Intangible assets—patents, brands, client relationships, skilled workers and organizational processes—generate most corporate growth and represent 90% of the market value of the S&P500. Corporate boardrooms have taken note: roughly half of the largest US and UK companies base executive compensation in part on intangibles.
Academic research supports the wisdom of this executive compensation trend. Caroline Flammer, Bryan Hong, and Dylan Minor’s recent study found that the adoption of ESG criteria in executive compensation is associated with an increase in long-term orientation, an increase in firm value, an increase in social and environmental initiatives, reduction in emissions, and an increase in green innovations.
With aligned incentives, institutional investors can bolster risk-adjusted returns by strengthening and supporting executive focus on those intangibles that are material to long-term value creation. This article, the third in a series on sustainability-related intangibles, highlights leading practices and development areas in corporate and investor executive compensation ESG targets.
Current Market Practice Among Large US and UK Companies
Overview. According to Willis Towers Watson research, 51% of the S&P 500 uses ESG targets in their incentive plans. The vast majority of companies in ESG-intensive sectors like utilities (90%) and energy (83%) use ESG targets in executive compensation, while only one-third of consumer discretionary (30%) and information technology (34%) companies do so. Similarly, according to a recent PwC and the London Business School’s Center for Corporate Governance report, 45% of FTSE 100 companies use an ESG measure when setting targets for executive pay.
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Bonuses. 50% of the S&P500 and 37% of the FTSE 100 include ESG targets in annual bonuses. Most standalone targets make up 10% of bonuses for S&P500 companies, but because some companies use multiple targets, the typical weighting is 15%-18%. Similarly, in the average weighting of ESG measures in FTSE 100 bonus plans is 15%.
In S&P500 executive suites, the most common annual incentive plan weightings include a 10% weighting for: customer service, environmental and stability, people and human resources, employee health and safety, and governance; and a 5% weighting for diversity and inclusion. Among the FTSE 100, the most common category of measure in the bonus is social, including measures focused on diversity, employee engagement, and health & safety.
Change comes slowly: almost twice as many FTSE 100 companies incorporate longstanding social and governance targets such as health and safety, risk, and employee engagement into bonuses than incorporate recently emerging stakeholder concerns, particularly around climate change, sustainability, and diversity (31% vs. 18% of FTSE 100 companies).
Long-Term Incentive Programs (LTIPs). 4% of the S&P500 includes ESG targets in LTIPs. One in five (19%) FTSE 100 companies include them in their LTIP with an average weighting of 16%. Among the FTSE 100, environmental measures are rapidly rising in prevalence and are now the most common type in the LTIP. Environmental goals are long-term in nature, lending themselves to longer-term targets. The measures typically focus on decarbonization and the energy transition.
There are a number of challenges to including ESG metrics in incentive plans. According to a Willis Towers Watson survey of board directors and senior executives of publicly traded companies, the most common ones include setting targets (52%) and the identification (48%) and definition (47%) of ESG performance metrics.
More specifically, 55% of ESG targets are based on ESG dimensions categorized as material to the company under the SASB Materiality Map, which means that nearly half at 45% are not. Harvard Business School research finds that firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, while investments in immaterial sustainability issues have little positive or negative, if any, value implications.
Although 51% of the S&P500 measure and pay using ESG, just over 15% of S&P 500 companies use hard, quantifiable metrics to measure their performance. Consequently, ESG is applied subjectively for most companies, and in early 2020, nearly 70% of weighted ESG annual incentive measures are paid out at target or above for S&P 500 companies using them in bonuses despite significant unmitigated environmental and social risk at most companies. As former acting SEC Commissioner Allison Herren Lee noted, “as much as 93% of the US equity market is exposed to harms from climate change, with [last] year’s intensified fire and hurricane seasons offering a devastating preview of more to come.” Regarding social issues, one might argue that as much as 100% of the US equity markets are exposed to harms from the pandemic and racial injustice.
Turning Building Blocks Into Building Blocks
The importance of focusing on material ESG issues is well established. 50 leading institutional investors with $41 trillion in assets are actively promoting the corporate ESG disclosure using the SASB framework. As large institutional investors continue to encourage corporates, regulators, and accounting bodies like IFRS to adopt SASB, corporate focus on material ESG issues should grow.
As interest in integrating ESG grows among S&P 500 stakeholders, the use and measurement of metrics will need to improve. Companies would benefit by providing expanded disclosures that more specifically detail how ESG impacts pay.
Because LTIPs reward employees for reaching specific goals that lead to increased shareholder value, to optimize long-term value creation, use of ESG targets in LTIPs must become more common than 4% and 19% of the largest companies in the US and UK, respectively.
The ESG targets themselves need to be thoughtfully designed. At 55%, the majority of FTSE 100 executive compensation ESG metrics are output, rather than input, measures. Output measures are those with quantifiable targets, such as scope 1 and 2 carbon emissions, against which performance is assessed. By contrast, input measures relate to specific activities that a company undertakes, such as investing in green energy sources. Most ESG targets in the FTSE 100 are scaled targets, with thresholds and maximum performance levels because 100% achievement is not the expectation. This is particularly the case when an ESG metric is linked to a key standalone strategic priority, like the energy transition. However, when a particular ESG factor is considered a minimum requirement, sometimes ESG goals are better suited to an underpin. Health and safety could fall into this category.
What Investors Can Do
The investor-corporate dialogue is the most reliable type of sustainable investing for investors seeking impact, in the sense that it has been clearly demonstrated empirically. It is therefore critical that institutional investors themselves have the right incentives to strengthen and support executive focus on those intangibles that are material to long-term value creation. A number already do.
Canadian pension Caisse de dépôt et placement du Québec (CDPQ) introduced a formula to integrate carbon targets into employee variable compensation. Now, employee variable compensation rises and falls in tandem with achieving carbon intensity reduction objectives. Specifically, CDPQ sets carbon budgets for its investment teams.
Private New York-based asset manager Neuberger Berman includes ESG considerations in bonus determinations for investment staff. Research analysts are rewarded for keeping ESG analysis current, as well as for the value created by applying the analysis to the investment portfolio.
Identifying those intangibles that are material to long-term value creation and designing the right incentives for corporate and investment executives to foster them is already underway in boardrooms. ESG targets in executive compensation remain a space to watch, and let’s hope that companies and investors continue to innovate.