Many retail, institutional, and private equity investors have increased their focus on environmental, social and governance (ESG) issues, which has resulted in heightened scrutiny of large public companies and private equity-backed companies alike. In that regard, investors evaluating a company’s ESG performance might consider a broad spectrum of criteria including whether a company is operating sustainably or engaging in sustainable practices; how a company is building its relationships socially with its employees, suppliers and communities; and how a company operates through its leadership, executive compensation, shareholder rights, internal controls and financial reporting.
Companies are increasingly discussing ESG in their annual 10-K reports, proxy statements, and directly with their private investors, but the public disclosures widely vary in scope and depth of content. As shareholder communication continues to evolve, larger public companies are leading the charge to differentiate their ESG practices from market competitors. Companies are now creating ESG committees of the board of directors, publicizing ESG policies and initiatives, separating ESG reports from other required reporting and incorporating ESG metrics in executive compensation programs. While some companies have incorporated ESG metrics into their incentive programs, there are still many companies that are taking a “wait and see” approach on adopting ESG metrics into their compensation plans.
Companies may struggle with identifying ESG performance metrics for executive compensation purposes due to the wide range of specific metrics, and the challenge of ensuring that they can be quantified and effectively measured.
Adopting ESG metrics that incentivize meaningful change in individual and corporate behavior takes time to develop. Industry leaders are beginning to push corporate ESG disclosure changes, but still struggle to fully bridge the gap between ESG and executive performance. While disclosures generally are becoming more detailed, most companies are using ESG metrics discretionarily in the overall decisions around executive compensation. Even companies forging the path to incorporate ESG metrics into executive compensation plans are still providing limited insight into the overall impact of their ESG linked metrics on incentives or behavior. As one Fortune 50 company, whose executive annual incentive plan (AIP) has included a culture and diversity factor since 2016, notes its investors continue to call “for additional clarity on our approach to including ESG commitments in our executive compensation program.”
Among those companies that are incorporating ESG metrics into their incentive plans, diversity and inclusion topics are gaining significant traction. However, a detailed explanation as to how this metric is measured is often not disclosed. In large part, diversity and inclusion metrics have been more qualitative than quantitative. Examples of measures include consideration of executive sponsored or created initiatives and public recognition of the company through diversity and inclusion awards.
Like other non-financial or non-operational performance metrics, some companies use ESG metrics to fund discretionary bonus payments based on the assessment and discretion of the compensation committee. If a company strongly believes in a specific ESG initiative, it might fund a discretionary bonus pool to reward participants for their efforts and dedication. Thus, alternative approaches can provide compensation committees tools to recognize ESG progress.
Depending on the quality of the ESG metric, it may be difficult to initially discern whether including the metric in executive compensation plans effectuates positive results in the community, executive behavior and company performance. However, increased investor demand for transparency and disclosure could motivate companies to incorporate meaningful ESG metrics into executive compensation plans that produce desired outcomes from their ESG-related initiatives.
Increasing focus on ESG factors in executive compensation can drive corporate and cultural change. While there is still uncertainty with ESG factors and their application to executive compensation, market trends are headed towards more ESG investments, policies and performance metrics.
For companies facing ESG-related challenges, contact A&M’s Human Capital team today.