Corporate Governance

Shearman & Sterling LLP ESG and Incentive Compensation Plans: Are Investors Satisfied? | 32 ACTION ITEMS FOR INCORPORATING ESG METRICS The following is a list of action items for companies looking to incorporate ESG metrics into their incentive compensation programs and provide related disclosure that will go towards satisfying investors: Set Goals With a lack of historical context by which to measure ESG progress, consider providing the compensation committee with discretion to determine how executives have performed with respect to the company's ESG goals. Although issuers may decide to measure success against targets set by third parties, such as ISSB, these external targets may not be appropriate for every issuer. Also, determine whether goals should be annual or long term. As shown in the survey data, most ESG metrics are tied to annual incentive plans, reflecting the long-held belief that long-term goals should relate to financial and shareholder return metrics. 2 The DOL's Rules on ESG Investing for ERISA Plans — The Pendulum Swings Again In promulgating its proposed rule on climate-related disclosures, the SEC characterized the proposal not as an ESG proposal, but rather as one aimed at providing information on risks that are reasonably likely to have a material impact on business, results of operations or finances. The debate over the economic relevance of ESG factors is perhaps most notable, however, at the Department of Labor (DOL), where each new administration offers its own set of guidance or rules as to the extent to which ERISA plan fiduciaries may consider ESG factors when making plan investments. In December of 2020, the DOL published a final rule with respect to ESG investing in the ERISA context. Purporting to reflect the DOL's long-standing position that ERISA fiduciaries may not sacrifice investment returns in order to promote social, environmental or other policy goals, ESG factors may be considered only to the extent they present material economic risks or opportunities. In addition, if two alternative investments appear economically indistinguishable, a fiduciary may "break the tie" by relying on ESG factors. Because, however, the DOL (at that time) believed true ties rarely exist, a fiduciary must document the basis for concluding that the investment alternatives were indistinguishable. Upon taking office, the Biden administration swiftly announced that it would not enforce the December 2020 rule and, in October of 2021, promulgated its own proposed rule intended to eliminate concerns surrounding investments in ESG funds that are economically advantageous. Echoing guidance issued under previous Democrat administrations, the proposed rule explicitly acknowledges that consideration of the projected return of a portfolio may require an evaluation of ESG factors. Review Your Executive Officer Scorecards As discussed, unlike financial metrics, ESG performance generally cannot be boiled down to numbers on a spreadsheet and require a subjective analysis. Therefore, when evaluating the overall performance of the issuer's executive officers, the board should include relevant ESG metrics on its scorecards. 4 Ensure a Line of Sight between the Executive and the Metric Incentive compensation metrics are without value if employees do not have the ability within their job function to achieve the desired outcome. For example, while improved safety may be an important goal for an organization, it is likely the CFO has little ability to effect change in this regard and his or her attention should be directed towards other goals of the issuer. 3 Adequate Disclosure A review of the comment letters sent to the SEC in respect of the pay vs. performance rule provides insight into the types of disclosure investors may be seeking when a company ties incentive compensation to ESG goals. Items to consider include: (1) ESG items identified for inclusion, (2) why those metrics are material for the business, (3) how those metrics correlate with financial performance, (4) the targets for achievement, (5) the level of board or committee discretion and (6) an explanation as to why those goals are incorporated into the annual or long-term incentive plan, as relevant. 5 Identify the Appropriate Metrics Consider a task force comprising different stakeholders within the organization that can appropriately determine ESG metrics that reflect the company's strategy and promote value creation. 1 Engage with Shareholders As part of a company's regular calendar on shareholder engagement, the company should discuss with key shareholders the inclusion of ESG metrics into their incentive compensation programs. Companies should seek to emphasize that these metrics are not divorced from the interests of shareholders but are, in fact, value drivers. 6

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