This white paper is one of a four-part series, highlighting the findings from our interviews with 170 board directors across the globe on the future of the compensation committee. Our last article explored directors’ views on shareholder primacy and company purpose. In this paper, we seek to provide insights into the environmental, social and governance (ESG) discussions taking place in the boardroom as well as perspectives from individual board members around the world. In many markets, extending the remit of the board and the compensation committee to oversee a company’s commitment to ESG is becoming a matter of good corporate governance and a mandate from many large institutional investors.
01
ESG is like an elephant because there are so many components. Some people are describing the trunk and some the tail. Some want to talk about climate change and others want to talk about pay equity. Directors come from different backgrounds and are passionate about different things.
A question we raised during the interviews was how directors’ perspectives on their companies’ ESG priorities and agenda were being implemented at their companies. Most directors we spoke to in North America and Western Europe agreed that the companies they represent are paying more attention to ESG matters, but a clear agenda and ownership is often lacking. In Asia Pacific, Latin America and the Middle East, ESG’s emergence has evolved less consistently and often varies by country.
While practice varies, across geographies, the majority of directors interviewed agreed that there had been a greater focus on environmental than social matters in board discussions, often because environmental matters are more tangible and easier to measure. Social topics were discussed, but more as management updates and not in the context of ESG. However, recently the focus on social matters has intensified in light of the global pandemic as well as recent social events in some developed markets (e.g., racial injustice incidents in the United States). Board discussions have increasingly emphasized the health and wellbeing of employees as well as serving people in the local communities.
From these interviews, we learned that the global pandemic has affected companies’ ESG priorities and agenda differently. In industries that are more economically challenged, some companies have been prompted to temporarily reduce ESG investments as they struggle for short-term liquidity and long-term solvency. In contrast, among companies that have not been hit as hard, directors do not feel any pause in their companies’ ESG agenda; priorities have generally not changed.
If you are good with carbon footprint, you’re usually good financially because you’re operating efficiently.
In some industries (e.g., chemical, oil and gas, transportation, energy), environmental matters have long been a top business priority and risk management focus. Directors from these industries commented that it is instinctive to think about the environmental impact of their businesses, such as battling climate change as well as protecting clean air and water. In other industries, environmental agendas are often less mature and still evolving. The definition of social matters under the ESG umbrella is very broad, ranging from all aspects of human capital management to the company’s commitment to its customers as well as the communities it serves. Talent is recognized as a major component of a company’s assets. The majority of the directors we interviewed believe it is critical for management to focus on inclusion and diversity, succession planning, workforce upskilling, leadership development and building a compelling organizational culture. Board members see effective use of human capital and the ability to attract, grow and retain the best talent as top business imperatives.
02
At the end of the day, our company is part of this community. We helped build it and we love it. It is in our best interest for the community to like us. Otherwise, they are going to kick us out.
The importance of returning value to local communities was highlighted by several directors we interviewed. They feel the responsibility to do right by the communities they operate in, especially when operations are in less developed markets. Businesses recognize their symbiotic relationship with the public and broader society. In the long run, investments in local communities create a sense of pride among employees. This in turn fortifies a strong culture.
What has changed for us is that our investors have become more up-front about what they want. The challenge is that sometimes investors tell us to focus on different things.
Boards’ focus on environmental and social matters may also be motivated by expectations from investors. It is of note, however, that many directors we spoke to believe that institutional investors continue to be primarily driven by operational and financial excellence. Some directors went as far as to point out that while the leaders of institutional investors highlight ESG as priorities in public, their investment professionals are pushing hard on operational and financial performance during shareholder engagement meetings. That said, a considerable number of directors interviewed pointed out the increasing prominence of ESG issues in the investment agenda. Growing momentum of ESG investing (otherwise known as sustainable investing) is clearly making its way into boardrooms.
In some markets, particularly in Europe, the evolving regulatory environment also continues to push environmental and social matters, such as greenhouse gas emission, waste disposal, gender pay gap disclosures and data privacy on to board agendas. These regulatory requirements prompt institutional investors to raise more ESG-related questions at the board level, further pushing companies to develop their ESG agendas. In industries and countries where these regulatory pressures are less prominent, ESG may be a lower priority for the board.
Many directors were cognizant that a company’s ESG agenda often plays a role in attracting and retaining a new generation of talent. Some cited research showing the positive correlation between employee engagement and the ability to make a positive environmental and social impact at work. In particular, some directors highlighted that ESG priorities are critical to attracting and retaining talent, particularly millennials. These employees in turn accelerate the discussions and help shape the company’s ESG agenda.
Ultimately one of the board’s most critical tasks is safeguarding the company’s reputation, and ESG goals and outcomes directly impact the company’s reputation with the public and employees.
For most directors, ESG is often discussed in the context of managing business risk. Failure to appreciate the ramifications of certain environmental or social issues may attract public scrutiny and, in some cases, harm the business’s reputation and financial return. In some industries (e.g., consumer goods, retail), consumer behaviors may be influenced by a company’s ESG priorities in that some customers appear to be more willing to spend with brands or retailers that align with their values on specific ESG issues, such as buying only sustainably or responsibly sourced and manufactured products. The potential reputational impact may also lead to more environmentally friendly business practices. From that perspective, a company’s ESG agenda and its financial results are directly linked.
Sourcing energy from coal-fired plants is almost seen as akin to selling cigarettes to children. Investors and employees will continue to push us for positive change.
03
Degree of board alignment is all over the map. That’s OK as you need a healthy level of debate and diversity of opinions. In general, skepticism on ESG is waning.
It is important to note that ESG discussions and inherent priorities are often shaped by board composition, committee accountability and country-specific circumstances:
04
Incentive is a powerful tool. If you want people to act a certain way, reward them for it.
The majority of interviewees shared the view that ESG goals should be incorporated into executive incentive plans; however, we did see some divergence by country and by organization type. Boards of public companies are increasingly receiving direct pressure from investors (and often also from proxy advisors), which will put board members and management in a reactive position when finding a balanced linkage between their ESG priorities and how executives are rewarded.
Among privately held or family-owned companies, views vary quite significantly by individual and company-specific circumstances. With a more stable ownership structure, these companies can manage the business with a longer-term orientation and are less susceptible to corporate short-termism and pressures of quarterly financial reporting. Depending on industry and the owners’ philosophy, executive incentive plans may incorporate specific aspects of ESG (e.g., sustainable sourcing of raw materials, carbon emission, human capital metrics). On the other hand, the lack of a broad investor base may lead to a less pronounced focus on ESG matters.
Directors were pragmatic in pointing out that selecting the right ESG metrics to incorporate into executive incentive plans is no easy task. As the compensation committee expands its remit, meeting agendas are often packed, and there may not be sufficient time for members to delve into an in-depth ESG metrics discussion. While some board members tend to agree that it is increasingly possible to identify quantifiable and measurable metrics, they question whether a simple set of key performance indicators (KPIs) suffice to cover a topic of such breadth.
The last thing we want is to be accused of is ‘greenwashing.’ We care because we know our customers care. Adding a metric is a way to show that you ‘walk the talk.’
Most find it challenging to narrow down the discussion on suitable ESG metrics out of hundreds of options. That said, there is a consensus that companies should not incorporate ESG metrics for the sake of “checking the box” but should instead identify ones that truly drive long-term sustainable value creation in the company’s context. Compensation committee members, in particular, expect management and the full board (both supervisory and management boards in a two-tier board system) to set out an ESG framework in the hope of keeping a narrow focus on how they hold management accountable to a manageable set of ESG metrics.
Despite worldwide efforts to standardize ESG disclosures and long-standing environmental metrics, such as greenhouse gas emission, lack of standardization and comparability remains a source of frustration for board members. Nonetheless, there is an acceptance that any standardization must consider local circumstances. Many directors highlight the need for better comparability across companies within the same industry. As it stands, ESG measures are very much internally focused specific to each company’s priorities and situation.
By contrast, some directors feel that there is limited benefit in any industry or peer group comparison of ESG performance. Instead, they underscore the importance of having year-over-year consistency in ESG metrics so that progress can be monitored over time. In the search for the best approach to ensure a holistic view, some board members are in favor of applying discretion or qualitative individual performance assessments. Their argument is that ESG pursuit should not be boiled down to a number.
Directors are mindful of unintended consequences or undesired behaviors if ESG metrics are not thoughtfully designed. Speaking from experience, some board members feel that instilling the mentality of “chasing a number” tends to diminish the integrity and importance of ESG from the perspectives of risk, business and social responsibility.
We find the idea of paying for ESG achievements almost offensive. This is not new in our industry. It is what we do. If somebody doesn’t believe in it, they shouldn’t be here in the first place.
While a minority view, some directors pointed out that despite the importance of driving ESG, incentive plans should not include ESG metrics. Often from industries with long-standing history of measuring their business’s impact on the environment, these board members believe that driving the ESG agenda should be a core part of their organizational culture. It is important to keep management accountable by measuring KPIs related to ESG, but management should not expect to get paid for it.
How ESG metrics are incorporated into executive incentive plans today may seem to contradict the notion that ESG investment drives long-term sustainable financial and market performance. Latest research from Willis Towers Watson shows that 98% of the S&P 500 that use ESG incentive metrics incorporate them into the annual, not long-term, incentive plan. Among top European companies (i.e., constituents of the top indices in each country, such as the FTSE 100 in the U.K., CAC 40 in France and DAX 30 in Germany), ESG metrics are also more often included in annual incentive plans. While including ESG metrics in long-term incentive plans is more prevalent in Europe than in the U.S. (15% of top European companies versus 4% of the S&P 500), it remains a minority practice. Board members are generally not surprised by this data point, attributing this tendency to the difficulty in setting fair ESG goals for longer periods in light of how quickly the ESG dialogue is progressing. Most agree that these annual ESG goals should be informed by and build toward a longer-term ESG agenda.
Through our interviews, we have learned to appreciate the need to look at ESG through country-, industry- and business-specific lenses. There is no clear consensus on whether, and much less how, ESG metrics should be incorporated into executive incentive plans, but most agree that management should be accountable for driving the company’s ESG agenda. When companies do decide to use an ESG metric in incentive plans, directors agree that it should be substantiated by thoughtful deliberation and underpinned by a clearly defined ESG agenda that is linked to the company’s long-term strategy.
In the next article, we will dive deeper into one particular aspect of the “S” within ESG and focus more on the board’s and compensation committee’s role in shaping a company’s organizational culture and in governing its human capital.
