As sustainability and environmental, social and governance (ESG) metrics become a standard feature in executive incentive plans, institutional investors expect boards and management to clearly articulate how these metrics play a role in driving long-term and sustainable value creation.
A recent WTW global study on ESG incentive metrics revealed that ESG and non-financial metrics in general tend to yield higher payouts than financial metrics in the United States as well as select markets in Europe. Among S&P 500 companies, we found that the average payout for financial metrics is 113% of target, which is lower than those of general non-financial metrics (121%) and ESG metrics (123%).
This finding prompted renewed interest in better understanding whether target-setting is as rigorous with ESG incentive metrics (and non-financial metrics more broadly), especially for qualitative ones, as it is with financial metrics.
In this context, this article summarizes the perspectives of heads of stewardship at select institutional investors about the quality of ESG metrics globally. Our goal is to provide boards and management with greater insights into what investors are looking for when they assess pay proposals with ESG metrics in executive remuneration. As a condition of their participation in this study, none of the comments here are attributable to a single firm.
Most institutional investors publish their voting policies on executive remuneration. Some, such as Legal and General Investment Management (LGIM), take a prescriptive approach in their guidance. For example, LGIM states specific expectations on the use of climate transition and discourages the use of employee engagement targets.
Conversely, most investors we interviewed take a more principles-based approach, especially those with large equity portfolios. There also are smaller investment funds, such as Cevian Capital, a hands-on owner of a tightly focused portfolio of 10 to 15 companies, that make it clear that sustainability-linked metrics are important to preserve and create long-term value. However, these smaller investment funds leave it to the company to do the work and define significant, measurable and transparent metrics that are linked to long-term goals.
With a principles-based executive remuneration guideline, European institutional investors generally expect the use of sustainability metrics but do not have a predefined point of view on how ESG metrics are implemented in executive remuneration. However, some investors noted that they may have a less definitive view about use of sustainability metrics outside Europe. In general, investors expect the board to evaluate the link between ESG and value creation, and to work collaboratively with management to ensure that only ESG metrics that are material to the business are selected.
This approach allows companies to tailor metrics to their unique contexts and strategic goals. A common sentiment among institutional investors is that ESG metrics should not replace traditional financial metrics; rather they should complement them to provide a balanced view of performance. Under this sentiment, ultimately the company’s selected ESG and financial metrics should work together to drive long-term shareholder value.
Predictably, investors overwhelmingly stated that any good practice related to incentive design in general also would apply to ESG metrics. The consensus is that ESG metrics should be meaningful, measurable, clearly disclosed and aligned with the company’s long-term goals. With a principles-based approach to executive remuneration guidelines, investors largely refrain from stipulating the specifics on the types of weighting on ESG metrics.
Although there are no set rules on what could trigger an automatic red flag from institutional investors, there are some common pitfalls they shared with us to avoid:
Lack of clear connection to business strategy and value creation. This includes the use of metrics that overly rely on subjective judgment, or the use of ESG metrics that are not clearly defined or do not clearly align with the company’s strategy, competitive strengths or material business risks.
Use of broad ESG indices or compliance-related metrics. Investors do not favor ESG indices as an incentive metric because they are too broad and lack focus. The use of ESG indices also goes against the overarching theme of business materiality. In addition, investors cautioned against the use of compliance-related metrics, as they consider compliance a baseline expectation of executive performance.
Too many metrics. Too many metrics over-complicate incentive plans and dilute the impact of individual metrics. This weakens the alignment between pay and performance and makes it less meaningful for incentive plan participants. For similar reasons, investors also cautioned the use of less measurable ESG scorecards with undefined weighting of each scorecard element. Additionally, the optics is that the company is building in flexibility to selectively choose which metrics they would add weight to retrospectively when assessing performance and deciding associated pay outcomes.
Non-financial metrics weighted more heavily than financial metrics. Investors generally shy away from a prescriptive guideline on a minimum or maximum weighting on ESG metrics. However, they noted that, in principle, a small weighting (e.g., lower than 10%) likely will not impact behaviors. A thoughtful approach to selection will naturally result in more meaningful weighting on each individual metric. There also was consensus among the investors that if ESG or non-financial metrics are weighted more heavily than financial or shareholder return metrics, it will draw closer examination. Some investors also expressed concern about high ESG scores offsetting lackluster financial performance in remuneration outcomes.
Consistent above-target payout. This may signal a lack of rigor on performance goal setting, especially for qualitative measures that require judgment-based assessment.
Lack of transparent disclosure. Like disclosures on financial metrics, investors expect transparency in the rationale behind metric selection (both retrospective and prospective), with acknowledgement that market norms vary by region), weighting for each metric and achievement against targets. While some companies may cite commercial sensitivity as an argument to omit disclosure of performance goals, investors are mostly unsympathetic to this argument. They assert that ESG targets are generally far less sensitive than financial targets and, if commercial sensitivity does come into play, companies should still be able to disclose the targets and achievement levels retrospectively, after the performance period concludes. Prospective disclosure of targets is encouraged and should clearly show how short- and long-term incentive targets (which often have a one- to three-year time horizon) connect to longer-term sustainability commitments, such as net-zero goals and their transition pathways.
There are varying perspectives among investors about whether ESG metrics should be included in short- or long-term incentive plans. Some investors expressed a general preference for the long-term incentive plan given the longer-term nature of ESG initiatives. Meanwhile, others preferred to leave this decision to management and the board – as long as the company follows their principles-based guidelines and good practices in incentive compensation design.
Ongoing or ahead of annual general meetings (AGMs), institutional investors take advantage of engagement opportunities to share their perspectives on the use of ESG metrics and executive remuneration in general at their portfolio companies.
Engagement is an important tool for investors to obtain context that often is too nuanced to be addressed in public disclosures as well as share their view on best practices. Some investors maintain a consistent engagement (and voting) policy across all portfolio companies.
Investors with a broad equity portfolio (e.g., investments in thousands of companies) may not be able to take a hands-on engagement approach with every company they have an equity stake in. Instead, they may set out criteria to develop focus lists, considering factors such as the size of their equity holding and whether a company has historically seen challenges in their governance, remuneration and ESG practices.
These criteria may vary slightly by region to reflect the corporate governance landscape (e.g., definition of board independence, possible regulatory or market requirements on board diversity, whether say on pay is binding or non-binding). Alternatively, they may publish a voting policy or guidance specifically for ESG metrics that apply equally to all portfolio companies.
The say-on-pay vote is an opportunity for investors to express their views on the alignment between executive compensation and company performance, including the use of ESG metrics in executive incentive plans. However, institutional investors who take a principles-based approach to executive remuneration clearly indicated that the absence of ESG metrics alone does not necessarily mean that they will not support say on pay.
Instead, they would take a more holistic approach, evaluating the entire compensation package and considering the overall alignment between pay and performance. Investors also may have a higher threshold when voting against executive remuneration in countries in which say on pay is binding, such as the United Kingdom, than in countries with non-binding say on pay, such as the United States.
Investors also tend to use their say-on-pay vote strictly on issues related to executive remuneration and would not use it as a tool to signal their overall dissatisfaction with the company’s ESG, sustainability or climate progress. In more extreme cases, investors are more likely to cast a vote against the re-election of specific board members, such as the Sustainability Committee Chair, if they see consistent issues with the company's approach to ESG and sustainability.
ESG metrics are among the most common metrics in executive incentive plans across all major markets, prompting stakeholders to place greater emphasis on the quality of these metrics. Through our interviews with some of the world’s leading institutional investors, we learned that investors prefer to stay away from ideological debates.
Rather, investors focus on a company’s ability to articulate how an ESG metric aligns with business strategy, helps mitigate material business risks, and / or drives long-term sustainable value creation when incorporated into executive incentive plans. Thoughtful metric selection, transparent disclosure and robust target-setting comprise the cornerstone to designing good executive remuneration plans, and these themes apply to ESG metrics just as they do to traditional financial / strategic measures.
