Should businesses consider ESG-related performance measures in employee incentive plans?

Performance conditions for employee incentive plans, whether those plans are short-term annual bonus plans or long-term incentives such as share plans, have traditionally centred around financial metrics. The nature of these financial conditions varies depending, for example, on the industry in which the company operates, whether it is private or listed, and the objectives of the company and its shareholders.

Most commonly, these would be conditions related to the success of the business. For example, share price, total shareholder return, a profit measure such as EBITDA or the value achieved on a specific corporate event such as an exit. These conditions are sometimes supplemented with financial conditions relating to the performance of a particular part of the business for which the individual is responsible, or even a financial condition relating to the individual’s particular role.

What ESG performance conditions are being used?

In recent years, companies have increasingly sought to use performance conditions to further their environmental, social and governance (ESG) objectives, and to demonstrate these objectives to investors and the wider public. For example:

• for companies pursuing a ‘net-zero’ agenda it’s common to include performance conditions relating to achieving this. Depending on the length of time over which a business is seeking to achieve this objective, the conditions may relate to milestones along the way or to having completed this objective entirely and reached net-zero status. Alternative ‘E’ performance measures often include energy use, greenhouse gas emissions, waste recycling and resource use/efficiency;
• businesses in some sectors include workplace safety conditions, for example related to injuries or deaths in the workplace. Other ‘S’ performance measures used include diversity, pay equity, colleague engagement and community impact; and
• ‘G’ performance measures used in employee incentives include stakeholder relations, transparency, risk management, anti-corruption measures and compliance with regulations.

Some companies choose to include a single ESG metric in order to focus the mind of employees onto one priority, such as increasing diversity or reducing carbon emissions. Other companies adopt a ‘basket’ of ESG performance measures to reflect the organisations broader ESG priorities.

What do shareholders think about ESG conditions?

As with many trends in corporate governance, the use of ESG performance conditions was initially largely seen in FTSE 100 businesses (which now almost all incorporate ESG conditions into their employee incentive plans), before gradually spreading to the FTSE 250, AIM and now increasingly to privately-owned companies. To some extent, this has been driven by investor demands.

The reaction from investors to ESG performance conditions does however remain mixed. Data suggests that the majority of investors believe that ESG-related measures should be included in incentive plans.

Although, there is a greater divergence of views as to whether these should be included only where they are consistent with the creation of long-term shareholder value. Almost all investors have been clear that ESG conditions must operate alongside rather than instead of financial measure. Typically financial measures continue to be the predominant determinant of incentive outcomes.

In some incentive plans, ESG measures are used as a discrete metric, with perhaps 20% of the payout being determined based on ESG related conditions. In other plans, ESG measures (historically often health and safety-related measures, but increasingly a broader range of ESG conditions) act as an ‘underpin’ or ‘hygiene factors’, with a minimum level of ESG performance required in order to allow payment notwithstanding the level of financial performance. We have seen some incidences of remuneration committees applying downwards discretion to payouts where there has been a significant failure on an ESG matter even absent a specific ESG underpin.

Why are so many companies choosing to include ESG performance conditions?

If the adage ‘what gets measured gets done’ has any truth, the inclusion of ESG performance metrics should also help a company achieve its ESG objectives alongside its financial objectives. 2022 research by the Harvard Law School Forum on corporate governance found that helping the business achieve its ESG objectives was cited by more than 50% of companies having adopted ESG-based performance measures.

However, with perceptions continuing to be a key driver behind many ESG measures taken by businesses, this was eclipsed by 90% of respondents who cited ‘signalling that ESG is a priority’ as a reason behind their inclusion. Responding to employee expectations was a key motivator for many companies in that research. It’s clear that employees increasingly wish to work in a business that has a mission beyond pure profit generation, and recognising these wider objectives in an incentive plan makes a statement to a company’s people and the wider world that the organisation’s stated purpose and values are more than just a PR exercise and are a fundamental motivation that influences how the business is run and how its people are rewarded. If a business genuinely does place significant weight on achieving ESG objectives, employees could reasonably draw conclusions to the contrary if incentive arrangements are focused solely on financial measures.

How should a business go about adding ESG conditions to its incentive plans?

Any performance conditions should be about creating alignment between employees and the company/its shareholders. For this reason, the first step for any business considering ESG-related performance measures should be to determine what the company’s ESG objectives are and then to design performance measures that are a suitable measure of success. The conditions could be quantitative or qualitative and could either be absolute or (where this information is available) relative to other companies in the sector.

Setting measurable and appropriate targets for ESG metrics can be challenging, and sufficient attention needs to be paid to ensuring that these are effective. They should be re-visited regularly to ensure that remain effective and relevant.

Performance-based remuneration provides employers with the opportunity to change the behaviours of their people, and to make a significant improvement to the probability of the organisation achieving its objectives. Where those objectives include ESG-related matters, employers should seriously consider adopting such performance measures in their incentive plans.

If you like to discuss any of the areas mentioned above, please contact Martin Cooper.