The conundrum of profit versus sustainability
Executive pay packages have traditionally heavily relied on share price-related performance. This has engendered “runway compensation”. Now a new movement of engaged stakeholders are urging companies to demonstrate accountability and transparency through linking ESG performance with pay. For instance, Cevian Capital and Allianz Global Investors have pledged to vote against major European companies that do not incorporate ESG objectives into executive compensation contracts. A few bodies have provided guidance towards ESG-linked pay and have underlined the importance of scrutiny by investors. (see PRI recommendations and The UK Transition Plan Taskforce (TPT)).
One of the debates around ESG-linked pay is evidence around ESG outcomes associated with ESG pay. Stanford Professor Stefan Rechelstein and his colleagues published a study on a sample of nearly 4,400 public companies in 21 countries which found that “when firms include emission-specific metrics in their executive compensation packages, they also achieve a subsequent decrease in their CO2 emissions,” and “the adoption of ESG pay is also accompanied by relative improvements, as measured by third-party ESG ratings”. Then comes the next question: Do ESG outcomes impact shareholder wealth? In an article
published in the Review of Corporate Finance, researchers suggest that ESG targets are likely to compete with financial targets and put additional demand on a CEO’s skill set. They observed that generalist CEOs (versus specialists) have a broader skillset and are more likely to succeed in ESG-linked contracts as they are best suited to address the complexity of ESG delivery. Both research pieces show that in the short term ESG outcomes do not improve financial performance. Researchers propose a new concept of “shareholder utility” versus
“shareholder wealth” to reflect the benefits to society of ESG outcomes.
Finally, there is scepticism around the choice of ESG indicators to tie to executive pay. Chosen metrics (qualitative and quantitative) might not necessarily capture the most critical factors of a company’s operations resulting in material issues being ignored. The choice of metrics could also have a reverse effect on ESG performance. E.g. in the case of a lagging social
indicator, there might be pressure to not report issues in order to achieve the metric.
There is too little data yet to fully assess the effectiveness of ESG-linked pay over a company’s ESG outcomes but one fact is certain, companies with an ESG-linked pay are showing that they care about governance.
Sources:
Patrick J. Kiger. Does It Pay to Link Executive Compensation to ESG Goals? Insights by Stanford Business (2023).
Cohen, S., Kadach, I., Ormazabal, G., & Reichelstein, S. (2023). Executive Compensation Tied to ESG Performance: International Evidence. Journal of Accounting Research.
Homroy, S., Mavruk, T., & Nguyen, V. D. (2023). ESG-Linked Compensation, CEO Skills, and Shareholder Welfare. The Review of Corporate Finance Studies.
Transition Plan Taskforce (2022).The Transition Plan Taskforce Implementation Guidance.