Panel Discussion 1 – Executive Incentives and Non-Financial Performance

The first panel of the forum discussed the topic of non-financial performance measures and their increasing prevalence. In particular, the focus was on whether scorecards have become bloated with non-financial measures, and what are the most appropriate approaches to incorporating these measures into variable incentives.

The panel opened with an attempt to name the main drivers for the growing inclusion of non-financial metrics in scorecards. While it may differ by industry, the panel alluded to regulatory bodies being a major driving force in some instances. For example, the Australian Prudential Regulation Authority (APRA) and its release of CPS 511 mandated the inclusion of non-financial measures to promote effective management of non-financial risk in the financial sector. It was noted that, in some instances, boards are also the driving force for the inclusion of non-financial metrics.

The discussion moved to what the incorporation of non-financial metrics looks like in practice. The two main aspects were discussed – alignment to strategy and measurability. A well-designed scorecard should have measurable non-financial metrics that are fit for purpose and aligned with the company’s current strategy.

The importance of financial measures was also acknowledged as the component of the scorecard that ultimately funds the incentive pool. At the same time, the panel emphasised that good non-financial measures lead directly to financial results. If there is a material risk that is not managed, it will have financial consequences, and, similarly, non-financial goals that support strategy can result in financial benefits. Hence, it was pointed out that the term “non-financial metrics” is somewhat misleading as it distorts the inextricable link between strategy, culture, risk management and financial performance.

In terms of short versus long-term performance, the appropriate structure should depend on the company’s specific pathway. Generally, long-term ESG measures should have challenging, aspirational targets with milestones along the pathway included under the STI. Some noted that the inclusion of ESG metrics under the LTI can be quite problematic given the challenge of setting appropriate targets for a 3–4-year period. For that reason, some boards will be more comfortable including those metrics under the STI rather than LTI. One of the panellists suggested that if a company is going to spend capital to move a dial over a longer term, then it may not be properly captured under the STI which usually uses a year-to-year comparison as a baseline.

Next, the panel discussed the need to make adjustments to scorecard metrics when the company’s circumstances change. For example, a metric can be brought in and out of a scorecard when it requires focus or development. However, a metric which was, but no longer is included in the scorecard would suggest that the goals were achieved, and only require oversight rather than development efforts. Generally, the panel agreed that having a balanced scorecard with too many measures that do not have meaningful weighting on their own will not be effective in motivating desired performance.

Incorporation of a financial or non-financial gateway is viewed as a good practice. It can alleviate some concerns with incentive structures including the inclusion of business-as-usual metrics or the vesting of the non-financial component when financial performance disappoints.

The use of board discretion was also discussed. While we are seeing a more generous attitude towards boards applying discretion on the upside, it is still one of the main drivers of shareholders’ protests against remuneration reports. The panel noted that positive discretion may be appropriate in circumstances that were unforeseeable. Financial measures and targets can only be incorporated into a scorecard to the extent their outcome is somewhat predictable. The panel also conveyed that during an unforeseen event, executives tend to be faced with additional workloads which may form the basis for positive discretion. The emphasis needs to be put on providing a clear and convincing rationale. The board should also consider the experience of shareholders and other stakeholders when considering if discretion is appropriate.

The panel received a question about whether reputation should be used as a metric and whether it is a holistic assessment of non-financial performance. A panellist noted that some relative reputation score measures can provide skewed results due to the low response rate and the limited number of stakeholders captured. Reputation can be a good metric depending on the industry or whether the appropriate stakeholders are engaged.

When asked if the pendulum had swung too far towards the inclusion of non-financial metrics, panellists differed in their opinions. A panellist opined that scorecards had become too crowded, and had lost focus, with the addition of many non-financial measures. Others felt non-financial measures had a rightful place and that measuring additional factors helps us drive value in a more sophisticated way.

© Guerdon Associates 2024
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