Monday, November 22, 2021

ISS study sees “tipping point” in companies increasingly tying executive pay to ESG metrics

By Lene Powell, J.D.

A new report by Institutional Shareholder Services (ISS) finds an accelerating upward trend in the number of U.S. companies using environmental and social (E&S) metrics in executive compensation programs. Across all companies examined, the use of such metrics has increased from 3.5 percent in 2012 to 10 percent in 2020, with a sharp jump from 2019 to 2020. The trend is stronger at large companies, with 20 percent of the S&P 500 now using one or more such metrics, ISS reported.

“If observed trends continue, more companies will continue to include E&S metrics in their [short-term incentive plans] next year and beyond,” wrote ISS.

ISS observes that companies are increasingly looking beyond traditional shareholder value and seeing benefit in good environmental, social and governance corporate practices, as reflected in the Business Roundtable’s shift from the “shareholder model” to the “stakeholder model.” ISS sees social developments as driving expectations, including increased climate change awareness, the #MeToo and Black Lives Matter movements, and the COVID-19 global pandemic.

The report, A New Yardstick for Pay: Environmental & Social Factors, is available on the ISS website.

Social trends driving increased metrics use. Many institutional investor expectations are evolving as broader societal expectations have evolved, said ISS. Reflecting this shift, the Business Roundtable endorsed a “stakeholder” model of company purpose rather than a purely “shareholder primacy” model in 2019. The group’s Statement on the Purpose of a Corporation has now been signed by over 240 CEOs who have committed to “lead their companies for the benefit of all stakeholders—customers, employees, suppliers, communities and shareholders.”

ISS sees a focus on employee wellbeing in the prominent use of social metrics. For example, staff health and safety metrics represent 50% of all metrics used in compensation programs. Next are customer and product responsibility (24%), environmental protection (9%), corporate social responsibility (7%), staff relations/engagement/training (6%), diversity (4%), climate change and energy use (1%).

The utilities and energy industries have led the integration of E&S metrics into compensation plans, said ISS. This reflects that these two sectors have tended to include safety-related metrics in their compensation plans for some time.

Broader social trends are also driving the uptick, said ISS. Metrics relating to climate and diversity saw the sharpest increases over the last three years. ISS observed that active climate-related investor campaigns targeted prominent companies in the 2021 proxy season. For example, three board seats went to the dissident side in a successful proxy fight at Exxon, motivated largely by climate change. The #MeToo movement and race-related social unrest of 2020 have also had an impact. Some companies have made diversity-related commitments, and some of these commitments have entered the executive compensation sphere, said ISS.

A new SEC focus might be having an impact also. ISS pointed to the new ESG task force focused on enforcing violations relating to climate disclosures. The SEC is also looking at human capital management (HCM) regulation and the COVID-19 pandemic. The pandemic has affected nearly every company and workforce, leading to an increase in HCM metrics, as observed in the sharp increase in the use of staff relations/engagement/training metrics, said ISS.

Although social metrics are so far the dominant E&S metrics used in short-term incentive plans (STIPs), the use of environmental metrics is growing faster. From 2016 to 2020, the number of social metrics included in STI plans increased by 24 percent, while the number of environmental metrics increased by nearly 200 percent, more than doubling between 2018 and 2020, said ISS.

Short-term vs. long-term incentives. The report found that the use of E&S metrics is higher in STIPs than in long-term incentive plans (LTIPs). In 2020, approximately 20 percent of the S&P 500 index (100 companies) included E&S metrics in their STIP. The report further found that when companies do include E&S metrics in their STIPs, they often include more than one. In contrast to STIPs, only about 1 percent of all metrics used in LTIPs are E&S metrics.

ISS pointed out that LTIPs usually make up the bulk of executive pay and explored possible reasons that companies are using E&S metrics more in STIPs than LTIPs. Some observers point out that companies are still collecting data and that STIPs provide flexibility in the evolving E&S landscape. Some think LTIPs might not be well-suited to promoting sustainable results and that stock price adequately reflects value. Some see a possible lack of true commitment to change.

Effect on say-on-pay evaluations. ISS noted that current investor and advisor tools for evaluating compensation programs remain shareholder-centric, even as stakeholder-centric views begin to proliferate. In ISS’s view, the low rate at which E&S metrics are currently included in compensation programs does not yet require a different compensation program evaluation model.

However, that could change if ESG metrics continue to take hold in compensation programs. And that is the trend ISS predicts.

“While 10 percent remains relatively low, it appears that we are passing a tipping point, and the upward trend is accelerating,” ISS wrote.