Senior Client Partner, Head of the Board Effectiveness Practice
Kicking off the ESG and sustainability discussion with your board
What is ESG? How much of an issue is it for your organization? Do your shareholders care? What about your customers and employees? Who’s accountable for it? What should your board be doing about it? Is this trend here for the long term? How do you measure progress/success? Should you tie executive pay to it, and if so, how?
As our earlier article on ESG and sustainability highlighted, your board needs to evolve to oversee, enable and support delivery of your ESG strategy. Your board will also play an active role in discussing and answering all of these questions highlighted above. And while the implications of Environmental, Social and Governance (ESG) and sustainability vary from industry to industry and organization to organization, we see several common threads in these conversations:
- ESG and sustainability is a board level topic. It is growing in importance and urgency and it isn’t going away anytime soon.
- ESG is a significant risk management issue, yet it also offers new growth opportunities.
- Investors, shareholders, activists, lenders, regulators, customers and employees are asking questions, expecting answers, and taking action when there is an inadequate response.
- To avoid ESG being seen as “greenwashing,” it needs to be integrated into strategy and risk management, so it transforms the way an organization operates.
- As a communication challenge, it requires careful planning and execution.
- For most organizations, the importance of ESG merits tying a portion of senior leader rewards to success.
The role of boards in ESG governance
So how do boards need to evolve to oversee, enable, and support delivery of ESG strategy?
Governance is part of ESG, and in turn ESG must inform all aspects of corporate governance. This begins with a thorough assessment of the materiality and implications of ESG for the enterprise.
The board and senior leadership share accountability for developing a strategy to address the associated risks and opportunities, and the board should hold senior leaders accountable for implementing the strategy to achieve near-term and longer-term ambitions.
The board’s role starts with education and building awareness. While “ESG” has been colloquially adopted as a subject for discussion and debate, definitions are inconsistent, and there is a wide range of understanding what the term means, what’s included under each of the letters “E, S and G”. With a growing body of research under each of the three categories of Environmental, Social and Governance issues, it is imperative that boards and senior leaders understand the implications of this research for their organizations.
7 things boards need to do to ensure the right ESG governance
Boards should also ensure they have the right governance processes in place to provide proper ESG oversight, monitoring and support of the organization’s ESG strategy development and execution.
This requires seven distinct areas of activity.
1. Alignment: in-depth discussions with senior leadership to ensure appropriate alignment of priorities, clarity of roles and ongoing advice and support
2. Integration: challenging management to demonstrate that ESG has been integrated into strategy development and risk management processes
3. Time and information: board agendas may need to be revised to ensure there is time for critical discussions, and the right data needs to flow into the boardroom to ensure the discussion is well informed
4. Structure: establishing new committees or, more often, rewriting existing committee charters – no committee will be untouched by ESG considerations
5. Engagement: listening to, and sometimes engaging with, internal and external stakeholders
6. Disclosure: robust reviews of ESG disclosures using common frameworks such as the Taskforce on Climate-related Financial Disclosures (TCFD) and the Sustainability Accounting Standards Board (SASB)
7. Compensation: revisiting executive compensation strategy and program design – with implications for how annual and/or long-term incentives are structured and administered
ESG is a topic that is evolving quickly and has the attention of a broad and diverse group of stakeholders. So, to implement your strategy successfully, the board will need to comprise a group of professionals who are diverse in their backgrounds, skills and experience. Board members will need to commit to continual learning, agility and new ways of thinking and communicating to address the topic fully and credibly.
Some boards may decide to add specific ESG expertise (for example, a successful track record of integrating ESG into operations versus deep knowledge of climate science), but most boards will want to ensure all directors have basic ESG-competence.
What are the implications of ESG governance on executive pay?
Once boards thoroughly assess the impact of ESG on their organizations, they may decide to tie a portion of executive pay to achievement of ESG objectives. This sends a strong signal that it is a priority for the enterprise.
We have already seen this trend in North America and Europe, as many companies take their first steps to incorporate one or more ESG metrics into their annual and/or long-term incentive programs. At face value, this seems like an obvious step to take in ensuring good governance – it visibly aligns executive pay with strategic priorities and can, in turn, motivate behavior to achieve goals.
What is less clear is how best to do this. We will need to answer the usual questions about eligibility, how much to pay, which metrics to use, and over what period of time to assess performance. But this can be is more complicated than traditional financial or operational metrics.
Addressing changes in executive pay
First, the eligibility question: whose pay should we tie to specific ESG achievements? This is likely the CEO and their direct reports. But what about others? Many organizations believe that ESG and sustainability success relies on a joined-up ecosystem of stakeholders – which could include employees, investors, suppliers and customers. That being the case, there could be many others in the organization whose rewards should vary with ESG success.
The next challenge is deciding which parts of the compensation program to tie to ESG – should you use the annual incentive program, the long-term incentive program, or both? Annual incentives can be used to reward the achievement of progress milestones, while longer-term incentives can be used to reward results generated over time.
Should you hard-wire a defined amount for ESG goal accomplishment, or should you instead use ESG results to modify the incentive awards already triggered by financial and operating performance measures?
How much should you pay for accomplishing ESG objectives? If you make it too little (say, 10% or less of total incentive compensation), it may not have much impact on board behavior, and it may send a signal that ESG is not really all that important. But if you make it too much (such as 40% or more of incentive compensation) it may be viewed as overweighting a narrow set of non-financial priorities – especially if they are less clearly tied to long-term value creation than other metrics.
Selecting the right performance metrics and standards is always a challenge, especially when it comes to ESG. Most organizations prefer metrics that are empirically tied to long-term value creation. But with ESG, there is not a lot of history to draw on, and it isn’t easy to reliably forecast the longer-term economic benefit to the organization of achieving various ESG milestones.
Assessing the risks of tying ESG governance to executive pay
If incorporating ESG metrics into an incentive program wasn’t already difficult, we also need to recognize and address a range of risks. For example, in some cases ESG strategies will likely dampen near-term financial results due to significant upfront investments, while the longer-term benefits may not be realized for several years – if not decades. And if the success of an ESG strategy cannot be fully measured for more than a decade, how effective will it be to incorporate ESG into incentives for people who may not even be with the organization when that determination can be made?
Also, it may not make sense to tie executive compensation to achievements that can’t be tangibly and reliably linked to value creation. And if that link is weak, boards may need to feel comfortable with possibly overspending on incentives (and risking negative shareholder reaction) or underspending (and risking executive retention issues).
Clearly, the task of tying senior leader pay to ESG objectives is fraught with challenge and uncertainty. But most organizations will need to give serious consideration to this important aspect of governance – because neglecting to do so could send a signal that it’s not a priority for the enterprise after all.
Boards need to change today to ensure they remain relevant tomorrow
ESG and sustainability are becoming so integrated into strategy development, risk management and financial statements that boards will need to invest time to understand and evaluate these issues in the context of their organizations.
These are not new considerations, but they are increasingly important to a broad group of stakeholders. When boards make ESG and sustainability a top priority, they will also need to assess their composition, governance processes, and other tools to ensure they can appropriately address the complex issues that are continually emerging.
Executive compensation is one of the most important tools to consider. However, boards need to take care in determining who to reward for accomplishing ESG and sustainability objectives, and how best to structure that reward. Once a board understands the complex questions surrounding executive compensation in line with its ESG and sustainability strategy, it can move forward with restructuring executive compensation to fully align with the organization’s ESG priorities.