ESG performance hurdles in incentive plans holding management accountable for ESG progress
14 October 2022
14 October 2022
Environmental, social, and governance (ESG) topics have continued to be central to the conversation happening between Boards and investors during the 2022 reporting season. Investors have made their ESG expectations known to Boards and will likely continue to use their voting power to hold companies accountable for failing to meet self-imposed ESG targets.
Boards rely on their management teams to ensure that companies are meeting their ESG targets – but how can Boards hold management to account if those ESG targets are not met or reward management if those ESG targets are exceeded? Given evidence that positive ESG results can drive long-term shareholder value, Boards should consider including “quantifiable” ESG hurdles in executive incentive plans.
Financial hurdles have long been the predominant component of executive incentive plan designs, including the achievement of revenue, EBIT/EBITDA, EPS, or cash flow goals. Incorporating transparent financial hurdles into executive incentive arrangements is a reasonable way to encourage executives to drive value for a company. Similarly, incorporating transparent ESG hurdles into executive incentive arrangements should incentivise executives to ensure that ESG targets are met and treated the same way as financial targets.
Provided that there is a balanced approach to the types of hurdles used in incentive plan designs, using incentives as a means to reward executives for driving ESG outcomes (or penalising them for failing to achieve ESG outcomes) can benefit shareholders and further promote a pay-for-performance philosophy that aligns with creating long-term, sustainable value.
On 11 August 2022, Diligent released a report entitled "Executive Compensation in the Era of the Great Resignation". That report included the following findings:
This demonstrates that Australian investors are becoming used to seeing ESG hurdles included in management compensation schemes. However, it is important that the ESG targets (like all performance targets) are measurable and explainable to investors. As with any performance conditions, it is essential that ESG hurdles are clearly linked to the implementation of the company’s strategy. Setting ESG hurdles that have not been carefully considered, or adding an ESG hurdle as an afterthought, can be counterproductive.
As with any other hurdle, tying hurdles to clear, reported and audited numbers will be more palatable to shareholders and other stakeholders. There is a risk that shareholders view ESG hurdles as 'soft' and companies will need to take care that the targets are not achievable simply as ‘part of the day job.’
England has a more developed practice (when compared to Australia) regarding the inclusion of ESG hurdles in LTIP grants and bonus arrangements. Including ESG hurdles in LTIP grants and bonus arrangements is now common-place for most FTSE 100 companies. A key theme of the 2022 AGM season was the focus on the alignment of pay with ESG strategy.
In June 2022, FIT Remuneration Consultants noted that over 80% of FTSE 350 companies are now using ESG-related measures in their bonus schemes and over 30% include ESG measures in their LTIP grants. This follows FIT Remuneration Consultants' report in 2021 which found that approximately 40% of FTSE 350 companies have one or more specific ESG measures included in determining annual bonus payments, with the median weighting being 20% of the total award. For long-term incentives, 15% of FTSE 350 companies include an ESG hurdle, with the median weighting being 25% of the total award.
According to a report published by PwC in 2021:
Some key questions and considerations that the Board and management can discuss when determining the appropriate ESG hurdles to include in executive incentive arrangements include:
With increased regulatory attention and continued community focus on ESG, it is clear that companies will need to continue to demonstrate their ESG credentials. Incorporating ESG hurdles appropriately into executive incentive plans is a way for the Board to hold management accountable for progress against the strategy, as well as signal the company's ESG focus to stakeholders.
Authors: Miriam Kleiner, Partner (Legal Governance Advisory).