Integrating ESG Metrics into Executive Pay

A company’s ESG journey requires a tailored strategy, based on understanding its material risks and opportunities, setting meaningful goals and milestones, and driving accountability through strategies that may include executive compensation incentives, according to a recent article by Semler Brossy. The third in a three-part series, the article explains the key steps boards should take when considering including ESG metrics in executive incentives. 

 To include or not to include

ESG metrics should be included in incentives when they are an important driver of a company’s business strategy. To determine the most effective design approach, boards should clearly define the reason they are tying the metrics to pay – whether it is to drive accountability, satisfy external stakeholders, or communicate a message.

 The article also provides a helpful list of factors that should be considered when determining which ESG metrics are right for a particular company.  Companies are advised to take care in selecting metrics so that they avoid misaligned incentives or unintended consequences. Boards should consider other non-pay related approaches to driving accountability when good metrics are not readily available.

 Developing the design

The authors acknowledge the seemingly contradictory finding that, despite the long-term nature of ESG goals, most linkages to incentives take place in the annual plan. Explanations could be the time horizon of typical ESG goals exceeding the common 3-year LTIP performance period; the desire to extend ESG goals to a larger population; and the accounting treatment of LTIP goals that discourage the exercise of discretion. As we have found in our Center surveys, many companies choose to break long-term goals into annual milestones better suited to an annual plan. However, the article provides excellent options for including ESG metrics in either the annual or long-term plan and discusses the pros and cons of individual assessments, scorecards, or separately weighted ESG components.

 Reinforcing accountability

The authors conclude with an important reminder that companies have other tools at their disposal to reinforce accountability for ESG performance, including disclosure, regular reporting, and performance management. For example, promoting individuals who provide leadership in this area sends a powerful signal about the importance of ESG priorities, while also providing increased compensation opportunities.