It turns out that it isn’t easy figuring out how to reward people who are trying to do good—at least when it comes to improving a firm’s efforts on environmental, social, and governance issues.
In recent months, a host of multinational firms including Apple, McDonald’s, and Chipotle have announced plans to tie bonuses and long-term incentives for the CEO and other executives to diversity and sustainability targets. And the list will grow longer: surveys say one out of every five public firms have indicated that they plan to connect some amount of executive compensation to ESG metrics.
The only question: How? “Using metrics for ESG is still in its infancy,” says Gillian Emmett Moldowan, a partner in the law firm Shearman & Sterling’s compensation and governance practice. One concern is how goals are measured and rewarded could result in unintended consequences. Hiring a bunch of diverse talent one year can swiftly boost racial representation, for instance, but it won’t create a meaningful impact if the new hires leave the following year. “That’s not the outcome boards are trying to achieve,” says Moldowan.
Incorporating ESG metrics into bonus plans is not new, but it has been growing since the pandemic. Indeed, studies suggest that as many as 50% of S&P 500 companies now use ESG metrics in incentive plans. But a closer look at the data shows that only 18% of companies have diversity and inclusion targets, while only 14% have environmental and sustainability goals. Moreover, only 4% of companies using ESG targets include them as part of their long-term incentive plans.
For its part, McDonald’s aims to have 35% of its US senior management from underrepresented groups by 2025, a roughly 5% increase from the current level. Meanwhile, Chipotle will tie 10% of its top executives’ bonuses to sustainability measures, such as increasing the amount of organic and locally sourced food used in the restaurants. Apple also plans to increase or decrease annual bonuses for executives by up to 10% based on ESG measures, though the company didn’t set specific targets.
Experts say the biggest dilemma right now is whether to include the incentives for short- or long-term performance, or both. Currently, most ESG goals are short-term, since employees, investors, and customers want to see changes in these areas quickly. “The best way to drive immediate movement and reaction is through the annual bonus plan,” says Irv Becker, vice chairman of executive pay and governance at Korn Ferry. At the same time, he says between one-third and one-half of his clients are devising specific, measurable long-term targets too.
What boards are trying to do, he says, is thread a fine needle between generating progress in the short term without risking management making too big of an adjustment too fast, which could cost the organization financially and culturally. However, he says, the goal for boards is to evolve ESG initiatives to become more a part of long-term incentive plans, “because that’s the best way to achieve business goals and attract the best talent.”
Ultimately, the views of outside stakeholders and investors will weigh heavily on all these plans too. These groups can be fickle, notes Michelle Lowry, academic director of Drexel University’s Gupta Governance Institute. For example, a firm might set a benchmark for diversity targets or carbon reductions—only to hear investors wanted something different. “The incentives have to be aligned with how stakeholders are evaluating the company,” Lowry says.