Incorporating ESG metrics into variable remuneration arrangements - what are the challenges?

Last month, the UK Investment Association (the IA) published its updated principles of remuneration (the 2022 Principles), setting out members’ expectations on executive remuneration and long-term incentives for the 2022 AGM season (see our recent blog post here). One of the 2022 Principles’ areas of focus for the forthcoming AGM season is environmental, social and governance (ESG) metrics in variable remuneration arrangements. This blog post discusses the main considerations and challenges for remuneration committees (RemCos) when incorporating ESG measures into incentive plans.

The number of listed companies incorporating ESG metrics into their variable remuneration arrangements has increased rapidly in recent years. ESG issues have soared up the boardroom agenda because of key events including extreme weather emergencies, Black Lives Matter protests, and the #MeToo movement. Consequently, various market studies have found that ESG is increasingly being used in annual bonus plans or long-term incentive plans (LTIP) or both. The Covid-19 pandemic has accelerated the prominence of ESG issues even further and we expect this trend to continue in the coming years.

Where companies incorporate the management of material ESG risks and opportunities into their long-term strategies, the 2022 Principles say that RemCos should consider management of these risks as performance conditions in the company’s variable remuneration arrangements. The ESG metrics selected should be quantifiable, clearly linked to the implementation of the company’s strategy and the rationale should be disclosed to investors. Other institutional investors have also weighed in on the issue.  Where ESG metrics are included in variable remuneration arrangements, Glass Lewis expects robust disclosure on the metrics selected, the target setting process and corresponding pay out opportunities.

It is clear that institutional investors now expect listed companies to consider ESG issues as a matter of course, including in their executive remuneration arrangements. But this is not easy to implement. There is a variety of guidance for companies to consider but no consistent framework or detail. 

One fundamental problem is that ESG is a somewhat broad and nebulous concept. There is a plethora of different ESG reporting frameworks but a lack of consistency and comparability of metrics. This lack of clarity makes it more difficult for companies comply with the 2022 Principles. More broadly, target setting has been cited as the most common challenge when incorporating ESG metrics into executive remuneration plans. But we are slowly beginning to see a standardisation of ESG metrics.The World Economic Forum has published a paper identifying 21 core and 34 expanded universal, material ESG metrics and has recommended disclosures that could be reflected in annual reports of companies across industry sectors and countries. Other bodies are also beginning to get in on the act. For example, last year the European Commission published the Taxonomy Regulation which seeks to establish a clear definition of what is ‘sustainable’ and amends the Non-Financial Reporting Directive and the Sustainable Finance Disclosure Regulation such that companies must disclose in line with the Taxonomy Regulation. Further development of the Regulation is underway to include a taxonomy for the ‘S’ of ESG. Listed companies should monitor future standardisation efforts and select the most meaningful metrics for their business.

Another challenge for employers after setting targets is deciding how to measure those targets and how much weight to give to each metric. Companies should consider whether the relevant target will be measured based on internal or external factors and whether the target will be assessed over the short or long-term. For example, health and safety targets can be measured on a short-term basis and can therefore feature in an annual bonus plan, whereas environmental targets are measured over a longer time period and might therefore be more suitable for an LTIP. The target should clearly state how it is to be achieved and there should be data available allowing the company to make this assessment. 

Crucially, businesses will need to find the right balance between targets. Might separate E, S and G considerations be at odds with each other? The three are inextricably linked and often overlap; for example, setting diversity targets in relation to minority or female board representation can straddle both social and governance targets. However, setting too many targets at once may work at cross-purposes, so RemCos should be thoughtful in their approach.

Will companies use soft ESG targets to compensate for poor performance against financial metrics? Clearly, this should be avoided. There are concerns among investors that non-financial targets will be used to increase pay, or to make payments where financial targets are unattainable, so companies should disclose their progress towards ESG targets where possible. Ultimately, the method used for setting and measuring targets will be bespoke to each business and some will find this easier than others. Companies in carbon-intensive industries may find it easier to set environmental targets, whereas financial services, may find this more difficult.

Listed companies will also need to consider how to report on their remuneration arrangements, taking into account any disclosure requirements to which they are subject. Under UK corporate governance rules, listed companies must disclose the details of short and long-term incentives for each director in their directors’ remuneration report. This includes retrospective disclosure of awards and targets in the implementation report and prospective disclosure in the remuneration policy report. There have already been instances of shareholder revolts over companies’ approach to climate change, and this could extend to shareholder votes on remuneration.

The integration of ESG metrics into incentive plans is clearly not going away anytime soon, as stakeholder pressure grows. However, implementing and disclosing such arrangements is far from straightforward. When considering ESG targets, RemCos should ensure that they pay close attention to investor guidance and ultimately drive stakeholder value. Failure to do so may result in shareholder revolts and reputational damage.