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Purpose driven leadership: the evolving role of ESG metrics in executive compensation plans

Environmental, social, and governance (ESG) issues are undeniably making their way onto corporate boardroom agendas today. Many large institutional shareholders are  asking companies to focus more, do more, and disclose more about ESG efforts. 

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ESG metrics: The roadmap to readiness

Thinking through implementation

Which metrics and weighting?

Some companies are using a dozen or more different types of ESG metrics in their compensation plans. Which metrics are right for the company’s executive team will depend on a number of factors. Currently, the most common types of metrics relate to human capital management and social issues. Among the S&P 500 companies that use ESG metrics, 41% use some kind of human capital-related metric, with diversity and inclusion (D&I) metrics being most common. Only 14% are using one or more environmental-based metric.

To whom should the goals apply?

Some boards start by creating goals that apply only to the CEO. Others choose to hold the entire executive team accountable, and still others create broad-based goals that apply to employees much further down in the organization. The right answer for a company might depend upon: 

  • How closely is the ESG goal tied to company strategy?
  • What is the scope of responsibility for the metric within the organization?

 

How do the metrics operate?

Executive compensation plans are complex and varied. Different types of plans present different options for building metrics. The current plans in place at a company may limit the options available now, but as the topic evolves, boards and compensation committees may start to consider slightly different plan structures depending on their goals and perspectives.

What time horizon is appropriate?

ESG metrics are most commonly used in annual bonus plans, rather than long-term incentive plans. Shorter-term annual plans tend to have more flexibility, allowing for strategic and/or individual performance goals. But many ESG goals do not fit naturally into a one-year time horizon. Long-term incentive plans may align better with the long-term changes companies are pursuing as part of their ESG strategy. But even then, common measurement periods may not be long enough to capture ESG goals.

How will this affect disclosure?

Currently, sustainability disclosures are predominantly voluntary, meaning that companies take a variety of approaches to ESG reporting. Many companies publish a stand-alone report, or create a separate section of the website. When ESG metrics are added to executive compensation plans, the nature and extent of the disclosure changes too.

What could go wrong?

For boards and compensation committees thinking about adding new metrics to compensation plans, it’s important to consider the risks associated with those changes.

Setting targets and establishing metrics sets expectations for executives. But with brand new types of metrics, it’s possible to discover that you’ve incentivized the wrong behavior. An executive team might be able to meet emissions goals with a big spend on a carbon sink, for example, or meet D&I goals with a short-term hiring blitz at the end of the year. These methods may sacrifice longterm shareholder value for the sake of hitting short-term targets.

New metrics can create complications just by being new. Partway into the performance period, the compensation committee may realize that the targets were too far off to be reasonable, leading the committee to want to make adjustments. Those adjustments can be hard to explain and can damage the company’s credibility with shareholders.

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Maria Castañón Moats

Maria Castañón Moats

Governance Insights Center Leader, PwC US

Leah Malone

Leah Malone

Director, Governance Insights Center, PwC US

Chris Hamilton

Chris Hamilton

Principal, Workforce Transformation, PwC US

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