In its third annual study on global ESG executive incentives in Europe and North America, WTW reported that 69% of U.S. companies surveyed are using ESG metrics to help determine executive incentive compensation. While the number is rising in the U.S., it still leaves the U.S. behind Europe and the U.K, where 90% of companies use similar incentives. We talked to Ken Kuk, WTW's senior director, executive compensation and board advisory, about the report's findings.
Directors & Boards: What trends are we seeing in the area of ESG metrics in executive incentive plans?
Ken Kuk: We have been seeing increased adoption of ESG metrics in the last three to four years. We expect the prevalence to gradually increase over time. In the U.S., social and human capital metrics, such as DEI, have been the most common. We are seeing early signs of climate transition becoming more prominent and expect it to get more attention in the next few years.
DB: What metrics are being used the most in compensation plans, and why?
KK: This is generally consistent with the top ESG priorities we observe in the market – in the last few years, in the U.S., it's been a lot about DEI and other social metrics. During the pandemic, there was heightened focus on employee well-being and community. We expect metrics related to climate transition, such as measurement of carbon emission reduction, to ramp up going forward. We also expect there to be greater attention to the “G” in ESG. Even though corporate governance practices in the U.S. are very mature, new governance risks and issues are emerging (e.g., cybersecurity and climate audit).
DB: Are there particular industries that are more inclined to include ESG metrics in their exec comp plans? If so, what are they?
KK: Based on our research, ESG metrics are the most common in high-polluting industries such as energy, utilities and transportation, given the heavy scrutiny from investors and regulators they get on carbon emission. Similarly, in energy, utilities and manufacturing, safety incentive measures have been around for decades. We see prevalence rising quickly in other industries, especially those with a heavy focus on talent (high-tech) and where there is more scrutiny from regulators and investors (financial services).
DB: Can you explain the difference between qualitative and quantitative measurement of ESG metrics in incentive plans, and which method is garnering the most acceptance?
KK: Quantitative measurement is where a specific numeric goal is set for the specific ESG metric. So, for instance, X% reduction in carbon emission vs. 2010 levels, increase renewable in energy portfolio by X% or X% increase in female representation in leadership positions. In this case, payout is determined based on a formula with little management or board discretion. Qualitative measurement is where goal achievement is based on qualitative assessment. This provides a greater degree of flexibility to how goals can be set but does not necessarily mean that it's fully discretionary. In some cases, it could be set up as milestones. For example, a qualitative ESG goal may be to complete the transition to renewable energy for particular facilities. In many ways, ESG metrics are just like any incentive metric – quantitative is generally preferred by investors and stakeholders because it is perceived to have a stronger link to performance. But there are some caveats with ESG metrics, such as companies' ability to reliably measure and audit quantitative ESG achievement and the level of rigor applied to the corresponding quantitative performance goals.
DB: How exactly are ESG metrics being incorporated into incentive plans in the U.S. and is there a difference in how they are incorporated in long-term and short-term incentive plans?
KK: Quantitative metrics are used about one-third of the time in the U.S. – globally it's about 50%. Quantitative metrics are more prevalent in long-term incentive plans than short-term incentive plans. In the U.S., prevalence of ESG metrics in long-term incentive plans is quite low (8%). It is a bit contradictory to the essence of ESG performance, which tends to materialize over a long time horizon. We suspect most U.S. companies put ESG metrics in their short-term incentive plans for a few reasons:
- Using strictly financial and shareholder return metrics in long-term incentive plans has been deeply rooted in the U.S. executive pay culture.
- Many companies remain skeptical about their ability to set reliable long-term ESG goals.
- Putting ESG in the short-term incentive plans allow them to potentially reach a broader population, as long-term incentive plans are typically only reserved for top leaders
DB: In a general sense, how does the United States compare in the utilization of ESG metrics when compared to Canada, Europe and the United Kingdom? Is the U.S. lagging behind other nations and areas?
KK: U.S. lags all three markets in terms of prevalence, especially in the use of ESG metrics in long-term incentive plans. The gap is particularly large when compared to Europe and the U.K. That said, we should be careful about making the conclusion that high prevalence is certainly better without understanding the context. ESG metrics in executive incentive plans are most effective when they are tied to clear ESG strategy, robust measurement methodology and techniques, as well as rigid performance goals setting. If ESG metrics are not implemented considering these connections, companies could risk the scrutiny of greenwashing or using ESG as an excuse to elevate executive pay. In addition, the U.S. also lags these markets in terms of the use of ESG metrics in long-term incentive plans and the use of quantitative ESG metrics.