If stakeholders judge companies based on meeting environmental, social, and governance (ESG) goals, it’s natural to tie executive compensation to those goals. After all, environmentally friendly companies may one day attract more and cheaper capital and achieve higher valuations.
But there’s a long way to go before most compensation committees find the optimal way to incorporate ESG into pay packages. Nevertheless, a March study by the London Business School and Pricewaterhouse Coopers found that 45% of large U.K. companies have introduced ESG metrics into executive compensation plans. Not only that, but one-in-four U.K. companies have added ESG metrics to long-term incentive programs.
The United States has incorporated ESG metrics more slowly. According to a June Willis Towers Watson study, Apple, Chipotle Mexican Grill, McDonald’s, Clorox, and Starbucks link a portion of their executive pay to metrics for emissions reduction and employee diversity. But overall, only about one-third of public companies have followed suit.
And in the United States, ESG targets are most often part of bonus pay. That’s an effective initial strategy because it gives a board’s compensation committee a bit of flexibility and the chance to course-correct if the performance targets prove faulty, said Tom Gosling, executive fellow of the Centre for Corporate Governance at London Business School, on a panel at the Council of Institutional Investors’ fall conference.
Globally, ESG metrics are “toughening up,” Gosling said. Traditionally linked to employee engagement surveys and employee health and safety records, ESG targets are evolving to include carbon reduction goals and diversity and inclusion efforts.
“Over half of companies are setting targets based on key performance indicators on quite specific, measurable outcomes, as opposed to some of the rather wishy-washy KPIs that we saw in earlier adoption,” said Gosling.
The problem is there are too many ESG metrics to pick from, and there’s only so much real estate on an ESG dashboard. A fellow panelist of Gosling’s, Nishesh Kumar, a managing director in asset management at JPMorgan Chase, recommended that companies look at ESG compensation metrics through a behavioral lens — what management behaviors are they trying to incentivize and reward?
Kumar separated these kinds of metrics into three buckets:
Table stakes. Workplace safety, anti-corruption, other compliance issues — “all those things that businesses execute on day in and day out” said Kumar. These may be best used for discretionally reducing payouts if a target isn’t hit.
Business as usual. These metrics closely correlate with a company’s bottom line. So closely that including them as ESG metrics runs the risk of executives double-dipping. “Because they’re all important, they’re already included in the financial KPIs,” Kumar said. That doesn’t mean they shouldn’t be used, however. An emissions reduction target for a transportation company’s executives, for example, can have a powerful signaling effect for employees, customers, and regulators.
Strategic objectives. The third category comprises metrics tied to strategic goals. These tend to be very objective metrics, like a Net Promoter Score (verified by third parties). “These metrics have the most impact when there’s a clear strategic priority to improve an ESG dimension,” Kumar said.
The Investor View
Investors won’t give boards an infinite amount of time to determine which ESG goals merit incentive pay or bonuses. Some institutional investors have taken a very aggressive approach to move things along. One U.K.-based activist investor wrote to all of its portfolio companies demanding they have ESG targets in executive pay by 2022 or it would vote against their exec comp plans.
AllianceBernstein, however, takes a more measured approach, said CII panelist Diana Lee, the asset manager’s director of corporate governance & engagement.
“We’re not requiring companies to incorporate ESG metrics at this time, but we have been encouraging them to be more transparent about how they are integrating ESG as part of their strategy and how they are incentivizing executives to do so,” she said.
What does AllianceBernstein want? Substantive and meaningful metrics reflecting the company’s strategic direction. Boards need to explain how new pay structures fit with the business’s goals, she said.
While many companies are trying to include plain-vanilla diversity and inclusion and emission reduction targets in compensation metrics, the more advanced ones are introducing “solution-based, action-oriented KPIs,” Lee said. For example, she pointed to a utility company that set a goal of increasing its non-greenhouse-gas emitting capacity to a certain percentage of total generating capacity in a set length of time.
Fools Rush In
The fear investors and other stakeholders (and probably boards themselves) have is that, in scrambling to introduce ESG targets into compensation plans, companies will adopt “not terribly well-constructed targets that investors won’t have the time to analyze,” Gosling said. If that happens, he said, investors will probably end up “tolerating a certain amount of softness” — metrics that merely pad executives’ total compensation.
“There’s a real risk that more ESG just means more pay,” Gosling said.
Tied into that is the question of materiality. Under the Sustainability Accounting Standard Board’s framework, Gosling said, a real “bone of contention” is whether ESG metrics support long-term shareholder value. “How much are [the metrics] about responding to societal concerns, which actually may not have so much to do with shareholder value?” he asked.
Indeed, adding ESG targets to every executive team’s compensation plan may not make sense. “Demanding inclusion of ESG metrics [at all companies] just sends the wrong message,” Lee said. “It’s not like we demand inclusion of profit growth to [all-stage] companies across all sectors.”
Where will ESG metrics work best in comp plans, at least initially? In the small number of industries where ESG issues are most material, where there is a degree of consensus around the metrics, and “where investors have the time to apply a little bit more scrutiny to what the targets are so that compensation committees know they’re under that scrutiny,” Gosling said.