August 15, 2022

ESG metrics in compensation plans—a growing trend

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Cooley LLP

Consultant Semler Brossy’s new report, ESG+Incentives, examines the prevalence of various ESG metrics as part of incentive compensation structures among companies in the S&P 500. Although some view ESG targets as just too nebulous to measure—how do you measure company culture?—and too amenable to “architecting” to ensure executive payouts, the use of ESG metrics as part of executive compensation plans appears to be a growing trend. The report concludes that the majority of companies in the S&P 500 now include ESG metrics, largely reflecting increased stakeholder interest in human capital and environmental issues. In 2022, “there was a nearly 23% increase in the proportion of S&P 500 companies applying ESG metrics in incentive plans, at 70% prevalence compared to 57% prevalence a year ago”—that’s a 13 percentage point increase year over year. Metrics related to human capital management were included most often as part of comp plans—used by 65% of all companies in the S&P 500, meaning that almost all companies that included any ESG metrics included HCM metrics. And, while environmental metrics still remained scarce at only 23%, that percentage reflects a 64% increase over the 14% reported last year. The report indicates that the predominant metric overall was diversity and inclusion (46% of companies in the S&P 500); carbon-footprint metrics predominate in the environmental category, having increased by over 300% from last year.

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In her lengthy speech on ESG to the Brookings Institution in 2021, SEC Hester Peirce touched on ESG metrics used in compensation plans. The SEC’s mission is to protect investors, not stakeholders, she contended, but, in her view, ESG advocates “hope to use the securities laws to force issuers to make disclosures about ESG issues important to them and ultimately to compel companies to make behavioral changes. They know that requiring public disclosures about particular employment or environmental activities might cause issuers to avoid those activities altogether, regardless of the costs of those changes to the investor. Investors stand to lose from these changes.” To the extent that management comp is tied to achievement of ESG metrics, it dilutes “accountability to shareholders for financial performance,” she argued, and corporate managers “stand to benefit.” (See this PubCo post.)

The report indicates that ESG metrics are primarily included as part of annual comp plans (98% of those that use ESG metrics), but the use of ESG metrics as part of long-term incentive plans appears to be growing (currently only 14%). Of that 14%, approximately 11% include ESG metrics in both types of plans. About 41% used a scorecard approach, which identifies a group of metrics that are not individually weighted, but form part of a broader initiative. SB indicates that the scorecard approach “allows companies to designate a certain percentage of an incentive plan to a group of two or more metrics, which may include strategic or operational goals in addition to ESG. The scorecard provides Committees more discretion to assess performance and to update goals and priorities each year without adjusting the fundamental incentive plan design.” About 23% of companies in the S&P 500 that include ESG metrics use “discrete, weighted metrics,” which are metrics that are assigned “a specific goal and a designated weighting.” SB contends that discrete weighted metrics are “often the most impactful design elements in incentive plans, used primarily for metrics that are “operationally focused, as opposed to sustainability oriented. [SB expects] that this trend is driven by the longer experience with these metrics and relative ease of goal setting.” And 28% are purely discretionary, with ESG metrics that are “not fully quantified but rather included as an additional layer of discretionary considerations that may impact final payouts, generally in an individual component.”

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In this 2021 article from SB, the authors recommended initial adoption of a “scorecard” approach that combines the company’s ESG priorities and includes some qualitative measures, with results determined in the board’s discretion, accounting for about 20% of total comp. As the board gradually becomes more familiar with these incentives, the authors suggested, “they can replace the scorecard with hard metrics measuring annual progress towards long-term goals. These goals will likely extend to the long-term incentive (LTI) plan as well since most require multi-year effort. Even if you start with qualitative assessments, it’s important to use objective metrics to inform the assessments. Those hard numbers help make the evaluation meaningful and communicate to the organization what successful progress looks like.” (See this PubCo post.)

ESG can include a broad mix of metrics, but SB has divided the mix into three categories: human capital management, environmental and a group of operational, consumer-focused and broader social measures, which SB has grouped together as “other ESG.” More specifically, in the category of “other ESG” SB includes customer satisfaction (employed as a metric by 32% of companies in the S&P 500), community engagement (11%), product quality (10%) and cybersecurity (6%). According to SB, 65% of all companies in the S&P 500 include some type of HCM metrics, only 23% include environmental metrics and 41% use metrics in the “other” category. About 45% of companies in the S&P 500 include metrics from two or more ESG categories; 14% include a mix from all categories.

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In this article from Fortune, the author contends that “ESG concerns from shareholders have started to move the say-on-pay needle,” and using ESG metrics in comp plans is one way to try to address that issue. However, one commentator observed that many boards are reluctant to consider adding ESG metrics, especially those that are “more entrenched” and “very stuck on this position” that ESG should not be a component of pay. One commentator cautioned that “boards must design pay schemes that incentivize action, not theater. A skeptic might argue that linking ESG metrics to compensation ‘just means [companies] are going to make up some B.S. measure and they’re always going to hit it, and no real change is happening’….He’s not alone in his reservations about how the heightened ESG focus could play out. ‘One of my big fears about this sort of stampede toward including ESG targets in executive pay is that it’s likely just to lead to more pay and not more ESG,’” according to another commentator. Another concern cited is that companies may be satisfied with achieving some social ESG targets, but ignore significant expansions of their carbon footprints. In this article from Bloomberg, an academic commentator opined that investors “‘are right to cast a critical eye over adding ESG metrics to executive pay plans….The challenge is the data we have are, frankly, bad. It’s really easy to reward the wrong thing because we can measure it.’”

Human capital

As noted above, HCM is the category most commonly included in comp plans. In the SB report, HCM includes as metrics diversity and inclusion (which was used in 46% of all S&P 500 comp plans), safety (33%), talent development (27%), employee satisfaction (22%), turnover/retention (20%) and company culture (16%). SB found that all HCM metrics increased “substantially in prevalence year over year,” driven, SB believes, by “stakeholder focus on talent-related issues, intense competition for talent, and the growing knowledge of how to measure and assess HCM performance.”

Consistent with last year, D&I is both the most prevalent metric within HCM and overall ESG (46% of companies in the S&P 500, compared to 28% last year), and the metric that experienced the second highest year-over-year increase of 64% (18 percentage points). Notwithstanding the dominance of D&I, SB found that companies generally looked at accomplishments in the category of HCM more holistically, with 86% of companies including at least one other HCM metric along with D&I, and about 61% including at least two additional HCM metrics.

Environmental

As noted above, environmental metrics appear least often as a category of ESG metrics, but the category increased significantly by 64% year over year, from 14% to 23%, the largest increase in category year over year. Included among environmental metrics are carbon footprint (used as a metric by 16% of companies in the S&P 500), emissions/chemical containment (8%), energy efficiency (5%), waste reduction (4%), sustainable sourcing (3%), and water consumption (2%). Why the big increase? SB attributes it to the growth in use of carbon footprint metrics, which “have been a key driver of this increase and have emerged as the environmental metric of choice for S&P 500 companies. Carbon footprint metrics experienced an over 300% year-over-year increase in prevalence, from 5% to 16% prevalence across the S&P 500. This was the largest increase among all ESG metrics year over year.”

According to SB, environmental metrics have historically been tricky to incorporate into comp plans because they are sometimes poorly defined and hard to assess or quantify. SB suggests that “goal-setting and measuring achievements in a timely manner” have presented challenges that have deterred companies from incorporating environmental measures. However, in light of increasing pressure on climate from major institutional investors, together with “two-thirds of S&P 500 companies having set greenhouse gas emissions reduction targets,” SB expects carbon footprint metrics to continue to lead among environmental measures. In addition, adoption of the recent SEC proposal on climate disclosure “may further accelerate this trend. [SB expects] that as more companies are disclosing information around how they consider environmental measures in compensation, they are setting the standard and paving a path for more companies to follow suit.”

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How do companies choose which metrics to include? In 2021, SB suggested that an ESG measure should be considered for inclusion as a comp metric if management and the board:

“Identify the issue as a strategic priority
Understand that elevating one ESG issue may send unintended signals about other issues
Have clarity on an effective strategy and the outcomes that define success
Are committed to maintaining the metric for an extended time period, with durable goals
Are willing to set real, stretch goals for driving change, not easily-achieved goals for publicity
Understand that goals may be missed and [are] willing to disclose why”

At the same time, a 2021 study from the GECN Group identified the following as best practices for incorporating sustainability in incentive comp:

“Select one to three goals that are consistent with the company’s purpose, reflect business priorities and culture, and resonate with plan participants; in other words, don’t overcomplicate or dilute the focus of the plan
Weight measures in a meaningful way. (Most companies currently weight such measures at approximately 20%)
Set clear goals for each measure
Determine whether to incorporate measures in short- and/ or long-term incentives, considering the time horizon of the journey as well as the challenge in setting goals
Craft the narrative for communication materials to investors, employees, and other constituencies to test the consistency and credibility of the message before decisions are made”

(See this PubCo post.)

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.