A Vanguard Investment Stewardship insight has cautioned that poorly constructed ESG metrics in compensation plans could result in inflated pay relative to performance.
The four-page September report moved to clarify that while Vanguard does not expect companies to incorporate ESG metrics into their executive compensation plans, those who choose to do so should apply the same level of diligence as with traditional financial metrics.
The asset manager noted a move towards the use of ESG metrics in companies across the U.K. and Europe. “Regulatory frameworks, governance codes, and guidance from industry bodies in the U.K. and Europe increasingly encourage companies to create linkages between compensation and sustainability goals,” the report noted.
Scenarios involving the use of ESG metrics that would trigger concern included those that are not clearly aligned to a company strategy, and metrics that are not linked to a financially material risk, even when targets are quantifiable.
Vanguard also flagged increased weightings placed on ESG metrics or replacing financial metrics with ESG metrics without compelling rationale.
The report outlined a number of suggestions that compensation committees could follow when implementing such metrics such as focusing on materiality, aligning metrics to appropriate time horizons, robust disclosure, and a thoughtful approach to external indexes.
“We do not believe there is a one-size-fits-all approach to executive compensation. We encourage portfolio companies to adopt pay plans that incentivize outperformance versus industry peers over the long term and align executive compensation outcomes with shareholder outcomes,” the report said.