Including ESG Metrics the “Right Way”: A Framework

Although “addressing stakeholder impact has always been a part of business,” the new label of “stakeholder capitalism” has increased the focus on the role of the corporation in helping to address a variety of environmental and social issues under the broad and evolving meaning of ESG, according to a recent Semler Brossy piece featured in Directors & Boards. The piece is particularly relevant as the Supreme Court has just struck down race-based admissions at Harvard and UNC, which will transform college admissions and could have far-reaching effects on employer diversity initiatives.

While measures such as employee safety and customer satisfaction have always been included as metrics in management and executive incentive programs, the prevalence and variety of ESG metrics in annual incentive programs has increased dramatically.   Semler Brossy reports that in 2019 ESG metrics were prevalent in 57% of S&P 500 companies and increased to 70% by 2021.  The authors caution that while there are heightened expectations that companies will include ESG metrics as key performance metrics, companies should not lose sight of the primary incentive objective of creating shareholder value and that financial and other traditional performance metrics “should remain the most prominent incentive plan elements for executive pay programs.”   

The authors offer a suggested framework to help guide company decisions regarding the potential inclusion of ESG metrics in incentive arrangements:

• How integral are ESG issues to the company; how aligned are such metrics with the company strategy and values?
  
  
• How do existing company programs and practices address ESG topics; is the inclusion of ESG metrics into pay programs necessary to communicate to various stakeholders the company’s commitment to critical social and environmental issues?
  
  
• What strategic ESG elements can be measured, and with what degree of precision; can performance on relevant ESG metrics be accurately measured and correlated with company performance?

 The key takeaway from the suggested framework is to ensure that traditional principles of effective incentive design guide the assessment of the appropriateness of including new or expanded metrics into incentive arrangements.