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Environmental, Social and Governance considerations (ESG) are expected to play an increasing role in equity pay determinations for executive officers. About 50 percent of S&P 500 companies used ESG metrics in cash-based, short-term incentive compensation plans during 2020. Conversely, only about 4 percent of S&P 500 companies used ESG metrics in long-term equity incentive plans. This should change beginning with 2021 awards due to anticipated SEC-required disclosure of ESG business risks. ISS, Glass Lewis and large investors (e.g., BlackRock, Vanguard) have made calls for more ESG disclosure. Banks increasingly view ESG risks as credit risks. In addition, national media outlets have made the case for executive pay to tie with ESG goals.

In recent years equity awards made to executive officers have been tied to achieving company performance goals. But these performance evaluations are usually linked to relative total shareholder return or financial metrics such as EPS or return on invested capital. As the tide shifts to include ESG metrics, the question now asked is, “how do we set equity awards for executives to help our company attain its ESG goals?”

Establishing Metrics

Companies are finding new ways to identify issues and establish measurable goals for ESG. Issues may vary by industry and company. For example, energy companies may focus on carbon footprint as a datapoint, while beverage companies may focus on water usage. Conversely other ESG issues may apply to all businesses, such as diversity and inclusion, pay equity, human rights, community impact and employee satisfaction.

Companies often find difficulty in determining the standard of measurement for ESG.  Multiple organizations offer their assessment systems to be used, including the Sustainability Accounting Standards Board, Global Reporting Initiative, and the International Business Council of the World Economic Forum. Currently, most ESG efforts use subjective measurements, but in order to show real progress, the data for ESG must be made quantifiable as it is for customer satisfaction, employee safety and product quality.

Identifying ESG risks and establishing goals may seem daunting, but there are several considerations to keep in mind as companies identify their ESG model.

  • Understand the ESG risks for your company and industry
  • Review your company’s ESG disclosure, particularly in light of evolving SEC disclosure standards
  • Look at industry peers for insight
  • Consult with your investors
  • Start with STI and progress to LTIP
  • Establish whether metrics should be based on individual, group or company goals
  • Determine how ESG should be measured (stand-alone metric or modifier)
  • Determine the weighting of metrics
  • Do not overpromise ESG behavior changes linked to any new pay design
  • Test your model rigorously
  • Consider the disclosure in the proxy and to other stakeholders (such as employees) of any failure to achieve ESG goals
  • Be aware of litigation risks of material misrepresentation for not “walking the talk”

Looking Ahead

Climate change and other environmental goals have taken center stage with ESG metrics. That said, companies are beginning to react to public pressure in regard to social justice, from pledges for greater diversity to giving substantial donations and making promises that align pay with D&I goals. Coming this year, more substantial ESG goals will be set for long-term equity incentive awards for executive officers.