Is Executive Compensation the Answer to ESG Accountability?
May 09, 2023
Company boards are more closely linking incentive plans with the achievement of ESG goals. Positive outcomes could lead to a competitive advantage.
Across the global business landscape, companies are devoting enormous attention to environmental, social and governance (“ESG”) issues. Driven by concerns around employee well-being, social unrest, climate change and geopolitical turmoil, they face intense pressure to improve their ESG efforts from shareholders, social activists, consumers, regulatory bodies, employees and the media.
Within this context, the idea of putting one’s money where their mouth is has been gaining traction among companies when it comes to achieving ESG goals. Increasingly, companies are integrating non-financial ESG factors into executive compensation programs as a way to drive accountability toward goals and respond to the concerns of investors and others.1
Properly designed incentive compensation structures are not new, of course. They have long been seen as driving financial performance and shareholder returns. But incentive programs that target ESG goals are still relatively novel. Thus, they often raise questions around the right way to successfully integrate them into an executive compensation structure.
There are several factors to consider when integrating ESG goals into an incentive program. Before diving into some of the specifics, the following is a look at the mandatory prerequisite every company must consider for successful integration: a functioning ESG ecosystem.
Establishing a Functioning ESG Ecosystem
An ESG-impacted executive compensation program can only succeed within a structured, efficient and meaningful ESG ecosystem. That ecosystem is grounded in two elements that are the purview of the board: 1) a thorough understanding of the ESG risks and opportunities that are most material to successfully executing company business strategy; and 2) verifiable systems in place to track the relevant data, and key performance indicators to evaluate the company’s achievement of those ESG goals.
Only after the board understands what is material to the company and its various stakeholders can it begin to identify key goals fundamental to the achievement of its long-term ESG strategy and decide how best to integrate those goals into executive compensation.
Integrating ESG into a Compensation Plan
Once a board has satisfied the two elements of the ecosystem, the compensation committee can then begin to think about integrating ESG into its executive compensation program. However, because the process is not yet well established, many questions are bound to arise. Compensation committees should assess, at a minimum, the questions listed below (and the answers that follow each) to successfully integrate ESG into executive compensation.
Where do ESG goals fit into the company’s executive compensation program? Is the program part of annual incentive compensation, long-term incentive compensation, or both?
- Boards should take a thoughtful approach toward where ESG fits into an executive compensation program.
- To date, ESG has most often been integrated into annual incentive plans. This approach is consistent with the view that companies should make annual progress toward their longer-term ESG goals and that investors generally prefer to see the long-term incentive plan based on the achievement of financial results and shareholder returns.2
- On the other hand, ESG goals that companies have identified are often long-term oriented, with the achievement of targets several years in the future. In this sense, integrating ESG into the long-term incentive plan may be a better fit for a company’s ESG strategy.3
How should the ESG goals be incorporated into the compensation structure? Should they be included as a discrete percentage of the overall bonus? Or should they be a modifier?
- Compensation committees with existing incentive plans based on the achievement of financial goals may be inclined to simply keep that structure in place and add a modifier based upon the evaluation of ESG performance of +/- 10%-15%, for example. The obvious advantage of this approach is that it does not reduce the importance of financial performance in determining executive pay, yet it takes into consideration the concerns of shareholders, who, as much as they want to see ESG integrated into executive compensation determinations, still see financial performance as paramount.
- A disadvantage of this approach is that if the company does not demonstrate a rigorous assessment of performance against the ESG goals, it could receive criticism that it used the modifier to simply pay the executives a percentage more than they would have otherwise been paid.
How many ESG goals should be included in the executive compensation program?
- This determination should be based on the company’s materiality assessment. Has the company identified two ESG risks or opportunities that are significantly more material than others? If so, the right approach may be to include those goals as either a specified percentage of the overall incentive bonus (i.e., reducing the percentage allocations of other metrics) or as the basis for determining the overall bonus modifier.
- Does the company have 10 material ESG goals that are relatively equal? If so, a scorecard approach may make more sense so that the company can evaluate its overall performance against all 10 goals as either a specified percentage of the overall incentive bonus or as the basis for determining the bonus modifier.
How should performance against the ESG goals be evaluated?
- Compensation committees may be inclined to evaluate performance qualitatively as not all ESG goals are strictly quantifiable. If this is the case, the compensation committee should still demonstrate a rigorous assessment and a thoughtful rationale behind the evaluation. Otherwise, shareholders may feel the compensation committee is simply paying executives more for little-to-no additional performance.
- An alternative is evaluating quantitatively without predetermined targets. This method allows shareholders to know exactly what ESG goals the compensation committee is evaluating but does not require the establishment of specific targets to hit.
- Quantitative evaluation (with proactive targets) is most like current best practices for establishing financial objectives in executive compensation structures, which is the main advantage of this approach. It comes with risks, however. How rigorous should those targets be? If they appear too easily achievable, criticism can follow. If they’re set too high, the company may experience reputational risks for not achieving one or more of its most material ESG goals. No company wants to see a headline saying an executive received less pay because the company missed a safety goal, for instance.
It’s important for compensation committees to remember that adding ESG goals to the compensation program is only the first step when integrating ESG into a plan. An equally important next step is disclosing performance metrics and the actual pay at the end of the year. Transparency is key here: Committees that assume they will please shareholders if they tie 10% of an annual bonus to ESG goals, for instance, will create trouble for themselves if they do not consider what that disclosure will look like in the future.4
While there is an emerging consensus across the business landscape that integrating ESG into executive compensation is a critical way to drive accountability, there is no one-size-fits-all approach. Compensation committees would be wise to consider the above questions before attempting to integrate ESG into their executive compensation programs. They should do so only when the time is right and once they have engaged with company stakeholders to gain their perspective.
1: Spierings, M. (2022) Linking executive compensation to ESG performance, The Harvard Law School Forum on Corporate Governance. Available at: https://corpgov.law.harvard.edu/2022/11/27/linking-executive-compensation-to-esg-performance/ (Accessed: April 10, 2023).
3: Frimpong, E. (2021) The growing influence of ESG in executive compensation, Diligent Institute. Available at: https://www.diligentinstitute.com/commentary/the-growing-influence-of-esg-in-executive-compensation/ (Accessed: April 10, 2023).
4: Why greenwashing and competence greenwashing are risks to ESG integration and Corporate Sustainability, Phys.org. Kyushu University. Available at: https://phys.org/news/2023-03-greenwashing-esg-corporate-sustainability.html (Accessed: April 10, 2023).
© Copyright 2023. The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
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