Investor Considerations for Assessing ESG Metrics in Executive Compensation Plans

In recent proxy seasons, one area of continued activity has been the inclusion of environmental, social and governance (ESG) metrics within short- and long-term compensation plans of listed companies globally. Recent statistics based on 2024 disclosures indicate that more than 75% companies within the S&P500 Index constituents incorporate ESG metrics within their executive compensation plans, compared to two-thirds in 2021. On the shareholder proposal front, there has been continued activity related to the filing of shareholder proposals seeking the inclusion of environmental and/or social metrics into compensation plans for shareholder vote.

Executive compensation plays an important role in incentivizing management and influencing behaviour. So, structuring executive compensation plans to align with strategic priorities, including the management of material ESG risks, may be warranted to incentivize performance in these areas, especially when performance is lagging.

To this end, when investors assess whether and what ESG metrics should be included in a portfolio company’s executive compensation plans, a holistic framework approach to analyzing metric inclusion is most appropriate. While not exhaustive, outlined below are certain key relevant factors that investors should consider when assessing ESG metrics in compensation plans. Such factors include whether a metric is relevant and financially material, the company’s performance in relation to the metric, the degree of existing disclosures already made available in a company’s other filing materials, and whether a portfolio company’s plans related to the ESG issues linked with such ESG metrics in compensation arrangements have credibility. This approach should take into account the specific circumstances of the portfolio company to drive appropriate behaviours and outcomes. Overall, investor focus should remain grounded in the philosophy that management incentives should be tied to long-term value creation.

Metric Relevance, Materiality and Company Performance

The ESG metrics which are selected for inclusion in executive compensation plans should be relevant to the specific company’s circumstances or industry, and importantly, they should be financially material. When a company lags in performance vis-à-vis its peers in a particular area, ESG risks, including ESG metrics, in these areas, becomes more appropriate.

Existing Disclosures

Consideration may also be given to whether the company has already made robust disclosures in other publicly disclosed documents (such as information circulars, ESG reports and annual reports). The lack of disclosure from a company elsewhere may mean that including such environmental or social metrics in pay plans would at a minimum indicate that the company will now likely measure relevant metrics on an annual basis to account for performance. Such inclusion may also mean improved disclosures if the company incorporates additional details regarding the measured metrics in the Compensation Discussion and Analysis (CD&A). Measurement at the very least makes issues top of mind for management, which can incentivize behaviour. Disclosures in the CD&A, on the other hand, may mean that investors might have access to more timely and relevant metric data, whereas before such inclusion, updates in this regard may not have been as regular.

Plan Credibility

Assessing whether a specific ESG metric should be included in executive compensation plans starts with examining whether the portfolio company has credible plans to tackle the financially material issue at hand. From a compensation philosophy standpoint, companies should link executive compensation to areas that require management’s focus and attention. If the portfolio company is making good progress against a credible plan, ESG metric inclusion may not be required or appropriate, as investor preference may be for the portfolio company to focus its efforts (and pay plans) on more material and pressing issues, all else being equal. However, even when compensation plans include financially material ESG metrics, such as carbon emission reduction metrics, if the company lacks a well thought-out and credible plan to reduce overall carbon emissions, no degree of metric inclusion will create the conditions necessary to incentivize management, as the plan likely doesn’t contain achievable or appropriate targets.

Concluding Thoughts

It is important for investors to recognize that independent directors are often in the best position to design programs that best incentivize management to create long-term value. This is due to the fact that independent directors acting from within the tent are far more familiar with the unique circumstances of a company than outside observers are. However, while deferring to the board and entrusting it to do what is best for shareholders, investors should take an active role in verifying whether their fiduciaries are properly discharged. As portfolio companies continue to consider ESG performance metrics in their compensation plans, investors must regularly engage with compensation committees on these topics, using the framework approach such as the one outlined above to remain active and responsive stewards of capital.

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Author

Jackie Cheung

Vice President, Sustainable Investment

TD Asset Management Inc.

As a member of the firm's Sustainable Investment team, Jackie serves as a subject matter expert for ESG, corporate governance, and proxy voting issues. He co-leads the firm's overall global stewardship program and works closely with investment teams on ESG integration and investment stewardship activities. Prior to joining TDAM, he spent ten years advising public issuers and other stakeholders on complex shareholder matters at two specialist shareholder engagement consultancies, giving advice on strategies for navigating high-stakes situations. In these roles, he routinely advised boards and management teams across the Canadian, U.S. and Latin American markets on all matters related to corporate governance, ESG and shareholder activism. Jackie holds a B.B.A. with Distinction from the Schulich School of Business and has completed the CFA Institute's Certificate in ESG Investing.