Reward Executives for Environmental and Social Success

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Idea #868

Reward Executives for Environmental and Social Success

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KEY CONCEPT

More companies are including environmental, social, and governance (ESG) metrics in their compensation plans for executives, driven by concerns for the costs and risks of low ESG performance, pressure by shareholders, and a desire to support ESG pledges with positive ESG results.

IDEA SUMMARY

A significantly increasing number of companies—from 3% in 2010 to more than 30% in 2021—are incorporating environmental, social, and governance (ESG) metrics, in their executive compensation plans.

The number of global companies incorporating environmental, social, and governance (ESG) metrics—e.g., lower carbon emissions, greater diversity, or a positive, effective company culture—in their executive compensation plans have increased from 3% in 2010 to more than 30% in 2021.

An in-depth study of ESG metrics in executive compensation identifies three rationales that explain why firms adopt “ESG pay” (to use the terminology of the study):

Costs and benefits. ESG pay reflects an appreciation for the costs and benefits impact of a firm’s ESG performance. ESG metrics are seen as leading indicators of financial performance and potential risks.

Alignment of managerial incentives with shareholder preferences. Institutional investors, for example, look for higher ESG performance, based not only on their own organizational values but also to satisfy client concerns.

Proof of follow through on ESG commitments. Firms want to prove that their explicit ESG pledges are not window-dressing but reflect a sincere effort to improve the ESG performance of the firm.

Using the Executive Compensation Analytics database of proxy firm ISS, the researchers analyzed the executive compensation criteria for 4,395 public firms from 21 countries between 2011 and 2020. This compensation information was correlated with data from multiple sources covering the metrics required for the research, including firm greenhouse gas emissions, ESG ratings, institutional ownership, and financial performance, as well as broader information on country attitudes towards ESG and industry ESG constraints.

The study found that each of the three rationales explained in part the adoption of ESG metrics in executive compensation plans.

The research did not link ESG pay to better financial performance, but did highlight the influence of costs and benefits concerns in prompting firms to adopt ESG pay. Specifically, the researchers found that firms with ESG pay were more likely to be:

In countries with heavier ESG regulations and a greater social sensibility to sustainability issues and in industries with a higher environmental footprint—factors that increase the cost of lower ESG performance.
Larger firms, who were more likely to be scrutinized for their ESG performance by both activists and regulators.
Firms with higher levels of carbon emissions and that exhibited volatility in stock returns—factors that render ESG performance indicative of future firm performance.

The research also confirmed that the influence of shareholder preference in ESG pay. Focusing on the connection between the firms studied and the Big Three asset managers—BlackRock, Vanguard, and State Street—the researchers found that ESG pay was more likely in firms with a higher percentage of institutional ownership. The study also linked ESG pay and the engagement, voting, and trading activities of these institutional investors. Specifically, institutional investors were more likely to engage with firms with ESG pay through substantive phone calls and in-person meetings, vote for directors and compensation plans that supported or incorporated ESG pay, and increase their holdings in firms with ESG pay.

Finally, the researchers found that firms that made explicit pledges of good governance and environmentally and socially friendly behaviour, and who fulfilled their commitments with higher ESG performance, were more likely to institute ESG pay for their executives.

BUSINESS APPLICATION

Through its broad review of the country, industry, and firm-level considerations behind the decision by a growing number of firms to incorporate ESG pay, this study offers designers of executive compensation plans can use this study to review the range of factors—from the unique environmental and political context of their firm to whether ESG factors are leading performance indicators in their industry to their shareholder preferences—that will contribute to the creation of a compensation package that ensures maximum managerial incentives for the levers of the firm’s success.

REFERENCES

Executive Compensation Tied to ESG Performance: International Evidence. Shira Cohen, Igor Kadach, Gaizka Ormazabal, and Stefan Reichelstein. IESE Business School Working Paper; Stanford University Graduate School of Business Research Paper (March 2023).

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4094283

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Idea conceived

November 17, 2023

Idea posted

Dec 2023

Subject

Corporate Social Responsibility

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