The Advisors' Blog

ESG metrics have been under the microscope for some time now, with investors concerned about “ESG overperformance” and companies setting “softball” goals, causing outsized payouts compared to company financial performance. Now, as Liz shared last week, the use of ESG measures seems to be reversing course with a renewed focus on financial measures.

For anyone still tinkering with proxy disclosures describing the continued use of ESG measures in 2024 plans, WTW recently sought to better understand what investors are looking for when they consider pay proposals at companies that use ESG metrics. While many investors reported that they consider the use of ESG metrics on a case-by-case basis, WTW shared some common pitfalls that were identified by surveyed investors.

– Lack of clear connection to business strategy and value creation. This includes the use of metrics that overly rely on subjective judgment, or the use of ESG metrics that are not clearly defined or do not clearly align with the company’s strategy, competitive strengths or material business risks.

– Use of broad ESG indices or compliance-related metrics. Investors do not favor ESG indices as an incentive metric because they are too broad and lack focus. The use of ESG indices also goes against the overarching theme of business materiality. In addition, investors cautioned against the use of compliance-related metrics, as they consider compliance a baseline expectation of executive performance.

– Too many metrics. Too many metrics over-complicate incentive plans and dilute the impact of individual metrics. This weakens the alignment between pay and performance and makes it less meaningful for incentive plan participants. For similar reasons, investors also cautioned the use of less measurable ESG scorecards with undefined weighting of each scorecard element. Additionally, the optics is that the company is building in flexibility to selectively choose which metrics they would add weight to retrospectively when assessing performance and deciding associated pay outcomes.

– Non-financial metrics weighted more heavily than financial metrics. Investors generally shy away from a prescriptive guideline on a minimum or maximum weighting on ESG metrics. However, they noted that, in principle, a small weighting (e.g., lower than 10%) likely will not impact behaviors. A thoughtful approach to selection will naturally result in more meaningful weighting on each individual metric. There also was consensus among the investors that if ESG or non-financial metrics are weighted more heavily than financial or shareholder return metrics, it will draw closer examination. Some investors also expressed concern about high ESG scores offsetting lackluster financial performance in remuneration outcomes.

– Consistent above-target payout. This may signal a lack of rigor on performance goal setting, especially for qualitative measures that require judgment-based assessment.

– Lack of transparent disclosure. Like disclosures on financial metrics, investors expect transparency in the rationale behind metric selection (both retrospective and prospective), with acknowledgement that market norms vary by region), weighting for each metric and achievement against targets. While some companies may cite commercial sensitivity as an argument to omit disclosure of performance goals, investors are mostly unsympathetic to this argument. They assert that ESG targets are generally far less sensitive than financial targets and, if commercial sensitivity does come into play, companies should still be able to disclose the targets and achievement levels retrospectively, after the performance period concludes. Prospective disclosure of targets is encouraged and should clearly show how short- and long-term incentive targets (which often have a one- to three-year time horizon) connect to longer-term sustainability commitments, such as net-zero goals and their transition pathways.

In terms of institutional investor policies on this topic, unsurprisingly, many are still not looking for companies to incorporate ESG measures, but when they’re used, they want to see alignment, goal rigor and transparency.

– Meredith Ervine