ESG goals in incentive plans should follow strategy

Introduction

For the last 12 months, businesses have been dealing with the challenges of the pandemic, but the need to address climate change, and heightened public awareness of governance and the societal impact of business, are now pushing environmental, social and governance (ESG) issues to the fore for investors, consumers and regulators.

As ESG moves up the agenda, there are expectations that executive pay should be linked to it, presenting an additional challenge for Board Remuneration Committees. In considering which ESG targets should be incorporated into executive incentives, organisations should assess how these metrics connect to their overall business strategy. Remuneration Committees should consider what is most relevant to the business, whether it can be measured effectively, and how to ensure that targets are stretching but also realistic and achievable.
A legacy of ESG in business

Environment: Awareness of environmental impact started to gain traction in the 1990s, with such developments as the UN’s Rio Earth Summit in 1992 and Kyoto Protocol of 1997, and stakeholders started to urge companies to build sustainability into their business models. With global awareness and increasing governmental action, especially since the Paris Agreement on climate change in 2016, growing pressure is being placed on corporations to achieve sustainable, low carbon operations. The Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) published its final recommendations in 2017, aiming to achieve more consistent and transparent disclosure of how companies are incorporating climate-related risks and opportunities into their strategic planning and performance measurement. The UK Financial Conduct Authority announced a new Listing Rule (9.8.6R (8)) in December 2020, applying to accounting periods starting on or after 1 January 2021, requiring companies with a UK premium listing (some 460 companies) to include statements in their annual reports regarding compliance with the TCFD recommendations The UK Government is also consulting on making these disclosures mandatory for all publicly quoted companies, large private companies and LLPs. The United Nations has also prioritised 17 goals in its 2030 Agenda for Sustainable Development, adopted in 2015.

Social: Concepts of social responsibility in UK business can be traced to the early industrial social reformers such as Robert Owen and his New Lanark Mill in the early 1800s, the Quaker entrepreneurs who aimed to run their companies according to non-conformist Christian principles of respect for all individuals, and the early founders of the co-operative and friendly society movements. More recently, these concepts have manifested themselves in a growing focus on workforce diversity and equality, living wage, and concerns about the labour conditions in local and international supply chains.

Governance: Principles of responsible corporate governance have also been growing in prominence over the last 30 years. The precursors to the current UK 2018 Corporate Governance Code, the Cadbury Report (1992) and the Greenbury Report (1995), focused on ensuring that shareholders’ interests were properly protected by company Boards The 2018 Code included additional emphasis on the protection of the wider community of stakeholders.

Most recently in 2020, the World Economic Forum (Davos) published its ‘four Ps’ of stakeholder capitalism:

• Principles of governance – the quality of the governing body, stakeholder engagement, and ethical behaviour;
• Planet – climate change, land use and preservation, and freshwater availability;
• People – dignity, equality, health, and future training; and
• Prosperity – economic contribution, innovation of better products, and community vitality.

ESG covers a broad range of topics, much of which overlaps with the WEF’s ‘four Ps’:

‘Environment’ indicators include: energy use; greenhouse gas emissions and carbon footprint; waste recycling and disposal; biodiversity, forest and environmental protection; and, resource use/efficiency.

‘Social’ indicators include: respect for human rights; health & safety; labour conditions and standards; diversity; pay equity and thresholds; colleague engagement and training; and, community impact.

‘Governance’ indicators include: the independence, diversity, expertise and accountability of directors; executive compensation policy and practice; stakeholder relations and shareholder rights; transparency; risk management; anti-corruption; and, regulatory compliance.

Around one-third of FTSE 100 companies, but only about one-fifth of FTSE 250 companies, have an ESG category in their annual bonus metrics, and only one-tenth of FTSE 350 companies include ESG measures in performance share plans (PSP). Early insights into FTSE 100 2020 year-end reports indicate further development: of the first 40 reports published, the number with an ESG metric in their PSP appears to have increased from 15% to 30%. Over 20% have introduced a new metric into the bonus assessment.

There is an ongoing debate about the extent to which positive action on ESG topics helps to drive company performance and shareholder returns — and is therefore not only a matter of ethics, but also makes sound commercial sense. Whether or not you accept the argument and evidence that a direct causal relationship exists between ESG and company performance, action, or inaction, on ESG topics is likely to affect corporate reputations and therefore have consequences for sales revenues, share price and investment.

Which aspects of the ESG agenda are most relevant to your business?

Businesses that aim to tie executive pay to ESG measures should determine which metrics are most relevant to their business strategy. It is important to consider how to define goals, how progress will be measured and how targets will be set. If you cannot measure performance accurately and set reliable targets, it is difficult to tie to compensation.

Targets can be categorised as follows:

Output targets: measurable outcomes, typically quantifiable, but reliant on good data collection and measurement. These are generally preferred by investors and voting agencies, including when ESG is used in incentive plans.

Input targets: focused on plans and actions (eg. developing and implementing a programme). These are usually qualitative and therefore harder to measure, but nevertheless can be very demanding. Sometimes these can be defined as milestones of achievement, which are timebound even if not quantifiable.

Rounded assessment: data, observation and reports are used to inform a rounded assessment by the Remuneration Committee, potentially across a ‘basket’ of indicators, which might include both inputs and outputs.

In most listed companies, executives have both annual bonus and long-term incentive plans (LTIPs) – typically with a three-year performance period. ESG objectives are, by their nature, long-term projects, so might fit more naturally into the time-horizon of an LTIP. However, investors are generally more tolerant of non-financial metrics in the annual bonus, so it is likely that ESG metrics will be adopted fastest in these shorter-term incentive plans. Inclusion of ESG metrics in an LTIP is likely to involve a higher burden of proof on the Remuneration Committee to demonstrate that the goals are specific, measurable and critical to the longer-term strategy.

Whilst all ESG indicators are important, some will have greater urgency or relevance in certain sectors. For example, in the energy, mining, construction, and manufacturing sectors, the most prominent measures might be carbon footprint, environmental impact, resource sustainability, worker safety and international labour conditions. Whereas, issues such as local community impact may feature more highly in some service sector businesses.

Underpin or discrete metric?

Some businesses have introduced ESG only as an incentive underpin, rather than a specific part of the incentive scorecard. As an underpin, the impact is limited to downward adjustment of the payment outcome when there is poor or unsatisfactory performance on ESG criteria. This avoids the need to set a precise performance scale for the ESG indicators and treats ESG as a ‘hygiene factor’ — that is, a necessary pre-condition or minimum standard for doing business. This treatment of ESG may not give it the necessary positive emphasis or create a clear set of goals for progress in ESG performance. It also leaves open the question of how large an adjustment is appropriate when there is an ESG underpin failure. However, it is always important for the Remuneration Committee to be able to apply downwards discretion where there is a significant ESG failing, and this flexibility needs to be available even where ESG forms part of the scorecard.

A few select metrics or a broader ‘basket’ of indicators?

Another key question is whether to focus on one or two ESG indicators selected from the broader ESG agenda, or whether to take a more holistic approach and have a basket of ESG indicators covering a range of different elements. The first approach may be simpler, easier to quantify and require less judgement in the assessment. However, the second approach can avoid an over-emphasis on a few narrow areas that become a distraction for management at the expense of the bigger picture.

Determining the correct weightings

Where ESG metrics are used, their weighting is typically 10-20% of the scorecard. The level of emphasis depends on the overall strategic priorities with the company. This raises a number of related questions: If you wish to introduce ESG metrics, where should you reduce other KPIs, such as financial or other non-financial metrics? How will investors respond to such action? If investors signal apprehension at reducing the emphasis on financial performance, perhaps there are non-financial areas you can de-weight?

ESG metrics need to fit into the wider remuneration policy. It is best to approach ESG goal-setting with a view that balances near-term, realistic goals and longer-term visions and ambitions. Often, it is difficult to maintain that balance in the face of activist investors, vocal customers and regulators.

Conclusion

ESG is likely to become an enduring feature of business strategy and executive incentive scorecards, as companies act to protect and enhance their reputations and brands, and respond to the challenges and preferences expressed by their stakeholders.

As this shift of focus progresses, Remuneration Committees may need to become as adept at understanding, target-setting, measuring and assessing ESG performance as they are in matters of financial or total shareholder return performance.

A&M can help

you would like to discuss this area further, please contact us. We are also able to draw on the expertise of A&M’s specialist ESG advisory team, who are highly experienced in developing ESG strategies and metrics for companies.

https://www.alvarezandmarsal.com/insights/esg-goals-incentive-plans-should-follow-strategy-0