safety, Jarden also raised a red flag on companies that included safety as a long-term incentive only, and highlights James Hardie in this respect. 

Jarden advises investors also watch out for a lack of clear scorecards, targets or breakdowns of the percentage allocated to each component – a strong trend in reporting season. 

The analyst estimates that among the array of STIs, 46% of companies include at least one factor without detail. 

Jarden numbers ANZ Bank ((ANZ)), ASX ((ASX)), Fisher & Paykel Healthcare ((FPH)), Macquarie Group ((MQG)), REA Group ((REA)), Reece ((REH)), and Sonic Healthcare ((SHL)) among these.

The analyst also observed that 18 companies use the terms Sustainability or ESG as a catch-all phrase with an unclear target. Another 13 had no scores or weren’t explicit around ESG.

Cleanaway and Qube Holdings ((QUB)) took the walk of shame after not mentioning fatalities in their results, with Cleanaway caught out by the media. More on that in the next exciting instalment.

Thumbs Up For Remuneration Linkage

Several companies garnered notable mentions for the construction of their ESG remuneration packages.

Fortescue we have already mentioned.

Brambles ((BXB)) was flagged for using a performance modifier to the STI to capture sustainability targets, health and safety, performance and behaviours.

Cochlear ((COH)) used a group financial performance gateway for the STI with minimum underlying net profit threshold to drive global alignment.

Goodman Group has clear targets linked to stated sustainability targets and incorporates metrics into the STI and LTI as gateways (behaviour and culture) and includes a LTI penalty of up to 20% for ESG.

Many also gained a gong for safety metrics, which we round up in the next instalment.

Cybercrime Wiping The Floor

Cybercrime raised its ugly head in FY23 in a big way with several companies announcing high-profile hacks.

The federal government responded by threatening to penalise companies with repeated breaches, leading consultancy.com.au to ask whether Australia will witness its first -$1bn data privacy fine this year.

According to Cybercrime Magazine, cybercrime will cost the world US$10.5trn annually by 2025 – that’s more than double the forecast annual investment in renewables to drive the transition and nearly half of US GDP of US$25.46trn.

This journalist finds this figure astounding. With that kind of dough, fraudsters must now be close to ruling the world, if not doing so already. It would suggest every man and his dog is involved.

Even on the most conservative estimates, in FY23, billions of dollars in shareholder value was lost to cybercrime.

The most obvious conclusion from these figures and prevailing news coverage is that a lot of companies are being hacked and few are reporting it, and when they do, only to those directly involved. 

This is one area in which investors would like greater transparency as costs rise but companies remain cautious of reporting incidents given fear of the reputational damage involved (also a director’s responsibility).

Perhaps a solution to this dilemma could be to adopt a Brailsford approach, setting up many small metrics designed to improve cybersecurity based on industry averages, so that shareholders can at least see which companies are taking proper steps towards tightening loopholes. 

Cybercrime certainly took a toll on shareholder returns in FY23 with several companies forced to announce costly hacking incidents, both to earnings and reputation.

ASX-listed companies to report cybercrime in FY23 included:

-Latitude Financial announced 330,000 people’s accounts had been compromised by hackers, including driving licenses in Australia and New Zealand and 50,000 passport numbers. Another 6m customer records were stolen. 

-In 2022, Optus and Medibank Private ((MPL)) had details stolen (Medibank’s entire customer base). 

Optus ended up in a head-to-head with government on whether human error or a sophisticated attack was to blame. 

To Medibank’s credit, it was more transparent. The hack cost the company -$46.4m in non-recurring costs in FY23 and management forecasts another -$30m to -$35m in 2024. 

The company awarded a zero 2023 STI for the CEO and key executives.

IPH ((IPH)), JB Hi-Fi ((JBH)) – a third-party supplier breach — and Spark New Zealand ((SPK)) –a fraudster impersonating individuals – also gave updates on data breaches.  

The IPH breach cost the company -$2.8m in FY23 and STIs were deducted accordingly.

Woolworths and Medlab Clinical also reported issues. The latter sat on the knowledge for five months, after 223,000 customers details were posted on dark web – case study in what not to do.

And cybercrime is by no means confined to ASX-listed companies, a reminder that blue chips need to closely monitor supply chains.

For example, Meriton is one large private company to report a breach and analysts have identified cybercrime as a key issue for REITs.

All up, it begs the question: is automation worth it?

That’s the end of our first instalment on social and governance metrics. Stay tuned for our second instalment, which dives deeper into company performances on TRIFRs, reconciliation action plans, modern slavery and gender.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

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