A checklist for introducing ESG factors in incentive plans

Companies are including performance measures based on environmental, social and governance (ESG) factors in remuneration frameworks. While it may surprise some, relative to global peers, ASX-listed companies are leaders (see HERE).

Below is an “ESG in executive incentives” checklist for common ESG incentive pitfalls.

1. Metrics that do not align with value creation

ESG should not be thought of as separate from the business strategy: ESG factors that are deemed important enough to feature in incentive plans should create value, including via risk mitigation.

Boards will recognise that most if not all ESG factors have a link to the long-term health of the business. This does not necessarily mean that all potentially important ESG factors should feature as metrics in an incentive plan as this will likely result in diluted scorecards with lack of focus on those that contribute most value.

2. Style over substance

Companies sometimes expect to improve public relations and get positive mentions in media by adopting ESG factors in executive remuneration frameworks. This may help in communicating the company’s ESG efforts, but it can also backfire if investors and proxy advisers do not see the link to improving the long-term value of the business as strong enough (see above).

3. Box-ticking

Guidelines set minimum standards. If companies set ESG targets based only on complying with rules and regulations, the view of both internal and external stakeholders may be that the company appears reluctant to go above minimum requirements.

Our GECN Group’s recent interviews with directors of the world’s largest companies (to be published soon) placed compliance with guidelines a poor last as a reason for incorporating ESG factors into incentive plans.

4. Inconsistent metrics across the management team

While different performance metrics and weightings in incentives plans for different employees permit tailoring to an individual’s accountability and authority to get things done, there is a risk that companies end up with inconsistent ESG standards and strategies in different divisions or geographies if ESG factors in incentive plans vary too much. This can lead to potential gaps and risk exposures to which the board does not have a clear line of sight.

5. Focus on ESG ratings

ESG ratings provided by third-party agencies can be helpful for boards to get different perspectives on potential issues. Good ratings can help with communicating the company’s ESG efforts, but they should only be seen as an outcome of the company’s initiatives and not as a lead indicator. They may also be of limited value as different rating agencies often provide widely different ESG ratings for the same company. While a few investors incorporate ESG ratings in their asset management algorithms, the inconsistency between rating agencies, and mixed results in predicting performance may be a reason that over 70% of asset managers do not factor it in, other than for basic screening. Interestingly, the ESG factor that seems to pop up in multi-factor analyses as a predictor of performance appears to be executive remuneration (this has been known for some time – see HERE for example).

This is different for stewardship matters, whereby most now have platforms and guidelines eschewing ESG requirements for their investments.

While inclusion of ESG factors in executive remuneration frameworks today may have a limited impact on ratings provided by third-party agencies, this could change in coming years as agencies refine their measures and discover what boards think are material enough to feature in incentives does have an impact on performance.

© Guerdon Associates 2024
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