Sustainability is one of the most pressing issues of our times and crucial to companies’ long-term financial success. The CEOs surveyed in our 2022 CEO Outlook believe that ESG programs improve financial performance, help secure talents, strengthen employee value proposition, attract loyal customers and raise capital.
ESG has many facets: It ranges from climate change and workforce diversity to corporate governance and risk management. Increased regulatory requirements, rising stakeholder sentiment as well as customer and employee demand are now pushing employers to make good on their ESG goals. This is why companies are currently under pressure to enhance their license to operate and commit to sustainable value creation.
But how can companies ensure that their ESG strategy is on track? ESG-related incentive pay is a tangible way to spur meaningful action, ensure accountability and enforce ESG objectives. But companies face risks when aligning ESG metrics with compensation plans in Switzerland – also from an employment law perspective.
Key risks in ESG-linked incentive plans and how to address them
Companies should think carefully about the design of ESG-related incentive plans to ensure that they are effective. Otherwise, such incentive plans may be a barrier to, rather than a driver of, ESG progress within employer organizations.
As a crucial first step, companies need to assess their progress on the ESG journey and whether their ESG strategy is consistent with the broader business strategy and meets stakeholders expectations. A well-defined company-wide ESG strategy is key when linking compensation to ESG. This allows companies to focus on high-priority ESG aspects when setting specific targets as a basis for incentive compensation. Carelessly formulated incentive structures tend to disappoint and frustrate stakeholders, especially employees. Employees typically want enough clarity when it comes to target setting because they need both certainty and predictability. Nonetheless, companies at times consciously opt for targets with considerable discretion to have sufficient flexibility to measure performance and consider circumstances.
Second, when defining key ESG metrics, companies should be aware of the challenges in selecting ESG metrics stemming from competing stakeholder interests. Tying rewards to emissions reduction, for example, could be interpreted as a sign that diversity & inclusion is not as important, which could affect employee morale and recruiting objectives. This is why companies must balance these interests and make well-informed decisions in favor of one or the other interest during the target setting process, depending on their needs and Swiss (employment) law.
Finally, it is important to have the necessary capabilities (e.g. processes, technologies, people) in place to fully implement and measure the performance of the ESG incentives. Companies should monitor and report on their ESG strategy and on whether ESG-linked pay really has an impact on a company’s ESG targets. This will in turn strengthen stakeholders’ confidence in the company’s ESG commitment and ambition.
What Swiss employment law aspects do you generally need to consider for incentive compensation liked to ESG targets?
Under Swiss employment laws incentive compensation essentially either qualifies as bonus or variable salary. As a general rule, but depending on individual circumstances such as the amount of total compensation and nature of potential targets, an employee has no claim to a bonus, whereas they are entitled to a variable salary (at least to a certain extent).
Fundamentally, a bonus lies in the employer’s discretion, e.g. in determining the amount of bonus or when the bonus depends on the employer’s subjective assessment of the employee’s performance / target achievement. Thus, a bonus is partially or fully a voluntary payment.
In practice targets are often set in connection with incentive compensation. Their achievement generally determines the amount of incentive compensation. Targets, which include a considerable amount of employer discretion in evaluation are called “soft targets”. Targets, which include no discretion of the employer and are objectively measurable are called “hard targets”.
This means that incentive pay linked to soft ESG targets (e.g. creating an inclusive work environment) principally qualifies as bonus to which the employee has no general entitlement. Incentive compensation linked to hard ESG targets (e.g. company’s reduction of absolute GHG emissions by 20%) principally qualifies as variable salary, to which the employee has a general entitlement (and likely needs to be provisioned for).
Hence, the definition of ESG targets is crucial in determining whether an employee may be entitled to an incentive compensation or not.
To properly define ESG-linked targets, companies must ensure a well-defined company-wide ESG strategy and monitor whether ESG-linked compensation really affects a company’s ESG targets. While employees typically desire predictability during target settings, companies often like to include considerable discretional elements – for flexibility reasons, but also to generally reduce entitlement risks under Swiss employment laws.
Hence, companies need to weigh these considerations and strike a fitting balance between ESG strategy, employee acceptance and Swiss employment laws.