With the rising interest in ‘corporate social responsibility’ principles, a broad set of ‘environmental, social, and governance’ (ESG) variables have been proposed as metrics to gauge corporate social responsibility efforts. Recent survey evidence suggests that the proportion of global firms that include ESG metrics in their executive compensation has grown rapidly (Gosling et al. 2021).
In a recent paper (Cohen et al. 2022), we conducted an international study of the practice of including ESG metrics in executive compensation schemes (henceforth referred to simply as ‘ESG pay’). Based on data from a wide cross-section of firms around the world, we document several empirical patterns.
The first striking finding is the recent growth rate of ESG pay. As shown in Figure 1, the share of firms indicating that some ESG metrics are key performance indicators (KPIs) for their executives has grown from 3% in 2010 to over 30% in 2021. In other words, Figure 1 highlights that the widespread use of ESG pay is a recent phenomenon.
Figure 1 Use of ESG metrics in executive compensation
Our empirical analysis is focused on two broad issues related to the practice of ‘ESG pay’: Who are the adopters of ESG pay and what economic outcomes are associated with the inclusion of ESG metrics in executive compensation schemes? And more specifically, what characteristics, such as geographic location, size, industry, and ownership structure, tend to make firms more prone to adopt the practice of ESG pay?
From an agency and stewardship perspective, one would expect reliance on ESG metrics in executive compensation packages, provided a firm’s owners and the board of directors acting on their behalf intrinsically care about ESG outcomes. Some institutional equity investors (e.g. BlackRock) have urged firms to articulate their responses to the impending financial risks resulting from climate change (Azar et al. 2021). In particular, carbon emissions are viewed as indicators of future financial risks. Reliance on ESG pay would then be in line with earlier agency-theoretic findings demonstrating the value of including operational metrics, such as product quality or customer satisfaction, in managerial incentive contracts (Sliwka 2002, Dutta and Reichelstein 2003). This prediction emerges even if the firm’s share price, a key indicator of future performance, is available for contracting purposes.
Another rationale for including ESG metrics in executive compensation schemes is that these metrics frequently pertain to external costs that are not properly accounted for in a market economy. Carbon emissions and climate change are prime examples in this context. Owners can then credibly convey to the firm’s stakeholders that management’s attention will be drawn to these external effects. In addition to improving the general corporate image, a firm’s commitment to be ‘ESG conscious’ may strengthen customer loyalty and make the firm’s equity shares more attractive for certain investor groups.
However, ESG pay could also be adopted as mere ‘window-dressing’ or an attempt at ‘green-washing’ (Grewal and Serafeim 2021). In the context of ESG pay, window-dressing may be tempting for firms whose owners are sceptical regarding the financial benefits emerging from higher ESG scores, except for the general benefit that results from improving the firm’s corporate image and its standing with certain stakeholder groups. Ideally, those firms would like to be perceived as being ‘ESG responsible’ without having to ‘walk the talk’. Window-dressing is arguably difficult to detect in the context of ESG pay because the measurement of these variables is frequently subjective at the firm level. Furthermore, outside observers generally do not have access to the relative weights given to different performance indicators, the use of targets and thresholds, as well as the exact form of the executive payout function.
Our analysis shows that several external factors appear to make firms more prone to adopt ESG pay. At a macro level, the inclusion of ESG metrics in compensation contracts is more common in countries that are generally perceived to be ‘ESG sensitive’, for example because some form of ESG reporting is already mandatory. As one might expect, firms operating in environmentally burdensome industries also have a higher proclivity to adopt ESG pay. At the firm level, we find that, aside from size and volatility, the practice of ESG pay is associated with firms that have publicly issued environmental commitments and those where institutional shareholders have a relatively large ownership share.
In terms of subsequent outcomes observed for the adopters of ESG pay, we find that these firms receive, on average, more favourable ESG scores from outside rating agencies. ESG pay adopters also tend to experience improvements for one key environmental ESG metric: the firm’s carbon dioxide emissions. These patterns are more pronounced in ESG sensitive countries, specifically countries within the EU.
Regarding executive compensation consequences, our results indicate that, after controlling for accounting and stock price performance, executives of firms exhibiting higher ESG ratings and lower CO2 emissions receive higher variable compensation. This finding does not emerge for firms that do not adopt ESG pay.
The effect of ESG pay on shareholder wealth is less clear-cut. We find no positive association with financial outcomes, such as return on assets, and even find a decrease in stock returns after the adoption of ESG pay.
Taken together, our findings on the determinants of and outcomes associated with ESG pay are consistent with the hypothesis that ESG pay provisions supplement traditional financial metrics in executive compensation packages in a substantive manner. The results also suggest that investment groups insistent on attention to ESG criteria are indeed willing to accept lower financial returns for improvements in ESG dimensions. Among other things, our evidence has implications for the ongoing debates around the current efforts to transition towards a greener economy (e.g. Bolton et al. 2021) and the role of institutions in the economy (e.g. Azar and Vives 2022).
Azar, J, M Duro, I Kadach and G Ormazabal (2021), “The Big Three and Corporate Carbon Emissions around the World”, Journal of Financial Economics 142: 674-696.
Azar, J and X Vives (2022), “Revisiting the anticompetitive effects of common ownership”, VoxEU.org, 15 June.
Bolton, P, S Reichelstein, M Kacperczyk, C Leuz, G Ormazabal and D Schoenmaker (2021), “Mandatory carbon disclosures and the path to net zero”, VoxEU.org, 4 October.
Cohen, S, I Kadach, G Ormazabal and S Reichelstein (2022), “Executive Compensation Tied to ESG Performance: International Evidence”, CEPR Discussion Paper No. 17267.
Dutta, S and S Reichelstein (2003), “Leading indicator variables, performance measurement, and longterm versus short-term contracts”, Journal of Accounting Research 41: 837-866.
Gosling, T, L Harris, C Hayes Guymer, P O’Connor and A Savage (2021), “Paying Well by Paying for Good”, PwC and London Business School.
Grewal, J and G Serafeim (2021), “Research on Corporate Sustainability”, Foundations and Trends in Accounting.
Sliwka, D (2002), “On the use of nonfinancial performance measures in management compensation”, Journal of Economics and Management Strategy 487-511.