Should the pay awards for Britain’s top CEOs be ESG compliant?

By Adam Lloyd

At 5:30pm on Wednesday 6 January, according to the High Pay Centre think tank, the average FTSE 100 CEO had been paid more for the first three days of 2021 than the average British worker would receive for the whole of the year. Apparently, that figure is down slightly on 2020 so an average FTSE 100 CEO had to work an extra hour in 2021, about 34 hours, before achieving that milestone.

In simple terms, the average FTSE 100 CEO gets paid about 120 times the national average. Even though 2020 was a flat year for executive pay Britain’s top executives have seen their remuneration packages soar by comparison to the rest of society. And this is nothing new, in the early 1980s the multiplier was about 20 times and by the turn of the millennium that had increased to 50 times.

Having the best management talent steering our corporate leviathans is clearly desirable to ensure their success, which is good thing for all of us and the economic health of the nation. Indeed, the Adam Smith Institute, that bastion of free market thinking, believes that profitable businesses make “a big difference to workers across the UK, anyone with a private pension and shareholders.” The implication of their argument is that the risk of having the wrong people running an enterprise is too great to allow concerns over management pay to get in the way of recruiting and retaining the best people.

The Boards that approve these generous pay awards will also argue that they have to pay the market rate to secure the unique skills and expertise necessary to deliver the profits that shareholders demand. The boardrooms of corporate Britain take it as a given that the scarcity of top management talent justifies CEO pay because if the talent pool were larger market forces would make the pay awards smaller.

The problem with this argument is that it is hard to support when you dig a bit deeper. Is management talent really in such short supply? If we are to believe that market forces are at play then such attractive pay would only serve to drive up the supply of suitable people, which it has. The world’s foremost business schools are producing thousands of highly trained graduates every year and the alumni of these esteemed schools number in the tens, if not hundreds of thousands. In a globalised economy the talent pool for CEO candidates is also global. For every potential CEO vacancy there are potentially thousands of suitably qualified applicants. The fact is the usual laws of supply and demand do not appear to apply when setting CEO pay.

If that £3.6m salary were just £600,000, namely at the 1980s level of 20 times the national average, would the performance of the business be so profoundly affected? Are there really no suitable candidates available to successfully run a business at the lower rate? The lack of diversity in Britain’s boardrooms may lead some to argue that they are not be recruiting from the widest possible talent pool. CEOs are predominantly white males like the boards that hire them.

A stronger argument is that these awards are a reward for success. CEO pay is heavily weighted by performance related incentives with three quarters of their pay on average consisting of long and short-term incentive payments like bonuses and share awards. These incentives are measured against a range of different performance targets, the vast majority of which are related to the financial success of the business and the share price, with less than 5% tied to employee welfare metrics and none based on employee pay.

Without that connection from the top to the bottom of the pay scale, the gap between them has widened to the extent that Britain has higher levels of income inequality than almost all our European neighbours - only Romania, Bulgaria, Latvia and Lithuania are worse.

In the coming years, the question for the Boards of all businesses will be what KPIs should they be using to incentivise their top executives? Up to now Boards and shareholders have been satisfied that CEO pay has been linked almost exclusively with financial performance and shareholder returns.

ESG funds were the biggest winners in 2020 seeing record levels of fund inflows. In years gone by a swing to ethical investing would often be derailed by a crisis but this time quite the opposite has happened. The big challenge for all listed companies is that shareholders are beginning to take a much broader view. The incorporation of ESG factors into their investment decision making process means that share price performance is becoming increasingly linked to an ethical business strategy.

The likelihood is that CEOs will increasingly be measured by criteria that benefit the environment and society at large. With the big institutional investors already making strides in that direction the future headlines on executive pay could be quite different.

If CEO pay is to keep rising as fast as it has for the last 40 years, they will undoubtedly need to bring a lot more people along for the ride by ensuring the rewards for their shareholders are matched by the rewards for their employees and society as a whole.