ESG performance hurdles in incentive plans holding management accountable for ESG progress

Environmental, social, and governance (ESG) topics have continued to be central to the conversation happening between Boards and investors during the 2022 reporting season.  Investors have made their ESG expectations known to Boards and will likely continue to use their voting power to hold companies accountable for failing to meet self-imposed ESG targets.  

Boards rely on their management teams to ensure that companies are meeting their ESG targets – but how can Boards hold management to account if those ESG targets are not met or reward management if those ESG targets are exceeded?  Given evidence that positive ESG results can drive long-term shareholder value, Boards should consider including “quantifiable” ESG hurdles in executive incentive plans.

Financial hurdles have long been the predominant component of executive incentive plan designs, including the achievement of revenue, EBIT/EBITDA, EPS, or cash flow goals.  Incorporating transparent financial hurdles into executive incentive arrangements is a reasonable way to encourage executives to drive value for a company.  Similarly, incorporating transparent ESG hurdles into executive incentive arrangements should incentivise executives to ensure that ESG targets are met and treated the same way as financial targets.

Provided that there is a balanced approach to the types of hurdles used in incentive plan designs, using incentives as a means to reward executives for driving ESG outcomes (or penalising them for failing to achieve ESG outcomes) can benefit shareholders and further promote a pay-for-performance philosophy that aligns with creating long-term, sustainable value.

What is the current state of play in Australia regarding the use of ESG hurdles?

On 11 August 2022, Diligent released a report entitled "Executive Compensation in the Era of the Great Resignation".  That report included the following findings:

• 67 companies in the ASX 100 have included ESG hurdles in their management team's performance indicators.
• The most prevalent ESG hurdle related to the social category (eg diversity).
• The average weighting of ESG hurdles (as opposed to other performance metrics such as TSR) was 9.4%.
• Most ESG hurdles were implemented in the STI component in the compensation plans. 
• Australian companies pay more for positive ESG outcomes than other countries, with 81% of ASX100 companies incorporating ESG hurdles in their CEO's remuneration framework compared with 67% globally.
• Amongst the Australian companies surveyed, nonfinancial incentives were 30% of the overall incentive opportunity, compared with 20% globally.

This demonstrates that Australian investors are becoming used to seeing ESG hurdles included in management compensation schemes.  However, it is important that the ESG targets (like all performance targets) are measurable and explainable to investors.  As with any performance conditions, it is essential that ESG hurdles are clearly linked to the implementation of the company’s strategy.  Setting ESG hurdles that have not been carefully considered, or adding an ESG hurdle as an afterthought, can be counterproductive.

As with any other hurdle, tying hurdles to clear, reported and audited numbers will be more palatable to shareholders and other stakeholders.  There is a risk that shareholders view ESG hurdles as 'soft' and companies will need to take care that the targets are not achievable simply as ‘part of the day job.’

What is the current state of play in England regarding the use of ESG hurdles?

England has a more developed practice (when compared to Australia) regarding the inclusion of ESG hurdles in LTIP grants and bonus arrangements.  Including ESG hurdles in LTIP grants and bonus arrangements is now common-place for most FTSE 100 companies.  A key theme of the 2022 AGM season was the focus on the alignment of pay with ESG strategy. 

In June 2022, FIT Remuneration Consultants noted that over 80% of FTSE 350 companies are now using ESG-related measures in their bonus schemes and over 30% include ESG measures in their LTIP grants.  This follows FIT Remuneration Consultants' report in 2021 which found that approximately 40% of FTSE 350 companies have one or more specific ESG measures included in determining annual bonus payments, with the median weighting being 20% of the total award.  For long-term incentives, 15% of FTSE 350 companies include an ESG hurdle, with the median weighting being 25% of the total award.

According to a report published by PwC in 2021:

• 58% of FTSE 100 companies include an ESG hurdle in their executive incentive arrangements;
• 46% of FTSE 100 companies include an ESG hurdle in their bonus plans, and 32% of FTSE 100 companies include an ESG hurdle in their long term incentive plans (LTIP);
• 20% of FTSE 100 companies include an ESG hurdle in both their bonus plans and LTIP; and
• the average weighting of ESG hurdles in bonus plans is 16% and 20% in LTIP.

Considerations for the Board in determining ESG hurdles for management

Some key questions and considerations that the Board and management can discuss when determining the appropriate ESG hurdles to include in executive incentive arrangements include:

• What ESG related topics or issues are relevant to the company? Performing a periodic ESG materiality assessment, and supplementing this with ongoing stakeholder engagement activities, enables companies to have a multi-stakeholder view of priority ESG topics for the business.  These in turn should form part of any ESG hurdle for management.
• Which ESG topics or issues have the greatest impact on value? It is important for businesses to work cross-functionally to fully understand the risks and opportunities associated with each ESG topic or issue.  It is also important to consider the impact of the issue on shareholder value – and not in isolation.
• How is ESG performance reliably measured? Obtaining assurance in relation to ESG performance measures can be important in signalling confidence in the quality of ESG disclosure to the market and giving both external stakeholders and decision-makers more confidence in its integrity.  To the extent an ESG measure is too hard to quantify in the early years of adoption and the Board wants shareholders to understand the importance of holding executives accountable for (and making progress toward) the measure, the company may want to consider only using downward discretion (e.g., 5% of the incentive payout will be reduced if progress toward goals are not made).
• What is the appropriate performance period for measuring achievement of ESG hurdles? In Australia, we are used to see 4 year performance periods applied to financial hurdles in long term incentive plans.  As ESG hurdles appear more commonly in STI plans, typical time horizons for ESG measures are in the 2-3-year range.  However, in America, the typical time horizon is 3-5 years with some companies including a much lengthier performance period (10 years and longer). 

With increased regulatory attention and continued community focus on ESG, it is clear that companies will need to continue to demonstrate their ESG credentials.  Incorporating ESG hurdles appropriately into executive incentive plans is a way for the Board to hold management accountable for progress against the strategy, as well as signal the company's ESG focus to stakeholders. 

 Authors: Miriam Kleiner, Partner (Legal Governance Advisory).