Due to the increased relevance and the transparency requirements to be implemented in the future in terms of a company's sustainability strategy, the term "ESG" ("Environmental, Social and Governance") has now also become an integral part of the day-to-day work of the Treasury/Finance function. Beyond the high-profile issuance of ESG-linked financing (e.g., green promissory note loans or green bonds1) and their hedging (ESG-linked hedging), the ESG considerations have also been playing an increasingly important role in the design of share-based forms of compensation for several years.

Although sustainability aspects in share-based compensation programs have not been observed across the board in the major German stock indices, they have been present in isolated cases for several years. In this context, it is interesting to note that the "ESG density” has increased noticeably in the recent past and the topic of sustainability is now seen as an integral part of a modern, share-based compensation program.

In concrete terms, there is a wide variety of interpretations of the term "ESG", and the corresponding targets or indicators are interpreted in a heavily company-specific manner. For example, sustainability targets are operationalized in the form of a target for future CO2 emissions of the production facilities2, a company-specific sustainability score (measured on the basis of various indicators such as emissions, recycling rates, working conditions, etc.)3 or through participation in a corporate sustainability assessment and the company's ranking in this assessment.4 Besides, in share-based forms of compensation, at times a rather low weight is given to the achievement of targets for any ESG components compared to the overall target achievement (usually around 20%). However, their relevance is expected to increase in the future as the sustainability debate gains more public visibility. In addition, the increasing standardization of sustainability reporting by the ISSB is expected to establish standardized KPIs, making "ESG" objectively measurable and comparable, if necessary, even based on market data available in the future.

With share-based compensation, ESG components are currently designed both as non-market performance conditions within the meaning of IFRS 2.19 (fulfillment of target criteria within the vesting period) and in the form of non-vesting conditions within the meaning of IFRS 2.21A (fulfillment of target criteria is measured, for instance, over a longer performance period compared with the vesting period or is conditional on the recoverability of the instruments granted). While non-market performance conditions are reflected in the so-called quantity structure and their expected target achievement can be taken into account based on a "more likely than not" approach, non-vesting conditions must be included in the measurement of share-based compensation program’s fair value. The challenge in this regard is to quantify the effect of these very conditions on the fair value. However, due to the current data availability and heterogeneity of the target design, in many cases this can only be accomplished by a haircut estimated by "management judgment". In other share-based compensation programs, however, ESG components are embedded in a manner that requires them to be treated as a non-market performance condition and included in the quantity structure. While no effect on the fair value can be identified in this case, a realistic estimate of the expected target achievement is necessary for an appropriate accounting treatment and is recognized in profit or loss.

In addition, the expected increase in the value contribution to the overall target achievement of a share-based compensation program will also lead to an increased complexity of decision-making on the design and measurement of ESG components in the future. A possible standardization of ESG KPIs by means of a preceding standardization of ESG reporting allows the creation of an objective measurability and at the same time an improved comparability by means of market data that will be available in the future. As such, it remains to be seen whether and to what extent ESG components will be standardized through reporting and, if so, how generally available market data will find their way into the valuation and accounting of share-based compensation programs. As a result, businesses will be forced to modify existing share-based compensation programs or even launch new programs in order to sustain a competitive compensation model.

Are you facing challenges related to incorporating sustainability criteria and their impact on the accounting and valuation of your current or future share-based compensation program? Our finance and treasury management specialists can draw from many years of know-how in the areas of program design, accounting and assessment as well as economic impact or scenario analyses. Additionally, they have the appropriate methods and tools to provide you with individual support. We look forward to exchanging first ideas with you without any obligations on your part.

Source: KPMG Corporate Treasury News, Edition 122, June 2022
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Marie Czentarra, Managerin, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Philipp Wallis, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG


1 Edition 107, KPMG Treasury Newsletter "Increasing Significance of green finance"
2 See BASF annual report 2021, page 281
3 See Continental annual report 2021, page 188
4 See Metro annual report 2021, page 253