ESG Considerations for Incentive Compensation Programs
January 11, 2021
Stakeholder attention to environmental, social and governance (ESG) issues continued to grow throughout 2020 driven by the COVID-19 pandemic (health and safety), the Black Lives Matter movement (diversity and inclusion) and worldwide wildfires (climate change), to name a few. Prodded by investors and other stakeholders, companies have increasingly realized the importance to their businesses of managing human capital and monitoring human rights, whether in respect of their own workforces or their supply and customer chains. Further, disclosure and engagement around companies’ human capital management (HCM) practices have become more important and even the Securities and Exchange Commission, which had in the past largely avoided specific ESG disclosure mandates, has weighed in and now requires disclosure regarding human capital resources in annual reports on Form 10-K.
While many companies have long looked to certain ESG-related measures such as employee engagement and workplace safety in their incentive programs, usually for annual bonuses, the use of these measures was typically as a modifier or as a consideration for a discretionary individual performance factor. However, the ESG issues highlighted in 2020 are long-term challenges that are likely to impact long-term value and, accordingly, should be considered in terms of long-term performance. In addition, there is growing pressure by institutional investors for companies to demonstrate, and boards to monitor, progress on ESG goals. For example, in its recently released 2021 Stewardship Expectations, BlackRock stated that “[o]ur revised Global Principles and voting guidelines mark several key changes in our expectations across environmental, social and governance factors, as well as changes in how we will hold boards and management accountable in our voting.”
Designing an ESG-Driven Incentive Program
As a result, boards and compensation committees have begun to consider and in some cases include more specific and longer-term ESG goals in their incentive programs. However, ESG is not a monolithic, one-size-fits-all framework and not all companies should focus on the same issues or use the same metrics. Before adding ESG-based incentives to compensation programs, a company needs to be able to clearly articulate the primary issues arising from its particular circumstances, assess the areas requiring improvement and map out strategies for addressing them. Many companies have developed sustainability plans and included ESG factors in their long-term business plans and so have done some of the necessary groundwork. However, integrating ESG goals into incentive compensation structures requires an additional and different set of considerations, especially with respect to HCM issues.
Designing any new incentive compensation program requires a veritable forest of decision trees.
- What employees will participate?
- To what extent will the criteria be quantitative versus qualitative?
- To what extent will achievement be determined by absolute results versus relative results of industry or other peers?
- How much of a participant’s incentive award will be tied to which metrics? Should there be equal upside and downside in respect of target achievement or is another payout slope better suited?
- To what extent will board or compensation committee discretion play a role?
- And, more specifically, with respect to long-term compensation, how much discretion will there be to alter goals in light of circumstances changing over time?
Addressing all of these questions is difficult enough when using financial or operational metrics; implementing incentives based on ESG measures – especially employee-driven HCM issues such as diversity, equity and inclusion, retention and development, community and culture – raises the stakes. Making the necessary choices in program design, award grants and final payouts is a daunting task for boards, compensation committees and management when all such choices will be scrutinized by audiences ranging from award recipients, other employees, institutional investors, social advocates, industry peers and the media.
Key Takeaway – Tread Thoughtfully
Boards and management need to be thoughtful when including ESG goals in incentive plans as performance criteria need to be based on measures carefully tailored to the company and its business, measures for which the company has internal reporting resources necessary to assess performance accurately and measures that are capable of being clearly explained to and by all constituencies. Almost as importantly, boards and management have to be prepared for criticism. Any goals chosen are almost certainly going to strike some as too challenging and others as not challenging enough or even as entirely misconceived. The use of any discretion will similarly be subject to debate, not using enough may risk unfairly punishing participants and using too much may risk alienating investors, advocates and employees and undermining company-wide progress. The board will be required to make hard choices and must be ready to explain them and defend them, if necessary.
Many decisions in 2021 will be driven by the events of 2020. However, companies must be careful that any such decisions surrounding ESG incentives are proactive and grounded in corporate strategy, not reactive and made hastily in light of public opinion. A well-designed and implemented ESG-based incentive program should be focused on driving long-term value for all stakeholders.