Proxies, Pay, and the Brave New World of ESG

Environmental, social, and governance (ESG) matters are now the subject of significantly greater regulatory scrutiny and are becoming a more prominent part of public companies’ mandatory filings, shareholder proposals, and activist campaigns.

ESG is a many-faceted construct, which makes it challenging for many companies to fully grasp its scope and the requirements around it. Its environmental ambit runs from greenhouse gas (GHG) emissions to deforestation issues. The social component includes everything from corporate philanthropy to diversity and inclusion. Governance topics range from board structure and executive compensation to privacy and cybersecurity.

ESG reporting deals with the public disclosure of data from these silos. Corporations and their boards are now subject to a marked rise in accountability for each in light of the demands of market participants and regulators.

The Climate Change Context

On March 21, 2022, the Securities and Exchange Commission (SEC) issued proposed rules that would enhance and standardize climate disclosure requirements provided by public companies. The proposed rules are extensive and comprehensive, and they represent a significant shift in the perspective of public companies’ disclosure on climate.  If adopted, the proposed rules will require those companies to provide relevant data in registration statements and annual reports, including the following:

• Oversight and governance of climate-related risk by board and management
• A process for identifying, assessing, and managing associated risks and impacts
• Climate-related financial impacts and expenditure metrics
• Discussion of related targets, goals, and transition plans
• An assessment of impacts from severe weather events and related natural causes
• Pertinent assumptions in the financial statements

The proposal also requires disclosure of certain GHG emissions. These are divided into three categories, referred to as “scopes”:

• Scope 1 refers to direct emissions that occur from sources controlled or owned by an organization (for example, emissions from fuel combustions in boilers or vehicles).
• Scope 2 refers to indirect emissions associated with the purchase of electricity, heat, cooling, and the like.
• Scope 3 refers to sources (say, suppliers) that are not within the parameters of the first two scopes. Also called “value chain emissions,” they often represent the bulk of an organization’s GHG discharge. This section of the proposal is prompting the most debate and the SEC is reviewing public comments on the cost and challenges of these disclosures of emissions throughout a company’s supply chain.

Given the sheer quantity of data that is implicated by this regulatory regime, proactive public companies are implementing a handful of best practices, including the following:

• Providing disclosure of ESG risk management and board oversight
• Maintaining consistency and accuracy in disclosing climate-related information, including support for statements
• Bearing in mind that SEC review and scrutiny goes beyond ESG reporting in SEC filings, including the following:
  • Company websites
  • Press releases
  • Marketing materials
  • Blogs
  • Corporate social responsibility (CSR) or sustainability reports
• Conducting regular internal audits, but also commissioning third-party verifications or audits
• Carefully considering hard-and-fast commitment language regarding the achievement of ESG goals by a given date
• Benchmarking disclosures against peers’ public filings
• Contemplating the use of forward-looking statements and, as needed, adding disclaimers

Executive Pay-for-Performance Disclosure

On August 25, 2022, the SEC adopted new rules to require enhanced pay-for-performance disclosure that will apply to 2023 proxies for calendar year-end companies. Registrants are required to comply with the new amendments in proxy and information statements in Item 402 executive compensation disclosures for fiscal years ending on or after December 16, 2022.

A new survey from The Conference Board and ESGAUGE indicates that linking executive compensation to ESG principles is used by the “vast majority” of S&P 500 companies. That figure rose from 66% in 2021 to 73% in 2022. The most common approach is use of diversity, equity, and inclusion-related goals, which rose from 35% in 2020 to 51% in 2021. S&P 500 companies that tied carbon footprint and emissions reduction goals to executive pay grew from 10% in 2020 to 19% in 2021.

However, it’s not one-size-fits-all. Companies factoring ESG into executive pay employ various approaches:

• As modifiers to the overall performance ratings (6%)
• As stand-alone specific metrics (24%)
• As part of a broader business strategy scorecard (48%)
• As part of an executive’s individual performance rating (49%)

Companies that incorporate ESG measures into executive compensation for any reason may want to consider the following:

• Use ESG goals for one or two years before including them in compensation programs to allow time to see if the goals are relevant and to obtain management buy in.
• Remember that developing and compiling reliable, meaningful data used to measure and report company performance against ESG goals requires meticulous care, as assessing ESG goals may be less straightforward than typical and more easily measurable performance goals.
• Tailor incentive models to the company’s specific situation.
• Be prepared to explain why ESG goals are included as part of the executive compensation program, how they comport with the company’s fiduciary responsibilities, and how they will move the needle on the company’s performance.

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