There’s been a lot of attention lately to the use of ESG metrics as incentives in executive compensation, perhaps because the concept of ESG has become something of a lightning rod in the political landscape—particularly given the fallout from recent court decisions on diversity as well as escalating activity by anti-ESG groups. As discussed below, consultants have found that the use of ESG metrics seems to have levelled out, as some institutional investors have begun to view them cautiously and some academics studies have questioned their rigor and even their benefit. Companies employing ESG metrics as part of their comp plans may want to consider some of the issues raised by these studies, such as level of challenge and transparency, in designing their ESG metrics.
Pervasiveness of ESG metrics. In this report, 2024 ESG + Incentives, consultant Semler Brossy looked at the pervasiveness of ESG metrics in executive incentive plans among companies in the S&P 500. According to the report, the prevalence of ESG metrics “rapidly increased from 57% in FY2020 to 70% in FY2021. However, the adoption of ESG metrics in incentives has since plateaued, with prevalence changing from 72% in FY2022 to 74% in FY2023” (proxies filed from May 2023 to April 2024). Semler Brossy suggests that companies may be “shifting their focus from adoption to refinement of ESG metrics, with prevalence in annual incentive plans (AIPs) and long-term incentive plans (LTIPs) remaining relatively consistent since FY2021 as companies continue to prioritize the use of short-term ESG goals. However, companies continue to adjust existing plans away from discretionary incentives and towards weighted metrics. In FY2023, 87% of companies with ESG metrics in incentives reported using weighted metrics, up from 72% in FY2021.”
The report indicates that metrics related to human capital management are used most often, “as stakeholder focus on talent management remains strong, and Diversity and Inclusion (D&I) remains the most common metric. Environmental metrics show the largest year-to-year increase and will likely continue to ramp up with the finalization of the SEC’s new climate risk disclosure rules.”
More specifically, Semler Brossy reports that, for FY2023:
- “D&I continues to be the most prevalent single metric used at 54% of S&P 500 companies—but adoption of this metric has slowed. Other HCM metrics oriented around talent and retention show larger year-over-year increases in adoption as companies continue to focus on HCM more holistically rather than just on D&I
- 42% of S&P 500 companies use environmental metrics in incentives in FY2023, up from 35% of companies in FY2022. We predict this upward trend to continue as shareholder and SEC focus on environmental disclosures continues to persist
- Companies continue to shift towards formal, weighted structures for including ESG metrics in incentives vs. discretionary structures, as weighted structures are used at 87% of companies that include ESG in incentives in FY2023, up from 81% in 2022
- 34% of companies with ESG metrics disclose some detail on performance goals in FY2023, up from 29% in FY2022. We do not anticipate significant movement towards full disclosure as companies seek to manage social and legal risk, particularly amidst recent court rulings on affirmative action and additional political and legal scrutiny towards ESG and D&I”
Semler Brossy observed a notable decrease in the use of D&I metrics—following “years of historically high adoption rates”—among later filers in FY23, which they suggest “may be driven in part by the June 2023 Supreme Court ruling on affirmative action.” With regard to environmental metrics, the report observed that the highest increase year over year was in carbon footprint, reaching prevalence of 30% in FY2023, up from 25% in FY2022. The report noted that, for the “vast majority“ of companies, disclosure regarding specific metric goals was limited, and Semler Brossy indicated that they did “not anticipate ESG metric goal disclosure to increase as companies seek to manage social and legal risk through limiting disclosure.”
Academic studies. In academia, some studies have raised questions about the rigor and effectiveness of ESG metrics in executive comp. For example, in this paper from the Rock Center for Corporate Governance at Stanford, ESG Overperformance? Assessing the Use of ESG Targets in Executive Compensation Plans, the authors examined the practice of linking executive compensation to ESG performance among companies in the S&P 500 during the 2023 proxy season, comparing executives’ success rates in meeting financial targets versus ESG targets in their comp plans. And guess what? Executives seemed to be really good at achieving the ESG targets. The financial targets? Less so. The authors considered whether this “ESG overperformance” was “associated with exceptional ESG outcomes or, instead, [was] related to governance deficiencies.”
First, the authors determined that, at least initially, ESG metrics have been incorporated, “overwhelmingly,” into companies’ short-term annual incentive (AIA) plans rather than to the “more substantial” long-term equity incentive (LTI) plans. But does a short-term bonus plan actually provide real incentives in this context? The authors observed that, “because the AIA plan tends to be a much smaller component of annual compensation than the LTI plan and because the ESG weights within an AIA average just 15%, the overall impact on a CEO’s expected annual compensation is typically 3% or less.” So the financial impact of achieving a short-term ESG target in an AIA plan was relatively modest, compared to achieving short- and long-term financial targets. To the authors, that effect suggested “reasons for skepticism as to whether this structure will meaningfully influence management behavior.” While some studies have shown valid reasons for use of the AIA plan for non-financial objectives, one explanation offered by the authors was that the intent was “to communicate strategic priorities to shareholders and other stakeholders” in a way that signals commitment but “avoids charges of ‘window dressing’ or ‘greenwashing.’” But that “signal can also be reversed if a company appears to be too successful in pursuing them, such as by meeting or exceeding all of its stated ESG objectives. Or, consistent with our findings regarding say-on-pay votes, the signal might be muted for a company that has deficiencies in setting executive compensation.”
The effect of being too successful in meeting ESG metrics provided the second theme of the paper— just how difficult was it to achieve the targets? Industry guidance cited in the paper suggested that “performance incentives for AIAs should be set at levels that are met 60% of the time.” In looking at goal-setting, the authors focused on two issues—transparency and level of difficulty:
“In an ideal world, the criteria for establishing a performance goal should be that it is both obtainable and challenging to achieve. Relative to financial performance measures, however, satisfying these criteria for ESG-related measures is likely to be more challenging for at least two reasons. The first relates to transparency. Whereas financial metrics used in executive compensation plans are typically tied to publicly available accounting or market metrics, ESG metrics are more likely to focus on less transparent operating measures, such as those relating to carbon emissions, workplace conditions, or hiring and promotion practices. This lack of transparency impairs the ability to assess the difficulty of an ESG performance target relative to past performance and to verify that the target has in fact been achieved. The second reason relates to incentives. Given the direct relationship between management compensation and achieving performance targets, it should hardly be surprising if managers were to use less transparent targets to set targets that are easy to achieve. In the context of ESG targets, such incentives may also be amplified to the extent companies adopt ESG performance measures to satisfy investors who expect a company to outperform on its ESG goals.”
The authors found that ESG targets were achieved “at a rate that is notably higher than the rate at which firms satisfy their financial performance metrics.” Among the 315 firms incorporating ESG metrics into their AIA plans, 247 provided disclosures regarding whether the identified targets were achieved. Of the 247 companies, over 76% reported “entirely meeting or exceeding all identified ESG performance measures,” but only 2.4% reported a total miss. Not the case for financial performance metrics: of 469 companies that provided disclosures, only 44% reported that they “entirely met or exceeded all financial performance metrics, while 22.8%…reported entirely missing the identified financial metrics.”
Was this high rate of achievement for ESG metrics the result of excellent ESG performance—actual achievement of ambitious goals—or the result of inadequate corporate governance oversight—managers “exploit[ing] less transparent ESG metrics to set them in ways that are likely to be achieved either to enhance their compensation or to appease institutional investors and other stakeholders who demand greater ESG accountability”? To assess these two theories, the authors first looked at whether companies with executives that met or exceeded their ESG goals showed an increase in their ESG ratings. Although adoption of ESG performance incentives was associated with higher ESG scores in some cases—supporting “the idea that a serious commitment to ESG underlies the adoption of these compensation plans”—the authors found no such improvement (of any statistical significance) arising out of meeting the goals. How about an increase in the level of support for say on pay? In this instance, they found a negative relationship that was statistically significant: companies “that met or exceeded all of their ESG performance targets were significantly more likely to receive a greater percentage of ‘against’ votes in the say-on-pay vote during the 2023 proxy season. Moreover, no such association exists with regard to firms that met or exceeded all of their financial targets set forth in their AIA plans.” The authors also found that companies that missed one or more ESG targets tended to have “more transparent quantitative targets based on metrics that are either formally regulated or follow an industry standard,” such as an OSHA worker safety measure. To the authors, this evidence suggested that ESG metrics may be set at levels that allow executives to be rewarded even without strong ESG performance.
The authors observed that their “findings are broadly consistent with the conclusion that setting truly challenging targets can benefit from greater transparency and standardization.” In addition, the authors suggest,
“[i]nstitutional investor demand for increased quantification and transparency of the setting and assessment of ESG performance is consistent with these implications, and the desire for firms to move away from qualitative ESG metrics suggests that institutional investors are skeptical of these approaches. This skepticism may be due to our observation that qualitative targets appear to be easier to meet than quantitative ones. There may also be concerns that instead of vigorously policing the performance of executives, boards may be captured by those executives in a way that leads them to ‘move the goalposts’ when executive compensation plans ask them to make assessments that impacts the compensation of those executives. That sentiment would help account for the higher ‘against’ votes during say-on-pay elections for firms where executives have met or exceeded all of their ESG performance goals.”
How to achieve greater transparency? Not necessarily an easy task. Although the requirements for comp disclosures have expanded substantially over time, the authors point out that “there remains no explicit requirement to disclose whether and how performance targets were met. Nor is there a prevailing standard for how firms should disclose this information to the extent they choose to volunteer it. The curious analyst is thus left to a costly and potentially error-prone scavenger hunt through a firm’s sprawling proxy statement. As a policy matter, this challenge suggests the value of amending Item 402 of Regulation S-K to include a standard method for disclosing whether and how performance targets have been met across both the AIA and LTI plans.”
Finally, in this post, Are ESG Metrics in Executive Compensation All Hat and No Cattle?, published on the Columbia Law School Blue Sky Blog, from several academics from—no, not Texas—Germany, the authors consider whether ESG metrics used in executive comp in Europe are “effective in generating incentives for executives to improve ESG performance, or are they merely symbolic, allowing companies to appear socially responsible without driving real change?” Given that many tend to perceive Europe as more advanced than the U.S. when it comes to ESG, it’s interesting to consider the results of this European study by comparison. They turned out to be surprisingly similar.
The authors examined data for 674 executives from 73 large, listed companies from 2013 to 2020 to see whether the structure of ESG-linked compensation can influence executive behavior. The data included “both (1) the ex-ante design of performance-linked pay contracts—such as the number and weight of various performance metrics—and (2) ex post data on realized performance and actual payout.”
The authors showed that 60% of executives in Europe with short-term incentive plans had at least one ESG metric in those plans. But, similar to the finding in the Stanford study, the financial weight of those ESG metrics was “minimal. On average, ESG metrics account for less than 5 percent of total performance-linked pay. This low weighting raises doubts about whether these metrics give executives material incentives to strive for desirable ESG outcomes.”
The authors distinguished between metrics that they termed “binding” and “discretionary.” Binding metrics have a “predetermined weight at the beginning of the fiscal year, providing clear and reliable goals for executives” and “strong incentives for executives to focus on specific ESG outcomes.” With discretionary metrics, boards and comp committees have more flexibility to “adjust the weight or significance of these metrics at the end of the fiscal year (i.e., ex post) at their discretion, which introduces uncertainty about how much an executive’s ESG performance will affect their pay. As a result, executives may feel less pressure to prioritize these goals throughout the year, knowing that the actual payout tied to ESG performance can be adjusted later.” The authors found that “discretionary ESG metrics are particularly common in industries like financial services, where ESG factors may not directly affect business outcomes in the same way they do in industries with greater impacts on the environment. In contrast, industries with large environmental footprints, such as energy and utilities, tend to use more binding ESG metrics with greater weight, aligning executive incentives more closely with sustainable outcomes.”
The authors found that, notwithstanding the increased prevalence of ESG metrics, they had relatively little impact on comp. Rather, financial and other non-ESG metrics were paramount in the calculation of comp, with binding non-ESG, traditional business metrics accounting for 87% of pay risk (as measured by variation in executives’ short-term incentive pay). Even in Europe, “binding ESG metrics account for only 1 percent of the total variation in pay.” The authors concluded that this “tiny contribution suggests that ESG performance metrics are largely symbolic. Even if we focus only on the subset of executives with at least one ESG metric in their compensation contract, these metrics still contribute far less to overall pay variability than their non-ESG counterparts.” In addition, the authors found that comp that depends on ESG metrics was less volatile, leading the authors to conclude that the “lack of variability may indicate that ESG goals are less ambitious than traditional financial targets, further diminishing their potential to drive meaningful change.”
The authors here also experienced some skepticism about the purpose of the ESG metrics—and the term “greenwashing” comes back into the picture. Are ESG metrics potentially “more about optics than actual change, especially in industries and companies under heavy public scrutiny. Large companies, particularly those in the financial sector, often include a multitude of mostly discretionary ESG metrics in their compensation plans but fail to assign them meaningful weights. This suggests that for many firms, the inclusion of ESG metrics may be a form of ‘greenwashing’ — a way to signal commitment to sustainability without creating real incentives for substantive improvements.” But where ESG is “closely tied to financial outcomes, such as energy, utilities, and manufacturing,” companies tended “to use binding ESG metrics with more substantial weights. In these industries, improving ESG performance is often linked to reducing costs (e.g., through energy efficiency) or avoiding regulatory penalties (e.g., emissions targets), giving executives stronger financial reasons to prioritize sustainability goals.” Surprisingly, the authors also found support for the greenwashing theory from their finding that, relative to their CEOS, positions such as chief human resource officer were not more likely to have comp dependent on workforce-related metrics nor were chief technology officers more likely to have comp tied to environmental metrics.
The authors concluded that, while the use of ESG metrics may be increasingly common, the actual influence of ESG metrics on executive incentives “remains limited. For ESG metrics to drive real corporate change, they must move from being a side note in compensation plans to playing a central role in how executives are evaluated and rewarded. Without this shift, ESG-linked pay risks remaining all hat and no cattle—offering the appearance of progress without delivering the incentives necessary to achieve it.” Perhaps in the future, they suggest, “regulatory and investor or proxy adviser pressure may play a critical role in pushing companies to design more robust ESG-linked compensation schemes.”
