Companies are under increasing pressure to review and consider the role of environmental, social and governance (ESG) factors within the business. This is not necessarily a new concept, but has been increasing in prominence given pressures from investors and proxy advisory firms, as summarized in our previous article, “What steps should compensation committees take as HR becomes part of their expanding responsibilities” Executive Pay Matters, November 13, 2018.
This scrutiny now extends beyond the focus of ESG funds as various investor groups are asking more questions about ESG. Although generally viewed as a risk mitigation activity, that view is expanding. It is now also seen as a measure of how nimbly an organization addresses the increasing pace of change and disruption, and as a way to ensure its long-term sustainability and ability to create value. However, investors have indicated that a focus on ESG cannot replace a strong focus on financial and operating results. In other words, ESG might differentiate companies, but only if they have similar underlying performance characteristics.
In the fall of 2018, the Sustainability Accounting Standards Board (SASB) issued ESG standards for 77 different industries. They include a wide range of measures across many aspects of ESG. For example, the standards for the oil and gas exploration and production industry includes close to 30 measures across a variety of topics, including environment (air, water and climate change), community relations, workforce health and employee safety, reserves valuation, business ethics and risk management. Each standard, provides an accounting metric which is either quantifiable or qualitative (i.e., discussion and analysis).
The Task Force on Climate-related Financial Disclosures (TCFD) under the Financial Stability Board released its June 2017 report addressing the financial implications of climate change. It advocates for greater consistency in understanding how a move to a lower carbon economy, a change which may provide both risks and opportunities for organizations to help investors better inform their investment decisions. The report outlines four main recommendations—universal adoption; inclusion in the financial filing; decision-useful, forward-looking information; a focus on risks and opportunities—which can significantly impact executive program design and calibration. The TCFD released a status report in September 2018 indicating that they have over 500 supporters and provided a summary of current disclosure practices.
Proxy advisory firms are also incorporating ESG analytics and perspectives within their summary reports. Glass Lewis uses a framework from Sustainalytics which provides an overall ESG score and a perspective on the organization’s ESG risk profile, performance under each of the three ESG pillars and identification of key ESG controversies within the issuer’s industry. Institutional Shareholder Services (ISS) expanded its QualityScore to consider environmental and social factors in addition to its previous focus on governance matters.
What are the three main challenges in the inclusion of ESG within incentive plans?
- Numerous measures — ESG is a broad concept that can be measured in numerous ways, and there is not one “bottom-line” number that can be referenced (unlike financial or market performance, such as EPS or total shareholder return (TSR), respectively). As noted above, the SASB standards include a large number of different measures; in many cases, they need to be measured on a qualitative basis (e.g., discussion of engagement processes and due diligence practices with respect to human rights, indigenous rights, and operations in areas of conflict). In addition, there are numerous other platforms that provide ESG scoring, including those from the proxy advisory firms.
- Comparability — Unlike many financial measures, there are no requirements for measures to be stated in certain ways. While there are industry standards for certain measures (e.g., employee safety) and SASB articulates specific standards, it will take time for consistent standards to develop. In the meantime, companies need to define performance carefully so that the measures are sustainable over the long-term and are fair when compared to their peers.
- Not aligned to strategy — Many sustainability reports and the underlying ESG measures are usually managed by a specific team within the organization and may not necessarily be reviewed nor approved by executive leadership and/or the board. Therefore, the selection and calibration of ESG measures may not receive the necessary attention and oversight. The TCFD has suggested that the reporting needs to be incorporated into financial filings to provide decision-useful information, which would also increase its prominence within and outside of the organization.
How could ESG be considered within incentives?
- In the short- or long-term plan? ESG measures (e.g., employee safety and reliability) have typically been included within the short-term incentive plan (STIP), but some measures such as emissions reductions and community relations, might be better assessed in the long-term incentive plan (LTIP) given the long-term orientation of these measures and the limited year-over-year change in progress.
- If the measures are included in the STIP, we find that organizations tend to focus on continuous improvement and the long-term trending of these measures. For example, the performance target and the range around target can be set relative to performance over the past 3 to 5 years (e.g., target is equal to the 5-year average plus 10% improvement while the threshold is equal to the 5-year average and the maximum is equal to the best in the past five years). The weighting is generally limited to 10% to 15% of the total award, so financial and operating results continue to be seen as the primary measures.
- We have only seen a few examples of companies that have incorporated ESG measures within the LTIP. Some may argue that successful execution of ESG should lead to strong TSR over the long-term term (i.e., ESG drivers lead to TSR outcomes); however, this is an indirect relationship and investors may want to see a more direct relationship where long-term targets are established and measured within the LTIP.
- Do you include separate measures or is it a holistic assessment? In many cases, companies have included the most material measures as separate measures within the incentive arrangements, particularly measures such as employee safety and reliability that can easily be measured and tracked. Some measures can be more difficult to quantitatively measure and might be better assessed on a holistic basis relative to the underlying plans and milestones associated with each measure. An overall ESG modifier could be incorporated into the STIP such that the corporate factor is adjusted up or down within a predetermined range (e.g., +/- 20%) based on an overall assessment of the organization’s progress towards its ESG objectives. If the organization is on track, no adjustment would be made, but this modifier would provide the board and management the basis to agree upon ESG objectives and progress towards them.
- Should ESG be part of an executive’s individual objectives? The achievement of an organization’s ESG priorities needs to be addressed in different ways through the organization, and there might not be clear line of sight between corporate progress and an executive’s contribution to the organization’s success. The primary advantage of incorporating ESG factors within individual objectives is to provide greater focus on specific outcomes that might be not be managed on an organization-wide basis. However, there are a couple of potential disadvantages. First, depending on how individual measures are developed, reviewed and approved, incorporation of measures at an individual level may not get the right degree of attention and oversight. Second, many measures, such as employee safety, are important cultural drivers and, while not all roles are directly responsible for employee safety (e.g., corporate employees), all employees have some indirect impact on the organization’s employee safety success.
What’s the best way to include ESG?
We have found through our consulting experience that it can be useful to adopt Willis Towers Watson’s Guiding Principles and Elements of Effective Executive Compensation Design when reviewing the inclusion of ESG within your incentive arrangements. The overarching principles consider:
- Purpose — What is the underlying purpose for why the organization exists, and how do ESG factors support the organization’s purpose? ESG needs to be embedded throughout the organization and supportive of the organization’s ability to achieve its purpose. What is important to the organization in the short-term, and what are some of the longer-term risks and opportunities (e.g., impact of a lower carbon economy)?
- Accountability — Who are the key stakeholders of the organization, and what ESG factors are important to them? Stakeholders can include employees, customers, areas where the company operates and shareholders, and each can have a different perspective on which measures are most important and why.
- Alignment — How do you align incentive plan participants with material ESG factors ensuring sufficient line of sight between their actions and behaviors and performance? For example, are measures better addressed at an individual or team level, or corporate-wide? Are there measures that are better addressed holistically, while others can be tracked more quantitatively and are understood by participants? Do we need to include ESG factors as separate measures, or are they already captured in the underlying “values” of the organization so that they’re fundamental to how we operate?
- Engagement — How do we ensure that participants remain engaged through sufficient communication and understanding of the measures, their importance and how the organization is tracking? Do we need to do a better job communicating our sustainability reporting within the organization in addition to broad external reporting?
As we look forward, we anticipate that organizations will be under increasing pressures from investors and proxy advisory firms to better understand their ESG priorities and to develop ways to better integrate their priorities into their executive compensation designs and incentive arrangements.
Be sure to register for our upcoming December 6 webcast where we will discuss this and other executive compensation topics in a look back at 2018 and a look forward to the 2019 proxy season.
Ryan Resch is a managing director in Willis Towers Watson’s Toronto office. Email email@example.com or firstname.lastname@example.org.