ESG metrics are increasingly used to shape executive compensation packages, but firms still struggle to find the right balance.

More than half of the S&P 500 now has incorporated ESG goals into their executive incentive compensation programs. Despite this widespread use, many companies still struggle with the nature and number of goals to include, as well as what weighting to give them relative to other key executive priorities. Challenges with evaluation and transparency are also common.

Navigating this environment first requires an understanding of the current state of pay. Here, the key issues around ESG in executive packages will be discussed, including critical trends, benefits, how investors view these measure, and upcoming challenges.

Current trends in executive pay

In a recent global survey by Willis Towers Watson, more than three-quarters of board members and senior executives said strong ESG performance is a key contributor to their company’s overall financial performance. This high level of buy-in to the impact of ESG has helped create space in pay packages for more goals tied to hitting ESG targets.

These goals are increasingly linked not to far-off metrics, but to short-term goals. Remuneration specialists are also seeing ESG goals receive higher weightings in overall performance incentives, at times eclipsing certain operational objectives, according to PwC Global. ESG goals are now more likely to receive a 10 to 15 percent weighting in short-term plans and 20 percent or more in long term incentive plans (LTIPs) for executives.

Key benefits of including ESG in executive pay

There are a number of reasons for this increase in weighting and impact. Some are linked to the corporate purpose – adopting these standards is a part of the company's indentity, and expressing them as a part of individual and executive pay is a way of expressing that identity. Other firms admit to being driven by activist and lobbying groups, some of which can have major impacts on consumer buying behaviors.

Another factor is the extent to evolving regulations and public sentiments have made ESG targets in executive pay a condition for maintaining a good reputation as an employer. Public rankings and scorecards assign scores that firms may find useful in public relations, hiring, and retention. By voluntarily including ESG metrics – and especially by leading field in terms of weighting or specific initiative types – firms can create meaningful reputational and competitive advantages.

The investors’ view of ESG

Of course, it’s not just about social and reputational benefits. Investors’ view of ESG is that it matters, and they’re willing to shift significant amounts of capital around to show exactly how much it matters to them. This is not merely a retail investor level phenomenon, as large financial firms increasingly pay attention to ESG standards when placing funds.

Many private equity groups will not invest in companies that do not include ESG elements in executive pay packages. An increasing number of investment firms and pension funds are even enjoined by their own covenants from investing in companies that don’t clearly support ESG initiatives. For example, CalPERS, California’s enormous pension fund, has used its clout in the marketplace to influence policy and pay with more than 733 companies over the years, with a special emphasis on sustainability and diversity issues.

Thus, by including ESG in executive pay, companies are ensuring that they will have access to the maximum number of potential investors and that they keep certain activist investor groups satisfied with their financial priorities

Key challenges ahead

It’s a delicate dance to satisfy all the key stakeholders. With ESG metrics as a part of the executive package, many firms are in new territory, and it remains to be seen if their long-term outcomes will truly be what they expect. According to a report from the United Nation’s Principles of Responsible Investment (PRI) group, for all of the conversation around it, ESG as a part of compensation is still relatively new territory. There is a worldwide shortage of remuneration experts who can consult with boards and executives on the topic, and little standardization in terms of form and implementation compared to more long-standing and established compensation structures such as perks packages and stock awards.

This relative newness also spills over into the transparency and reporting around whether or not executives are hitting the ESG goals in their compensation packages. Many firms disclose that the metrics are included in the weighting of the goal, but don’t disclose the specific targets set or the systems being used to measure achievement. This can make it hard to judge whether a goal is going to be a comfortable win that won’t actually change any behaviors or if the goal is a stretch metric that will make a meaningful difference in executive priorities and daily practices, notes PwC.

As ESG continues to be a hot button topic in public and private conversations, firms must rise to the challenge. New standards of evaluation are being developed in Europe, where the European Union formalized ESG reporting requirements for both asset managers and medium-to-large businesses in 2021, and the UK government has now mandated detailed reporting on certain ESG metrics for all large public firms. Though a higher percentage of blue chip firms in the US have ESG in executive pay than other countries, the nation lags the world in formalizing standards despite commissions and strongly worded memos from the likes of the SEC. As a result, it is up to individual companies across the country to determine whether they want to be leaders or followers on this issue, and whether the international standards can be adapted to be US standards, too.