Maximizing the Benefits of ESG Performance Metrics in Executive Incentive Plans

20 December 2023 / Brief

Companies have crossed the Rubicon in integrating environmental, social & governance (ESG) performance into their executive incentive plans. With three-quarters of S&P 500 index companies embedding some type of ESG metric into their leadership compensation policies, the practice is now deeply ingrained. But there is an opportunity to move beyond generic goals and tailor ESG performance measures in a way that contributes to competitive advantage and long-term growth.

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Expect companies to continue to link executive compensation to ESG performance, even in the face of growing ESG backlash. According to 2023 disclosures, 75.8% of S&P 500 companies incorporate ESG performance in compensation design, compared to 66.5% in 2021. As part of their general response to ESG backlash, companies should take a fresh look at how they include ESG objectives in executive compensation. Choosing these metrics carefully is crucial to ensure an executive compensation plan that drives sustainable value creation.

Compensation committees should identify and prioritize ESG factors tied to their company’s long-term business strategy. Currently, ESG performance metrics tend to relate to the company’s industry: for example, only 24% of information technology companies integrate environmental performance metrics in their executive incentive plans, compared to 80.2% of energy companies. As organizations integrate sustainability more deeply into their operations, they should select incentives that give them a competitive advantage while serving a broader societal purpose.
Companies now have more experience with ESG metrics and a greater wealth of benchmarking information to enable them to include ESG measures in long-term incentive programs. The percentage of S&P 500 companies that integrate ESG performance metrics in both their annual incentive plan and their long-term incentive plan has grown from 7.3% in 2021 to 12.4% in 2023. Given the long-term nature of many ESG goals, incorporating them in LTI plans may be a natural fit.

While considering ESG as part of individual performance assessments continues to be the predominant practice, companies are moving toward more quantifiable and less discretionary objectives. In the S&P 500, 31% of firms now use discrete, weighted (stand-alone) ESG metrics, compared to 25.5% in 2021, and 35.2% use strategic scorecards that include one or more ESG metrics, compared to 20.9% two years ago. Compensation committees may wish to consider a combination of approaches, depending on the nature and ability to quantify the specific objective.

Companies that do not yet do so should investigate using ESG metrics to drive human capital management and environmental performance—two areas where investor and regulatory scrutiny continue to increase. Some 90.4% of S&P 500 companies now integrate at least one HCM-related metric in their executive incentive plan, and 53.6% deploy environmental metrics. In so doing, companies should consider measures that reflect their specific workforce strategies and environmental risks and opportunities, rather than just off-the-shelf GHG and DEI metrics.