Factoring ESG and Other Nonfinancial Goals into Your Variable-Pay Policy

The jobs of nearly three-quarters of CFOs are impacted by expectations of how their companies should perform in the environmental, social and governance (ESG) realm, according to a recent survey by Deloitte Consulting. The emphasis on ESG matters is likely to continue.

So far, few companies have ESG performance metrics baked into their variable-pay plans. But that's likely to change. Regulators, including the Securities and Exchange Commission (SEC), are working on plans to mandate corporate disclosure of their performance based on ESG criteria. The challenge for the SEC and businesses is to develop disclosures that would offer meaningful insight into ESG "performance."

The Pressure Is On

Privately held companies won't be directly impacted by SEC regulations. Even so, a lot of people—possibly including many of your customers—may prefer to do business with companies that promote diversity and inclusion within their ranks and act as good environmental stewards. There's also a common belief that high ESG scores lead to increased profitability. That expectation may keep the pressure on all companies to incorporate some ESG indicators into bonus formulas to provide financial incentives for managers to achieve those goals.

Long before ESG profiles became a hot topic, other nonfinancial criteria—such as customer satisfaction and employee engagement—were used in variable-pay calculations, with the assumption that there would be financial rewards for shareholders. Yet research reported in MIT's Sloan Management Review found that the results may not be as anticipated. "Customer satisfaction is often a weak leading indicator of a company's future financial performance," and employee engagement levels are a poor predictor of profitability, said Sloan Management Review.

Why? Customer satisfaction could soar, for example, if front-line employees discounted or gave away products and services to customers. But that practice would lower profits.

No Perfect Solution

Suppose you decide to stick to using concrete financial performance criteria. Keep in mind, using those criteria to set your variable-pay formula can be disappointing. To illustrate, a company that overemphasizes short-term profitability could be motivated to take cost-cutting measures that, in the long term, are self-defeating.

Or a bonus formula that focuses on growth in earnings per share (EPS) could prompt executives to pursue debt-financed acquisitions of other profitable companies. Such acquisitions could result in an immediate increase in EPS but lead to problems down the road if there's a business slowdown and the company's debt burden becomes unsustainable.

If incorporating nonfinancial criteria into your compensation formula is the goal, start by tackling these three tasks:

1. Identify performance standards that are consistent with your company's values and will likely drive the desired level of performance,
2. Find measurable indicators of success in those areas, and
3. Build them into the overall incentive compensation mix using a balanced approach.

Next Steps

From there, you can focus on specific ESG goals. For instance, if your goal is to enhance the E in ESG, you might prioritize reducing your business' "carbon footprint." It's measurable, and if you don't want to do the calculation yourself, services are available to help with that. They might also provide mitigation strategies, such as supporting tree-planting projects and using more electricity from renewable energy sources.

It's important to be realistic about how much you can achieve over a given period and what it might cost you before building goals into a performance-based pay formula. Sticking with the topic of environmental focus, an example might be to switch from plastic to paper packaging. Ask yourself, what's achievable? What are the risks if you aim too high?

The S in ESG generally pertains to the treatment of your employees and any broader social costs to the way you do business. An example might be avoiding the use of suppliers in countries where safety and wage standards are below those used in the United States. 

Of course, a small company in a competitive business environment might not have the financial flexibility to switch to higher cost U.S. suppliers. But they can still promote social welfare domestically by rethinking their hiring practices and employee benefit plans. Instead of creating a recurring variable bonus for the manager tasked with improving your social "score" (however you define it), consider a one-time bonus for devising and implementing a plan that will have enduring positive social impact.

The G in ESG has been in the spotlight since the Enron corporate scandal a quarter-century ago. Governance reforms that followed were mainly focused on publicly held companies. But owners of smaller private enterprises can adopt bylaws that encourage—through their board structure—a diversity of perspectives applied to corporate policies and strategies. Those can result in creative variable-pay programs that motivate frontline employees and senior managers to achieve key nonfinancial objectives.

Final Thoughts

Nonfinancial performance metrics require a dose of skepticism in terms of concrete rewards to the company. What works well for another company might be a poor fit for your business, so don't adopt a plan just for the sake of change. You know your company better than anyone, and you might need to trust your instincts when developing nonfinancial goals for your variable-pay policy.

Before you approve any plan, it's a good idea to run it by your trusted financial advisor. They may be able to help you foresee the plusses and avoid any pitfalls.