More pressure on companies to incorporate ESG targets in executive pay.

Company executives will increasingly have another thing to worry about when it comes to how their compensation is calculated: how well companies are doing on environmental, social and governance (ESG) or non-financial matters.

Traditionally, executives have largely been driven solely by financial performance and shareholder returns. But some large public company executives in recent years have had a small portion of their compensation tied to ESG goals, about 5 to 15 percent of total pay.

And the Securities and Exchange Commission’s (SEC) rulemakings combined with increased investor demand could accelerate that trend, experts say. The securities market regulator has various ESG-related rulemaking projects as well as an executive compensation rule that was finalized late August 2022.

“Some companies have been using sustainability or ESG measures in their plan for a while, but it used to be just a very small share. But over the past year that has been gaining a lot of traction largely because investors have been pushing for it,” said Brian Bueno, ESG Practice Lead with Farient Advisors.

Bueno said that investors at first pushed companies to disclose details around ESG topics, such as greenhouse gas (GHG) emissions, employee diversity and turnover. But more recently, investors have been asking companies to actually make progress and meet ESG goals, such as reducing carbon footprint and hiring more diverse employees, and tie that to incentive plans. And an increasing number of companies have responded to such demands.

According to Farient’s ESG Tracker, 240 of 416, or 58 percent, of S&P 500 companies releasing proxies in 2022 have used ESG measures.

Christina Thomas,  who was until recently a partner at Mayer Brown LLP, agreed that it is becoming a trend. She emphasized, however, that there is no  “total disregard” for financial performance, saying that what we are seeing today is a steady integration of ESG metrics into incentive plans.

“Companies largely base their incentive programs on what they are hearing from their investors, as well as market expectations… [or] comparison to peer groups,” said Thomas, who previously worked at the SEC.

Consulting firm Farient’s Bueno, who was previously at proxy advisory firm Institutional Shareholder Services (ISS), said that companies have been looking at their peers as a reference point because they have been unsure about how they should proceed. Some adopted a wait-and-see approach to see what other companies in their industry were doing.

“And as they are seeing more and more peers using, they are feeling more comfort in seeing how to structure these into their plans, how to actually set up goals,” he said.

In general, how companies tie ESG metrics to compensation is similar to any other goals or targets they set for themselves on financial performance.

Thus, “if a stock hits a certain price, then the executive is granted a certain number of securities. It’s sort of similar to that, only it’s not tied to stock price,” Mayer Brown’s Thomas said. “If they are able to reduce emissions by a certain amount or increase diversity and inclusion by a certain amount, then you would see compensation sort of commensurate with that.”

And what ESG metrics a company incorporates into incentive plans depends on that particular company’s goals.

So far, companies have been using more of the S aspect of ESG, such as employee diversity, equity and inclusion than the E aspect—environmental issues.

“Part of the reason that is still low is that companies still don’t have as much familiarity with when measuring the topics around the environment: their emissions or their waste management or their water usage,” said Bueno.

But the SEC’s proposal on climate disclosure rule, if adopted, could change that.

The commission’s climate proposal, issued in March, includes disclosure of GHG emissions. The SEC is still hoping to finalize the rules by year-end as planned.

“It’s going to provide a wealth of data that will allow companies to actually have some reference point when they’re determining whether and how to include these measures into their plan,” Bueno said.

Thomas said that if the SEC rule moves forward, it will increase attention on climate-related targets and goals that a company has set for itself.

“There’s more of an ability to analyze what the company is doing with respect to climate,” she said. “But it’s going to be company specific.”

For example, the SEC proposal’s disclosure on GHG emissions data has different requirements. Scope 1 and Scope 2 are about a company’s direct emissions and indirect emissions from purchased energy. Scope 1 and Scope 2 must be separately disclosed, expressed both by disaggregated constituent GHGs and in the aggregate, in absolute terms not including offsets, and in terms of intensity—per unit of economic value or production.

Scope 3 is about emissions of other companies in the company’s value chain. The company must report it if it has set a GHG emissions target or goal that includes Scope 3 emissions. This must be in absolute terms, not including offsets, and in terms of intensity.

However, “I don’t know that the rule itself [would increase more companies tying climate goals to executive compensation] because the rule itself wouldn’t mandate setting of targets or goals,” Thomas said. But to the extent that companies increasingly set targets and goals, “we wouldn’t be surprised to see that incorporated in executive compensation as well.”

Other SEC Rulemaking Could Accelerate Trend

In addition to the SEC’s climate change rulemaking, there are other rules that will likely put more pressure on companies to incorporate ESG targets in executive pay.

The SEC’s final rules on performance versus pay require companies to provide total compensation and a measure reflecting executive compensation actually paid. Companies must provide financial performance measures that show total shareholder return, the company’s net income, and a financial measure chosen by the company, among other requirements. To be sure, there is no SEC requirement related to ESG metrics, but it could still further drive the trend.

The commission is also working on human capital management disclosure rule that is likely to be fairly prescriptive, and this will also likely accelerate the ESG-pay trend.

More Involvement by Board of Directors

With ESG disclosures becoming more prevalent, this also means that corporate directors will be more involved as well.

According to a May 2022 report by consulting firm SpencerStuart, companies surveyed are increasingly incorporating ESG goals and metrics into many elements of business: 71 percent of respondents are incorporating ESG goals and metrics into overall company strategy. Another 52 percent are incorporating ESG into integrated risk management, 48 percent into criteria for director appointments and 46 percent in executive compensation.

History

Dennis Beresford, who served as audit committee chair of public companies, believes that this trend “is a generally good thing.”

While everybody is talking about ESG today, this is not entirely new, said Beresford, a former chairman of the Financial Accounting Standards Board (FASB). Before leading the FASB, he worked in the national office of Ernst & Ernst, now Ernst & Young LLP, and he did a study on social responsibility reporting about 50 years ago.

“Back then, what we were looking for was how many companies made some disclosures in their annual reports about any of their non-financial statement type matters. We didn’t hear the term ESG back then, and it was mainly environmental type things that we were talking about; oil spills or things like that, or just where they were doing things positive to try to help the environment,” Beresford explained. “And a lot of companies were beginning to do things back then. But it was very primitive. And it wasn’t in the financial statements, and it certainly wasn’t in the compensation arrangements.”

Beresford also belonged to a committee of the AICPA that drafted a report on corporate social responsibility reporting.

“The thinking back then was that this was going to happen more and more often,” he said. “Nothing really caught on at that time” 50 years ago.

Beresford, who has not served on corporate boards for six or seven years, added that during his decade on corporate boards, directors did not talk about ESG much, but they did discuss some individual ESG topics.

“We talked about environmental matters. And we particularly talked about things like promoting more women and racial minorities…. And some of those things started to work their ways into the compensation determinations,” he said. “They weren’t a big factor back then when I was involved with corporate boards, but they were certainly starting to become more of a factor.”

“Frankly, back then, I think even now that the compensation factors for the senior executives focused more on performance by whether the corporation is making money whether they are increasing their sales and, you know, those kinds of financial metrics,” he said. “But I think that over time, there’s been more and more of these non-financial type things that have that have crept into the thinking of corporate boards and so, I think, it is probably still a smaller part of the overall determination, but it’s certainly becoming more and more of a factor.”

In the meantime, some academics also believe that ESG metrics should be included in executive incentive plans.

During a conference hosted by the Institute of Management Accountants in June, Babson College Professor Paul Juras said it is difficult to manage something that is not measured.

“So, if you are going to simply state that it’s important to us, and no one’s ever held accountable, then it’s probably not going to be successful,” he said. “We heard this morning a person said they wouldn’t disclose the number, but if certain metrics were not hit, then there was some compensation that was at risk. And so, it is happening. To me, it’s adoption of variations of balanced score card….There are companies that use balanced scorecard metrics for compensation. So yes, I think it could done, and it should be done.”

Brigitte de Graaff, a lecturer and researcher at Vrije Universiteit Amsterdam, who studied organizations, agreed.

“So. there were targets on carbon footprints and there were targets on water recycling and paper recycling and everything. But the moment that you’re making sure everything is followed, if you’re meeting your sustainability targets, [but] the guy literally says, ‘no one has ever been fired for not being sustainable,’” de Graff said. “So, it’s not that you should fire everyone who’s not sustainable, or doesn’t hit the targets, but it is good… that we have an incentive that helps.”

Not Everybody on Board with ESG-Metrics

While many, especially investors, have fully committed to an ESG corporate world, not everyone has been enamored of the trend. And critics are unhappy with the latest ESG development.

Jack Ciesielski, president of investment research firm R.G. Associates who previously published insightful analyses of company financial performance called The Analyst’s Accounting Observer, has never bought into the ESG-palooza.

“Right now, ESG is the flavor of the day. In fact, there are bonds that pay lower interest rates if the company achieves ESG targets,” Ciesielski said in the spring. “It’s a new metric mindset that might be even slipperier than non-GAAP earnings.”

Ciesielski, who has done extensive analysis of non-GAAP earnings, was never a fan of the adjusted measures. Non-GAAPs are customizable, which means they can be misleading and confusing to those who are trying to analyze the financial health and outlook of companies. Indeed, companies often use them to paint a rosier picture of their performance to boost their stock price.

“I think the consultant [Farient’s Bueno] is right about the possible increase in it if the SEC rule passes,” said Ciesielski, who also serves on the FASB’s Emerging Issues Task Force and the Public Company Accounting Oversight Board’s Investor Advisory Group. “There will be more targets to hang a hat on. Speaking for me, I would rather not see such targets. I’m more concerned about how the company performs on shareholder metrics.”

Indeed, there are others who question whether ESG is really an investment issue.

Former SEC chief accountant Lynn Turner said that under the Biden administration, “the pendulum had swung way to the other side of the spectrum under the prior [Trump] administration.” The problem today is that there is no sensible balance.

The Trump administration was more concerned about deregulation and enacting business-friendly policies. Companies largely believe ESG are not material to investment decisions but impose costs on them to respond to activist investors who push social agendas that have nothing to do with corporate financial performance.

“Many investors are very concerned about the impact of climate change on the performance and assets of a company,” Turner said, pointing to a 1975 speech by A.A. Sommer who was an SEC commissioner at the time.

But “this article raises the question, should the SEC ensure that investors receive the information they require to make informed decisions regarding how management is identifying, measuring, monitoring and responding to the impact of climate change,” Turner said. The “speech, while written long, long, long. ago, raises this same issue. And if many investors are requesting this information, as they are today—think Larry Fink Letters—is this an investment issue, or a social policy issue, from the perspective of investors and the SEC.”

And it is a debatable question; however, the trajectory today seems to be that ESG is an investment issue.

In his speech, Sommer discusses the concept of materiality, which is defined by the Supreme Court: companies should disclose information that a reasonable person would find important in the total mix of information to make a voting or investing decision.

In the speech almost 50 years ago, Sommer said that it is important to understand the investment process and the information that is important and relevant to investors, and the concept of materiality in new circumstances.

“However, I must express grave misgivings about the danger that logical constructs which may well serve and resolve the complexities of one problem may, carried a few steps further, involve us in disclosure problems far beyond those contemplated by the authors of the statutes under which we operate and take us far beyond good policy,” Sommer said.

For example, “If we insist upon including more information that may give us insight into the integrity or competence of management, must we compel the disclosure of the fact that the chief executive officer occasionally shows up drunk at the office, or that the treasurer is under investigation by the IRS, or that the executive vice president is having an affair with his secretary, or that the executives use the company’s jet for personal purposes on occasions?”

“The implications of these concepts are limitless and troubling,” he said. “It is tempting to move down this road, but it seems to me that it is a temptation which, yielded to, will exact a tremendous price. The hasty expansion of materiality concepts along this path may well result in a strain on the resources of the Commission that will impair seriously its ability to do that which has classically done so well—policy the disclosure system and the securities markets.”

 

This article originally appeared in the September 19, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.