Executive Compensation in an Era of Stakeholder Primacy: Integrating ESG metrics into pay plans.

• Author: Neel, Kathryn

Rising stakeholder expectations surrounding environmental, social and governance issues (ESG) are spilling into a growing corporate awareness of the need to address them. Though some companies have begun to demonstrate progress and commit to commendable goals on the issues--and make strides in integrating oversight at the board level --ESG has yet to become commonplace in executive compensation programs, seemingly the final step of solidifying corporate responsibility over the issues.

As corporations are increasingly seen as beholden to stakeholders beyond just shareholders, incorporation of ESG metrics in incentive programs represents an evolution towards substantiating this widening scope of responsibilities.

Despite the long-term nature of the issues, and where they exist today, ESG metrics are often found in annual incentive programs and are rarities in long-term programs. Although beginning to develop, companies currently lack confidence in their ability to define, measure and quantify the right ESG metrics to hold management accountable for their outcomes.

How should ESG metrics be meaningfully integrated into executive compensation programs? Here are some "thought starters" for boards:

Metric Selection

A crucial first step is metric selection, which depends first on defining which issues are most "material" to a given company. Determining these issues is outside the realm of compensation design. Here we assume the company has already defined material issues and set goals towards achieving them.

Annual Incentive Plans

One way to integrate ESG would be to emulate current approaches and add it to the annual incentive plan. This may be the preferred approach if the goals are truly short-term in nature or are easy to measure/ judge on an annual basis. There are three basic, common approaches:

Individual component: If a plan already has a measure of individual performance, ESG goals can be integrated into individual goals, providing the flexibility to tailor the goals to the executive most responsible for their achievement.

Scorecard: Metrics are also often added to a scorecard of goals, generally worth a collective 20%-30% of payout. This allows the flexibility to integrate qualitative and quantitative metrics, to combine ESG and other strategic goals, and promotes a sense of collective ownership. The danger with this approach is evident in the current market: too many goals on a scorecard --particularly qualitative goals--can dilute the...