Author: James Reda
ESG topics continue to dominate the executive incentive conversation. As investors and other key stakeholders made their ESG expectations known, many companies have started to incorporate ESG-related metrics into their short- and long-term incentive programs. Others that have not yet linked executive compensation to ESG have formally stated they're preparing to do so.
While as of today there's no proven causal link between ESG and shareholder value, society is demanding change. These demands manifest in substantial pressure from regulatory entities — the Securities and Exchange Commission, the Environmental Protection Agency, the Department of Labor — and such investors as investment management companies, pension funds, unions and others.
Incorporating ESG performance into the executive incentive programs is a good way for a company's board to hold management accountable for progress against the ESG strategy, as well as to signal the metrics' importance to stakeholders.
Current trends in incorporating ESG metrics into executive incentive programs
With the current focus on ESG, companies that haven't yet adopted ESG metrics into executive incentive programs must consider these two questions:
- Is now the time to use ESG in incentive programs?
- If so, where to begin?
Incorporating ESG into executive incentive programs is a multi-faceted process with a number of design parameters to consider. In addition, ESG is an evolving process — companies are not necessarily tied to their initial metric selections and plan designs. While there's no one-size-fits-all-approach, it's critical to find the right balance for today that leaves room for change and growth over time. Companies that prioritize an initial metric may expand their focus to include a handful of metrics in future years.
Gallagher's research1 indicates that approximately half of S&P 500 companies have started incorporating ESG metrics into executive incentive programs. Of these companies, the majority have focused on linking ESG to short-term incentive pay.
While ESG metrics remain much more prevalent in short-term incentive programs, some companies with particularly well-developed priorities may include ESG in long-term planning, since performance improvement on most ESG metrics requires a multi-year journey.
Few companies include one or two formulaic, quantifiable ESG measures linked to a stand-alone weighting (e.g., 10% to 20%) in the short-term incentive plan. Most companies employ a scorecard approach that combines the company's ESG priorities and includes some qualitative measures, with results determined at the board's discretion.
While some companies employ a modifier approach that uses performance against ESG goals to increase or decrease the overall award payout, the prevailing practice uses the segment approach. Under this model, companies dedicate a segment of the incentive primarily to achieve a set of individual or strategic goals, including ESG performance goals.
Choosing ESG goals is critical, and their "materiality" or level of importance to the company is key
Ideally, investors want companies to maintain quantifiable and measurable ESG targets and to disclose why they believe the chosen goals are the most material. Leaders find measures related to safety and/or diversity, equity and inclusion (DEI) typically easiest to quantify. These measures have remained prevalent ESG metrics in incentive plans over the past few years.
A deeper look into measure selection affirms that social metrics related to diversity continue to be the most common, followed by safety measures. Environmental measures are catching up quickly, as climate-related measures represent the top choice. Examples include such climate stewardship activities as reducing greenhouse gas emissions, prioritizing green energy and supporting sustainability initiatives. While few companies focus on governance measures, those that do generally incorporate measures related to business ethics.
Determining the best way to incorporate ESG measures into executive incentive plans will vary according to each organization's culture, business strategy and progress toward identifying ESG priorities. As with many compensation trends, linking ESG metrics to executive incentive programs has become more prevalent among the largest companies, and is trickling down to smaller companies.
Oversight of ESG issues typically is assigned to the nominating and governance committee
When it comes to oversight of ESG strategy and priorities, most S&P 500 companies (60%)2 assign ESG oversight to the nominating and governance committee. Of the remaining companies, 16% assign ESG to the full board, 15% assign ESG to a recently created committee related to ESG/sustainability/corporate governance, and the remaining 9% of companies scatter this responsibility among other existing committees. Gallagher's consulting experience suggests that a vetting committee submitting specific ESG recommendations to the board yields better outcomes than expecting all members to weigh in on unwieldy ESG issues.
Now may or may not be the right time to incorporate ESG measures into your organization's short- and long-term incentive programs. However, given the increased focus on ESG across many industries, now may be the time to have the conversation.
Contact Gallagher's Executive Compensation Consulting team to discuss ESG considerations that could make sense for your organization.