Three Questions Compensation Committees Should Ask About ESG

Mark Emanuel and Greg Arnold are managing directors at Semler Brossy Consulting Group, LLC. This post is based on their Semler Brossy memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders?, both by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

The environmental, social, and governance (ESG) drumbeat has been loud in compensation committee settings as an increasing number of institutional investors have expressed an interest in seeing issuers adopt ESG-related incentives. This trend raises pressing questions for compensation committees: What (if any) role should ESG play in their companies’ compensation plans, and if used, how should ESG-related incentives be structured?

There is a fine line between responding to the zeitgeist and assessing the materiality of ESG metrics to determine what will drive long-term progress. A well-crafted strategy for prioritizing and communicating ESG-related initiatives is a prerequisite for considering ESG incentives. Assuming companies meet this condition, compensation committees should address three central questions:

1. Does an ESG metric need to be incorporated into executive pay to reinforce key priorities?

Many large companies already have a culture or system separate from compensation that reinforces the importance of ESG progress. Examples include external public disclosure of various ESG goals and internal reporting on key operational metrics to the board. For some, these mechanisms may be sufficient to drive progress. For others, incorporating ESG metrics into compensation plans might be important for signaling priorities and establishing accountability. In this case, adopting an ESG incentive—even if only at a low weighting—can have an outsized influence on driving desired behaviors.

2. What is the company trying to achieve with an ESG metric?

For many companies, meaningful ESG progress is an important priority but subordinate to pressing financial and operational goals. In such instances, the objective of an ESG-related incentive might simply be to internally signal the importance of an ESG measure to energize company culture. A lower-prominence design may be warranted for the metric (e.g., include it within the individual component or include it as a modifier to overall financial results), as a more prominent design could consume valuable real estate in the incentive program. On the other hand, companies with a “burning platform” to make progress on a given ESG measure might consider a highly prominent design, such as a stand-alone weighted metric.

Many companies are relatively new to setting ESG-related goals and measuring progress. The ability to set meaningful goals with a clear eye toward the potential unintended consequences of a particular measurement approach is key to structuring ESG-related incentives. Those further along on their journeys to measure ESG progress will be better suited to higher-prominence designs.

Below are examples of companies that employ ESG metrics in incentive plans, ordered from least to most prominent design:

  • T. Rowe Price Group notes a diversity and inclusion metric as a factor considered in the assessment of the CEO’s individual achievements for the purposes of determining the annual incentive plan (AIP).
  • At Chipotle Mexican Grill, the AIP payout for company financial and individual performance can be reduced by up to 20 percent based on a food safety metric. This metric is used as a negative modifier only to overall corporate results.
  • At Chevron Corp., an ESG metric represents 15 percent of the total payout with unweighted but objective scoring tied to personal safety, process safety, and environmental and greenhouse gas management. This metric is formally included as part of a scorecard, along with other important strategic metrics.
  • Humana uses its Net Promoter Score with a 20 percent weighting in its AIP.

3. Does the company have enough history and experience to set meaningful incentive targets?

Companies that are relatively new to setting ESG-related goals may consider tracking a measure through a pilot program before formally incorporating it into compensation. This is a common approach when introducing new financial incentive metrics. Piloting metrics helps identify unintended consequences and allows the organization to refine communications and initiatives that support the underlying priority.

With these foundational questions answered, companies can better select the appropriate structure for an ESG incentive, ensuring alignment to strategic priorities and organizational realities.

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