Purpose driven leadership: the evolving role of ESG metrics in executive compensation plans
Environmental, social, and governance (ESG) issues are undeniably making their way onto corporate boardroom agendas today. Many large institutional shareholders are asking companies to focus more, do more, and disclose more about ESG efforts.
ESG metrics: The roadmap to readiness
Thinking through implementation
- Which metrics and weighting?
- To whom should the goals apply?
- How do the metrics operate?
- What time horizon is appropriate?
- How will this affect disclosure?
Which metrics and weighting?
Some companies are using a dozen or more different types of ESG metrics in their compensation plans. Which metrics are right for the company’s executive team will depend on a number of factors. Currently, the most common types of metrics relate to human capital management and social issues. Among the S&P 500 companies that use ESG metrics, 41% use some kind of human capital-related metric, with diversity and inclusion (D&I) metrics being most common. Only 14% are using one or more environmental-based metric.
To whom should the goals apply?
Some boards start by creating goals that apply only to the CEO. Others choose to hold the entire executive team accountable, and still others create broad-based goals that apply to employees much further down in the organization. The right answer for a company might depend upon:
- How closely is the ESG goal tied to company strategy?
- What is the scope of responsibility for the metric within the organization?
How do the metrics operate?
Executive compensation plans are complex and varied. Different types of plans present different options for building metrics. The current plans in place at a company may limit the options available now, but as the topic evolves, boards and compensation committees may start to consider slightly different plan structures depending on their goals and perspectives.
What time horizon is appropriate?
ESG metrics are most commonly used in annual bonus plans, rather than long-term incentive plans. Shorter-term annual plans tend to have more flexibility, allowing for strategic and/or individual performance goals. But many ESG goals do not fit naturally into a one-year time horizon. Long-term incentive plans may align better with the long-term changes companies are pursuing as part of their ESG strategy. But even then, common measurement periods may not be long enough to capture ESG goals.
How will this affect disclosure?
Currently, sustainability disclosures are predominantly voluntary, meaning that companies take a variety of approaches to ESG reporting. Many companies publish a stand-alone report, or create a separate section of the website. When ESG metrics are added to executive compensation plans, the nature and extent of the disclosure changes too.
What could go wrong?
For boards and compensation committees thinking about adding new metrics to compensation plans, it’s important to consider the risks associated with those changes.
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