How Can Companies Successfully Link ESG Goals to Executive Pay?

The current landscape of ESG-linked executive pay

77% of major companies across North America and Europe include ESG metrics in their executive incentive plans, up 68% from last year, reflecting a broader movement toward sustainable business practices. Broadly, companies are responding to pressure from investors, consumers, and regulatory bodies to consider ESG factors in their operations and strategy.

However, despite the growing inclusion of ESG metrics, there are concerns about their effectiveness, particularly those in executive compensation plans that are not tied to quantifiable, measurable targets. Without these quantifiable targets, it can be challenging to assess whether executives are genuinely making progress on ESG goals or if the metrics are simply a symbolic gesture without real impact.

More structure and consistency is coming for ESG-linked pay

It has now been recognised that efforts must be placed on standardisation and we expect to see more structure and consistency when it comes to ESG metrics, with a greater weighting in short-term plans. Climate related metrics will increase across all industries, with emphasis on targets and whether the reporting provides meaningful progress against a company’s ESG strategy.

Currently, metrics are classified as either leading or lagging indicators. Lagging metrics, which are backward-looking, represent foundational operational measures essential to the business. In contrast, there is now a heightened focus on leading metrics, which are forward-looking and transformational. 

Where shareholders are applying pressure

Executive compensation plans excluding non-financial objectives related to social or environmental issues will face increased scrutiny from investors. For example, AllianzGI, a global investment management firm, has begun voting against the pay policies of large European companies that do not integrate ESG metrics into their executive compensation plans.

We’re now seeing that the most frequently disclosed environmental (E) metrics focus on the energy transition and climate change. On the social (S) front, metrics related to diversity, equity and inclusion (DEI) and health and safety are reported most. With growing awareness and new regulatory requirements, there is now also interest among shareholders and investors in disclosing metrics on biodiversity, equitable pay, human rights, and modern slavery. 

Linking ESG-related pay to company strategy

To avoid such backlash, a compensation plan should highlight a company’s strategic priorities, be relevant to both the business strategy and its key stakeholders and demonstrate how the company is managing risks in an evolving regulatory landscape.

Companies should only incorporate ESG metrics into their compensation programs once a clear and well-understood link to the company’s strategy is established.

The board will work closely with management to identify the behaviours and objectives they wish to incentivise and in parallel, recognise and adjust any existing behaviours that may have been unintentionally encouraged and need realignment.

Transparency and reliability of these goals are crucial, as they help demonstrate accountability for who is achieving them.

Weighed metrics vs front-end performance conditioning

While it is common for ESG metrics to carry a 20% weight in executive compensation scorecards, a 30% weight on material ESG issues is considered a best-in-class approach. This higher weighting is particularly effective when it is clearly defined and linked to quantifiable targets, ensuring ESG goals are both significant and measurable within the overall compensation structure.

Some companies are beginning to link Long-Term Incentive Plans (LTIPs) to ESG measures through front-end performance conditioning. In this approach, annual performance, as measured by the Short-Term Incentive Plan (STIP) scorecard, influences the size of LTIP grants. This strategy is employed by organisations including major banks, Canadian Natural Resources Limited (CNRL) and Canadian Apartment Properties REIT, among others.

Of the two, incorporating ESG measures into LTIPs is considered a leading practice. This approach aligns well with the long-term nature of many ESG metrics and typically constitutes a larger proportion of an executive's compensation package, fostering a stronger commitment to sustainable business practices.

Balancing ESG metrics with financial metrics

Practically, when integrating ESG measures into incentive plans, it is crucial to balance these with key financial metrics, being mindful of potential trade-offs. 

These approaches ensure that ESG considerations are effectively integrated without compromising financial performance.

Linking ESG targets to executive pay involves navigating a complex and evolving landscape of regulations and shareholder expectations. We have extensive experience in supporting clients with ESG and sustainability leadership appointments on a global scale. Our expertise places us at the forefront of compensation changes and ESG developments, ensuring our clients are well-equipped to meet these emerging challenges.

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