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Regulatory scrutiny increases corporate appetite for ESG-related compensation

Recently proposed regulations from the U.S. Securities and Exchange Commission and Department of Labor highlight the potential impact of ESG factors on corporate financial performance. Corporations, in turn, face heightened public scrutiny on their handling of employee matters related to health, climate and social justice.

As companies increase their focus on ESG-related impact, many have begun to align their executive incentive-pay structure with corporate ESG goals. This shift toward tying an increased portion of executive pay to corporate performance on ESG-related goals was evidenced in the 2022 proxy season, which saw many prominent public companies disclose new or enhanced ESG metrics in their pay structures.

As attorneys in the nation’s preeminent executive compensation and employee benefits practice, we have assisted many executives and corporate boards in navigating these new ESG waters. This article shares advice and perspective based on our experience counseling executives and corporate boards on understanding and negotiating compensation structures.

Regulatory context

It should come as no surprise that companies are increasing their focus on ESG metrics just as the SEC and DOL are issuing strict regulations surrounding ESG-related corporate disclosures.

In March, the SEC released a proposed rule that, if adopted in its current form, would require public companies to disclose a broad range of ESG-related information. These mandatory disclosures relate to governance of climate-related risks and relevant risk-management processes; how climate-related risks have had or are likely to have a material impact on business operations; and how these risks have affected or are likely to affect strategy, business models and outlook.

In a similarly climate-conscious vein, the DOL recently released two pieces of guidance related to ESG and retirement-plan investing. The first, a proposed rule published in October, would make it easier for retirement-plan fiduciaries to consider ESG factors when making decisions related to the plan in question. The second, a request for information released in February, seeks input from industry stakeholders on whether there is more the DOL can do to address the potential risks climate change poses to retirement-plan savings.

The actions of the SEC and the DOL are part of a larger political and social trend pushing corporations to focus on ESG matters.

ESG focus takes hold in executive pay

As companies face stricter regulations and scrutiny surrounding ESG disclosure and impact, it is understandable that public company compensation committees will turn to linking executive pay to performance in these areas. Performance-based pay has long been accepted as an effective means of motivating executives to act in the best interest of their shareholders.

In our legal practice, we have witnessed firsthand the general trend of companies tying executive pay to corporate ESG goals. Of the $6.96 billion in compensation paid to S&P 500 CEOs in 2021, 8.6 percent of that, or $600 million, was tied to corporate ESG performance.

This correlates with the broader, steady increase in corporate focus on ESG-type performance metrics in the area of executive compensation. In 2019, 16 percent of U.S. companies included ESG considerations in their executive incentive plans; that figure rose to 21 percent in 2020 and 25 percent in 2021.

Certain performance-based ESG pay metrics are more popular

Based on our experience with executive-compensation structures, successful performance-based pay plans closely align executive performance metrics with overall corporate purpose and strategy. As such, the ESG metrics included in incentive-pay programs should (and do) differ based on industry and company culture. A specific company’s degree of involvement in environmentally or socially sensitive and labor-intensive industries influences the degree to which the overall corporate strategy weighs such ESG concerns.

As a whole, however, the ESG metrics most commonly selected by boards and compensation committees include those related to diversity and human capital management. These areas are more quantifiable than some other ESG metrics, which makes them easier to track for incentive-based pay purposes. They are also increasingly important to investors and other stakeholders due to their correlation with liability risk.

While it is still relatively common for companies to include generic or subjective references to ‘ESG-related’ goals in their performance-based incentive plans, some are introducing more specific and measurable targets …

We have seen numerous diversity- and other workforce-related goals in recent publicly filed incentive plans. For example, a large financial institution included “increasing diversity representation” as one of the individual performance criteria in its performance-based incentive-compensation plan effective Jan. 1, 2021, and an insurance company tied a percentage of executive annual incentive pay for 2022 to corporate achievement of the goal to increase employee use of a company-sponsored wellness plan.

Shift from subjective to objective measurements

Over the last couple of years, as public and regulatory pressure have mounted on companies to improve their disclosure and performance in ESG-related areas, we saw a shift in ESG-related performance goals from more general or subjective goals to more clearly disclosed objective and measurable goals. While some companies still use generic language when referencing ESG goals as performance metrics, many are making it more measurable and objective.

As an example of the more generic or subjective style of ESG performance goals, a large transportation company phrased a short-term incentive-plan performance goal for 2021 as follows: “Implement and document good faith efforts designed to ensure inclusion of female and minorities in the pool of qualified applicants for open positions and promotional opportunities and otherwise promote … commitment to diversity, equity, tolerance and inclusion in the workplace.”

Similarly, a retail company included “goals relating to environmental, social and governance criteria” at the end of a laundry list of other financial metrics to be listed as performance metrics in its 2020 stock incentive plan.

We refer to these types of ESG goals as “generic,” as they include subjective standards such as “good-faith effort” and, as such, are not quantifiable.

While it is still relatively common for companies to include generic or subjective references to “ESG-related” goals in their performance-based incentive plans, some are introducing more specific and measurable targets in response to increased regulatory and social pressure to broaden corporate sustainability efforts.

For example, an industrial machinery company decided to include in its 2022 short-term incentive plan a multiplier to the payout opportunity directly tied to measurable corporate progress toward achieving two longer-term goals: “a 50 percent reduction in Scope 1 and Scope 2 greenhouse gas emissions for 2030 and progress toward achieving gender parity among our executive leadership by 2030.” In other words, the short-term incentive-payout factor would increase or decrease by a multiplier of 1.1 to 0.9 based on measured achievement toward those specific and measurable long-term goals.

Similarly, an aerospace company’s compensation committee factored its 6.2 percent decrease in greenhouse gas emissions (as compared to 2020) into determining payout under its short-term cash-incentive program. There are other cases in which oil companies, for example, have considered emissions in determining payout under short-term compensation programs.

Elsewhere, a financial-services company recently tied annual incentive pay for executives to corporate performance on very specific and measurable ESG goals. This company disclosed in its 2021 proxy statement that executive payouts could increase or decrease by 10 percent overall, depending on two factors: corporate performance toward the goal of net-zero greenhouse gas emissions by 2040; and closing its gender pay gap.

Some companies have also moved toward disclosing the specific percentage of executive pay to be tied to progress on ESG goals. For example, a multinational food company disclosed in its 2022 proxy statement that 10 percent of the CEO’s performance score is directly tied to corporate progress on global ESG goals (related to healthy living and community support, environmental stewardship and responsible sourcing).

As regulatory and social factors continue to place pressure on companies to be more transparent with respect to their global impact and sustainability efforts, we expect an increasing number will tie executive pay to corporate ESG performance. We predict companies will shift toward more specific and measurable ESG-related goals in an effort to incentivize executives to focus more heavily on these areas. We also predict companies will continue to disclose their ESG-related pay structures as a public display of corporate commitment to and focus on ESG.

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