Although COVID-19 and its impact on business operations brought its own challenges to issuers’ incentive compensation programs, a review of 2020 proxies showed no slowdown in the incorporation of ESG metrics into plan design. Traditional incentive compensation metrics, namely quantitative shareholder return and financial and operational metrics, still dominate but, increasingly, qualitative “social” factors, such as diversity and pay equity, are playing a meaningful role in executives’ take-home incentive pay. In the Top 100 Companies, 15 have announced in their 2020 CD&As that incentive compensation for 2021 will include new ESG metrics. The move toward ESG metrics is both a response to stakeholder pressures and a growing recognition that these factors are important to long-term shareholder value.
This post discusses the forces leading companies to adopt ESG metrics, analyzes how those companies are incorporating ESG metrics into their incentive compensation programs and discusses the challenges of establishing meaningful metrics.
The Forces of Change
A number of forces have led to the increased use of ESG metrics in incentive compensation plans. These include:
1. Institutional Investor Focus on Sustainability
In January of 2020, Larry Fink, Chairman and CEO of BlackRock, noted in his letter to CEOs that failure to focus on the needs of a broad range of stakeholders will ultimately damage long-term profitability. In his 2021 letter, Mr. Fink reiterated this position and called for a single global standard with respect to sustainability disclosures. Survey data shows that asset managers agree that a focus on ESG brings financial benefits. According to the 2020 RBC Global Asset Management (RBC GAM) Responsible Investing Survey, 75% of institutional investors in Canada, Asia, the United States and the United Kingdom apply ESG principles to investment decisions, with a 26% increase in Asia. In addition, 43% of the respondents said they believe ESG-integrated portfolios are likely to perform best, which is a 14% increase from 2019. Notably, the United States lags behind its peers, as only 28% of U.S. institutional investors polled held this view.
2. Shifting Views of the Role of the Corporation
In August of 2019, more than 180 CEOs signed onto a Business Roundtable statement that, for the first time, expanded the view that corporations exist principally to serve their shareholders to say that corporations should commit to serving the interests of all stakeholders, including shareholders, customers, employees, suppliers and communities. The Business Roundtable’s position undoubtably reflects increasing public, investor and employee pressure on companies to focus not only on advancing profits, but to also contribute to solving societal problems such as income inequality and environmental sustainability. The incorporation of ESG into incentive compensation plans is a key measure that observers will use to track whether the signatories’ companies are honoring this new philosophy.
3. Regulatory Activities
In March of 2021, the SEC requested public input on climate change disclosure and tasked the staff with evaluating SEC disclosure rules related to climate change. The SEC received more than 550 unique comment letters in response, and three out of every four letters was in support of mandatory climate disclosure rules. SEC Chair Gary Gensler subsequently announced that the staff is developing a mandatory climate risk disclosure rule for the SEC’s consideration by the end of the year, emphasizing that investors are looking for “consistent, comparable, and decision-useful” disclosures in this regard. In addition, the removal of the “performance-based compensation” exemption from Section 162(m) of the tax code provides companies with greater latitude to use qualitative performance metrics and to implement a bonus “modifier,” which enables the company to increase the payable bonus as a result of a subjective determination, such as a commitment to the company’s ESG principles.
The Challenge of Metrics
Boards looking to incorporate ESG metrics into incentive compensation plans are faced with the dual challenge of choosing appropriate metrics and appropriately measuring success. Although there is a movement toward establishing a global set of standards for reporting ESG metrics—as is the case with financial reporting—there is an ongoing debate as to whether a global set of ESG standards is, in fact, beneficial. For example, in April of 2021, SEC Commissioner Hester Peirce argued that a “global reliance on a centrally determined set of metrics could undermine the very people-centered objectives of the ESG movement by displacing the insights of the people making and consuming products and services.” [1] Further, for any individual issuer, the chosen set of global standards required to be reported on may not align with the long-term business strategy of the issuer and, therefore, may not be appropriate as an incentive compensation metric.
As issuers continue to grapple with how best to incorporate ESG metrics in their incentive compensation programs, most provide for a qualitative review and include the metrics as part of an overall review of individual performance. Regardless of how the ESG metrics are utilized, they should come coupled with transparent disclosure to investors as to how and why the metrics were chosen, weighted and evaluated.
