As focus on the ethical, legal and environmental issues related to business has increased, driven by growing concerns over areas such as climate change and diversity, so too has pressure on companies to address them. ESG (Environmental, Social and Governance) factors have become critical to good business practice and are tied to the success and long-term sustainability of companies across all sectors. While we continue to see more and more companies making long term sustainable growth the focal point of their strategy, there is emerging pressure from investors, regulators, and other stakeholders to push this further and directly link ESG factors with areas of governance such as executive pay.
If your company is thinking about incorporating ESG measures into your executive incentive plans, below are some initial questions you may want to consider.
Do you need to include ESG measures in your executive incentive plans? In some cases, ESG may be strongly embedded in the company culture and strategy, and this value already embedded in financial measures that are already linked to executive pay. Decisions on KPIs and their relative weighting should take into account the risk of over-paying executives by linking unnecessary ESG measures, while also assessing the potential benefits to company performance, sustainability and reputation.
ESG for long term or short-term incentives? Although most ESG matters are long-term in nature (normally longer than the performance period for long term incentive plans), you may be able to identify some shorter-term milestones that are measurable and appropriate for either incentive plan. It is important that the timeline of these milestones is aligned with the performance period of your incentive plans, and that the measures set up do not encourage unsuitable behaviors which distort the longer term ESG agenda.
How should you include ESG measures? There are pros and cons for each of these methods and investors normally have their own preferences. For example, ISS suggested that ESG matters could be assessed through application of discretion (although bearing in mind that listed companies now need significant disclosure on the basis on which discretion is exercised). Legal and General Investment Management stated specifically that they would prefer ESG to be incorporated in the form of weighted, clearly measurable metrics.
Which ESG measures should be incorporated? One of the key challenges companies are facing when linking ESG measures to executive pay is deciding what measures to include. Our research shows that Environmental measures are most popular amongst the FTSE 350 but there is no correct single answer and the appropriateness of any given measure will vary depending on the nature of the business and your unique circumstances. Your chosen measures should align with your wider ESG agenda and fit into your overall business strategy. Investor views also need to be considered.
What is an appropriate weighting for ESG? While ESG measures are increasingly important, getting your weightings right is a balancing act. Applying a larger percentage to your ESG measure(s) is not necessarily better, but they do need to be material in the overall context of the executive remuneration package. Companies need to be mindful of other performance measures and their weightings and how ESG fits into the overall incentive plan.
ESG is clearly an area of growing focus and is here to stay. By linking performance related pay, businesses are showing their commitment to long term sustainability and their intention to encourage their executives to be the driving force in advocating ethical behaviors, creating an ESG aligned culture from the top down, and ensuring that they personally take into account the ESG impact of any decisions they make. Results show that ESG is becoming a vital component of reward strategies across the FTSE 350 and we expect it to remain so over the longer term.
The excerpt was taken from the KPMG Thought Leadership publication Paying for sustainable growth.