As discussed in our third alert in this series, legal risks will likely increase as ESG (environmental, social and governance) disclosures become more robust and stakeholders (and the plaintiffs’ bar) continue to become more sophisticated in evaluating and challenging the disclosures. At present, understanding and integrating ESG (or more broadly, sustainability) into business is a means to manage and mitigate reputational and operational risks. However, when ESG is viewed only through a risk management and/or compliance prism, a company will likely fall short of being well-positioned to adequately and fully balance all stakeholder interests. This will also likely leave gaps in disclosures and increase a company’s susceptibility to greenwashing and legal claims.
Boards and senior management can position the company to be proactive in shaping the ESG narrative versus reactive to the marketplace. More fulsome ESG disclosures may become mandatory. Before that time, boards of directors and senior management must evaluate (or re-evaluate), reimagine and create the necessary internal processes, protocols and structures for alignment of ESG with the business’s purpose and values for long-term sustainability and resiliency. Governance is the link that guides and challenges a company’s ESG focus, creates accountability, fosters transparency, eliminates the siloes and creates incentives for achievement.
At this point, it’s very likely that many boards and senior management have had discussions about ESG in some form. Boards will need to be more involved in understanding and challenging the ESG strategy with senior management to provide effective oversight and manage risk.
In this final alert of this series, we discuss ways the board can cultivate a dynamic with senior management that provides oversight and shape to an ESG strategy and the role of executive compensation in incentivizing its achievement.
Building Blocks for an ESG Strategy
Approaching ESG in a coordinated and holistic way involves assessing and identifying the ESG factors that are aspirational, are financially and non-financially important to the business presently and in the future, and are realistically executable in a cohesive manner. At a macro level, the following resources serve as guides in this endeavor. As a reminder, these frameworks apply to any public and private company, regardless of size or industry.
- UN Sustainable Development Goals (SDGs) – The UN SDG’s 17 goals can provide a foundation to assess, identify and establish a company’s aspirational and interim goals. The SDGs can be further organized into broad categories of climate, society and economy as shown here. Relatedly, B Lab’s SDG Action Manager is useful to set goals and track progress towards achievement.
- SASB’s Materiality Map - As discussed in our second alert, SASB’s standards and materiality map, organized by industry and sector, can focus on the ESG issues most likely to impact the financial performance of a company. TFCD’s disclosure standards can provide an additional resource on climate related issues.
- B Lab’s Impact Assessment – Whether or not B Corp certification is relevant or appropriate for a company, B Lab’s Impact Assessment is highly informative to assess and reshape the integration of non-ESG factors critical to a company’s culture and values. The questions and elements related to workers, communities, and business partners provide a clear pathway to evolve multi-stakeholder focused practices.
- UN Guiding Principles on Business and Human Rights – The UNGPs provide a helpful and increasingly expected framework for the commitment to human rights, including a supply chain that identifies, remediates and prevents forced labor and the associated due diligence framework.
Creating a cross-functional team of internal expertise, led by key members of senior management and counsel, is the most effective way to take stock of current practices, policies, and internal processes that likely already fit within ESG categories to identify a base line. Counsel, in-house and outside, can assist in guiding the process, and both identifying and bridging gaps in awareness, practice and policy. Next, the CEO and the appropriate internal team leaders can identify the strategy and ways to coordinate and implement the ESG factors relevant for the business.
Board Engagement with Senior Management’s ESG Strategy
Board oversight and engagement with senior management is fundamental to creating internal and external trust and holistically managing an ever evolving new paradigm of business. Initially, as part of the board’s assessment, it should evaluate whether the members have the necessary experience and expertise to address ESG matters. Then, to effectively fulfill its oversight role of management’s ESG strategy, the board should imbed sustainable governing practices and protocols into the corporate structure or charter to position themselves to best understand, support and challenge management’s approach to ESG.
- Board’s Role and Responsibility – Given the breadth of ESG issues, successful oversight and implementation generally requires the full board’s involvement. However, like the many facets of ESG, selected topics may be better suited for specific committees, including the human resources, audit and compensation committees. To the extent separate issues are delegated among committees, there should be reporting into the full board for discussion and approval.
- Understanding the ESG Strategy – The ESG strategy should reflect management’s understanding of the risks, opportunities and impacts for the business and it’s short- and long-term goals, both aspirational and tactical. The inventory referenced above should include such an assessment across the ESG topics and shared with the board. The board should challenge management on its processes for evaluating and developing the strategy (both short-term and long-term), how it is integrating ESG into decision-making and operations, the weaknesses and areas for improvement, and whether the strategy and approach is consistent with the purpose and ethos of the enterprise. This assessment should also be consistent with existing company policies and/or identify the ways in which existing policies need to be refreshed and unified with the ESG strategy.
- Multi-Stakeholder Concerns and Priorities – The board should develop a comfort level that senior management has a full and adequate understanding of its various stakeholders’ concerns and priorities. For management, this means engaging with and reconciling the concerns and priorities of its employees, major investors, customers, consumers, business partners and suppliers. For the board, it means understanding how management is engaging with these stakeholders.
In this regard, a cross-functional ESG team is imperative to coordinate and harmonize internal functions such as: investor relations, procurement and sourcing for supply chain issues (labor issues and diversity within both the raw materials and production supply chains), legal and compliance, marketing and corporate communications, and human resources, among others.
- Internal ESG Reporting – With so much emphasis on external reporting and to which stakeholder audience, senior management and the board should have protocols in place for the CEO and senior management to also comprehensively report internally on execution and implementation. In this regard, leveraging and tailoring existing protocols is a useful starting point.
- Infrastructure for External Reporting – It should go without saying that as sustainability reporting becomes more robust and fulsome in the move to a “know and show” disclosure approach, senior management should have adequate internal processes in place to be able to substantiate the disclosures, regardless of the ESG factor being disclosed.
An ESG strategy and the integration of it, however, is a continuous process that is intended to evolve. And as ESG continues to evolve, executive compensation can play a critical role towards achieving the identified ESG goals.
The Role of Executive Compensation
The link between ESG and executive compensation is debated just as much as the link between ESG and long-term shareholder value. Executive compensation is complex in its own right. Currently, the ESG-executive compensation link is tenuous, which reflects the lack of clarity around ESG’s role in a fragmented ecosystem.
According to Sustainalytics, only 9% of FTSE All World companies link executive pay to ESG criteria. Health and safety has been the dominant ESG metric with achievement assessed in annual incentive plans. Diversity and inclusion goals are increasingly becoming the new metric linked to ESG. These factors and other environmental or climate focused metrics (e.g., reduction in Green House Gas emissions) lend themselves to quantifiable measurement and are arguably verifiable. Incentivizing the other, less quantifiable factors have not gained traction.
At its simplest, compensation incentive structures – both annual, short-term and long-term – are intended to motivate, retain, and incentivize employees to achieve the company’s goals. Fundamentally, the performance metrics are reflective of the company’s larger business goals and strategy. But they also shape a company’s culture and focus, and are reflective of a company’s purpose and values.
Executive compensation is very market and peer-group driven. Companies typically evaluate their self-selected peer groups to assess market practices, and the dominant short-term and long-term metrics within the group and application to their company. The heavy emphasis on peer group data can operate to hold companies back from linking less financially driven ESG factors to incentives unless the company is willing to stand out. In this regard, there are many challenges and benefits to linking ESG and executive compensation.
- Selecting ESG metrics that make sense to incentivize
- Ascribing a weight to non-financially grounded metrics
- Verifying achievement
- Increases accountability
- Signals the company’s values and purpose to the stakeholders, whether investors, employees, and communities
- Reflects a move towards stakeholder capitalism
- Creates a new dimension of transparency (particularly for public companies required to explain its compensation philosophies in the annual proxy)
- Possible way to address the pay gap, diversity, environmental goals and other ESG targets
Despite the challenges, according to the World Economic Forum, the idea of aligning ESG with executive compensation is gaining ground. A fundamental question is whether executing on an ESG factor is part of an executive’s base roles and responsibilities. If not, is it something that warrants incentivizing? For example, cybersecurity is an area where a breach may happen rarely. When a breach occurs, it can create significant reputational damage. Should the lack of cybersecurity breaches be incentivized or is it just an expectation? If it should be incentivized, how does one ascribe a measurement and value to the lack of cybersecurity breaches? Alternatively, if it is not incentivized, should a breach trigger a clawback of pay?
In contrast, supply chain issues such as supplier diversity and labor rights have not traditionally been a base expectation. Yet, as modern slavery disclosures are becoming mandatory in several jurisdictions, the area has gained incredible attention over the past several years and is becoming top of mind, right behind pay equity and diversity and inclusion. Here, the question becomes whether the development, refinement, goals and targets around a human rights policy and due diligence practice warrant incentivizing for some period of time until it is integrated and becomes a base expectation.
What is clear is that alignment of executive compensation with ESG integration should be critically evaluated as the financial relevance of ESG to a company’s long-term value and will continue to evolve. Like the ESG movement itself, executive compensation as a tool to incentivize ESG integration is likely to become the expectation and a way to align profit and purpose.
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ESG issues are rapidly being recognized as, and are becoming, table stakes. As investors continue to have leverage and impact on these issues, voluntary reporting is expected to increase, become more sophisticated and robust, with reporting in line with SASB, TFCD and GRI standards. Legal risk will likely increase for companies whose actions are not aligned with disclosure. While climate issues will continue to be a focus, operational and supply chain issues related to forced labor will come into greater focus, including mandatory due diligence requirements with the EU taking the lead.
COV1D-19, combined with social and racial awakenings, are pushing companies to a tipping point where they must address these issues in some way. As a result, it behooves companies to develop the necessary structures and assessments to effectively and efficiently be proactive in addressing ESG now. We hope you enjoyed this series.