ESG, Human Capital Management and the Public Markets Impact on Compensation

ESG, Human Capital Management and the Public Markets Impact on Compensation and Rewards

COVID-19, the movement for racial justice, and ongoing concerns about the impact of climate change have accelerated interest from shareholders and stakeholders in how companies integrate environmental, social, and governance (ESG) factors into their overall strategy. The Biden administration has signaled that it will prioritize ESG policies,¹ and the U.S. Securities and Exchange Commission has indicated that ESG will rank high on the Commission’s agenda, particularly under new leadership from Chairman Gary Gensler.²

Given these rapidly evolving developments, boards are sharpening their focus on oversight of ESG issues, including linking ESG goals to executive compensation and overseeing ESG disclosures.

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During the April 22 webcast, “ESG, Human Capital Management and the Public Markets Impact on Compensation and Rewards,” Leann Balbona, managing director of KPMG U.S. Global Reward Services was joined by Parmjit Sandhu, principal of KPMG U.S. Global Reward Services; Annalisa Barrett, senior advisor with the KPMG Board Leadership Center; Candace Quinn, senior counsel at Seyfarth Shaw; and Ameena Majid, partner and co-lead of Seyfarth Shaw LLP’s ESG, Corporate Citizenship and Human Rights group. The following takeaways emerged from the discussion.

ESG oversight is a full-board responsibility. Regardless of where it sits within the committee structure, oversight of ESG matters rests with the full board. “The starting point is with the board and its role of oversight, which needs to be carried out in good faith,” said Majid. “With ESG dominating the marketplace dialogue, board members and senior management cannot ignore ESG risks and figuring out how to discharge [their] duties for ESG matters that are material and relevant to their organization.” The board should also consider which ESG oversight activities and interaction with management should involve the full board and which may be delegated to specific committees.

Incorporate ESG into strategy. Boards should consider ESG in the context of the company’s overall strategy. Adding an ESG lens to strategy, incorporating ESG risks into the overall enterprise risk management process, and establishing and tracking metrics for strategically significant ESG initiatives may require significant organizational change for some companies.

Prepare to engage directly with investors. Ninety-six percent of U.S. investors expect to increase prioritization of ESG as an investment criteria after the pandemic.³ Currently, $40.5 trillion in global assets under management are in funds that weigh sustainability factors—up from $22.9 trillion in 2016.⁴ A key aspect of the board’s role in ESG is how the board represents the interest of investors in overseeing ESG matters, said Barrett. “Investors are very focused on ensuring the companies in which they’ve invested have strong ESG practices. They now expect to engage directly with the board on topics such as employee health and safety, human capital management, climate risk, corporate culture, cybersecurity, diversity and inclusion, and more.”

Evaluate board composition. Does the board have the composition, structure, and processes to understand the company’s ESG risks and opportunities and to oversee management’s handling of these issues? Barrett emphasized that board diversity is key: “The board must have directors from underrepresented groups in addition to having the appropriate skills and expertise.”

Incorporate nontraditional metrics into executive compensation. “The use of nontraditional metrics as a factor of pay has increased since the pandemic, as the focus has shifted from shareholders to stakeholders,” said Quinn. “This focus includes investors, employees, customers, and supply chain/human rights concerns.”

Boards are under pressure to incorporate environmental issues—such as climate change and water usage—and social issues—such as diversity, pay equity, and employee health, safety, and well-being—into executive pay plans. In determining how to link ESG to compensation, compensation committees—working with the other board committees and management—should choose metrics that are material to the business, quantifiable, clear, and aligned with the company’s strategy. A KPMG Global Rewards Services analysis of recent public disclosures by 32 companies from Fortune 500 and Russell 1000 companies shows that 56 percent tied ESG metrics to short-term incentives, while 3 percent tied ESG metrics to long-term incentives.

“Disclosure is an opportunity to differentiate [the company],” said Sandhu. “It could shift the perceived value of the company.”

It’s important to ensure that there are clear opportunities for information flow from the organization to the board. “Directors should ask: ‘Which issues are most material for the company as they relate to ESG? How should they be communicated to the board and how should they be communicated to the public?’” said Barrett.

Sandhu suggested companies use the integration of ESG as an opportunity to redesign their incentive strategies. “ESG goals have been more incremental—for example, aiming to reduce the overall negative impact on operations,” she said. “Going forward, we expect more transformational types of goals such as converting distribution fleets from gas powered to electric. As companies rethink the entire value chain, we expect to see more long-term incentives tied to ESG.”