Aligning executive compensation with ESG goals
Authors
Jennifer Lennon
Ellie Kang
Sarah Fallis
Public company boards are facing increased scrutiny from stakeholders regarding how they are prioritizing environmental, social and governance (ESG) matters. As a result, there has been an uptick in incorporating ESG metrics into incentive plans in an attempt to align management behaviour with short- and long-term ESG goals. According to the Responsible Investment Association, approximately 60% of TSX-listed Canadian companies on the S&P/TSX Composite connect ESG criteria to executive pay in some way1. So, how should boards be thinking about incentive plans as a tool to facilitate management alignment with ESG strategies and targets?
Ellie Kang (00:06): In recent years, as ESG has moved up the corporate agenda, many companies are increasingly looking for ways to incorporate ESG considerations into compensation designs for their CEO and their other senior executive officers. The question for a lot of boards and their compensation committees then is this: How can we incorporate ESG considerations into various executive incentive plans in such a way that it is meaningful and makes sense for the enterprise as a whole?
I'm Ellie Kang, and I'm here with Jennifer Lennon to answer three most common questions that companies seem to struggle with. First, which ESG metrics should be used to measure performance? The second question would be whether to set the time horizon for measuring ESG performance on a short-term or long-term time horizon? And third, whether to use quantitative or qualitative ESG measures.
Jennifer, which ESG metrics would you advise boards to consider using?
Jennifer Lennon (01:14): So I think the key for any company is looking at the company-wide, broader ESG strategy, and that will vary from company to company. So I think the starting place is looking at the company-wide ESG priorities. And then within those priorities, thinking about which ones make sense to incorporate into your incentive programs. So it's still early days where we're seeing ESG in incentive plans, but we're seeing certain trends emerge in the marketplace.
One type of metric we're seeing is human capital-related metrics. So think of things like diversity, equity and inclusion targets, employee engagement, employee well-being and satisfaction. And these would all fall within the “S” and “G” buckets of ESG. And so those would be the social and governance-type categories. We're also seeing things like company community engagement and cybersecurity.
The one area we think we will see growing popularity in the coming years are metrics related to climate change, particularly as companies try to finalize their climate-related priorities. We imagine we'll start to see those more in incentive programs. So things like GHG emissions, carbon footprint and sustainable sourcing.
Ellie Kang (02:37): Yes, the choice of ESG metrics is one of the key decisions that needs to be made. Another key question is whether to incorporate ESG considerations in a short-term incentive plan or a long-term incentive plan. To date, we are seeing most public companies using ESG metrics in their short-term incentive plan. And the reason for that might be that in a long-term incentive plan, ESG metrics must remain relevant all the way from the year of grant to the year of vesting.
And that may not be conducive to a lot of the ESG metrics that might be relevant. In addition, many ESG goals are typically not achievable within the time frame of a typical long-term incentive plan horizon, which is three years. In contrast with the short-term incentive plans, companies can just set shorter-term goals that are achievable or set milestones that can then help further the ultimate ESG goals.
Jennifer Lennon (03:42): Yeah, I agree with you. I think up to this stage were mostly seeing these types of ESG metrics incorporated into STIPs or short-term ranges. And I think the last key question that companies are asking themselves are: Should these ESG metrics be qualitative metrics or quantitative metrics? And up to this point in time, I think we're seeing mostly in the nature of qualitative metrics, particularly because a lot of the metrics people are choosing relate to this human capital, social governance-type metrics, which are more challenging to see as a quantitative metric.
I think this might change over time. And certainly, once we start to see things like climate becoming more prevalent in incentive plans, we might see a shift towards quantitative metrics. I think regardless of the metrics you're choosing, I think what is important is that the metrics are robust, and that the company can explain to shareholders what the metrics are, they can explain to their executives how to achieve those metrics, how they will be calculated.
And the board also needs to be aware that once those metrics are set, the metrics themselves, as well as the company's achievements relative to those metrics, will ultimately need to be disclosed. So it's something to keep in mind when determining which metrics to pick and whether those will be actually qualitative or quantitative in nature.
Ellie Kang (05:13): Yeah, that really speaks to a key point in measuring ESG performance. ESG metrics and incentive compensation plans need to be really considered and designed along with the workflows and strategies of the enterprise as a whole. And incentive plans certainly cannot place undue weight on ESG factors relative to other operational or financial measures that are key to creating overall shareholder value.
So here it comes down to really sustainability. Boards and their compensation committees that are setting up or fine tuning their ESG metrics for their executive compensation plans, will find longer term, more sustainable success with the entire ESG strategy by taking an enterprise-wide approach.
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.
- “ESG in Executive Pay: A Look at the Big Canadian Banks”, available here.
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