June 2, 2023 Executive Compensation ESG & Human Capital Management Articles

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ESG & Human Capital Management

Executive Compensation and Stakeholder Capitalism When looking to incentivize behavior tied to ESG goals, time-honored principles still apply.

Addressing the needs of a range of stakeholders has long been a part of managing a company, though explicit “stakeholder capitalism” has grown in influence in recent years following Business Roundtable’s updates to “The Purpose of the Corporation” in 2019.

While the broader stakeholder focus is growing, shareholder value creation is still the primary company objective, implying that financial and shareholder value metrics should remain the most prominent incentive tools for executive pay programs. With the ongoing market evolution, many companies are more actively contemplating broader stakeholders and considering direct adoption of ESG metrics in pay programs. In these cases, many enduring principles of executive compensation should be applied to ESG metrics, including considering the alignment to company strategy and values and the incentive value that a broader view of performance can provide.

Addressing Stakeholder Impact Has Always Been a Part of Business

A common criticism of Business Roundtable’s definition of stakeholder capitalism is that navigating varying stakeholder expectations is part of the complex decision set that company leaders have always had to manage to drive long-term shareholder value creation. This view is supported by legacy executive pay program designs. Under a fairly broad definition of ESG that includes nonfinancial metrics such as customer satisfaction and safety, 57% of S&P 500 firms had such metrics in place in 2019, before the publication of Business Roundtable’s updated statement. However, the prevalence of ESG metrics has increased over the last several years, with 65% of S&P 500 companies disclosing a metric in 2020 incentive plans and 70% disclosing a metric in 2021 incentive plans. Customer satisfaction and safety metrics continue to be prominent in industries where those metrics are relevant. The two metrics with the largest increase in prevalence were human capital metrics, primarily measured through diversity and inclusion and sustainability metrics, primarily measured through carbon footprint, as companies have become deliberate about those topics.

In light of these trends, compensation committees should be intentional about whether and how to include ESG metrics as part of executive incentive plans.

Enduring Compensation Principles Still Apply to Measuring and Rewarding ESG Metrics

Despite pressure to include a broader view of performance, creating value for shareholders will continue to be the primary emphasis of management teams. As such, financial and shareholder value metrics should remain the most prominent incentive plan elements for executive pay programs. However, as companies consider supplementing more traditional metrics with ESG measurement, fundamental questions that apply to all incentive metrics should be considered.

How integral are ESG issues to the company?

Incentive metrics, including ESG metrics, should align with the company strategy and values. For some, being a leader in ESG topics is integrated into the brand, and this importance should be reinforced in incentive plans. For instance, industries in which people are the key value driver, such as technology and professional services, often need above-average focus on human capital issues. Likewise, industries where safety or environmental impact are important have a higher prevalence of metrics aligned to those issues. The principle of aligning metrics with company value drivers is consistent over time. Looking back to 2019, human capital metrics were most common in technology and financial services companies, while environmental metrics were most common among energy companies. The increased emphasis — both internally and externally — has led to an increase in human capital metrics over the last few years.

How do existing company programs and practices address ESG topics?

Some companies have good momentum and progress on broader stakeholder topics. At those companies, the incentive value of including new ESG metrics in the pay program is not necessary to demonstrate importance to employees or broader stakeholders, or to change behaviors. In other cases, the incentive program is a critical change management tool to help demonstrate a company’s commitment to critical issues. On this topic, individual company circumstances, company culture and management team orientation are important to determine whether there is a role for ESG in incentives.

What strategic ESG elements can be measured, and with what degree of precision?

Many ESG items are notoriously difficult to quantify, and it is also difficult to ensure that “positive” scores have a correlated favorable impact on company performance. However, many ESG-related items are now being measured more comprehensively and objectively, especially as companies publish corporate social responsibility reports and have increased SEC disclosure requirements. When ESG goals are used, it is important that they be rigorous enough to be assessed objectively. They should also be strong enough to avoid allegations of greenwashing.

While there is now a more explicit focus on broader stakeholders, shareholder value creation will continue to be the primary concern for boards, and traditional incentive plan design elements should apply going forward. Aligning incentive plans with alternative stakeholder impacts should be implemented only when it reinforces company strategies and values. While the terminology and emphasis on ESG are relatively new and evolving, the approach for measuring ESG-related metrics and incentivizing related behavior should follow many enduring principles of executive compensation design.

View the full article as it was originally published or download a PDF version of it.

Greg Arnold

Brant Shelor

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