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Maia Grecco

Canada’s second largest pension fund has an ambitious goal for a net-zero portfolio by 2050, and plans to get there in part through its practice of linking its employee pay to sustainability performance.

The Caisse de dépôt et placement du Québec (CDPQ), which manages more than $400-billion in assets, has an executive compensation system linked to achieving environmental, social and governance (ESG) targets. In 2018, it also became one of the first global institutional investors to tie variable compensation – pay given to an employee based on their results – to the achievement of climate targets. It applies to all employees.

Linking pay to sustainability performance is a powerful tool because bonuses are an important driver in the industry, says Bertrand Millot, CDPQ’s head of sustainability.

“We felt it was the right approach because it created opportunities as opposed to constraints. It also clearly demonstrated our commitment to our goals,” he says.

ESG pay links show sustainability commitment

Most companies are tying ESG performance to compensation to demonstrate their commitment to sustainability, says Coro Strandberg, a sustainability strategist and president of Vancouver-based Strandberg Consulting.

“They’re making room by giving real estate in the incentive plans to bring ESG forward,” she says.

The increase in ESG-linked compensation has been “quite dramatic” in recent years.

When Ms. Strandberg did a review in 2013 of the 60 large companies listed on the Toronto Stock Exchange, known as the S&P/TSX 60, she found 40 per cent had ESG-linked pay incentives. Today, she says that number is about two-thirds. About 70 per cent of companies on the S&P 500, which includes the largest 500 large companies listed on exchanges in the United States, link executive pay to ESG performance.

Companies have been forced to take more aggressive action amid the public’s pandemic-era introspection on issues such as climate change, diversity and inclusion and human rights. Stakeholders, including consumers, governments and shareholders, have been putting more pressure on companies to step up their ESG performance.

“It’s a very powerful signal to employees in the work force and suppliers and customers and investors and others of the company’s intent to move forward,” Ms. Strandberg says.

Meaningful, measurable change takes time

Still, there are challenges to the practice of linking pay to sustainability performance, Ms. Strandberg says.

For starters, making meaningful, measurable changes takes time but ESG-related bonuses are determined on a much shorter timeline. And many ESG-linked corporate bonuses are based on compliance measures like a lack of spills and leaks, death and injuries, she says. Those are about what happened the previous year, she explains, not leading indicators for how the company will behave in the future.

ESG-linked pay incentives are also relatively new and will evolve over time, Ms. Strandberg adds. Company executives and board members will need to determine more specific targets, related to their business and industry, to reach their unique goals, she says.

At CDPQ, there’s a strong focus on climate issues. The pension fund’s goals include holding $54-billion in green assets by 2025 and a 60-per-cent reduction in the carbon intensity of the total portfolio by 2030, as well as creating a $10-billion transition fund to decarbonize the main industrial carbon-emitting sectors and a complete exit from oil production by the end of this year.

Mr. Millot says the fund sets carbon budgets for each portfolio every year – and it’s up to each team to figure out how to achieve it.

“They have to consider climate as a key factor in every investment decision and they have three levers to reach their targets,” he says, which include investing in clean technologies, investing in best-in-class companies that are reducing their carbon intensity and selling companies that aren’t meeting ESG performance expectations.

Compensation is a sensitive topic and the success of the incentive program required buy-in from all employees, he says. A change-management strategy, which included meeting with employees to receive their input, was crucial to success, he adds.

“It has proven to be an efficient measure, as shown by the fact we have met and even surpassed our carbon reduction targets since it was implemented,” Mr. Millot says. “Our results have shown that you can reach climate targets, and achieve the returns needed to meet our clients’ needs at the same time.”

The risks of not doing enough

Investors will continue to press companies for demonstrable ESG performance, says Toby Heaps, co-founder and chief executive of Corporate Knights, a magazine on the sustainable economy, and executive director of the affiliated Council for Clean Capitalism.

“Having a say-do gap is getting dangerous,” he says. “Companies that say they’re doing something and are not paying their chief executives to get that thing done are at risk of not getting it done and then being potentially liable.”

Among Corporate Knights’ list of 50 “best corporate citizens” this year, 46 out of 50 have a pay link, but overall, companies that tie compensation to ESG performance are still in the minority, he points out.

And while the trend is headed in the right direction, Mr. Heaps believes not enough companies are transparent about the percentage of pay that is linked and the precise nature of the sustainability targets.

“There’s still a lot of room for transparency improvements and this is going to become a table stakes indicator,” he says.

Still, he says disclosure is getting more rigorous and the federal government is also expected to bring in stricter guidelines for mandatory disclosures.

Mr. Heaps would like to see not only a portion of annual bonus pay determined by meeting ESG targets but a reduction in overall bonus pay for failing to do so.

“I think we can say that people tend to do what they get paid to do,” he says.

‘What gets measured, gets paid’

One of the main challenges for companies in linking compensation incentives to ESG performance is the long-term nature of social change and climate goals within the short-term nature of Canada’s tax regime, says Dov Begun, a partner at Osler, Hoskin and Harcourt LLP. based in Toronto.

While Canadian investors spur action within corporate Canada, they should demand governments keep pace, Mr. Begun says.

“What gets measured, gets managed, [and] what gets measured, gets paid,” he says. But “If you’re trying to measure or quantify certain of these ESG metrics, I think it’s hard to evaluate them in a short-term period.”

Canada’s deferred compensation rules allow companies to defer bonus payments for a maximum of three years, he points out.

“The existing policies we have in Canada are impeding the effectiveness of ESG objectives and compensation arrangements, because of the different time horizons,” he says. “ESG objectives really need to be measured over a longer period because, in many instances, hiring reform or whatever it might be, three years is really not enough time to measure how successful you’ve been and what changes you may have introduced.”

There are a couple of options, he says: The government could simply clarify that arrangements to defer employment income linked to ESG objectives are not considered to have tax deferral as the main purpose and adopt a broader approach than the three-year rule in those cases. Or, it could go as far as introducing a new statutory regime that includes deferral longer than three years for compensation linked directly to ESG goals.

“It really needs to come from the government, because the CRA [Canada Revenue Agency] doesn’t make policy. The CRA is administering the legislation and the legislation, as it currently stands, says I can’t defer longer than three years,” he says.

It’s not ESG-specific, but the United Kingdom has allowed a five-year deferment, he says. And there is no reason such a rule couldn’t be specific to environmental, social and governance metrics, he adds.

“There clearly is a move in some jurisdictions to longer-term deferrals that could align with longer-term objectives and ESG-related policies,” Mr. Begun says.