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Sustainability Metrics in Executive Pay

August 20, 2013

There is strong investor interest in the ways that corporations manage sustainability issues, and in particular, how they incorporate them into executive pay plans. Companies may say they care about environmental, social, and governance (ESG) performance, but are executives’ paychecks being linked to achievement of non-financial goals?

Data collected by GMI Ratings shows that the answer to that question varies widely, both depending on industry and among companies in the same line of business. For example, among energy sector companies in the S&P 500, 91% say they use ESG factors in some way, 44% disclose the particular metrics they use, and 33% specify target performance levels for those metrics. Among S&P 500 financial services firms, about 60% say they use a sustainability factor, but only about 15% name specific metrics and target levels. In the healthcare and materials sectors, more than half of firms (55% and 53%, respectively) say they use an ESG factor, but well under a fifth of the companies in each sector name metrics or targets. Among retailers, meanwhile, less than a quarter of firms say they incorporate ESG issues, and none specify metrics or targets.

The specific issues incorporated into pay plans also vary by sector and industry. In the energy sector, as might be expected, safety and environmental accidents are the most commonly used factors. Unfortunately, it is much less common for companies to link pay to decreased operational carbon emissions, lower water usage, or other systematic improvements in their environmental profiles. In the financial sector, customer and employee satisfaction, diversity, ethics and regulatory compliance are often mentioned. A smaller number of firms also include measures of capital adequacy, liquidity, and asset quality. These are arguably among the metrics with the highest social impact, given the systemic importance of financial services firms, and the potentially severe human consequences of their failure.

The metrics most often used by healthcare firms include employee and customer satisfaction, as well as risk management and succession planning. Some also include ethics or regulatory compliance as pay plan metrics; however, the number of companies doing this is smaller than one might expect, given the many recent regulatory concerns in pharmaceuticals and other healthcare firms. Retailers, meanwhile, list diversity, customer satisfaction, and general topics such as “social responsibility,” but have not incorporated into their pay plans any measures of vendor standards or factory safety, even though many observers consider these the key risk factors for the industry. In sum, across all industries, compensation committees often seem to be neglecting the ESG issues of greatest importance to investors, even when they do use non-financial metrics to award executive pay.

Moreover, even when appropriate sustainability metrics are linked to pay, their impact on payouts remains low, since they often determine only a small part of the annual bonus. Furthermore, although many investors consider sustainability an inherently long-term theme, sustainability metrics are overwhelmingly used for annual bonuses only, and are rarely used in long-term incentive plans.

To be sure, there are some companies who give sustainability factors a prominent position in their pay plans. For example, at Alcoa, safety, carbon emissions reductions, and employee diversity combined make up 20% of the annual bonus. At the Bank of New York Mellon, the achievement of preset capital ratios is a prerequisite for the payout of both short and long-term bonuses. And at Tenet Healthcare, the annual incentive amount is determined by performance of a basket of metrics, including physician satisfaction (as measured by surveys), employee turnover, and regulatory compliance (based on internal and external audits).

It’s important to note that the plans described in annual regulatory filings may give an incomplete picture of how pay committees think about sustainability, since they tell us only about the metrics that are explicitly built into plans before the year begins. Committees may also be incorporating sustainability factors into their subjective evaluations of executives or their discretionary bonus decisions (as, for example, when Chevron cut bonuses last spring due to safety problems). Nevertheless, the filings provide a sense of companies’ overall approach to incentivizing sustainability performance through pay, revealing both the substantial progress that has been made and how much work remains to be done.

In the years ahead, institutional investors may wish to press companies on this issue. They should ask them both to expand their use of sustainability metrics in executive pay and to focus those metrics more effectively on the issues most material to the firm and its impact on the world.

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