Assessment and Integration: The Role of ESG in Executive Compensation

With the vast majority of investors acknowledging and acting on sustainability risks, they are laser focused on ensuring that the companies they are invested in are taking action on these risks when they’re material.

As the pressure to address these environmental, social, and governance (ESG) risks grows, along with the opportunities that addressing these risks creates, many companies are beginning to link ESG metrics to executive performance. A recent analysis found that 70 percent of S&P 500 companies had adopted ESG metrics in their compensation programs as of March 2022, with 13 percent having done so in the last year. As executive compensation programs evolve, here are a few steps boards can take along the way to successfully integrate ESG goals into their incentive programs.

Step 1: Examine Risk Assessment Systems

To begin, a board should consider this question: Does the organization have processes that will successfully identify and assess ESG risks?

It is a board’s fiduciary responsibility to take an active role in process assessment and risk identification. To ensure that their companies have risk management systems and processes in place that will help them identify ESG-related risks and opportunities, boards need to work with management to examine the strengths and weaknesses of their companies’ existing systems. The analysis of these risks and materiality assessments needs to be integrated into organization-wide systems, and material risks disclosed in the company’s sustainability report should be included in financial disclosures.

Step 2: Establish Oversight of ESG Risks and Opportunities

Once ESG and materiality risks are fully assessed, ESG risk oversight should be institutionalized within the organization and board operations. Since the time horizon of ESG goals can span years and likely will be implemented by different management teams, ESG topics should be standing items for board agendas. Boards should also amend committee charters to assign formal responsibility for ESG oversight, as charter language can survive board turnover. Boards can weigh the pros and cons of a stand-alone sustainability committee versus integration within an existing committee, such as the audit and risk or governance and nominating committees. As of July 2022, around 90 percent of S&P 100 companies had integrated ESG oversight into specific board committee charters, a number that has edged up steadily over the past several years.

Step 3: Apply ESG Goals to Corporate Strategy

Boards are responsible for the implementation of corporate strategy, goals and target setting, and management accountability. This process of board oversight should be applied toward establishing ESG goals and targets with a focus on long-term corporate strategy. ESG targets most often include greenhouse gas emissions (GHG) reduction goals and diversity, equity, and inclusion workforce goals. Targets around other material issues such as water, supply chain, or operational safety may also be appropriate.

Investors want consistent, clear communication of ESG goals and targets. There is much to consider when it comes to setting climate targets, such as how different GHG emissions scenarios will be addressed and the role of offsets in reaching net-zero targets. ESG targets should be aligned with climate science, and certification by the Science Based Targets initiative (SBTi) should be examined. More than 1,700 major companies worldwide have set ESG targets certified through SBTi. In applying these commitments, boards must also understand how management oversees progress toward ESG goals.

To reach their ESG goals, companies need to establish short-, medium- and long-term interim goals and targets. Investors are increasingly calling for disclosure of interim goals through transition plans. Boards will need to work with management to establish strong connections between long-term corporate strategy and ESG goals.

Step 4: Install ESG Metrics in Executive Compensation Programs

Once companies have taken these three steps, the next step is integration of ESG metrics into the executive compensation program. The inclusion of ESG metrics in compensation programs can serve various purposes, including as a driver of management accountability or as a response to external stakeholder pressure, but the key consideration should be the role of ESG goals in overall strategic priorities.

Companies often start with the annual incentive program (AIP), especially since the long-term nature of GHG goals can present challenges in the alignment of metrics with the typical three-year time frames of long-term incentive plans (LTIPs).

ESG metrics within compensation programs typically fall into two categories: sustainability goals, which are long-term, broad social and environmental goals, and operational goals, which are often stakeholder metrics aligned with business operations. GHG emissions targets have not typically been linked to compensation programs.

Recent research shows that, of the 70 percent of S&P 500 companies that have adopted ESG metrics in their compensation programs, 61 percent include metrics only in the AIP, 8 percent include metrics in both the AIP and the LTIP, and 1 percent include metrics only in the LTIP. While the proportion of companies with metrics in the LTIP is small (9 percent overall), it is growing. It is important to note that performance-based equity grants often make up the largest portion of LTIPs and compensation programs overall, with equity grants typically ranging from 35 to 50 percent of total executive compensation.

When companies restrict ESG incentives to only the AIP, they are structurally limiting the degree to which ESG metrics can be used to incentivize performance. Companies that link ESG metrics to the annual bonus typically have amounts of 1 to 3 percent of total compensation incentivized, although there are some cases in which the amounts are higher. In the refiner sector, proxy statements disclose that Phillips 66 links 3 percent of total compensation to ESG metrics in the annual bonus, while Marathon Petroleum links 3.35 percent of total compensation. Valero is unique in that it links its GHG emissions targets to its LTIP (5 percent of total compensation), as well as linking ESG metrics to the annual bonus (7 percent of total compensation).

There are undoubtedly structural challenges to linking GHG emissions targets and other ESG goals to LTIPs. However, there are solutions to these challenges, including the creation of interim ESG goals that would align with a three-year grant cycle, grants of annual awards (which is already quite typical), grants of longer-term awards (5–7 years), and grants of separate ESG awards. Perhaps it is time to take a fresh look at linking ESG goals to the LTIP.