[Trending News] Pushing for ESG-metrics in executive remuneration schemes

ESG metrics and modifiers

Throughout 2024, we have engaged with companies, predominantly from the US, which we deem have excessive remuneration schemes. An important objective of our engagement project is to push for the inclusion of ESG metrics in executive compensation schemes. These metrics should have quantifiable targets and be material and relevant to the company’s business.

Our analysis (see table) indicates that the majority of companies involved in our engagement project utilise ESG metrics as modifiers within short-term incentive (STI) plans, rather than as standalone performance metrics. While a performance metric typically influences a specific portion of the total payout, ESG modifiers adjust the overall payout by a predetermined percentage (e.g., +/- 10%). By implementing separate ESG metrics, companies could significantly enhance the emphasis on ESG factors in their overall performance evaluations.

Modifiers are generally employed to include a range of ESG metrics rather than focusing on a single metric. They are particularly prevalent in sectors such as consumer discretionary, information technology and industrials, which align closely with our engagement efforts. Conversely, utilities and energy companies seldom adopt these modifiers, likely reflecting their advanced understanding and experience in leveraging ESG performance metrics to drive executive behaviour in recent years.

Of the mentioned companies, Gen Digital applied the ESG modifier in fiscal 2023, the second year of our engagement with the company. While S&P 500 companies show a high adoption of ESG metrics, including ESG modifiers (77.4% in 2023), the use of pure ESG performance metrics has slightly decreased since 2021, with larger companies increasingly favouring ESG modifiers.

Transparency challenge

Significant hurdles remain in ESG-linked compensation, primarily stemming from a lack of transparency. Most companies lack quantified ESG targets and clear assessment criteria, making it difficult for shareholders to evaluate executive payouts. A key issue is the disconnect between annual bonuses and long-term sustainability goals. For instance, while companies include climate metrics in their annual incentives, they typically only disclose medium and long-term emission reduction targets, without specifying the required yearly progress. This lack of clear annual milestones makes it difficult to assess whether ESG-related payouts are justified.

Nevertheless, several companies have effectively integrated ESG metrics aligned with their business models, although their impact varies. Healthcare equipment company Zimmer Biomet, for example, uses a Quality Bonus modifier (±5%) based on specific FDA compliance and quality control metrics directly tied to medical device manufacturing success. While the metrics are clearly defined and business-relevant, the modest 5% impact might not be sufficient to drive significant change in executive behaviour.

Procter & Gamble has adopted an ESG scorecard to determine a modifier. This modifier, set at ±20%, affects the ‘Total Company Performance Factor’, which represents 30% of the annual executive bonus. The scorecard evaluates relevant sustainability areas, including emissions reduction, packaging circularity, water management, responsible sourcing and diversity – all critical aspects for a consumer goods company. However, P&G’s approach lacks specific achievement criteria and transparent assessment methods for these metrics, making it also in this case difficult to assess whether the bonus level is justified.

In summary, while some companies are making strides in ESG-linked compensation, the overarching issue of transparency remains a significant barrier to effective evaluation and accountability.

Making a case against discretionary awards

Remuneration plays an important role in attracting top talent and providing the right incentives for executives to act in the long-term interest of the company and its various stakeholders. That is why we believe that executive compensation should be based on pay-for-performance and linked to quantifiable metrics that are relevant to the company’s business model. We advocate for variable compensation performance criteria that encompass both financial and ESG metrics.

To uphold these principles, we strongly urge Boards of Directors and Supervisory Boards to eliminate discretionary awards for executives. As the name suggests, a discretionary bonus is given at the employer’s discretion. Our major objection to this type of bonus is that there are no specific goals set for it to be awarded. Moreover, the amount and timing of the bonus are not known in advance. Often a one-time arrangement, their purpose is usually to acknowledge exceptional performance, rather than a structured incentive.

Our commitment to transparency and accountability is reflected in our voting decisions against the proposed executive compensation packages at the 2024 Annual General Meetings (AGMs) of BE Semiconductor Industries (Besi), Vestas Wind Systems and Tomra Systems. In the case of Besi, the discretionary equity awards to its CEO have become a recurring topic in our engagements with the supervisory board in recent years. These engagements, partially in collaboration with Dutch corporate governance organisation Eumedion and other Dutch institutional investors, as well as dissent expressed by shareholders at AGMs, have finally led Besi’s Supervisory Board to exclude discretionary awards from its new remuneration policy.

Driving progress

Integrating ESG metrics into executive compensation is a powerful way to demonstrate a company’s commitment to sustainability. However, achieving effective implementation requires thoughtful consideration. It’s not enough to simply adopt ESG metrics; these metrics must be meaningful, quantifiable and closely aligned with the company’s business model. The real challenge lies in establishing clear, measurable targets that not only drive genuine sustainability progress but also support the company’s overall success.

Our discussions made clear that the companies we engaged with are on the right path, but that there is room for improvement. We are therefore committed to continuing the dialogue with them and other companies in our portfolios to drive positive change. We will also persist in calling on boards to refrain from giving discretionary awards to executives.