Linking Executive Compensation to ESG Performance

As companies address two fundamental and related shifts—the intensified focus on environmental, social & governance (ESG) issues driven by investors, employees, consumers, business partners, ESG rating agencies, and regulators,^[1] and the shift to a multistakeholder form of capitalism^[2]—corporate boards are not only incorporating nonfinancial matters into discussions of company strategy and business plans, but also increasingly considering ESG performance measures in incentive plans. At the same time, there are concerns about the benefits of incorporating ESG measures into compensation, the risks of doing so (e.g., rewarding the wrong behaviors, setting inadequate targets, and creating guaranteed bonuses), and challenges in providing investors with what they view as sufficient transparency and specificity in ESG-based pay plans. These concerns have now been compounded by skepticism about whether ESG can actually drive financial performance for companies and investors alike.^[3]

Insights for What’s Ahead

• The vast majority of S&P 500 companies are now tying executive compensation to some form of ESG performance—growing from66 percent in 2020 to 73 percent in 2021.The most significant increase was found in companies’ use of diversity, equity & inclusion (DEI) goals, rising from 35 percent in 2020 to 51 percent in 2021, as investors and other stakeholders continue to focus on diversity—making it a priority for companies as well. And as a result of the ever-growing attention to climate change, the share of S&P 500 companies that tied carbon footprint and emission reduction goals to executive pay also grew considerably, from 10 percent in 2020 to 19 percent in 2021.
• Companies are embracing different approaches to factoring ESG into executive pay and are continuing to refine their ESG measures as they expand their reach. For example, some companies are moving from including ESG measures as part of the often-qualitative individual performance section of the annual incentive plan to incorporating ESG performance as a more quantitative modifier of the company’s overall financial performance rating, which is more aligned with investors’ preferences and expectations. Other companies are expanding the scope of those whose compensation is affected by ESG measures beyond the C-suite, reflecting that achieving ESG goals requires the collective effort of the employee base more widely.
• Leading reasons companies are incorporating ESG measures into executive compensation, according to a poll of roundtable participants, are to signal that ESG is a priority, to respond to investor expectations, and to achieve ESG commitments the firm has made. While these are valid reasons, they also raise concerns. For example, some large institutional investors are skeptical about tying compensation to ESG measures, especially if there is not a strong business case for doing so and if the ESG goals are not sufficiently challenging or specific. Further, there are other less costly and disruptive ways of signaling ESG is a priority, including building ESG factors into professional development, succession, and promotion practices. Companies can also convey or achieve their commitment to ESG by enhancing disclosure on ESG performance.
• Companies should consider using ESG operating goals for one to two years before including them in compensation. That allows time to see if those goals are truly relevant for the business, develop strong management and employee buy-in, and address any kinks in measurement methodology and reporting. It is especially important for companies to take time to validate and socialize ESG goals before rolling them out as part of compensation plans for a broader management or employee base.
• It takes time to develop and compile reliable, meaningful data that can be used to measure and report actual performance against ESG goals. Companies can start by putting together a steering committee with representatives from various functions (e.g., compensation, finance, sustainability) who are engaged in the company’s strategy, and understand and have access to the data needed to measure and report on ESG performance.
• Companies can link executive compensation to ESG successfully; however, they will need to go beyond simply “following the trend.” Actions companies will need to take include 1) identifying goals that are material, durable, and auditable, 2) assessing whether what the firm’s peers are doing in this area is instructive, 3) deciding whether to make performance measures absolute or relative to the market, and quantitative or qualitative, 4) determining the scope of those whose compensation is affected by ESG goals, 5) considering timing and assessing whether the ESG goal is appropriate for the annual or long-term incentive plan, 6) ensuring the type of metric reflects the firm’s corporate culture, 7) carefully considering the reaction of various stakeholder groups, and 8) reevaluating goals periodically to ensure that the ESG measures are still relevant and effective.
• Companies will need to explain why including or adjusting ESG goals in compensation programs makes business sense and will “move the needle” on the firm’s performance and impact. Investors will want to understand how modifying the company’s compensation is necessary to achieve the firm’s financial, operating, and ESG goals—and whether the goals are sufficiently challenging to put compensation “at risk.” Those covered by the compensation programs will want to understand why a portion of their compensation is now linked to ESG goals. In some cases, the rationale may be obvious, such as when a company includes compliance-related goals in the wake of a widespread compliance failure. In other cases, boards and senior management will want to carefully consider whether they have a compelling narrative for adopting or adjusting such goals, especially as most companies say that including ESG measures in executive compensation is no more than “medium important” to their overall ESG efforts.
• Measuring the full impact of including ESG performance goals in compensation is more challenging than measuring the impact of traditional operating or financial metrics. Companies should consider what they are trying to achieve by including ESG measures in compensation programs: is it to improve the firm’s ESG performance, to enhance its operating and financial performance, to signal that ESG (or a specific ESG metric) is a priority, to have a meaningful impact on society and the environment, or some combination of all four? If companies are actually seeking to have a broader impact on society and the environment, they may want to give serious consideration to how, if at all, they are incentivizing executives to work collaboratively with others in the industry and across the firm’s value chain—because making a measurable difference may require collective action.