How do we incorporate ESG factors into incentive compensation?

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.”

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 the authors’ view, an ESG measure should be considered for inclusion as a comp metric if management and the board:

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.