ESG metrics in variable remuneration – Great Expectations (and how to meet them)

In recent months, institutional investors and proxy advisors, including the Investment Association (the IA), Legal & General Investment Management (LGIM), Glass Lewis and Institutional Shareholder Services (ISS), have published their principles and guidelines for the forthcoming AGM season in the UK. When it comes to remuneration, incorporating ESG measures into variable pay structures continues to be an area of focus. Indeed, with the establishment of the International Sustainability Standards Board by the International Financial Reporting Standards (IFRS) Foundation to harmonise and consolidate sustainability disclosure standards, the significance of ESG in variable pay, and the public scrutiny related to it, will only increase.

This blog post considers investor and advisor expectations in relation to this topic and how remuneration committees (RemCos) can meet those expectations in practice. Read this blog post alongside this table, which summarises the guidance published by the IA, LGIM, Glass Lewis and ISS on incorporating ESG metrics into variable remuneration arrangements.

Expectation: ESG metrics should be business-specific

The message from UK investors and advisors on ESG and remuneration has historically been inconsistent, but we are starting to see a convergence of expectations. Now, while investor and advisory bodies are generally supportive of companies incorporating material ESG risks and opportunities into remuneration plans, they also acknowledge that this should be predicated on each company’s particular circumstances, taking into account factors such as its business, industry and pay structures. For example, LGIM expects companies within sectors that can have a significant effect on climate change to link part of their pay to delivering on their climate mitigation goals, while Glass Lewis is mindful that not all remuneration schemes lend themselves to the inclusion of ESG metrics. It is therefore crucial that the ESG metrics chosen are aligned to the company’s long-term strategy and are material to the business. The IA also makes clear that ESG measures should not reward ‘business as usual’ activity, nor should they be used as a vehicle to increase overall quantum. Investors are particularly wary of potential greenwashing of remuneration disclosures.

Expectation: ESG metrics should be measurable

As explored in further detail in our previous blog post and recent briefing, a fundamental problem with many ESG metrics is that they are difficult to measure. Despite these challenges, the investor bodies are generally in agreement on the principle that companies must explain how progress against ESG metrics is measured and for performance against those goals to be disclosed. The IA expands on these requirements, expecting ESG metrics to avoid unnecessary complexity and to be suitably stretching. Where qualitative targets have been set, Glass Lewis believes that shareholders are best served when these are disclosed on an ex-ante basis, or the board should outline why it believes it is unable to do so. Further, LGIM expects environmental and social targets to be subject to third-party verification. Robust disclosure is key.

A good example of how difficult this is comes from the recent Financial Reporting Council (FRC) review of corporate governance reporting. Out of 35 organisations that included a culture-related underpin (linking to the “S” of ESG), most of them were related to health and safety, employee engagement and undergoing a culture change. However, the FRC found the information provided in annual reports insufficient to determine how meeting the target and receiving the associated compensation correlated to improvements in culture. For example, a high return rate to a company questionnaire does not automatically denote a satisfied workforce.

So, what exactly should RemCos do to meet the expectations that are placed on them?

Meeting expectations: the ‘what’

RemCos will need to consider which ESG metrics best reflect the company’s goals, how to measure those ESG metrics, which incentive plans to include them in, and how much weight to give to each metric. Glass Lewis expects companies to clearly lay out in their annual reports the rationale for selecting specific metrics, how the criteria align with company strategy and pay-out opportunities corresponding to specific targets.

The FRC review gives some examples of ESG measures being used by companies in their annual bonuses and long-term incentive plans (LTIPs) – these include health and safety, customer satisfaction, employee engagement, diversity and waste reduction. Taking two easy examples from these, health and safety targets can be measured on a short-term basis (for example, number of accidents) and can therefore feature in an annual bonus plan, whereas environmental targets (for example, percentage reduction in plastic packaging) are generally measured over a longer period and might therefore be more suitable for an LTIP.

LGIM is the most prescriptive on the ‘what’. To gain LGIM’s support for a new remuneration policy being put to shareholders from January 2025, LGIM expects to see certain climate targets within the LTIPs of companies in certain sectors including aviation, banking, oil and gas and technology. These targets should be in line with stated transition goals to reaching net zero and across the full value chain and, ideally, they should be SBTi-approved. The weighting for climate targets should represent at least 20% of the overall LTIP award and, for those companies that have a restricted share plan, one of the underpins should be specific to achieving set transitional carbon reduction targets.

Meeting expectations: the ‘how’

Once the types of ESG measures have been identified, when it comes to how to incorporate those into incentive plans, RemCos have a few approaches at their disposal.

• As a performance target. Some might choose to have a specific ESG measure as a standalone metric governing a percentage of an award, so that a payment would be triggered (or an award or part of an award would lapse) based on whether the particular ESG target is met. This would allow RemCos to set threshold, target and maximum goals for the specific ESG measure alongside pay-out opportunities. Alternatively, specific ESG measures could be incorporated into a scorecard to link pay-out opportunities to a mix of ESG measures. As an example, the FRC review reports that one company’s 2021 LTIP had an ESG scorecard with a 15% weighting which comprised measures focused on colleague diversity and a reduction in operational carbon emissions.
• As a performance modifier. Another approach is for RemCos to use ESG metrics as a performance modifier to increase or decrease the pay-out otherwise determined by reference to other (most likely financial) targets. For example, LGIM expects companies in high-risk sectors, where the health and safety of employees is key, to have a health and safety modifier in their annual bonus and/or LTIP.
• As an underpin. Alternatively, RemCos could use a particular ESG measure as an underpin such that payments are made only if the ESG measure has been achieved. This is an approach suggested by LGIM for certain companies with restricted share plans.
• As a factor for exercising discretion. Instead of or in addition to the approaches above, RemCos might wish to include ESG performance as one factor to consider when exercising their discretion to determine the extent to which (if at all) particular awards or parts of awards vest. ESG might even be a RemCo consideration in good and bad leaver determinations when participants leave employment. Using discretion would likely provide RemCos with more flexibility, although it is important to remember that there may be other constraints on the exercise of discretion (for example, the directors’ remuneration policy, and non-discriminatory exercise of discretion). If discretion is exercised, then RemCos should consider how it should be disclosed.

With various stakeholders, from institutional shareholders to the IFRS, introducing their own initiatives in the ESG arena, practice continues to evolve. So, when considering ESG issues for the next remuneration cycle, RemCos should pay close attention to the latest versions of institutional investor and proxy advisor principles and guidance, alongside other rules to which they may be subject (such as the UK Corporate Governance Code). Failure to do so may result in adverse shareholder sentiment and reputational damage.

For more information on this topic, please speak to the authors of this blog post or your usual Freshfields contact.