Performance Beyond Share Price: ESG and Incentive Compensation, (Bloomberg Law)
Partner Amy Pandit and associate Loren Kole describe how environmental, social, and governance (ESG) criteria are increasingly of interest to institutional investors and shareholders more generally, and how U.S. public companies have begun to incorporate non-traditional performance metrics, particularly in the ES areas, such as safety, diversity, and environmental performance, into their compensation programs to incentivize and reward achievement of these goals.
As environmental, social, and governance (ESG) criteria are increasingly of interest to institutional investors and shareholders more generally, U.S. public companies have begun to incorporate non-traditional performance metrics, particularly in the ES areas, such as safety, diversity, and environmental performance, into their compensation programs to incentivize and reward achievement of these goals.
The call for “responsible investing” is not a new concept. Manufacturers of chemical products used in the Vietnam War were subject to investor pushback for the impact of weaponized dispersal of such products in civilian areas. In the era of South African apartheid, many American companies faced pressure to develop codes of conduct for business in South Africa. In the 1990s and early 2000s, funds were pressured by socially responsible investing (SRI) advocates to divest from companies for a variety of reasons—from tobacco stocks in a response to healthcare and predatory marketing concerns, and from cosmetics and chemical company stocks where extensive animal testing was present, among others.
The transition to a focus on ESG, and the linking of ESG-related goals to incentive compensation, is a natural result of an increasingly connected and informed shareholder base that seeks to have its investments reflect its core values. Investments in SRI-focused funds have increased from $2.83 billion in 2015 to $17.67 billion in 2019 (through November). While SRI traditionally involved negative screens, such as avoiding certain companies or industries that are seen as having a negative influence or impact on society, ESG investing focuses on the intersection of environmental, social and governance responsibility with the policies and strategies of corporations.
According to a petition presented to the Securities and Exchange Commission, in 2017, 83%, 77% and 78% of the top 100 companies in the Americas, Europe, and Asia, respectively, published a corporate responsibility report; and 67% of the Global 250 have their reports assured by independent third parties.
The incorporation of ESG metrics into incentive compensation programs is currently industry- and sector-specific (with companies in industries that have more direct and significant environmental impacts taking the lead with the incorporation of environmental and social goals, such as safety, into their incentive programs). In May 2019, Mercer conducted a survey to capture ESG metrics in incentive programs of 135 companies from different industries. 30% of respondents already had included ESG metrics in their incentive plans and 21% were considering doing so.
Of the companies incorporating ESG into their incentive programs, they were most often a part of the short-term incentive program (as opposed to the long-term incentive program). Mining and metals companies led the field in ESG metric incorporation (82% of respondents in that sector), followed by the energy sector (52%). Companies in the technology and insurance sectors were the least likely industries to include ESG in their compensation programs.
Mercer's study also found that the types of ESG metrics used were highly sector-specific. While environmental and safety goals were the most prevalent in mining and metals and energy companies’ incentive programs, human capital management (HCM), corporate culture, and diversity and inclusion were the most prevalent factors in all other sectors surveyed. The study found that environmental metrics incorporated into incentive programs are most likely to be a set percentage of the formula, such as assigned a weighting of 10% in a short-term incentive plan. With the exception of diversity and inclusion metrics in short-term incentive plans, the Mercer study found that ESG metrics used in both short and long-term incentive plans tend to be measured on a quantitative basis.
Investor focus on ESG, and how companies are responding to environmental and social issues and concerns specifically, will continue to grow in importance and prominence in the coming years. In December 2019, KKR became a founding signatory to the Operating Principles for Impact Management, a new market standard for impact investing introduced by the World Bank's International Finance Corporation and joins 59 other signatories collectively representing over $350 billion in assets.
TPG issued a report on, among other matters, the positive environmental, social and governance impacts of its investments in April. In January, BlackRock committed to making sustainable investments its standard practice, and added its name (and approximately $7 trillion in managed assets) to the Climate Action 100+, a group of 370 fund managers and asset owners focused on urging companies to decrease their production of greenhouse gases to reduce environmental impact.
The Covid-19 pandemic, and associated social and economic impacts, have drawn additional attention to corporate responsibility and action. On May 19, 2020, Citigroup launched a new ESG investment banking group and emphasized this correlation, noting, “[t]he current Covid crisis will elevate the importance of ESG to our clients, as they increasingly focus on more sustainable and resilient strategies and on recovery plans that help drive the just transition to a net-zero emissions future.” A coalition of 195 institutional investor signatories, representing nearly $5 trillion in assets under management, has urged companies to provide paid leave to all workers, prioritize employee health and safety, and take every measure to avoid reductions in force. BlackRock and State Street have also indicated that, in light of the pandemic, engagement discussions with companies may emphasize immediate ESG issues, such as employee health and safety.
As shareholder focus intensifies in this area, corporations will increasingly feel the pressure to demonstrate their commitment to be environmentally and socially responsible citizens, including by tying incentive compensation to performance against ESG metrics that are relevant to their businesses to motivate employee achievement toward their respective environmental and social goals.