According to a review of S&P 500 companies’ practice of incorporating ESG metrics into executive incentive plans, there was a seven percentage point increase in the prevalence of ESG metrics in incentive programs from 2021 to 2022. The incorporation of ESG in incentive plan designs continues to be a growing practice, with 72 percent of S&P 500 companies including some form of an ESG metric in their incentive plans. The most common ESG category found in incentive plans continues to be social-related metrics. However, we do note an eight percentage point increase in environmental metrics over the past couple of years, while the use of governance metrics has remained relatively flat.
What Design Approach is Used to Incorporate ESG Into Incentive Plans?
Companies typically use three different approaches to including ESG metrics in their incentive plans:
• Carve-out: ESG metric(s) are a stand-alone weighted metric (similar to how most companies incorporate financial metrics into the incentive plan).
• Strategic scorecard: ESG metric(s) are included as part of a balance scorecard covering a variety of quantitative and qualitative metrics to evaluate executives.
• Individual performance factor: ESG objective (s) are considered when evaluating individual performance.
How is a Quantitative ESG Metric(s) Incorporated into an Incentive Plan?
For companies that have disclosed using a quantitative approach to measure ESG results in their incentive plans, the use of a carve-out is the most common incentive design approach. To no surprise, social is the most common category of quantitative metrics. We also note that it is very common for ESG metrics under the carve-out approach to have a minority weighting allocated to the incentive payout opportunity (i.e., ~10 percent or less).
For companies that use a carve-out design to incent ESG results, the number of ESG metrics measured using this approach can vary significantly. For example, 40 percent of companies that use a quantitative approach use one ESG metric and 20 percent of companies use five or more ESG metrics (a majority of these companies are in the utilities industry). We also note that more than 50 percent of these companies use more than one ESG metric.
Company disclosure of the performance curve for carve-out metrics is a minority practice, with 65 percent of companies providing no detail on the performance curve used to assess ESG metric performance. Approximately 25 percent of companies disclose the full performance curve (threshold, target and maximum performance goals), while around 10 percent disclose a modified curve (e.g., only target and maximum performance goals).
While the prevalence of using ESG metrics in executive incentive plans is a majority practice, the use of quantitative ESG metrics in incentive plans is yet to be a dominant market practice. Before a company embarks on incorporating quantitative ESG metrics into the incentive plan designs, it is important that companies adopt ESG dashboards and other ESG reporting tools to track results, as well as understand from institutional investors the role ESG should play in their company’s executive incentive plan design.