Corporate boards in the United States are increasingly considering ESG performance measures in incentive plans. However, there are important questions to ask about the benefits of incorporating ESG measures into compensation, the risks of doing so, and the challenges of communicating with investors, affected employees and others about what the company is doing and why. Those questions are even more urgent today, as companies face skepticism about whether ESG can drive financial performance.
Companies can successfully link compensation to ESG, but it requires a rigorous and methodical approach tailored to the company's particular circumstances and strategy. Here are five questions directors should ask management, what they should look for in each answer and potential red flags in those answers.
What Are We Trying to Achieve by Linking Executive Compensation to ESG Performance?
The majority (77% as of 2021) of S&P 500 companies are now tying executive compensation to some form of ESG performance. They're most commonly tying executive compensation to human capital management goals — 64% of the S&P 500 do so — and least frequently (25%) to environmental performance goals.
There are a number of reasons why companies tie executive compensation to ESG. A recent roundtable by The Conference Board in collaboration with Semler Brossy sheds some light. Corporate participants cited the top reasons as signaling ESG as a priority, followed by responding to investor expectations and achieving ESG commitments the firm has made. Top reasons for not doing so include the challenge of defining specific goals, followed by concerns about measuring and reporting performance and skepticism about their effectiveness.
What to Look for in Management's Answer
Above all, management should be able to explain what ESG or broader business goals it is trying to achieve and why including ESG measures in compensation is necessary (or at least helpful) in doing so — especially since most companies say that including ESG measures in executive compensation is not vitally important to their overall ESG efforts. Management should be able to put linking compensation to ESG in a broader context of what the company is doing to advance its ESG agenda (e.g., incorporating ESG into business plans, talent development and promotions) and explain why the benefits of tying executive compensation to ESG performance outweigh the costs.
Red Flags in Management's Response
Boards ought to be wary if the goals that management wants to tie executive compensation to are not the firm's core ESG goals (e.g., if the proposed goals aren't aligned with the business strategy and do not reflect the company's key ESG risks and opportunities).
Boards should also have doubts if management tells them that incorporating ESG measures into executive compensation is an important way to signal that ESG is a priority, or that it's what investors want. Despite what companies might think, investors do not uniformly support incorporating ESG measures into executive compensation. In fact, some large institutional investors have been agnostic about ESG-based pay, especially if there is not a strong business case to link compensation to ESG goals.
Whose Compensation Would Be Affected?
Increasingly, C-suite executives other than the CEO are being compensated based on ESG performance. Some companies go beyond the C-suite to include the next tiers of management and even all employees. This can make sense when achieving ESG goals requires the collective effort of the broader management and general employee base.
What to Look for in Management's Answer
In deciding whose compensation should be linked to ESG goals, management will want to consider the link between the goal and the business strategy as well as the scope of responsibility for implementing the goal within the organization. It will likely take some time to appropriately incorporate ESG incentives into a compensation plan for the broader employee base.
Management should also caution boards that there are potential unintended consequences in applying ESG measures to the broader employee base — for example, the risk of different parts of the organization competing with each other for resources to achieve the same goals. Therefore, management should assign responsibility for implementation to specific teams and individuals, clarify how employees can influence ESG performance and facilitate interdepartmental collaboration.
Red Flags in Management's Response
Modifying everyone's compensation by using a brand-new measure can catch employees off guard. In particular, setting up a situation in which employees' pay might be cut (even by just a few percentage points) based on metrics that are unfamiliar or beyond their control can be extremely demotivating. That's a recipe for disaster for a company in a market in which attracting and retaining talented employees is so essential. For a performance measure to be effective, everyone should understand the goal, its connection to the business and their own role in achieving it.
If We Add ESG Measures to Our Executive Compensation Programs, How Should We Do It?
While most S&P 500 companies are linking executive compensation to ESG priorities, there isn't a one-size-fits-all approach for doing so. Looking at what others have done is an important part of due diligence, but there is no off-the-shelf solution.
It is most common for companies to put ESG performance measures in their executives' annual incentive plans. Ninety-seven percent of S&P 500 companies incorporating ESG performance metrics in incentive compensation put them in the annual bonus plan. Only 12% of companies put them in long-term incentive compensation, but this percentage may grow over time. The type of performance measure varies, and some companies use multiple approaches simultaneously:
- 49% of S&P 500 companies consider ESG as part of an executive's individual performance.
- 48% include it in business strategy scorecards.
- 24% use stand-alone ESG metrics.
- 6% use ESG performance to modify a financial or overall bonus rating.
What to Look for in Management's Answer
If a company decides to proceed with linking executive compensation to ESG goals, boards will want to ensure management considers:
- Whether the ESG goal is appropriate for the annual or long-term incentive plan.
- Whether to make performance measures absolute or relative to the market, and quantitative or qualitative.
- Whether the type of metric reflects the firm's corporate culture (some employees respond better to qualitative vs. quantitative metrics).
- How various stakeholder groups will likely react.
- How to reevaluate goals periodically to ensure that the ESG measures are still relevant and effective.
Red Flags in Management's Response
It is understandable that companies might want to ease into the practice of incorporating ESG performance in compensation by starting off with purely qualitative measures. But if the goals are vague, are purely qualitative or rely too heavily on committee discretion, it may signal that the company is moving to incorporate ESG performance before it is ready. To pass muster with investors, and to give executives and employees something to aim at, goals should be measurable, reportable and accountable.
How Are We Measuring the Impact of Including ESG Performance Goals in Compensation?
Measuring the full impact of including ESG performance goals in compensation is often more challenging than measuring the impact of traditional operating or financial metrics. Sometimes, measurement is relatively straightforward when it relates to the company's operations or workforce (e.g., changes in greenhouse gas emissions, waste, water usage, employee turnover or injuries). Often, however, the expected impact goes beyond the four walls of a company and relates to its relationship and reputation with different stakeholders or to its ability to effectuate broader change in the marketplace.
What to Look for in Management's Answer
As a prerequisite to measuring impact, management needs to clearly articulate what the company is striving to achieve by including ESG measures in compensation programs. Is it to improve the firm's ESG performance, to enhance its operating and financial performance, to signal to its stakeholders that ESG or a specific ESG metric is a priority, to have a meaningful impact on society and the natural environment, or some combination of factors?
Red Flags in Management's Response
The failure to define what a company is trying to achieve, and how it fits into a company's overall business and sustainability strategy, should raise eyebrows.
How Do We Communicate Our ESG Performance Goals Internally and Externally?
Adopting ESG measures in compensation provides a catalyst and vehicle for communicating with internal and external stakeholders. However, to be effective, management will need to ensure that communication about ESG performance goals is clear and consistent in substance and tailored to meet the needs of different audiences.
What to Look for in Management's Answer
Management needs to ensure there is not only a plan to tell people what the company is doing to incorporate ESG into compensation, but also a process for promoting the idea with those affected and interested. A comprehensive communications plan will address factors like:
- How including ESG in compensation advances the company's strategy and supplements its existing efforts.
- How the company will respond to skepticism from investors, employees, the media and others.
- How the goals are both ambitious enough (so investors do not see them as a way of delivering guaranteed compensation) and achievable (so affected employees are motivated to attain them).
Red Flags in the Response
Especially in this era of ESG backlash, boards should be wary if management isn't prepared to deal with skepticism (internal or external), and if they are overly optimistic about stakeholders' reactions to these goals.
If boards are comfortable with management's answers to these five questions, they can proceed with some confidence. Even so, directors may want to pause for a moment and consider other ways of advancing ESG goals — and driving meaningful change — rather than adding ESG measures to compensation. If management does proceed, directors should continue to ask these questions annually to assess whether executive compensation to ESG factors remains a good idea as the company's strategy, goals and position in the marketplace continue to evolve.