- It should make sense to the business. While ESG metrics are important, a fundamentally sound executive incentive plan should only reflect metrics that are part of, or directly and materially support, the company’s business strategy.
- Go beyond optics. To make effective progress beyond noting an issue’s basic importance, the board must establish a baseline, determine what may be possible over what timeframe, and ensure that the executives who are charged with making this progress have clear line of sight to a successful outcome.
- Connect the dots. Whichever path your company takes, if you can clearly connect the dots between ESG concepts and business and leadership strategy, you will be progressing in the right direction.
Given the vital importance of environmental, social and governance (ESG) issues, how can your company move the needle on the ESG priorities that matter most to it as an organization?
With steady pressure from a variety of stakeholders — investors, employees and customers — to make significant progress, particularly in areas of diversity, equity and inclusion (DEI) and climate change, what should your board be doing?
In the push to facilitate ESG change, a general expectation has arisen that a key way to do so is to include ESG performance measures in executive incentive plans. According to proxy filings as of June 30, 2022 from Main Data Group, the prevalence of ESG metrics of any type in incentive plans has risen to majority practice, with 57% of S&P 500 companies including these metrics in either the short- or long-term plan as of 2021.
This figure is up from 43% in 2020 and 36% in 2019. Further, while the use of ESG metrics in long-term incentive plans is quite low, it has doubled in prevalence from 3% in 2020 to 6% in 2021.
As companies respond to these broader stakeholder views and demands, we will likely see more companies integrate ESG metrics into their incentive plans, even if they are not core to that company’s business strategy. And while ESG metrics are important in other ways and for myriad reasons, a fundamentally sound executive incentive plan should only reflect metrics that are part of, or directly and materially support the company’s business strategy.
The inclusion of one or more ESG metrics in executive incentive plans can be viewed as an effective way to signal how important these issues are to an organization, but optics should not be the goal. To make effective progress beyond noting an issue’s basic importance, the board must establish a baseline, determine what may be possible over what timeframe, and ensure that the executives who are charged with making this progress have clear line of sight to a successful outcome.
ESG goals should be discussed within the context of annual and long-term goal setting to ensure your company doesn’t end up with competing priorities, ineffective incentive plans or unintended consequences. Your compensation committee’s discussions about ESG must integrate the desire to make progress with the extremely specific conversation about goals and metrics.
Let’s consider a short-term incentive plan, where ESG metrics are currently more common. Many companies use a mix of financial and non-financial metrics in their annual short-term plans (e.g., 80% weight on financial performance and 20% weight on non-financial performance). For companies that already include non-financial metrics in their annual incentive plan, replacing a non-financial metric with an ESG metric is relatively easy.
However, incorporating an ESG metric is far more difficult for companies with annual incentive plans that only measure financial performance. Those companies will have to consider the degree to which ESG, or other non-financial priorities should “dilute” financial priorities.
And this is where it can get difficult pretty quickly, even if many of these companies are already considering ESG in their compensation deliberations outside the annual plan. Salary decisions or long-term incentive grant values could be influenced, and companies may not be adequately explaining this process to shareholders. This would be a missed opportunity to help clarify what is being done in service to ESG and why, as well as what is not being done and why.
Ultimately, investors expect progress. However, they will also push back when ESG metrics are not clear and/or too simple to achieve. Being very transparent about how your organization is pursuing its ESG goals and how it will be held accountable is essential. That can play out within incentive plans or through otherwise stated company objectives that have baselines, goals and timeframes outside of compensation, such as in standards-based corporate social responsibility reports.
Whichever path your company takes, if you can clearly connect the dots between ESG concepts and business and leadership strategy, you will be progressing in the right direction.