Our clients are actively discussing how best to signal to investors and other stakeholders the importance of Environmental, Social and Governance (ESG) objectives, and a variety of factors -- the global pandemic, climate change, social justice concerns -- are contributing to a rapid increase in the use of such metrics in executive incentive plans.
As companies develop their ESG objectives they strive to demonstrate alignment among execution and progress against articulated goals, business strategy and management accountability. Key areas of focus include Diversity, Equity and Inclusion (DEI) and environmental sustainability, but factors differ among industries and even among direct competitors. Additionally, there is sometimes a natural friction between traditional operating metrics and more strategic ESG goals even when the latter may be core to transformative business change.
The evolving policy guidelines of institutional investors emphasize the importance of ESG and promote action among companies. While interest is universal, there is significant concern about the most appropriate way to define metrics, measure performance and avoid unintended consequences, which may include:
- Pressure to set highly aspirational and potentially unachievable goals to demonstrate commitment,
- Embarrassment and criticism in the event of underachievement,
- Criticism from the proxy advisory firms and governance professionals for subjective measurement,
- Suboptimal short-term reaction to longer-term challenges, and
- Questions from investors and other stakeholders about the importance (or lack thereof) of excluded metrics.
FW Cook reviewed proxy statements filed by the 250 largest S&P 500 companies by market capitalization in 2020 and 2021 to determine the prevalence of ESG metrics in incentive plans and how such metrics are measured. These studies, along with bespoke analyses we have conducted for many of our approximately 750 active clients, indicate significant and rapid evolution of ESG-based incentive provisions.
Our 2020 study, which focused primarily on provisions in place during 2019, indicated ESG inclusion in 56% of annual incentive plans, with measurement typically through an individual or strategic performance measure that was qualitatively assessed against longer-term articulated goals, as opposed to fixed, quantitatively measured metrics. The 2020 study also indicated that ESG metrics were almost nonexistent in long-term incentive plans because qualitative measurement leads to poor accounting treatment and, generally, there is need for flexibility as ESG goals evolve over longer periods.
In advising clients on this topic, we anticipated a further increase in use of ESG metrics and that the prevalence of quantitative measurement and/or stand-alone measures would increase but continue to remain lower than qualitative approaches. Our 2021 study, which focuses primarily on 2020 practices and reflects filings through September 15, 2021, bears out these predictions. Here are key findings from the most recent analysis:1
- 160 companies (64%) use ESG in one or more incentive plans, up from 132 (56%) last year. This is a 21% year-over-year increase in prevalence
- 148 companies (59%) use ESG metrics in their annual incentive plan only, up from 53% last year
- Only 9 companies (4%) use ESG metrics in both the annual and long-term incentive plan, up from 3% last year
- Only 3 companies (1%) use ESG metrics in their long-term incentive plan only, versus no companies last year
- Of the 160 companies using an ESG-based metric, 54 (34%) measure performance using a formulaic metric or modifier approach. This differs considerably from prior year experience in which only 22% of companies employed a non-discretionary approach
Among the 160 companies most recently disclosing ESG-based metrics, Human Capital & Culture metrics were the most common (70%), followed by DEI and Environment & Sustainability (67% and 36%, respectively).
Additional detail from our 2021 analysis will be published shortly. In the meantime, as the debate continues and companies begin planning for 2022, it is appropriate to evaluate some key questions and factors regarding ESG and its inclusion in incentive plans:
- Status of Current Processes. Does the company have a measurement system to accurately track ESG metrics? Does the governance structure assign ESG responsibilities to a specific board committee or multiple committees?
- Signaling of Importance. Does the importance of ESG require its formal inclusion in the incentive plans, or can ESG be effectively measured and disclosed outside of the incentive plans?
- Balancing Multiple Stakeholder Perspectives. What are the business implications of including an ESG metric, recognizing that not all stakeholders embrace the same investment strategy, social agenda, or time horizon? What ESG metrics are most important to investors? If an ESG metric is included, which financial metric is de-emphasized (i.e., weighting reduced)? Is there willingness to disclose the specifics of ESG incentive metrics? Does inclusion of certain ESG metrics unintentionally imply that others are unimportant? Once in the incentive plan, can an ESG metric be removed without internal and external criticism?
- Goal Setting Period. Because progress on many ESG metrics will evolve over long periods (e.g., a decade or more, especially for climate change initiatives), it is natural to want to measure in long-term plans. But does the company have forecasting precision over periods as short as three years? If discretion in measurement is retained on an equity-based, multi-year incentive plan, is the company willing to accept variable accounting on the award? To reduce the impact of variable accounting, should ESG metrics apply exclusively to top level executives in a long-term plan? If lower-level executives are excluded, does it raise questions about the importance of the metric and/or accountability across the organization?
- Unintended Consequences. If one ESG metric is chosen over others, does it miscommunicate the degree of importance placed on the metrics not chosen? If qualitatively assessed, does this create the potential for criticism from proxy advisors? Does underachievement or setting a target goal below investor aspirations create possible public relations challenges or inconsistency with the company’s Corporate Sustainability Report? Might possible underachievement attract moral criticism to the company, and could this risk encourage suboptimal decision making?
For every potential ESG-based metric, there are numerous questions that need to be addressed in the context of the preceding challenges. Below are some factors to consider in evaluating, for example, DEI:
- Status of Current Processes. How mature is the current DEI strategy? Is it still evolving? Is it currently well understood by leadership and potential incentive plan participants?
- Measurement. Should DEI be an independently weighted metric, incorporated into an existing modifier, or an independent discretionary decision? Is it possible to assess performance/progress objectively and accurately? Can achievable goals be set that foster progress while preserving flexibility as circumstances evolve?
- DEI Goal Setting. Does it make more sense to set goals around DEI outcomes or activities/inputs? How does that change over time? If a company is shrinking headcount versus growing, how does this affect achievability? And does this affect the way progress might be viewed by investors, employees, and other stakeholders?
- Some companies are more focused on measuring activities/inputs now (e.g., training, building a more diverse pipeline for hiring/promotions) and will turn to measuring outcomes (e.g., senior leadership representation) in the future
- Disclosure. What level of disclosure can be provided on DEI performance? While greater detail sends a strong signal about commitment, it could expose the company to criticism for insufficiently ambitious targets and/or poor achievement versus truly stretch goals. Conversely, less detail may attract criticism from investors and proxy advisory firms
- Unintended Consequences. While few investors are likely to question the inclusion of a DEI metric, it could raise questions about why other items such as sustainability are not included in the incentive plans. Will it be possible to revise ESG-related goals as a company progresses in one or more areas to focus on different metrics without fostering confusion or misunderstanding? How will investors react if the company fails to achieve the DEI target? Does success on this target subject the company to higher risk of poaching?
In my three-plus decades of advising corporations on incentive plan matters there have been many trends in design. None have evolved faster than the ESG issue, and I anticipate that the focus is permanent. However, companies should recognize that there are numerous ways to communicate progress to stakeholders and to hold management accountable for ESG outcomes (e.g., promotional opportunity). As a result, companies that build ESG metrics into the incentive structure should take care to ensure they do so in an effective way that truly supports business objectives. At the present time, there is no single “best practice” or universal approach that works equally well for all companies. Numerous factors including industry, company maturity, investor views, culture, and a variety of strategic considerations all need to be evaluated.
1 Note that the 2020 study was based on a sample of 237 companies and the 2021 study is based on a sample of 250 companies.
Daniel J. Ryterband
Chairman & Chief Executive Officer
Dan Ryterband consults to organizations on all aspects of executive compensation strategy and design, including the related tax, accounting, and securities law implications, as well as matters of corporate governance and investor relations. He has over 30 years of consulting experience and his clients include U.S. and overseas multinationals in a variety of industries, as well as smaller start-up organizations. Dan has extensive experience working with Board Compensation Committees and is a frequent speaker in industry and academic forums.