What Boards Should Ask Management About Compensation and ESG: The board should understand the company's broader ESG goals to ensure the right approach is taken in linking pay to ESG performance.

• Author: Washington, Paul

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 this 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...