As demand for accountability in ESG initiatives grows, more companies are incorporating ESG metrics in their incentive plans. To avoid pitfalls, companies must ensure that, as with financial and operational measures, ESG metrics are actionable, measurable and aligned with their business strategy in order to drive long-term value creation.
ESG has reached a tipping point. Developments ranging from the #MeToo movement and #BlackLivesMatter to extreme weather occurrences and a global pandemic have prompted companies to sharpen their focus on ESG-related issues including social justice and equity as well as climate and environmental sustainability. Moreover, a company’s ESG strategy can confer a competitive advantage in today’s tight labor market as workers look to join and stay with companies that are committed to advancing social and environmental goals.
Growing regulatory pressures along with an increasing awareness of ESG risks and opportunities are prompting shareholders and investors to demand greater accountability in ESG matters. At the same time, employees, clients and consumers are also calling for companies to be held accountable for their ESG performance.
In response to stakeholder concerns, companies have increasingly incorporated ESG-related measures in their incentive programs. The WTW 2021 Global ESG Report reveals that 60% of S&P 500 companies integrated ESG metrics in their incentive plans in 2020, up from 52% the previous year. ESG metrics are much more common in short-term incentive plans (98% of those reporting usage) than long-term incentive plans (less than 10%). Over half of the companies using ESG metrics in some form of incentive report using social metrics (56%), followed by governance (30%) and environmental (13%) metrics.
Examples of leading companies incorporating ESG metrics in their incentive plans include the following:
In fiscal year 2022, the Coca Cola Company is including a diversity, equity and inclusion (DEI) metric in its annual incentive plan and an environmental sustainability performance measure in its long-term plan.
Moderna’s bonus program for 2022 includes ESG objectives aimed at ensuring it meets demand for COVID-19 vaccines from low- and middle-income countries. The program also includes objectives designed to promote a sense of belonging among its employees.
The Archer Daniels-Midland Company is making changes to its 2022 performance share unit (PSU) awards to include two ESG metrics: (1) progress toward gender parity, and (2) absolute reduction in greenhouse gas emissions over the three-year performance period.
Some investors, particularly in Europe, are calling for greater use of ESG metrics in incentives, and for metrics to be clearly defined. Recently, a group of Dutch investors threatened to oppose compensation plans of executives in the oil and gas sector if their companies failed to set climate change goals that were aligned with the Paris Agreement on climate change. Large US investors such as BlackRock, State Street Global Advisors and Vanguard to date have been agnostic on the use of ESG metrics in management incentives.
Nevertheless, as the number of companies using ESG metrics in incentives has expanded, some academics and business leaders have questioned the value of using incentives to accelerate ESG priorities, to the point that they suggest doing so could actually undermine the very priorities they are intended to support. ESG metrics are often seen as fundamentally different from other potential incentive metrics, giving rise to misconceptions and confusion about their value. To gain a better understanding of this issue, it can be helpful to examine the benefits and drawbacks of using incentives to drive ESG priorities.
The pros and cons of using incentives to advance ESG initiatives
Incorporating ESG metrics in incentive plans gives prominence to a company’s ESG strategy, communicating its importance as a business imperative. In addition, this clarifies a company’s ESG priorities, which may range from net-zero carbon emission commitments to inclusion and diversity (I&D) recruitment goals.
Furthermore, integrating ESG metrics in incentives builds accountability, something many stakeholders are demanding. Such a move will help to hold key leaders responsible and motivate them to take the bold actions required to achieve sustainable results.
Linking ESG metrics to compensation also signals positive intent to investors, customers and employees and helps position ESG initiatives as part of broader efforts related to risk management, brand value enhancement, and recruiting and retention.
Additionally, the use of ESG measures in incentives provides transparency with regard to the outcomes of ESG initiatives and supports disclosures.
On the downside, ill-defined external standards make it challenging to define “good” performance or at least to validate comparable performance across companies. It can be difficult to set goals given the long time frame required to realize meaningful change in certain areas (e.g., reducing greenhouse gas (GHG) emissions, improving leadership diversity). In addition, the metrics may not be relevant for all incentive participants. For example, relatively few employees can impact leadership diversity or GHG emissions.
Limited experience in defining performance ranges (threshold and maximum) can also contribute to the difficulties of integrating ESG metrics in incentive plans. While setting goals can be challenging enough, defining a reasonable range around a target is even more challenging. Once targets are set, lack of disclosure on most metrics or broadly agreed standards makes it difficult for outside parties to validate performance.
Finally, it is important to recognize that metrics cannot cover the full spectrum of ESG issues that matter to stakeholders. For example, employee wellbeing or diversity, equity and inclusion (DEI) are very broad and no single metric or finite set of metrics will cover the full scope of these issues.
Clearing up the misconceptions
It is critical to recognize that financial and operational metrics, along with their associated design characteristics, share many of the same challenges and drawbacks as ESG metrics.
As with ESG metrics, financial/operating metrics are not always comparable across companies. Companies in the same industry can make different strategic choices and operate under very different capital structures, operating models, geographic footprints and end markets, making it difficult for external parties to assess comparable performance accurately and fairly.
Setting performance ranges for financial/operational metrics can be daunting, especially in today’s highly uncertain operating environment not unlike the challenge with ESG metrics. Earnings per share (EPS) performance ranges that seemed reasonable in the recent past suddenly looked different with the emergence of COVID in 2020, supply chain issues in 2021 and global geo-political conflicts throughout.
Similar to ESG metrics, financial and operating metrics sometimes reflect the performance of a small number of people who have a disproportionate impact on results. For instance, relatively few people can influence how a company makes capital decisions, yet many people may participate in an incentive plan with return-on-invested capital (ROIC) as a metric. Similarly, tax, financial and share count decisions, which are controlled by a small handful of executives, can have a disproportionate impact on EPS.
Just as ESG metrics used in incentives don’t cover the full scope of ESG issues, most current incentive plans are based on only two to four measures, which may reflect key priorities at a given point in time but don’t fully reflect the financial and operating health of a business. In fact, many executives monitor an extensive dashboard of metrics to assess the overall performance of their organization. Most of these metrics do not find their way into the incentive plan yet remain important to the business.
Despite these challenges companies have developed incentive programs that effectively align pay and performance by focusing on the following levers:
Adopting metrics that best align with the strategic direction of the business
Using available data and informed judgment to select initial metrics and set goals, and then refining the approach as new data becomes available
Deploying multiple metrics across short- and long-term incentives in order to provide a diverse range of metrics, thereby enabling the company to balance the risk associated with establishing a valid metric in a given area
Applying well-earned judgment in how performance targets are set, balancing external perspectives and the unique characteristics of the business. For example, a homebuilder must take into account expected housing starts and demographic trends as well as the fact it is transitioning its primary market focus from traditional residential to senior living communities.
Deploying well-defined approaches in the short term and modifying those approaches over the longer term to calibrate the programs with ever-changing internal and external environments
Communicating clearly how incentives are aligned with business strategy, and when, why and how incentives need to change to maintain this alignment.
These same tactics can be used to integrate ESG metrics in incentives. With time and experience, companies, investors and participants can achieve the same comfort level with ESG metrics as they have with financial metrics in incentive plans.
Enabling success with ESG metrics
While it is possible to design effective incentives with ESG metrics today, there are several factors that can contribute to an improved alignment of pay and performance in the future:
Establish more consistent disclosure requirements. Consistent disclosure will improve transparency and accountability, allowing stakeholders to make more informed decisions. For example, this may involve the consistent adoption of the Task Force on Climate-Related Financial Disclosure standards, or more consistent Human Capital Report disclosures.
Improve external standards. Over time, with enhanced disclosures, companies and investors can develop better external standards. For example, the ability of organizations such as Institutional Shareholder Services (ISS) and Glass Lewis (GL) to develop and deploy compensation plan assessment models only exists because of robust disclosure that has evolved over time. We would expect to see the rapid development of external ESG standards once enhanced, consistent disclosure requirements are in place.
Compile a set of precedents. Similar to how companies learned to understand the pitfalls of using certain financial and operating metrics by trial and error (e.g., don’t measure working capital or cash flow at a point in time because it drives poor timing decisions at year end), companies will learn how to adjust incentives when encountering pitfalls with certain ESG metrics as they gain experience with those metrics.
Apply appropriate weighting to ESG metrics. A relatively small weight (e.g., 15-20%) should be applied to ESG incentive metrics to properly signal the importance of the metric while not disproportionately weighting these metrics. We see a similar approach taken with financial metrics such as revenue and working capital, which are typically weighted less than 25% of the total incentive.
Ensure ESG results are measurable, actionable and tied to business strategy. Similar to financial metrics, it is important and possible to make sure ESG metrics are linked to business strategy, can be acted upon by participants and are measurable. For example, goals tied to achieving greater leadership diversity may work best when an incentive plan is geared towards a limited population of senior leaders. And climate-related goals could be disaggregated such that all participants understand how their actions can contribute to the successful execution of the strategy, much like financial metrics such as EPS are broken down via value driver analyses.
Moving beyond the tipping point
The importance of ESG has reached a critical juncture for many companies around the world.
Stakeholders are looking for clarity on how ESG priorities integrate with company business strategy to ensure that they effectively manage both risks and opportunities. Incentives play a critical role in reinforcing the alignment between business strategy, performance and pay; this applies to financial, operating as well as ESG priorities.
While the use of ESG metrics is still in early days, debunking misconceptions about these metrics is an important first step towards improved accountability in ESG initiatives. Additionally, we expect that with time and experience, ESG metrics that are a critical reflection of business strategy can be used effectively in incentives to drive sustainable company performance and shareholder value.
A version of this article appeared in Corporate Board Member on May 26, 2022. All rights reserved, reprinted with permission.
