It is encouraging to see ESG-related KPIs increasingly featuring in legal documents, in an effort to drive behavioural change at the fund and asset levels.
When done well, the inclusion of ESG-linked targets in financial incentives (for example, carried interest structures, bonus and remuneration schemes, other management incentivisation schemes and debt finance packages) has real potential to achieve transformational sustainability outcomes and mitigate ESG risks. However, as the trend continues to grow and develop, care is needed to avoid superficially attractive targets that do not deliver meaningful change, or targets that inadvertently create perverse incentives.
Incentives designed to benefit society (and achieve positive ESG performance for a business) could have negative unintended consequences if not carefully considered.
In our well-intended quest to embed a positive ESG culture through use of ESG KPIs, there are many challenges to be navigated. For investors and businesses, the KPIs must, of course, be aligned with overall business strategy, which will usually require alignment with value creation aspirations as well as any integrated ESG policies or publicly stated targets.
Responding to market-driven demand from stakeholders such as institutional investors (and those who advise them) may be another factor here, prompted by the extensive ESG disclosure laws that are now coming through at different levels of the investment chain.
The chosen KPI must also be appropriate for the underlying incentivisation structure, and of course, must be achievable. In addition, the KPI selected and the underlying performance indicator will need to reflect the underlying sector, industry and geography-based ESG risks and opportunities relevant to the business. Unsurprisingly, with this emphasis on customisation, we are seeing a wide range of KPIs being used – covering such diverse topics as reduction in emissions, renewables targets, deforestation, health and safety, product traceability and social governance, to name a few – and there are different approaches to monitoring and reporting against these. Some are more easily measurable than others and there is risk, particularly where a KPI is difficult to measure, that we open doors to manipulation and, potentially, greenwashing.
It is important also that KPIs are accurately and clearly defined in legal documents (for example with reference to percentages or specific amounts and clear methodology where calculations are required). Having legal certainty over the scope, timing and targets to be met, and avoiding general concepts of reasonableness or materiality, should minimise scope for manipulation of KPIs and dispute between counterparties over whether or not targets have been met. This in turn should enhance the credibility and impact of ESG-linked incentives. There is clearly a risk that vaguely drafted KPIs will be counter-productive – for example, vague ESG metrics used in salary and bonus schemes, might become a route to salary padding. All of that said, not all KPIs are easy to draft with such precision.
We must also be mindful of inadvertently encouraging a culture of box-ticking – well-meaning and important social goals such as achieving ethnic or gender diversity targets on boards can quite easily become formulaic. We need more than “quick wins” to achieve long term sustainability. When considering social goals such as diversity, care is also needed to avoid infringing equality law in defining the targets – positive action (for example, taking steps to encourage women or ethnic minorities into senior positions) can be easier to justify, whereas positive discrimination (for example, hiring or promoting people because of their race, sex or background) is much more difficult.
In setting out to achieve a specific goal, there is real risk of optimising for that objective regardless of the consequences, or aiming solely for that target and going no further – which flies in the face of the maximisation concept implicit in the Paris agreement, requiring governments to pursue “the highest possible ambition”.
The carbon crisis requires far more than one-off wins, as does the movement for a diverse and inclusive culture. In fact, many ESG issues are multidimensional and cannot easily be reduced to a few measurable KPIs, so the risk of hitting the target but missing the point is significant. There is even an argument that setting ESG-targets might not be the correct approach – to quote the well-known Goodhart phenomenon, “when a measure becomes a target, it ceases to be a good measure”. It is certainly a principle to be alert to when employing ESG metrics, but there may be ways of drafting for this in legal documents, for example through a “no adverse consequences” construct. To avoid a box-ticking exercise, it may sometimes be appropriate to make targets subject to board discretion or assessment, although that may of course come with its own issues, as indicated above.
While customisation to a business or investor’s needs is important, a common framework of best practices that can be applied across KPIs may be helpful. It is encouraging that we are already seeing some advances in this regard, with a number of industry bodies publishing guidelines and frameworks for a more standardised approach to the collection and reporting of ESG data and market terms – we recently saw the publication of an industry-led ESG Data Convergence Project. The Sustainability Linked Loan Principles published by a joint working group including the LMA is another promising example.
There are also helpful developments in derivatives and debt capital markets, with the publication of ISDA’s Sustainability-linked Derivatives: KPI Guidelines and ICMA’s Green Bond Principles, as well with the European Commission’s announcement that it will establish an EU Green Bond Standard which is intended to operate as a voluntary “gold standard” for green bonds.
Industry collaboration and policy measures, with greater emphasis on transparency, oversight and clear technical drafting in legal documents will be the key to success.
The authors are George Weavil, partner, and Carys Clipper, knowledge counsel, both in the private equity and financial sponsors practice at law firm Travers Smith.