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Article | Executive Pay Memo North America

Use the ESG governance funnel for executive incentives

Governance Advisory Services |Executive Compensation
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By Don Delves | August 19, 2021

Board-level ESG discussions have increased in intensity among a wide variety of organizations, especially when it comes to how ESG measures might impact executive incentive plans.

In just about every board room, the topic of the day is ESG. Environmental and social issues are top of mind for many board members. In the United States, the focus has been more on diversity, equity and inclusion (part of the S in ESG), while in the United Kingdom, Western Europe, parts of Asia and Canada, the focus is more on environmental or climate-related issues (the E in ESG).

The intensity of board-level ESG discussions has picked up recently among the several hundred boards Willis Towers Watson advises, covering a wide variety of organizations. Many more boards are discussing ESG topics, more time is being taken discussing them, and there is more urgency and intensity in the conversation.

Quite often, boards or management ask whether the company should include an ESG measure or factor in its executive incentive plans. While approximately half of S&P 500 companies have an ESG factor in their executive incentive plans (and have for several years), this does not imply that companies are moving rapidly to add or expand ESG measures.

While companies and boards should take ESG issues seriously, they should proceed cautiously when adding them to incentive plans.

If an ESG measure is added to an incentive plan, it will typically be displacing another measure and take up a portion or percentage of the total incentive. There is only 100% to be divided among a small number of measures, most of which are critically important financial value drivers. So, this is precious real estate and should be used wisely and judiciously in ways that address the company’s most important issues. In other words, if an ESG measure is added, it should earn its way in by being strategically important to the future of the business.

Before considering whether an ESG factor should be included in executive incentives, it is important to take a much broader view, which can be visualized as an “ESG governance funnel.”

  • Management of ESG issues: At the widest, top part of the funnel is the whole range of ESG issues the company is addressing. The range and depth of what management is addressing will always be much broader than what can be summarized and presented to the board. However, the board may direct management to expand, contract or reprioritize the range and depth of ESG issues it is taking on.
  • Governance of ESG issues: One of the most important and pressing sets of issues for boards today is prioritizing which ESG topics are most important for the board to address, where they should be addressed (i.e., which committee, or the full board), how often to address them, and how to actually provide effective oversight. Providing effective oversight for an ESG topic typically takes extra time, requires board members with some expertise in the area, and must be done in the relatively time-constrained format of a board or committee meeting.
    The range and depth of ESG topics and material covered by the board will be far narrower than what the company manages, but still has to cover the areas that are most strategically important to the organization, or those that pose the most significant risks, or both.
  • Disclosure of ESG information: The next, narrower subset of ESG material is what the company decides to disclose to investors and the public. Given the increasing scrutiny of ESG disclosures by investors, rating organizations and regulators, it is important for management and the board to be in synch about what gets disclosed and how it gets communicated. Ideally, the board periodically reviews and discusses the programs and data that are summarized in public statements.
  • ESG factors in executive incentives: The smallest subset of ESG issues is those that earn their way into incentive plans. This entails being measured and tested by management, reviewed and vetted over multiple reporting periods by the board, and shown to be of significant value to the organization and investors.
The ESG governance funnel illustrating the inputs: Management of ESG issues; Governance of ESG issues; ESG Disclosure and ESG in incentives
The ESG governance funnel

Key takeaways

  • ESG topics are on the rise in many boardrooms. While companies and boards should take ESGE issues seriously, they should proceed cautiously when adding them to incentive plans.
  • Increasing influence. If an ESG measure is added to an incentive plan, it will typically be displacing another measure and take up a portion or percentage of the total incentive.
  • Boards should do their due diligence. Before considering whether an ESG factor should be included in executive incentives. It is important to take a much broader view, which can be visualized as an "ESG governance funnel".
  • Be deliberate in the process. If an ESG measure is included, it should be structured in such a way that it will influence and direct meaningful, sustained movement in that ESG factor or initiative.

Including an ESG measure or factor in an executive incentive plan sends a strong signal to the management team, the rest of the company, investors and other constituents. However, there are many ways to send strong messages. Incentives are powerful tools that influence performance and can accelerate or shift the direction of an organization. If an ESG measure is included, it should not only reflect something that is significantly important to the organization, it should be structured in such a way that it will influence and direct meaningful, sustained movement in that ESG factor or initiative. Otherwise, it is just window dressing, and a waste of valuable incentive plan real-estate.

A version of this article appeared in Workspan Daily on August 12, 2021. All rights reserved, reprinted with permission.

Author

Managing Director, Executive Compensation Practice Leader - North America (Chicago)

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