Investors are paying closer attention to box-ticking attempts and poor metrics as more banks globally start linking executive compensation to climate goals.

Sustainability targets are making their way into banks' variable remuneration policies, and the trend is likely to gain momentum in the wake of new guidance by the Basel Committee on Banking Supervision, a global standard setter for prudential regulation.

Investors, meanwhile, are raising their expectations, requiring pay plans to contain environmental, social and governance metrics that are material, measurable, clearly linked to company strategy and which have significant weight. Some asset managers have threatened to use their voting power if they do not see sufficient progress.

"Important investments need to be done today and transition needs to happen today. And this is why we think it makes absolute sense to have these incentives already today," said Antje Stobbe, head of stewardship at Allianz Global Investors, the investment arm of Allianz SE.

From next year, Allianz Global Investors, which oversees €637 billion in assets, will vote against executive remuneration plans at European large-caps that fail to include clear ESG-related targets.

Amundi, which manages $2.3 trillion, also put pay and ESG among its 2022 shareholder engagement priorities, saying it expects investee companies to integrate specific ESG and climate objectives in their long-term incentive plans. Legal & General Group PLC, which has over £1.4 trillion in assets under management, updated its voting policy for 2022 to request that companies link pay to net-zero emissions targets approved by the Science Based Targets Initiative.

Core strategy

Targets should relate to the core business and strategy of an organization, said Stobbe. Banks, for example, should focus on reducing carbon emissions related to their financing activities, and not only their own operational carbon footprint, she said.

Financial institutions should also focus on fewer performance metrics while giving them more weight, Stobbe said. Often banks will tie variable remuneration to a long list of ESG targets on a general management scorecard, giving low weighting to each individual objective, which makes it complex for stakeholders to monitor progress, Stobbe added.

Shareholders' focus on ESG in remuneration is an attempt to introduce incentives and accountability into sustainability strategies. Companies face a "huge incentive problem" when it comes to achieving their climate goals because the targets typically have a much longer-time horizon than the tenure of their current CEO, said Harlan Zimmerman, a senior partner at Cevian Capital, a Sweden-based activist investment firm.

"For companies that have made 2030 or 2040 pledges, that's going to be two or three CEOs away," Zimmerman said. A CEO today may even be disincentivized to make the necessary investments, or wind down business that is polluting but profitable, because such moves could have a negative earnings impact in the short term, Zimmerman added.

Cevian Capital last year adopted a policy to vote against compensation plans without measurable and transparent ESG targets. Since then it has been working closely with the businesses it invests in to ensure progress, resulting in all 13 companies meeting Cevian's requirements in 2022, up from three a year earlier.

The average tenure of CEOs on the board of FTSE 150 companies was 5.8 years in 2021, according to research by Spencer Stuart.

Patchy progress

Banks are already making progress in implementing sustainability targets into executive pay, with European institutions generally being more advanced, said Alexandra Beidas, global head of employment and incentives at Linklaters. EU and U.K. regulations and guidance already contain provisions that firms should consider including performance metrics around sustainability risk including climate risk, while rules have lagged elsewhere, said Beidas, who advises two-thirds of the top 20 global banks on remuneration.

British lender NatWest Group PLC, for one, gives climate targets a 10% weighting in its executive directors' 2022 bonuses. Metrics include a 40% reduction target for operational carbon emissions, a £17.5 billion sustainable funding target and the goal to develop a climate transition plan for publication in the next annual report. Climate objectives were also used to assess 2022 long-term incentive awards.

At U.K. peer Barclays PLC, executives' 2022 annual bonuses and 2022-2024 long-term incentive plan also include climate and sustainability goals, at a 10% weighting. Here, targets are more vaguely defined as "progress towards our green financing commitments" and "progress towards achieving our ambition to be a net zero bank by 2050," among other things.

KPMG research from December 2021 found that 84% of financial companies within the FTSE 100 link executive bonuses and/or long-term incentive plans to ESG metrics, a higher rate than most other industries. However, this proportion decreased to 26% when looking at financial companies in the FTSE 250.

Globally, just one in four of the world's 100 largest banks by assets tie CEO compensation to environmental targets, according to research released by Capital Monitor earlier this year. Most of them are European financial institutions. For those banks that do disclose, it is often patchy, Capital Monitor found.

The Basel Committee last month recommended that banks consider changing their compensation policies to take into account climate risk. This new guidance may lead to more global consistency in supervisory guidelines on this matter and encourage firms to go further, Beidas said.

Multiple global banks declined interview requests from S&P Global Market Intelligence.

Poor metrics

The issue of ESG in compensation has been on investors' agenda for some time. In a PwC survey of 235 investors globally from September 2021, 68% of respondents said ESG factors should figure into executive compensation. Some 30% said they had already engaged with companies to ensure inclusion of ESG in executive pay, while 58% said they were likely to take action on this in the future.

Pressure is meanwhile intensifying, and investor expectations are becoming more nuanced. Asset managers are asking for more than simply including a sustainability phrasing in a compensation agreement. ESG metrics should be material and measurable, which is often not the case in the rising number of pay plans with an ESG link, said Zimmerman of Cevian Capital.

"The problem is that, for many companies, the metrics aren't good enough," Zimmerman said. "A poor metric is almost worse than having no metric."

Banks that use measures that are not material to their organization may "hit the target and miss the point," said Phillippa O'Connor, national leader of PwC's reward and employment practice, who advises large listed companies on remuneration. "It's difficult to see how they can argue that it's about strategic alignment and not about box-ticking," O'Connor said.

More than 100 banks globally have joined the Net-Zero Banking Alliance, thus pledging to achieve net-zero emissions by 2050 and release interim targets for 2030 or sooner. The commitment covers emissions linked to banks' lending and investment activities, the so-called Scope 3 financed emissions.

Yet, none of the FTSE 100 financial services companies had Scope 3 emissions built into their long-term incentive plans last year, according to Deloitte research released in September. Instead, those plans typically included ESG metrics related to diversity and inclusion, Scope 1 and 2 emissions, green financing, risk management process, and conduct and complaints, it found.

Short-term targets

For banks, calibrating a 2030 or 2050 climate goal into specific short-term pay plans is anything but straightforward. "You can get that wrong," said Beidas. "I know that's what compensation committee chairs really worry about. There's a worry you're going to end up with something quite arbitrary."

While ESG factors such as diversity and inclusion and health and safety may be suitable for annual bonuses, environmental targets need to be measured over a longer period of time, said Paul Ellerman, a partner at Herbert Smith Freehills, who helps clients with executive remuneration and incentives matters. Even long-term incentive plans, which are typically three years for banks, "might not be long enough to actually see any meaningful change," Ellerman said.

To capture the long-term horizon of climate-related risk, banks may consider other changes to their pay policies, for example by introducing claw-back provisions in relation to climate issues, or by extending bonus deferral periods, said Beidas.

"This is an area that's going to evolve. Year-on-year, you're going to see firms coming up with different approaches," Beidas said.