Why are firms adopting ESG Pay?

A growing number of firms are incorporating ESG criteria in executive compensation contracts (henceforth, I will refer to this compensation practice as “ESG pay”). Based on data on thousands of firms across the world, a recent ECGI Working Paper finds that the percentage of listed firms linking executive pay to ESG performance has grown from 1% in 2011 to 38% in 2021. In some industries, this percentage is as high as 70%.

These statistics raise a natural question: Why are firms adopting ESG Pay? The answer is not obvious. To begin, one could argue that caring about the planet and social justice is a “must”, and thus should not be subject to variable remuneration. A related argument is that executives already have powerful non-monetary incentives to improve ESG performance in the form of social pressure, reputation, and the like. One could reply to the previous objections that monetary incentives are necessary because the current ESG ambitions of our society entail a dramatic transformation of the economy, which requires that executives go the extra mile. But even if we accept this perspective, it is not completely obvious that we need ESG pay. Let me elaborate.

Top executives frequently make a business case for ESG. For example, it is commonly argued that improving ESG performance has beneficial effects on the product markets (consumers care about ESG), on the labor market (ESG helps retain and attract talent), and on the financial market (investors increasingly demand ESG performance). Not only that, the effort to improve ESG could result in mitigation of critical risks such as those related to climate change and social unrest. And there is yet another potential benefit: higher ESG performance could prevent regulatory scrutiny and activism.

There is an ongoing debate about how to design sustainability reporting rules, and commercial ESG ratings are subject to substantial criticism.

If we buy into the above arguments, we should expect that ESG efforts translate into financial performance. So why do we need to introduce ESG metrics in compensation contracts? Doesn’t the previous argument suggest that ESG performance will eventually show up in financial metrics? Moreover, do we trust ESG metrics? Keep in mind that measuring ESG performance is an extremely difficult task. ESG is a multidimensional concept with many aspects that are hard to quantify. In fact, there is an ongoing debate about how to design sustainability reporting rules, and commercial ESG ratings are subject to substantial criticism. Let’s face it – we still have a lot to learn in terms of measuring ESG performance. The metrics we currently use suffer from important limitations.

When it comes to measuring ESG performance, financial metrics also suffer from significant constraints

The problem is that, when it comes to measuring ESG performance, financial metrics also suffer from significant constraints. First, performance measures such as ROA, EBITDA and EPS are based on accounting information. It is well known that financial statements have a limited ability to incorporate forward-looking and intangible information (among other things, due to accounting conservatism). For example, it is unlikely that accounting earnings fully capture the beneficial effects of ESG on shareholder returns, as some of these effects are hard to measure and too uncertain to be recognized in financial statements.

What about basing compensation on the stock price of the firm? True, the stock price is forward looking and does incorporate intangibles. However, it relies on market efficiency, which has its limits. For example, do stock prices capture the potential future consequences of climate risk and social unrest? Even the strongest advocates of market efficiency would doubt that the market can quantify future events that have a high degree of uncertainty.

Beyond performance measurement considerations, ESG pay could also be one way to signal to the market that the firm is committed to ESG.

Does this mean that there is a case for using ESG metrics in executive compensation schemes? Probably yes. These metrics could be valuable for contracting purposes to the extent that they can tell us something about future financial performance that financial metrics are not able to tell us due to the limitations of accounting earnings and stock prices. While important, the previously mentioned measurement issues do not necessarily mean that all ESG metrics are uninformative. Beyond performance measurement considerations, ESG pay could also be one way to signal to the market that the firm is committed to ESG.

But the previous discussion also suggests that the need for ESG pay varies across companies. Accordingly, a successful implementation of this practice requires a careful and tailored design of the compensation arrangement – especially of the ESG metrics – consistent with the characteristics and the strategy of the company. Firms should also keep in mind that incentive schemes should be clear and relatively simple; overcomplicated contracts could generate confusion and perhaps even unintended behavior.

------------------------

Gaizka Ormazabal is Professor of Accounting and Control at IESE Business School and Grupo Santander Chair of Financial Institutions and Corporate Governance, and ECGI research member.

This article first featured in IESE Business School Corporate Governance Insights newsletter

This article reflects solely the views and opinions of the authors. The ECGI does not, consistent with its constitutional purpose, have a view or opinion. If you wish to respond to this article, you can submit a blog article or 'letter to the editor' by clicking here.