Using ESG performance metrics to drive cultural change

24 November 2020

An increased focus on ESG is starting to flow through into executive pay and performance. Companies that want to further their ESG objectives are looking at executive pay as a tool to engage managers and executives. This note considers how companies might use their incentive plans to further their ESG ambitions.

The ESG landscape

  • Investors, stakeholders and politicians are challenging companies to embed ESG into their culture and drive responsible capitalism.
  • Influential investors such as Blackrock and proxy advisers such as ISS and Glass Lewis are increasingly scoring companies on their commitments to change - and customers and employees want to be associated with companies with a demonstrable commitment to ESG objectives.

Should the achievement of ESG targets inform remuneration alongside pure financial performance?

  • Directors’ remuneration can be used to entrench an organisation’s ESG aspirations. Linking ESG targets to variable pay increases the likelihood of the company meeting such targets - and in doing so demonstrates a commitment to ESG factors in a tangible way to shareholders and other stakeholders.
  • RemCos and Boards will need to identify ESG metrics relevant to their industry and sector that are tied to their company’s “emerging risks". Changes to remuneration can be linked to both short-term and long-term ESG targets.

ESG targets in the context of Covid-19

  • The ESG landscape, particularly the “social” category, has become even more important in light of Covid-19. Corporate behaviour has been brought to the forefront with companies under the spotlight for how they treat their employees, suppliers, investors and customers. Since the beginning of the outbreak, health and safety has become a huge driver for business decisions. The Covid-19 pandemic is likely to accelerate the trend towards ESG and responsible capitalism. How a company responds to Covid-19 and integrates appropriate ESG targets to executive remuneration could have a major impact on their reputation and popularity within the market.
  • The pandemic has highlighted how non-financial factors can pose a significant short-term risk to companies. There is a clear need for companies to plan for future crises by creating a long term strategy linking relevant ESG metrics and risks to remuneration. A long-term strategy may include:
    • reviewing HR policies and employment practices particularly those in relation to furlough, sick pay, paid/unpaid leave, working from home and redundancy;
    • improving health and safety practices including any emergency response mechanisms particularly in the context of any future crisis which may require similar employee social distancing and protective wear;
    • improving cybersecurity and online working practices, particularly when working from home;
    • adding an extra layer of ESG scrutiny when it comes to future investments;
    • creating dedicated board-level crisis or risk committees; and
    • increasing transparency and communication with customers and maintaining customer satisfaction.

How Macfarlanes can help you

  • If you are considering linking pay to long-term ESG performance, we can help you:
    • incorporate ESG metrics into your existing LTIP/PSP; or
    • create an entirely new ESG specific share plan; and
    • update your Directors’ Remuneration Policy accordingly.
  • Several companies have also cut executive pay and/or limited dividends because of the pandemic in an effort to show solidarity with the rest the workforce.

Incorporating ESG metrics into a company’s existing LTIP/PSP

  • Long-term incentive arrangements are well suited to incorporate metrics which are based on changes which will take some time to implement or yield results. Extensive changes to an existing LTIP/PSP would not be necessary to achieve this – for example:
    • adding ESG metrics as an underpin – a proportion of TSR/EPS entitlements could be adjusted where such ESG metrics are not also satisfied;
    • performance conditions – a proportion of the award could be directly tied to the satisfaction of ESG metrics;
    • clawback and malus policy – failure to satisfy a particular ESG metric could be introduced as a new trigger event;
    • current language around the manner in which discretion is exercised and applied could make express reference to ESG metrics;
    • good leaver/bad leaver provisions – these could be set with reference to whether personal ESG metrics have been satisfied as at the date of cessation of employment (and possible failure of ESG metrics 2 years post-cessation);
    • restrictions on exercise post-vesting (option plans only) - post-exercise share restrictions on transfer and assignment could be subject to the satisfaction of personal ESG metrics; and
    • option exercise price (option plans only) – the exercise price could be structured to adjust up or down according to achieving personal ESG metrics over an option’s vesting period.

Creating a new ESG specific share plan

  • A remuneration plan which is designed from the outset around ESG would put ESG in sharp focus – not least as it would require shareholder approval - rather than keeping it in the small print. Clearly it would be necessary to consider what the impact on other remuneration would be given that investors might not support the idea that this would be a top up to existing pay.
  • A company could consider any of the factors set out above to create a bespoke ESG plan – which would allow the integration of a range of ESG metrics across a variety of fields.

Linking ESG metrics to short-term remuneration - Incorporating ESG metrics into a company’s existing bonus plan

  • A significant number of companies have linked their short-term remuneration to ESG metrics by incorporating such metrics into their existing bonus plans.
  • Bonus arrangements lend themselves easily to the incorporation of ESG metrics particularly where those metrics do not require large lead times to implement and measure (such as volunteering days per executive, trees planted per house built), as opposed to endeavours whose benefits will not be measurable or are unlikely to manifest in a significant sense in the short term (perhaps greenhouse gas emissions).
  • Instead of incorporating ESG metrics into their existing bonus plan, companies could consider linking the payment of a “top-up” bonus to the achievement of a specific ESG metric. The bonus would be triggered when a percentage or proportion of the ESG metrics utilised in another segment of the remuneration package have been satisfied. This would complement an existing remuneration plan while introducing ESG considerations in parallel.