Aligning executive compensation with ESG goals

Don’t put the cart before the horse

Boards should ensure that the organization’s broader ESG strategies and targets are sufficiently developed and operational before incorporating them into incentive plans, including taking the below measures.

• Boards will want to determine priorities and develop procedures to track key ESG performance indicators, and regularly update and change ESG goals as existing targets are met.
• Boards will need to consider which ESG strategies are appropriate to include in incentive plans, the anticipated timeframes for achieving ESG targets and to what extent management is involved in setting and/or achieving ESG targets. In addition, boards should consider how the selected ESG metrics complement the creation of shareholder value.

Don’t forget disclosure

Compensation decisions made by the board, including relevant performance goals and whether these goals were met, must be publicly disclosed each year. Public companies must be prepared to disclose their ESG targets, explain why the targets were selected and describe the company’s performance relative to the targets year over year while keeping in mind that stakeholders look unfavorably on disclosure that “greenwashes” management behaviour.

Disclosing and assessing ESG metrics is challenging given that these metrics are often not easily comparable against a company’s peer group and that there is currently no best practice standard of disclosure regarding ESG metrics in incentive plans. For additional information, see our bulletin on the Canadian Securities Administrators’ recent amendments on corporate governance disclosures and best practice guidelines.

Key compensation plan design considerations

If a board believes the company has robust ESG practices in place and would like to further align management behaviour with its ESG goals through ESG-related compensation measures, here are some key plan design elements the board should consider.

Which ESG metrics should be measured?

The most commonly disclosed ESG metrics used in incentive plans relate to human capital management (e.g., diversity, equity and inclusion, employee safety and retention). We expect an increase in climate-related metrics (e.g., sustainable sourcing, GHG emissions and carbon footprint) as institutional investors continue to emphasize that climate risk is a material risk for all companies. Other ESG metrics include community engagement, product quality and cybersecurity. Boards will need to consider which ESG metrics are appropriate for their incentive plans in light of the company’s broader ESG priorities.

Should ESG metrics be incorporated in short-term incentive plans (STIP) or long-term incentive plans (LTIP)?

A majority of the public companies that have incorporated ESG metrics into their incentive plans have done so through a STIP (rather than an LTIP). While reasons for doing so may vary, equity-based LTIPs may not be conducive to incorporating quantitative or qualitative ESG metrics that remain relevant from the year-of-grant to the year-of-vesting. Moreover, many ESG goals are not achievable within the time frame of a typical three-year LTIP cycle. With STIPs, companies can set shorter-term milestones that further longer-term ESG goals.

How will ESG strategies and targets be measured?

Qualitative ESG goals remain relatively common. However, investors require sufficient information to understand how a board assesses and rewards performance against ESG objectives, particularly when it comes to discretionary and qualitative metrics. Many ESG targets (such as employee wellbeing, community engagement and sustainable supply chain sourcing) are not easily quantifiable. If the board incorporates quantitative ESG metrics, participating executives will need to understand how the metrics will be assessed and should have some level of influence over whether the applicable ESG target can be met.

While furthering ESG priorities is an important goal, incentive plans should not place undue weight on ESG factors relative to other operational and financial targets. An incentive plan should not be designed in a manner that would disproportionately compensate an executive for meeting ESG goals when compared to overall shareholder value creation.

Conclusion

Making ESG metrics a meaningful part of incentive plans requires a thoughtful process and planning across many operational levels. Although proxy advisors generally have remained neutral on linking executive pay to ESG criteria, there is growing pressure from institutional investors and governance bodies to do so. Boards should work with management to understand the current state of ESG strategies and which ESG metrics create value for the company’s shareholders and other stakeholders in order to design incentive plans with ESG metrics that are challenging yet obtainable, measurable and objective.