According to this report by The Conference Board, in collaboration with Semler Brossy and ESGAUGE, the vast majority (73% in 2021) of companies in the S&P 500 are "now tying executive compensation to some form of ESG performance." To be sure, some companies have long tied executive comp to particular ESG measures, such as diversity, customer satisfaction, employee and product safety and anticorruption programs. That has now expanded to a wider use of various ESG metrics, which the report attributes to a new intensified focus on ESG "driven by investors, employees, consumers, business partners, ESG rating agencies, and regulators," together with "the shift to a multi-stakeholder form of capitalism." The expanded use of ESG measures in executive compensation offers the obvious benefit of incentivizing and rewarding behaviors needed to achieve goals that so many stakeholders view as critical. At the same time, however, inclusion creates a number of risks and challenges. Not all large institutional holders, the report observes, view ESG comp measures favorably, and some are perhaps a bit skeptical-is the company just virtue signaling? Are the targets sufficiently rigorous to avoid simply "guaranteeing" bonuses for executives? Do ESG-based pay plans provide investors with "sufficient transparency and specificity"? Is performance against the targets measurable? Can ESG "actually drive financial performance for companies and investors alike"?

The report, based on roundtable discussions held at the end of the 2022 proxy season, identifies four different approaches:

  • "Stand-alone ESG metric: ESG is incorporated through specific (often quantitative) metrics;
  • Business strategy scorecard: ESG goals are included and assessed as part of a broader scorecard of ESG or nonfinancial business priorities;
  • Individual performance assessment: ESG is considered as part of an executive's individual performance rating, which is often a discretionary assessment by the company's compensation committee;
  • Modifier: ESG can be used to adjust the financial performance rating, the overall rating, or the payout under a plan."

Most often, ESG goals are integrated in individual performance assessments (49%) and business strategy scorecards (48%), but companies often later change or combine their approaches. For example, the report indicates that some companies are moving from using ESG measures to qualitatively assess individual performance to, often quantitatively, "incorporating ESG performance as a modifier of the company's financial performance rating. This has the benefit of mirroring how some investors view ESG." In some cases, the report indicates, employees other than executives are finding that their comp is subject to ESG measures, "reflecting that achieving ESG goals requires the collective effort of the employees."

Goals related to human capital management were included by 64% of companies in the S&P 500, the most frequently used measure, with the use of DEI metrics increasing from 35% in 2020 to 51% in 2021. As a general category, goals related to environmental performance increased the most in frequency, from 16% in 2020 to 25% in 2021, with the inclusion of carbon footprint and emission reduction metrics growing from 10% in 2020 to 19% in 2021. Among governance goals, the use of succession planning as a measure increased, but the use of customer satisfaction as a social measure decreased. Most often, these measures were included in executives' annual incentive plans, even though many ESG goals are long-term in nature. ESG performance goals were commonly found in more heavily scrutinized industry sectors, such as the utilities sector (100%) and the energy sector (90%).

Why are companies adopting ESG measures as part of compensation? The primary reasons ascribed are "1) signaling that ESG is a priority, 2) responding to (perceived) investor expectations, and 3) achieving previously made ESG commitments." However, the report observes, some large institutional investors have been "agnostic about ESG-based pay due to the lack of standardization and transparency," particularly in the absence of "a strong business case for doing so." The report cites ISS's 2021 Global Benchmark Policy Survey to demonstrate that 52% of investors believe ESG goals should be part of executive pay only "if they are specific and measurable," i.e., not simply part of individual qualitative assessments. What's more, many investors "may view companies' efforts with some skepticism: if a board decides to link part of executives' bonuses to qualitative ESG performance, investors may wonder whether the targets are rigorous enough, or whether that portion of the bonus is more or less guaranteed because the goals are fairly easy to achieve and/or executives are merely paid for something they already are (or should be) doing." In addition, some ESG goals are too long term for annual incentives and, depending on the industry, might be redundant, i.e, so integral to core operations that the company should already be doing it. In addition, some investors are "wary of crowding out other important financial or strategic goals."

The report advises that, before adding ESG measures to executive pay plans, companies should assess their current progress on ESG and engage with their investors to "better understand their expectations regarding ESG generally" as well as their views on ESG metrics as part of incentive comp: "there are other less costly and disruptive ways of signaling ESG is a priority," the report advises, "including building ESG factors into professional development, succession, and promotion practices. Companies can also convey or achieve their commitment to ESG by enhancing disclosure on ESG performance."

According to the report, participants in the roundtable also identified some of their reservations about incorporating ESG measures into executive comp, including "1) the difficulty in defining specific goals, 2) concern about the ability to measure and report actual performance against ESG goals, 3) skepticism about whether such goals are actually effective in driving performance, and 4) the fact that ESG performance is already covered by existing performance measures. However, only a minority of roundtable attendees indicated their company hasn't included (nor plans to include) ESG goals in compensation programs."

SideBar

This paper from the Harvard Law School Program on Corporate Governance, The Perils and Questionable Promise of ESG-Based Compensation, recognizes that the use of ESG metrics in executive comp is a growing trend, but contends that the practice is crucially flawed, one that "has at best a questionable promise and poses significant perils." The authors identify two key structural problems. First, they contend, common ESG metrics focus on the "welfare of a limited subset of stakeholders." As a result, "by incentivizing executives to improve performance on narrow and very partial measures, the current practice disincentivizes corporate leaders from focusing on many other important aspects of stakeholder welfare and fails to improve overall incentives," and may well "ultimately hurt, not serve, aggregate stakeholder welfare."

Second, they argue that "the push for ESG metrics overlooks and exacerbates the agency problem of executive pay." In their view, establishing effective incentives would require effective scrutiny by outsiders. To assess the "outside reviewability" of the ESG metrics used in their sample, the authors evaluated the presence of three characteristics that they viewed as requisite : "(i) whether the company discloses clear and objective ESG goals; (ii) whether the company discloses the actual outcome of the performance with respect to the ESG goals; and (iii) whether the information disclosed to the public provides sufficient meaningful context." The authors found that company disclosures regarding performance goals were too vague and non-specific and failed to disclose the outcomes or sufficient "contextual information to enable an outside observer to assess the meaningfulness of the performance." As a result, their analysis showed, in most cases, it would be "difficult if not impossible for outside observers to assess whether this use provides valuable incentives or rather merely lines CEO's pockets with performance-insensitive pay." The authors "warn that the use of ESG metrics threatens to reverse the progress achieved in the past few decades in making executive pay more transparent, more sensitive to actual performance, and more open to outside oversight and scrutiny." They concluded that "current practices regarding the use of ESG metrics, and the trend to increase their use, represent a serious setback in the attempt to address and mitigate the agency problems of executive compensation."

How should companies approach incorporation of ESG measures into incentive pay plans? The key seems to be taking enough time to carefully evaluate "whether there really is a business case for ESG" and if so, to assess the incremental costs and benefits of adopting ESG performance goals, as well as the company's readiness to move forward. The report advises that the company's ESG goals should be "1) clearly defined, 2) aligned with its business strategy, and 3) reflective of its key ESG risks and opportunities."

How should the company determine its ESG goals? The report recommends that companies "focus on ESG through the lens of their strategy, with awareness of stakeholder views. Companies that integrate ESG into business strategy and planning processes don't just view ESG as a source of risk but capitalize on business opportunities and innovation associated with emerging environmental and social issues. Therefore, instead of viewing ESG merely as a matter of governance, risk management, and/or compliance, companies should assess where they can have the biggest impact-as this is where their biggest opportunities lie."

The report advises that companies "consider using ESG operating goals for one to two years before including them in compensation. That allows time to see if those goals are truly relevant for the business, develop strong management and employee buy-in, and address any kinks in measurement methodology and reporting. It is especially important for companies to take time to validate and socialize ESG goals before rolling them out as part of compensation plans for a broader management or employee base." The report also notes that boards may take six or eight months just to make a decision about using ESG metrics as part of pay. Global companies will also want to consider how their ESG goals might vary in different countries.

SideBar

You might recall that at the recent PLI Securities Regulation Institute, panelists suggested that companies approach ESG beginning with an ESG "materiality assessment," a process through which a company determines the aspects of ESG that are most critical to its business and stakeholders and which metrics will best measure the company's performance. Board input here can be important. How do these key elements align with the company's enterprise risk management framework and its related board discussions? In these assessments, the panel noted, the issue of diversity, equity and inclusion often emerges as a top factor, one which is also often tied to executive comp. (See this PubCo post.)

Another time-consuming component of the process is developing reliable data to measure performance. To that end, the report recommends that companies create a cross-functional team with representatives from "compensation, finance, sustainability and others who are involved in the company's strategy and have access to the data that are (or might be) needed to measure ESG performance."

The report also advises that companies "consider upfront how to address changes in ESG performance measures," including what types of adjustments that "will be permissible (e.g., M&A or pandemic-related) and disclose how the board may exercise its discretion in those instances.. Companies that do need to make an adjustment should critically assess why the original goal isn't working and be sure to communicate with transparency, integrity, and humility." In any event, the company must ensure that compensation is still at risk and is performance-based, "ideally reward[ing] relatively strong performance."

Linking ESG to executive comp demands a rigorous and tailored approach, the reports cautions; merely following the trend of peers will not suffice. According to the report, companies will need to take a number of actions, including

"identifying goals that are material, durable, and auditable, 2) assessing whether what the firm's peers are doing in this area is instructive, 3) deciding whether to make performance measures absolute or relative to the market, and quantitative or qualitative, 4) determining the scope of those whose compensation is affected by ESG goals, 5) considering timing and assessing whether the ESG goal is appropriate for the annual or long-term incentive plan, 6) ensuring the type of metric reflects the firm's corporate culture, 7) carefully considering the reaction of various stakeholder groups, and 8) reevaluating goals periodically to ensure that the ESG measures are still relevant and effective."

The report recommends that companies develop an explanatory narrative for including ESG goals in executive comp-why the move makes "business sense" and is expected to "move the needle" on company performance and impact. Employees will need to understand the reasons behind the changes to their comp. Investors, the report says, will want to understand the rationale for the change, whether it will help achieve the firm's financial, operating and ESG goals and whether the goals are sufficiently challenging. Will the new ESG metrics, like other incentives, "influence and reward the behaviors needed to successfully execute the company's strategy"? Participants in the roundtable indicated that they generally viewed "the inclusion of ESG performance goals in executive compensation programs as part of a broader effort to achieve their ESG initiatives." "Ideally," the report suggests, "companies should incorporate ESG goals because they are linked to the company's strategy and can drive meaningful change."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.