The importance of ESGs in incentive plans

August 20, 2021

The use of Environmental, Social, and Governance (ESG) metrics in incentive plan design is expanding as ESG investment strategies are becoming the norm for many institutional investors.

Across the board, companies are subject to greater transparency, employees have greater access to company decisions, and the court of public opinion influences customers' decision-making through social media. So, getting ESG priorities right is crucial.

In 2019, Mercer conducted a spot survey of 135 US and Canadian companies across all industries. At that time, 30% reported using ESG metrics (primarily short term) in their incentive plans and 21% were considering doing so soon.

This year, Mercer analyzed the incentive plans for roughly 300 S&P 500 companies whose fiscal year ends between June 2020 and December 2020. Of those researched, 38% used at least one ESG metric in their executive incentive plans, with 8% indicating their intention to adopt an ESG metric in 2021 and another 8% listing an ESG-related accomplishment in Named Executive Officer (NEO) performance assessments.

The growing trend in ESG investing is leading to an increasing prevalence of ESG incentive design.

What exactly are ESGs?

ESG measures nonfinancial factors that help companies achieve desired sustainability and social impact goals. Companies must align ESG goals and metrics with overall company financial and cultural goals in a meaningful way to make an impact.

ESGs can come in many different forms but for this research, six categories were identified in order of prevalence in Mercer's recent study:

  • 27% Diversity, Equity, and Inclusion (DEI)
  • 16% Employee Health and Safety
  • 15% Other Human Capital Metrics
  • 11% Environmental Stewardship
  • 7% Environmental Safety
  • 6% Employee Engagement

Mercer's research showed that ESG metrics tend to be measured quantitatively. The type of ESG often determines the ESG incentive program design. Environmental Safety and Stewardship and Employee Health and Safety metrics are frequently stand-alone metrics. DEI, Human Capital, and Employee Engagement metrics often modified a broader group of strategic or individual goals for the year.

Incorporating ESG measures into executive compensation plans

ESG incentives must also be meaningful — large enough to drive change and yet achievable. Usually less than 25% of the goals are nonfinancial, with weightings for ESG incentives typically ranging from 5% to 10%.

ESG goals should be focused and the messaging clear. Adding too many ESG goals can inadvertently dilute the impact of reaching those goals. Alternatively, prioritizing particular ESG issues over others can also mislead stakeholders who hold different values.

Empty or false virtue signaling should be avoided by ensuring that the ESG factors are relevant to the company's business strategy and results. Failing to meet ESG goals can lead to loss of reputation and employee distrust.

Environmental and social measures are prevalent

Environmental Stewardship is expected to continue to grow steadily over the coming years as climate change and sustainability remain a societal focus. A broad collection of companies researched have adopted environmental and climate stewardship metrics, which includes activities like:

  • Reducing CO2 emissions
  • Prioritizing green energy
  • Supporting sustainability initiatives

Social and DEI incentives were the most prevalent among the research sample. Although most DEI metrics are measured qualitatively and disclosure around specific goals is often limited, some companies have opted to be especially transparent with DEI goals and metrics.

DEI incentives may include activities like:

  • Representation: Increasing Black, Indigenous, and Latinx representation at the manager level and above
  • Supplier selection: Company-wide spending of 12% with diverse suppliers
  • Bias training/Program development: Accountability for completion of specified training and education requirements by corporate employees

Short-Term Incentive or Long-Term Incentive

Effective incentive compensation programs start with selecting the proper performance measures for your company and establishing the most suitable correlation between success and payout.

Short-term incentive (STI) plans often include metrics that are company-specific and can be adjusted annually. A large majority (96% overall) of the companies Mercer researched have ESG metrics as part of their STI plans.

With the emphasis on future and long-term results inherent in the typical design of long-term incentives (LTI), environmental stewardship metrics are most often included here.

ESG initiatives contribute to the company’s overall culture and performance. It sends a message to employees, clients, and investors about company priorities and goals for the future. What message is your company sending?

Mercer has plenty of experts ready to help you incorporate ESG initiatives into your incentive plans. Give us a call (866-605-1031) or drop us a line.