Why Include ESG Goals in Executive Compensation?

ESG goals

Every parent who has tried to get a child to do something that child may not want to do knows that we humans are all about incentives. Executive compensation plans have long included incentives (such as bonuses, RSUs, and option grants) that are mostly based on achieving objective, quantifiable financial goals related to things like revenue growth, cash flow, EBITDA, earnings per share, return on equity, and so on.

But as the Harvard Law School Forum on Corporate Governance explains, a shift is underway in many companies as non-financial goals become more common. As of March 2021, more than half of companies in the S&P 500 (57%) used at least one ESG metric in their plans. The Harvard Law School Forum quotes a 2021 Global Benchmark Policy Survey published by Institutional Shareholder Services which found that 86% of investors think it is appropriate to incentivize executives with non-financial ESG metrics, but that it needs to be done right, saying “metrics should be carefully chosen and should align with a company’s strategy and business model.”

The Harvard Law School article goes on to provide these specific examples of non-financial ESG metrics that could be an appropriate part of an executive compensation plan:

Waste reductionEmployee engagement/satisfactionWater consumption
EmissionsProduct qualityBusiness travel efficiency
Employee (or Customer) safetyClimate commitmentSustainable sourcing
Customer satisfactionCarbon footprintData security and privacy
Energy efficiencyWorkforce diversity & inclusion goalsEmployee turnover/retention

Source: https://corpgov.law.harvard.edu/2022/03/19/the-evolving-role-of-esg-metrics-in-executive-compensation-plans/

Focusing on the company’s main priorities and setting clear expectations would seem to be obvious elements of including sustainability goals in an executive compensation plan. That may restrict these goals to ones that are measurable, but we believe the examples above can be quantified with the right data sources. 

What if sustainability goals conflict with financial objectives? The jury is still out on this one. PwC’s Global Investor Survey published in December 2021 (the survey results are so interesting, we recommend you take a few minutes to review it), shows that 41% of institutional investors think that including ESG metrics in executive performance measures has value even if they conflict with long-term returns, while about the same percentage (42%) disagree. 

Of course, many sustainability goals are aligned with business goals (in fact, we would argue that sustainability is focused on creating a world where businesses can thrive). This thoughtful article, “How to Translate ESG Imperatives into Executive Compensation” from Semler Brossy (a consulting firm specializing in strategic compensation, talent, and board stewardship) provides these examples that show how tying ESG metrics to executive compensation can make good business sense:

Directly Related to the BusinessExample
Core to the company’s mission or purposePharmacy chain provides healthcare clinics in underserved areas
Directly related to core capabilities or expertise that the company can materially affectSupermarket opens stores in “food deserts” or offers nutrition counseling
Represents a business opportunityBank partners with phone companies to provide mobile banking in rural and/or emerging markets
Brings a major social benefit at minimal cost to the companyEnergy company offers hydrogen fuel to local communities
Easily controlled by the companyConstruction firm gives preference to suppliers that capture carbon in concrete
Important to Major StakeholdersExample
Substantial customer groupSenior citizens may prefer companies that embrace employing older workers
Employee groups critical to the value chainMinority groups not fully engaged without efforts that promote diversity, equity and inclusion
Suppliers of critical parts/services that are vulnerable  to rivals that undermine ESGSuppliers seeking restrictions on child labor that rivals might use to reduce costs
Community groups suffering from company-caused externalitiesA community opposing a polluting factory by challenging the company’s license to operate

Source: https://semlerbrossy.com/insights/how-to-translate-esg-imperatives-into-executive-compensation/

Sustainability is inherently a long-term effort

According to an article published by Aon, over half (57%) of S&P 500 companies now use ESG metrics in their executive compensation plans, but fewer than 10% of companies within the Russell 3000 (excluding those companies that make up the S&P 500) do so. Still, only a small percent of a total bonus may be tied to ESG goals. It is ironic that many criticize executive compensation for being too oriented toward achieving short-term goals, while making progress on most ESG goals is best measured over many years. 

Ideally, one part of an incentive plan would contain things that most companies currently have, namely metrics that emphasize shareholder value and focus on both annual and longer-term financial metrics. A second part of the plan would emphasize sustainability, using ESG metrics that relate to creating long-term value for shareholders by making the company and its industry more sustainable. Such a plan could also impose penalties if, as a result of the companies actions or inactions, important stakeholders suffered material harm. 

While changing the compensation plan may be more than what some companies are ready to do, there are other ways to encourage certain behaviors from the C-Suite. As Semler Bossy points out, achieving ESG goals can play a role in promotion and hiring decisions, and can be celebrated with spot bonuses or other types of recognition. And just like the child who is more likely to put those toys away when there’s a good chance it will lead to ice cream, incentives that reward executives for doing the right thing could help to create a better world.