In BlackRock Investment Stewardship’s recent commentary, BIS observed that ESG-related metrics have increasingly been incorporated as performance measures in companies’ incentive plans. BIS cited a recent study from the GECN Group, which showed that 67% of companies in the study used ESG measures (but only 56% in the U.S. alone) and that COVID-19 had accelerated the incorporation of ESG factors into incentive plans. Importantly, however, BIS cautioned that, to the extent that companies included sustainability metrics in their incentive plans, they should “be material and aligned with a company’s long-term strategy. It is important that companies using sustainability performance metrics explain carefully the connection between what is being measured and rewarded alongside business goals and long-term performance. Failure to do so may leave companies vulnerable to reputational risks and undermine their sustainability efforts.” How do companies determine which sustainability objectives are most material for them, and how do they transform those goals into measures for purposes of incentive compensation? This new article from consultant Semler Brossy offers some advice. What is the overarching message? “Move carefully, but move.”
To set the stage, the authors point out that companies are under pressure from a variety of stakeholders to demonstrate their bona fides when it comes to sustainability, and it’s not surprising that these discussions would develop into questions about driving change and establishing accountability by making sustainability a compensation metric: “if progress in ESG has become so important, shouldn’t we measure and tie pay to it?” At this point, however, the authors believe that “investors are being prudent in their guidance on ESG. They want to see focus and progress, with measurement and board oversight, but they generally are not insisting on a compensation link.” Accordingly, the article concludes that “[c]ompanies themselves seem to be driving most adoption.” (That conclusion is consistent with the study from the GECN Group, which reported that companies “are following their own compass. They, themselves, are driving the quest for [ESG] value. They are not doing so only in response to external forces, such as investors, proxy advisors, environmental activists, unions, or regulators.”) In that light, the authors recommend a cautious and deliberate approach that begins with selection, application and testing of ESG measures before linking them to compensation:
“Linking ESG metrics to executive pay is a powerful way to drive change. But compensation is a sensitive instrument, so we urge caution. As with any other new metric, a board should craft it to reflect the company’s context and ESG priorities—and to complement the existing pay incentives. The board should also test a metric before including it in compensation, to reveal unintended consequences or the possibility of gaming. Rather than a single decision, new pay metrics involve a journey that begins with elevating certain issues internally and externally.”
As described by the authors, the journey undertaken by some early adopters began with “asking pointed questions, customizing ESG goals and metrics for their company, and measuring them. They began holding themselves accountable, and the board oversaw the process to make sure it happened. Eventually, where it made sense, they linked compensation to some of those metrics, along with other reward and recognition practices.”
Efforts to link ESG factors to executive comp have been a common thread in a number of shareholder proposals. In 2020, consultant Clermont Partners reported that, while in 2016, 23% of shareholder proposals on compensation were E&S-related, in 2020, that percentage grew to 55%. With regard to environmental matters, for example, proposals have requested that boards prepare reports assessing the feasibility of integrating sustainability metrics into executive incentives or disclose environmental targets used in incentive compensation. With regard to social issues, proposals have addressed matters such as the pay gap across gender, race or ethnicity. Shareholder support for these proposals has also climbed, averaging 23% approval in 2019, with some receiving as much as 36% support.
In determining whether to include ESG metrics, the authors advise that board buy-in is critical: the commitment must be to a serious, multi-year effort; while inclusion of ESG metrics will likely be viewed positively by the public, subsequent dilution of those metrics probably will not. And given the number of performance metrics that companies employ, it is important to prioritize and balance all of these metrics for optimal effect. The authors recommend that boards start with the most important ESG issues, taking into account where the impact will be most significant, where the gaps are greatest, what can be measured and whether the goal is risk mitigation or taking advantage of opportunity. For example, companies in certain industry sectors may look to particular industry-related goals, such as carbon emissions in energy or anti-slavery in apparel. More generally, some companies have focused on human capital objectives, such as diversity-and-inclusion goals. In that context, the authors remind us that incentive comp is not the only tool available to motivate change. For example, hiring and promotion, organizational culture and other rewards can also be used to drive sustainability.
In May 2019, comp consultant Mercer conducted a spot survey of 135 companies, looking at the prevalence and types of ESG metrics used in incentive compensation plans, including metrics related to the environment, employee engagement and culture, and diversity and inclusion. The survey found that 30% of respondents used ESG metrics in their incentive plans and 21% were considering using them. ESG metrics were used by 28% of respondents in their short-term incentive plans, most commonly environmental metrics (66%), followed by social metrics (employee engagement and culture) (37%), governance (diversity/inclusion) (18%) and other (most commonly employee health and safety) (13%). ESG metrics were used in only 9% of long-term incentive plans, again most commonly environmental metrics (67%) followed by social (58%) and 17% for governance. In the energy and metals and mining sectors, 96% used an environmental metric, compared to 22% for other sectors, while 76% of other sectors used a social metric, compared to only 22% for energy and mining. (See this PubCo post.)
In the authors’ view, an ESG measure should be considered for inclusion as a comp metric if management and the board:
- “Identify the issue as a strategic priority
- Understand that elevating one ESG issue may send unintended signals about other issues
- Have clarity on an effective strategy and the outcomes that define success
- Are committed to maintaining the metric for an extended time period, with durable goals
- Are willing to set real, stretch goals for driving change, not easily-achieved goals for publicity
- Understand that goals may be missed and [are] willing to disclose why”
Initially, the authors recommend a “scorecard” approach that combines the company’s ESG priorities and includes some qualitative measures, with results determined in the board’s discretion, accounting for about 20% of total comp. As the board gradually becomes more familiar with these incentives, “they can replace the scorecard with hard metrics measuring annual progress towards long-term goals. These goals will likely extend to the long-term incentive (LTI) plan as well since most require multi-year effort. Even if you start with qualitative assessments, it’s important to use objective metrics to inform the assessments. Those hard numbers help make the evaluation meaningful and communicate to the organization what successful progress looks like.”
In the authors’ study of the use of ESG incentives at Fortune 200 companies last year, 62% reported the use of an ESG incentive for senior executives, and only 23% of those used a specific metric, with the remainder including ESG as part of individual discretionary evaluations (45%) or as part of a scorecard (32%). Most companies included ESG in their annual incentives (which the authors recommend initially), with fewer than 10% including them in long-term comp. Gradually, these measures can be introduced into long-term comp “where ESG measurement naturally belongs.” As always, companies should be sure to consider the risks, including the risk of missing a target that affects comp and requires disclosure as well as the risk that the core business could be sacrificed to some extent to achieve an ESG goal.
The GECN Group identifies the following as best practices for incorporating sustainability in incentive comp:
- “Select one to three goals that are consistent with the company’s purpose, reflect business priorities and culture, and resonate with plan participants; in other words, don’t overcomplicate or dilute the focus of the plan
- Weight measures in a meaningful way. (Most companies currently weight such measures at approximately 20%)
- Set clear goals for each measure
- Determine whether to incorporate measures in short- and/ or long-term incentives, considering the time horizon of the journey as well as the challenge in setting goals
- Craft the narrative for communication materials to investors, employees, and other constituencies to test the consistency and credibility of the message before decisions are made”