Corporate Governance

2020_Corporate Governance and Executive Compensation

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Shearman & Sterling LLP 22 | ESG Slowly Finding its Way into Incentive Compensation Plans ESG Slowly Finding its Way into Incentive Compensation Plans Matthew H. Behrens, Annie P. Anderson and Sonia S. Khandekar Insights Incentive compensation has long been a board's primary tool to ensure that the interests of management are aligned with the interests of a company's shareholders. To that end, the ongoing challenge facing compensation committees is choosing metrics that motivate management to optimize shareholder value without incentivizing behaviors that focus on short-term stock price appreciation that can threaten the company's long-term interests. As a result, traditional incentive compensation metrics measure performance through quantitative shareholder return and financial and operational metrics that reward longer-term performance. Although the traditional metrics still dominate, a number of forces have recently resulted in the incorporation of more qualitative ESG factors. This article discusses the forces encouraging companies to adopt ESG metrics and analyzes how companies are incorporating ESG metrics into their incentive compensation programs. THE FORCES OF CHANGE A number of forces have led to the increased use of ESG metrics in incentive compensation plans. These include: Institutional Investor Focus on Sustainability As Larry Fink, Chairman and CEO of BlackRock noted in his January 2020 letter to CEOs, the failure to focus on the needs of a broad range of stakeholders will damage long-term profitability. This view is widely held by asset managers. According to the 2019 RBC Global Asset Management Responsible Investing Survey, 70% of institutional investors in Canada, the United States and the United Kingdom apply ESG principles to investment decisions, with over half of those investors citing a positive performance impact as the prime motivator. As a sign that ESG investing is an increased priority, reports indicate that the amount of assets invested in sustainable funds in 2019 was nearly four times larger than in 2018. 1 1 Shifting Views of the Role of the Corporation In August 2019, more than 180 CEOs signed onto a Business Roundtable statement that, for the first time, rejected the view that companies exist principally to serve their shareholders. Rather, the statement asserted that corporations should commit to serving the interests of all stakeholders, including, in addition to shareholders, customers, employees, suppliers and communities. The Business Roundtable's updated position reflects increasing investor, employee and community pressure on companies to not only advance profits, but to also contribute to addressing societal problems such as income inequality, diversity and environmental sustainability. The incorporation of ESG into incentive compensation plans could become a key measure that observers will use to track whether the signatories' companies are actually honoring this redefined philosophy with real changes in practices. 2 1 See Financial Factors in Selecting Plan Investments, Proposed Rule, ยง 2550.404a-1, citing Jon Hale, "The ESG Fund Universe is Rapidly Expanding," https://www.morningstar.com/articles/972860/the-esg-fund-universe-is-rapidly-expanding (March 19, 2020).

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