Environmental, social, and governance metrics are receiving increasing attention as measures of corporate performance. This column uses cross-sectional data to assess the prevalence and impact of including such metrics in executive compensation schemes. The use of ‘ESG pay’ has grown rapidly over the past decade, with more than 30% of organizations including ESG metrics among their key performance indicators by 2021. This is more common in countries considered sensitive to ESG concerns. Companies adopting ESG pay receive more favorable ESG scores from rating agencies, but the impact on shareholder wealth is unclear.
With the growing interest in ‘corporate social responsibility’ principles, a wide set of ‘environmental, social and governance’ (ESG) variables have been proposed as metrics to measure corporate social responsibility efforts. Recent survey evidence suggests that the proportion of global firms that incorporate ESG metrics into 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 incorporating ESG metrics into executive compensation schemes (henceforth simply referred to as ‘ESG pay’). Based on data from a broad cross-section of firms across the globe, we document several empirical patterns.
The first interesting finding is the recent growth rate of ESG salaries. As shown in Figure 1, some ESG metrics are Key Performance Indicators (KPIs) for their executives whose share of companies has increased from 3% in 2010 to 30% in 2021. In other words, Figure 1 highlights that widespread use of ESG pay is a recent phenomenon.
Figure 1 Use of ESG Metrics in Executive Compensation
Our empirical analysis focuses on two broad issues related to ‘ESG pay’ practices: who receives 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, make firms more prone to adopt ESG pay practices?
From an agency and stewardship perspective, one would expect reliance on ESG metrics in executive compensation packages, if a firm’s owners and the board of directors acting on their behalf care intrinsically about ESG outcomes. Some institutional equity investors (such as BlackRock) have urged firms to disclose their responses to impending financial risks from climate change (Azar et al. 2021). In particular, carbon emissions are seen as an indicator of future financial risk. Reliance on ESG pay would then be consistent with previous agency-theoretic findings demonstrating the value of 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 argument for including ESG metrics in executive compensation schemes is that these metrics often relate 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 communicate to the firm’s stakeholders that management’s attention will be drawn to these external influences. In addition to improving the general corporate image, a firm’s commitment to being ‘ESG aware’ can strengthen customer loyalty and make the firm’s equity stake more attractive to certain investor groups.
However, ESG pay can also be perceived as mere ‘window-dressing’ or an attempt at ‘green-washing’ (Grewal and Seraphim 2021). In terms of ESG payoff, window-dressing can be tempting for firm owners who are skeptical of the financial benefits arising from high ESG scores, apart from the general benefits of improving the firm’s corporate image and its standing with certain stakeholder groups. Ideally, those companies want to be perceived as ‘ESG responsible’ without having to ‘walk the talk’. Window-dressing is arguably harder to detect in the context of ESG pay because the measurement of these variables is often subjective at the firm level. Furthermore, outside observers typically do not have access to the relative weights given to various 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 make firms more inclined to adopt ESG pay. At a macro level, the inclusion of ESG metrics in compensation contracts is more common in countries that are generally considered to be ‘ESG sensitive’, for example because some form of ESG reporting is already mandatory. As one might expect, firms operating in environmentally laden industries also have a higher propensity to adopt ESG pay. At the firm level, we find that, excluding size and volatility, ESG pay practices are associated with firms that have expressed environmental commitment and where institutional shareholders have relatively large ownership.
Looking at subsequent results for ESG payees, we find that these firms receive, on average, more favorable ESG scores from outside rating agencies. ESG payees also experience improvements for a key environmental ESG metric: the firm’s carbon dioxide emissions. These patterns are more pronounced in ESG sensitive countries, especially those within the EU.
Regarding the results of executive compensation, our results indicate that, after controlling for accounting and stock price performance, executives in 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 impact of ESG pay on shareholder wealth is less clear. We find no positive relationship with financial outcomes, such as return on assets, and even a reduction in stock returns after adopting ESG pay.
Taken together, our findings about the determinants and outcomes associated with ESG pay are consistent with the hypothesis that ESG pay provisions complement traditional financial metrics in executive compensation packages. The results also suggest that investment groups that insist on paying attention to ESG criteria are actually willing to accept lower financial returns to improve ESG levels. Among other things, our evidence has implications for current efforts to transition to a green economy (e.g. Bolton et al. 2021) and ongoing debates around 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), “Rethinking 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 disclosure and the path to net zero”, VoxEU.org, 4 October.
Cohen, S, I Kadach, G Ormazabal and S Reichelstein (2022), “Linking Executive Compensation to ESG Performance: International Evidence”, CEPR Discussion Paper No. 17267.
Dutta, S. and S. Reichelstein (2003), “Leading Indicator Variables, Performance Measurement, and Long-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 Good for Paying”, PwC and London Business School.
Grewal, J and G. Seraphim (2021), “Research on Corporate Sustainability”, Foundations and Trends in Accounting.
Sliwka, D (2002), “On the Use of Non-Financial Performance Measures in Managerial Compensation”, Journal of Economics and Management Strategy 487–511.