Editor’s Note: This is the third of a six-part, monthly series in Workspan Daily produced by Korn Ferry for the benefit of our readers and to encourage further discourse on topics vital to compensation professionals. Each article will address Korn Ferry’s “Top 10 Questions for Compensation Committees in 2021,” a publication produced at the beginning of the year.
ESG is everywhere. In the past 12 months, environmental, social and governance (ESG) topics have popped up in more and more proxy statements, compensation programs, and investor presentations. Even the Securities and Exchange Commission (SEC) is taking notice; they may propose new rules for the disclosure of ESG information. ESG seems ubiquitous, but some of the more pointed discussions on the matter are happening in compensation committees right now.
With our own clients, we see that ESG is a topic at nearly every compensation committee meeting. Companies that are not yet using ESG in pay programs want to (or wonder if they should), and those already with ESG want to update and refine. In either case, committees are actively working on it.
There is, however, a common stumbling block in these committee discussions. The selection of an ESG metric is a challenging topic and it can be difficult to know where to begin. Does a company follow the lead of its peers? Are systems in place to measure progress against goals? Will a particular ESG metric be important five to 10 years from now? These issues breed discomfort, but metric selection is of critical importance, as it is one of the most external signals of a company’s commitment to ESG.
In most conversations with clients, the first ESG question a director often asks is, “What are our peers doing?” This is not surprising. Committee members want to know the terrain before setting out. However, this external view in conjunction with the broader cultural focus on diversity, equity and inclusion (DEI) has strongly influenced metric selection.
In the United States, Korn Ferry research shows that metrics with a lean toward DEI have gained significant traction in incentive programs during the last few years. While the promotion of diversity and inclusion through corporate action is unquestionably a social good, companies should not be treating these metrics like an add-on. Rather, any incorporated metric, whether it be DEI or something else, should be used to propel corporate strategy.
Instead of looking outward, companies should begin their ESG analysis by looking within. With any metric, particularly non-financial metrics, adoption should be done only after careful consideration of the long-term benefit to corporate strategy. While peer information is an important data point, corporations should not lose sight of their own strategies.
Understanding which ESG metric fits into the corporate strategy begins with an examination of two questions. First, a committee should ask themselves what corporate actions would benefit internal and/or external stakeholders. Second, does the corporation expect to receive any long-term benefit in return? There may be multiple answers to these questions, but it is important that the committee be able to eventually articulate a clear external and internal benefit after adding the extra heft of an executive compensation metric.
While metric selection is particularly vexing at times, many questions still present themselves: short or long term, quantitative or qualitative, full disclosure or not, part of a scorecard or standalone? Many of these logistical questions can be answered by acknowledging where a company is on its ESG journey. For example, if a company is just starting out with ESG, perhaps a qualitative metric in a scorecard is the most appropriate.
We believe companies have aligned themselves with the following four general “strategies” when deliberating over ESG metrics:
- Basic: The company has taken the first steps to understand the utility of an ESG metric. The metric is typically qualitative, in the annual incentive program, and not thoroughly disclosed to the public.
- Progressing: There is a recognition that ESG is an expectation from the public. There are measuring systems in place and the reporting mechanisms are trusted. ESG metrics are still typically in the annual incentive program, measured quantitatively and may be used as a modifier.
- Advanced: There is a recognition that ESG furthers corporate strategy. Metrics are quantitative and typically in the long-term incentive program, but they may be in the annual incentive program as well.
- Leading Edge: ESG is foundational to the company’s purpose, and ESG success may be largely measured by financial outcomes. The company’s strategy is inseparable from ESG outcomes. Incentive programs may or may not include long-term, non-financial ESG metrics. For example, Tesla is often a company we cite to demonstrate this “Leading Edge” strategy.
It is important to note that there is no expectation of advancing through these strategies. Rather, each is standalone and describes typical behaviors of companies wrestling with how to incorporate ESG into their program. For example, companies with a “Progression” strategy may not need to or want to pursue an “Advanced” one.
We are in the midst of the biggest change to executive compensation in more than 20 years. The opportunity this change offers begins with the metric a company chooses. This signaling carries a powerful message to the outside world and should be considered in the context of corporate strategy and values. Given this, we believe ESG is going be a big differentiator for many companies.
And that is why we think ESG is here to stay. It is everywhere for a reason.
About the Authors
Kurt Groeninger is a senior principal, executive pay and governance, at Korn Ferry.
Todd McGovern is the senior client partner, executive pay and governance at Korn Ferry.