As the wider world becomes increasingly aware of environmental, social, and governance (ESG) issues, so too are businesses across many industries looking to link their performance metrics with employee compensation.
Whether it’s business partners, consumers, employees, investors, or regulators, expectations on ESG now come from multiple directions, and companies are taking heed and reacting in terms of how they do business, with linking ESG performance metrics to employee share plans one of those initiatives.
What is ESG?
The three legs of the ESG stool refer to a range of activities, expectations, and issues that companies can identify and set measurable targets for progress against. ESG programs have been described as an exercise in risk management, in that the focus is on issues that bring potential for material or reputational risk, and ESG goals are designed, in part, with a view towards reducing those risks.
However, to see it merely through the lens of risk would represent too narrow a view. Embracing ESG fully will also mean devising targets with an eye on looking to tap into the possibilities around innovation and translate that into financial gains.
There is no definitive list of ESG issues, and individual items may fit into more than category. Broadly, environmental factors relate to the natural world, social factors concern people and relationships, and governance factors focus on how a company is run.
Among the questions companies looking at ESG may ask themselves are:
- What is your carbon footprint?
- When will you achieve net zero carbon emissions?
- Do you know how and where you source your raw materials?
- How far down the road are you on implementing polices geared towards diversity, inclusion, and equity in the workplace?
- What are your policies on employee health and safety?
- Do you have rigorous rules in place on data protection and privacy?
- How do you guarantee accountability and transparency among board members and company executives?
- Do you have a whistleblower policy?
- Does your audit committee have the resources it needs to oversee ESG disclosures?
There are many reasons why a company will look to link ESG performance metrics to equity-based compensation for employees. Among those most commonly cited are:
- To send a clear signal that ESG is a priority
- To respond to investor concerns and expectations
- To help drive efforts to achieve whatever ESG pledges have been made
- To keep pace with actions being taken by peer companies
- To impact positively on operating and financial performance
Find out what works best for you
To come up with the right set of ESG performance metrics and then link them to equity compensation will by necessity take time. You will need to consider several points as you work through the process, including:
- Identify goals that are relevant to your business
- Learn from what other companies in your industry are doing
- Be clear on how you intend to measure your progress, e.g., quantitative and/or qualitative, at the individual performance level, standalone ESG metrics, absolute or relative to how the market performs
- Be open to re-evaluating ESG goals over time, to ensure they remain relevant and effective
Remember, for any performance metric to be effective, everyone involved needs to be clear on the objective, how it relates to the business, and their own role in the process. Also, the company may need to put procedures in place to facilitate collaboration across departments, with a view towards ensuring that different parts of the company don’t compete with each other for resources in ways that may prove counterproductive, i.e., focusing on their own objectives rather than necessarily working in harmony towards the overarching goals.
When might investors be wary of linking ESG performance to employee compensation?
While investors are often seen as encouraging businesses to do more in the ESG area, it is not necessarily the case that there is 100% support all the time for linking ESG performance with employee compensation.
According to the ISS Governance 2021 Global Benchmark Policy Survey results, 52% of investors polled specified that their support would be dependent on ESG metrics being “specific and measurable”, while just 34% were in favor of metrics that could not be measured in terms of direct financial impact being incorporated into compensation programs.
What is the current state of play?
Despite the fact that some investors remain somewhat agnostic on the merits of linking ESG to compensation, a recent report highlighting data for 2021 showed a trend whereby large US companies are increasingly moving in this direction, with 73% of S&P 500 companies reporting linking ESG to compensation up from 66% in 2020.
A similar pattern has been detected in the UK, with recent reports stating that almost 90% of FTSE 100 companies incorporated ESG performance metrics into their long-term incentive plans (LTIPs) in 2022. That represents a significant increase on the figures for 2021, when the comparable figure was 60%.
How to get started
Some ESG specialists recommend that a starting point on that journey can be to create a steering committee, with members drawn from various departments of the business who are fully informed on what the company is trying to achieve and has access to the kind of data that will be necessary in order to properly measure and report on ESG performance.
On a broader level, when companies are determining what ESG-related issues are most pertinent to them, they will usually consider the topic in the context of business strategy, while also factoring in the views of relevant stakeholders. When companies look to incorporate ESG into their overall strategy, they should consider doing so, as mentioned earlier, not merely through the lens of risk, but with an eye on the opportunities associated with a focus on environmental and social issues.
Against that backdrop, far from seeing ESG as a matter of box ticking or merely complying with regulatory requirements, companies will be better served approaching it as an exercise in which they seek to identify where their efforts can have the most impact, where they can find the biggest opportunities. That, in turn, will create a business backdrop against which linking those performance metrics with employee equity compensation is more likely to yield positive results.
What kind of compensation plans should ESG metrics be linked to?
In general, companies will look to link ESG metrics to annual bonuses and/or LTIPs. As mentioned above, many ESG targets will by their nature be geared towards the long-term, e.g., carbon emissions, but some can also be measured on a more short-term basis, e.g., targets related to safety in the workplace.
Linking ESG performance metrics to employee equity compensation has become more popular in recent times, and there is little to suggest that this trend is set to reverse anytime soon. That being the case, companies owe it to themselves to investigate whether going down this route will work for them, and if so, to then take the time to figure out how best to go about it.