Linking Sustainability Performance and Executive Compensation

It is no secret that incentive elements of executive compensation arrangements have long been tied to financial performance and increasing shareholder value as demonstrated by improvements in share prices.  Certainly financial success is important to the long-term viability of the business and provides the CEO and other senior executives with access to the capital necessary to remain competitive and pursue and commercialize innovative products, services and technologies; however, there is growing interest among stakeholders, including many institutional investors still very interested in financial returns, to create links between executive compensation and sustainability measures (i.e., metrics based on environmental, social and governance targets).  A Global Compact publication recommended that the duties and responsibilities of the compensation committee include:

• Ensuring that sustainability issues are included in the compensation philosophy (e.g., the intent to reward sustainability performance and innovation, pay a living wage, ensure equitable pay, ensure appropriate CEO to worker pay ratios and limit excessive compensation, etc.)
• Drafting a CEO position profile/description that includes reference to sustainability experience, values and leadership, fostering a sustainability culture, incorporating sustainability into corporate strategies and enterprise risk management, ensuring effective internal controls and management systems for sustainability and maintaining quality stakeholder relationships
• Mandating that the CEO’s annual performance plan and evaluation/review include sustainability objectives, leadership and competencies
• Implementing succession planning and management/leadership development programs that include sustainability competencies, leadership and values alignment; incorporate sustainability as a factor in position profiles, development plans and career planning for executive leadership and potential successors; and integrate sustainability into talent management strategies and discussions

While a strong business case can be made for including sustainability in the overall strategic goals and objectives for a company and, in turn, integrating sustainability into the elements of executive compensation, it is still far from settled practice.  In fact, surveys conducted by executive compensation consultants among S&P 500 companies have found that only 2% of the companies tied voluntary environmental targets (e.g., reduction of greenhouse gas (“GHG”) emissions) to executive compensation and that just 2.6% of the companies had a performance metric tied to diversity. Several practical issues need to be overcome in order for sustainability performance to take a more central role in executive compensation. For example, compensation arrangements become unworkable if they attempt to address too many metrics. According to Burchman and Sullivan, compensation consultants have traditionally recommended that compensation plans focus on no more than five metrics—one or two financial metrics, such as sales growth or earnings per share, and two or three nonfinancial metrics, in areas such as quality or innovation—and cautioned that including additional metrics, such as sustainability, will likely dilute executive focus.  Another problem, at least in the US, is that regulators have been slow to prioritize sustainability and environmental risks in their pronouncements regarding reporting; however, regulators outside the US, notably in Europe, have moved aggressively to formerly include sustainability into corporate governance frameworks,  voluntary reporting on sustainability has become increasingly prevalent and companies are becoming more sophisticated with respect to integrating sustainability and financial performance in the disclosures they make to their stakeholders.  Advances in sustainability reporting provide a foundation for constructing sustainability metrics that can be added to the financial results and measures of quality and innovation.
While the compensation and organizational development committee is the body of the entire board of directors that focuses its efforts on executive compensation, significant actions in that area must still be reviewed and endorsed by all of the directors.  Directors have long considered financial performance and long-term shareholder value to be the bedrock of their fiduciary responsibilities; however, in recent years boards have shown a willingness to “explicitly embrace the proposition that sustainability is a core indicator of the CEO’s and internal company’s responsibilities and performance”.  The key, according to Burchman and Sullivan, is to focus on those environmental, social and governance (“ES&G”) factors that are “relevant to a company’s business” rather than attempting to address all 17 of the sustainable development goals identified by the United Nations.  Any ES&G factor recommended for inclusion in executive compensation performance metrics must be grounded in a solid business case and accompanied by a clear plan of action with milestones that are reasonably within the scope of the CEO’s direct authority—in other words, as explained by Burchman and Sullivan, “well-defined metrics tied to concrete plans”.  Burchman and Sullivan noted that if companies are not yet able to define a specific sustainability metric, the board can still reasonably incentive the CEO and other executive to “do no harm” by retaining the right, which should be laid out specifically in the executive compensation policy, to reduce incentive awards in case of substantial damage to the company’s business or reputation due to a failure to take adequate precautions (e.g., an oil spill or harm to workers in the supply chain due to malfeasance by the company’s supply chain partners that should have been discovered).
The future of linking sustainability performance to executive compensation may be anticipated by observing the steps that have already been taken by a handful of high profile companies around the world, especially firms operating in industries where it is clear that operational activities can and do have significant and visible environmental and social impacts.  For these companies it is already fairly straightforward to make the business case for targeted, and relatively easy to track, sustainability initiatives such as managing and reducing GHG emissions and energy or water use, improving workplace diversity and enhancing employee safety.  What is needed is for companies to make the pitch to investors that pursuit and achievement of these goals is not only the “right thing to do” from an environmental and/or social perspective but also will reap financial benefits in the form of cost savings, better risk management and a stronger brand that will attract new customers and talented workers.  Metrics must be creatively designed given the end results of most sustainability initiatives cannot be learned for many years, often decades after they are first launched.  In these situations, executives must be incentivized by rewards that are based on achieving clearly defined interim milestones.
Sources for this article included The Essential Role of the Corporate Secretary to Enhance Board Sustainability Oversight: A Best Practices Guide (United Nations Global Compact, September 2016); S. Burchman and B. Sullivan “It’s Time to Tie Executive Compensation to Sustainability”, Harvard Business Review (August 17, 2017),; K. Larsen, “Why tying CEO pay to sustainability still isn’t a slam dunk”, GreenBiz (May 26, 2015); and In-Depth: Linking Compensation to Sustainability (San Francisco: Glass Lewis, March 2016).
This article is adapted from material in Sustainability and Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.
Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business.  Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedIn, Twitter and Facebook.