Investors increasingly want to talk about a company’s long-term environmental, social and governance (ESG) goals and how it is tracking progress against them. For several years in shareholder engagement discussions, shareholders have had many questions for companies regarding their progress against ESG commitments. With increasing frequency, many are also asking whether companies will incorporate ESG metrics in incentives. As with other operational or strategic metrics, adding ESG metrics to incentive plans can be a signal of importance and a sign of commitment.
For the most part, large companies have already made significant investments in ESG, and more often, these companies are adding ESG elements to their incentive plans for executives. Our 2022 ESG + Incentives report found that 70 percent of S&P 500 companies have already adopted ESG metrics in incentive plans. While we acknowledge that companies do not always need to put metrics in their incentive plans for ESG to be a priority, incentives can be a visible sign internally and externally that companies are serious about meeting ESG commitments.
However, when ESG objectives are incorporated in incentives, shareholders are looking for a genuine commitment and not just easily achieved objectives or loosely defined qualitative assessments that won’t move the needle. Over time, we believe that shareholders will demand increasing disclosure and transparency related to ESG goals in incentive plans, as with other commitments to ESG.
Getting It Right
Meeting these growing shareholder expectations on ESG in incentives requires:
Identification of two or three explicit ESG metrics that align with the company’s long-term sustainability. Companies have many ESG goals they can track, but for incentive purposes, it’s important to prioritize where the greatest impact lies. Sometimes that’s all within the social realm, focused on diversity, equity, and inclusion (DE&I). Other times it’s part of broader social discussions such as delivering quality products and services that improve customer well-being. And it’s becoming more common within environmental areas. Investors will look for ESG metric designs that reflect the company’s strategic priorities and context.
Explicit goals with rigor around them and a willingness to be transparent. Even if the evaluation of ESG goals isn’t entirely formulaic, management and the compensation committee must align on their chosen objective ESG measures and how they will share information about them. Early forays into ESG measurement were more qualitative, but shareholders are increasingly expecting higher objectivity in ESG assessments, so the achievements are more visible.
Meaningful compensation opportunities and consequences. Typically, this means assigning 10 percent to 20 percent of target incentive opportunities to these metrics. If the ESG metrics are only one in a long list of individual objectives or receive only a de minimis weighting, their prominence may not be high enough to attract sufficient attention.
While progress toward ESG goals and shareholder engagement on the topic is complex, companies can overcome most challenges through effective communication and planning. This includes:
Be willing to fail when it comes to ESG metrics. Companies must be willing to set stretch ESG goals and miss them, just like they do for any other goal. They can also turn a missed goal into an advantage. Some businesses shy away from setting stretch goals because of concerns about reputational harm if they miss them. However, discussing why a goal was missed and how the company plans to improve it can strengthen stakeholders’ trust.
Be smart about legal considerations, but don’t let them be a false barrier. Well-intentioned metrics and the commitments they convey should not put the company at risk, so it’s important to engage legal advisers early on. Legal advisers can help companies structure ESG measures to meet objectives while avoiding unintended legal distractions.
Recognize factors beyond management’s control when assessing results. For example, a hiring freeze or mergers and acquisitions can undermine management’s ability to achieve ESG goals. If a company is not able to bring in new talent from the outside, it might find representation goals entirely out of reach. Likewise, investments in a more sustainable supply chain might temporarily take a back seat as companies address short-term supply chain issues. Boards can, however, anticipate these events by planning for reasonable allowable adjustments to their compensation plans and taking them into account when assessing performance.
Investors have made it clear that they are interested in companies walking the talk on their ESG commitments. Incorporating ESG metrics in incentives can be a meaningful step in that direction. ESG metrics in incentives can elevate the conversation and create urgency to achieve ESG objectives. However, both investors and employees will detect “window-dressing.” For organizations including ESG in their incentive plans, greater expectations for disclosure and commitment are on the horizon.