Executive compensation is one of the most visible aspects of a publicly listed company’s corporate governance program and needs to be competitive to attract and retain executives. From a shareholder perspective, best practice is to align with financial performance and how well an executive delivers on the company’s strategic objectives.
Performance metrics have typically focused on financial or operational objectives and shareholder returns. However, as companies continue to place more emphasis on Environmental, Social and Governance (ESG) strategies, metrics tied to ESG performance or goals are increasingly becoming an additional element in executive pay. This creates an additional layer of evaluation for shareholders in deciding how to vote on Management Say on Pay (MSOP) proposals.
Including ESG performance metrics into executive compensation planning is a relatively new development, although it is more common in larger companies versus smaller peers. In 2020, 57% of S&P 500 companies included ESG metrics in executive compensation plans, compared to 10% of Russell 3000 firms (excluding S&P 500 companies); as of the 2022 proxy season, 75% of TSX60 companies have incorporated ESG metrics into executive compensation or have noted an intention to do so within the year. These findings may not be surprising given larger companies tend to be further along in their ESG journey.
Many companies incorporate ESG performance measures into short-term incentive plans (STIP); in 2022 thus far, 68% of the TSX60 companies that incorporate ESG metrics in incentives do so only in the STIP, 27% include ESG metrics into both the STIP and the long-term incentive plan (LTIP), and 2% include ESG metrics only in the LTIP. Many of these companies use a scorecard approach, where various ESG metrics are grouped with other corporate objectives, typically without a specified weight. Others employ standalone weighted ESG goals, and some use ESG performance as a modifier to increase or decrease the entire payout.
ESG metrics can be forward-looking, such as emissions reduction targets, or lagging indicators, such as health and safety performance or customer satisfaction scores. There are numerous ways companies can structure executive compensation goals. Investors would expect a company’s objectives to be relevant and significant to the business. Human capital and social issues comprised the majority of corporate ESG objectives, although 2022 saw an increase in the number of environmental and climate-related metrics added across sectors among large Canadian companies.
With so much variation and limited historical precedent, below are some considerations for investors when engaging with a board around executive compensation:
- The board should be able to explain the rationale for choosing certain ESG metrics and goals, and how they align with the company’s business and financial significance.
- The board and compensation committee should be able to discuss why the ESG measures selected are incorporated into the specific compensation components, such as the STIP and/or LTIP. Backward-looking operational metrics are typically considered short-term measures and likely better suited for the STIP, whereas forward-looking targets are reflective of the long-term vision, and more suitable for the LTIP. Too many ESG metrics could indicate a lack of focus and come at the expense of other important business goals, while an emphasis on operations based ESG objectives only may be insufficient to incentivize the progress needed to address ESG objectives.
- The board should be able to articulate its governance oversight process to monitor the selected ESG metrics.
The ESG measures and goals chosen should be supported by data that is accessible and transparent to stakeholders. Many companies include human capital objectives, such as diversity and inclusion (D&I) and employee engagement and culture. However, D&I disclosures are still an area for improvement for many companies, and corporate culture remains intangible. Having clear measures helps shareholders understand how ESG performance is aligned with executive compensation.
Inclusion of ESG metrics in executive compensation is a relatively new area and is nuanced and contextual to each company. Investor expectations and evaluation frameworks should continue to reinforce best practice principles such as pay-for-performance and transparency.
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.