Integrating ESG issues into executive pay

Existing remuneration plans for senior executives do not necessarily promote sustainable value creation for their companies. However, the inclusion of appropriate environmental, social and governance (ESG) issues within executive management goals and incentive schemes can be an important factor in the creation and protection of long-term shareholder value.

Within this context, the PRI and Global Compact LEAD (a leadership platform within the UN Global Compact) have facilitated discussions between a diverse group of institutional investors and companies to identify the rationale, feasibility and effectiveness of corporate practices which include ESG factors within executive management goals and incentive schemes.

The main objective of the resulting guidance is to support and enhance the investor-company dialogue on these practices. The set of recommendations and guidance points presented aspire to reflect a common understanding of major opportunities and challenges, as well as practical examples. This document will therefore provide a tangible engagement tool to guide dialogue between shareholders and investee companies on this topic, and help improve corporate boards’ practices to the benefit of both companies and their investors.

More specifically, dialogue amongst the members of the group has identified three main areas of discussion:

• how to identify the appropriate ESG metrics for each company;
• how to link these metrics to executive pay packages;
• how to provide high-quality disclosure on such practices.

With these three questions in mind, this publication utilises a three-tier structure to develop a series of overarching recommendations for investors and companies to consider.

Companies should adopt a clear process for identifying appropriate ESG metrics that relate to sustainable shareholder returns and company strategy. In an effort to provide further guidance, the following key points have been identified:

• ESG metrics should have a clear link to the optimization of shareholder value and be aligned with the long-term business strategy
• Companies are encouraged to develop their own definition of sustainable value creation and use it to select appropriate ESG metrics
• In identifying ESG metrics, a company should consult with its shareholders and attempt to achieve a thorough stakeholder mandate to enhance internal and external support
• Companies should focus on ESG metrics that are generally forward looking, clear, attainable, replicable, comparable and time-bound
• When selecting key ESG metrics to be tied to compensation, companies should ensure balance, diversity and relevance

Companies should link appropriate ESG metrics to reward systems in a way that they form a meaningful component of the overall remuneration framework. Key guidance points:

• ESG targets should be integrated into an appropriate time horizon that is in line with business strategy
• ESG targets should be stringent and challenging to ensure incentivizing outperformance
• Companies should select appropriate mechanisms and structures when creating incentive pay packages to ensure long-term shareholder value creation
• Incentive compensation should be subject to downward discretionary adjustments by the compensation committee to account for unusual events or unintended consequences as well as claw-back provisions
• In quantifying ESG metrics and measuring performance, the board may apply a clearly substantiated degree of discretion

Companies should endeavor to disclose the rationale, method and challenges presented by the incorporation of ESG metrics into executive pay clearly and concisely. Key guidance points:

• There should be clear disclosure of the rationale in identifying ESG metrics linked to executive compensation and evidence of alignment with business strategy and shareholder value
• Disclosure of metrics and performance targets should be understandable and there should be clear and concise information regarding the structure and mechanisms used in linking ESG metrics to compensation
• Disclosure should provide sufficient information to allow investors to assess performance against ESG goals
• Disclosures of relevant ESG goals and their associated links to compensation should be integrated into official pay disclosures