Stefan Reichelstein of the Mannheim Institute explores whether ESG pay schemes are effective at improving a company’s delivery of CSR measures

Interest in corporate social responsibility (CSR) has been on the rise for the better part of half a century, accompanied by the increasingly common use of environmental, social and governance (ESG) metrics to gauge the strength of commitment in organisations to responsible behaviour.

The last decade has seen a rapid increase in the number of ESG pay adopters, that is, companies that claim to include ESG metrics in their executive compensation schemes. According to the global ISS Executive Compensation Analytics database, the percentage of firms indicating that ESG targets feature among key performance indicators (KPIs) for executives climbed from just 3% in 2010 to over 30% in 2021. What data is available from the last year suggests this might have now grown to around 38%.

The theory behind so-called “ESG pay” is that if executives are rewarded with bonus pay for making progress on their company’s commitments to responsible and sustainable practices, they will be more likely to devote a greater amount of their time and attention to this end. But do the outcomes of ESG pay schemes match their intent?

Firms experience a number of benefits from articulating that they care about ESG outcomes. Some stakeholder groups have been shown to care about companies behaving responsibly, especially regarding social issues and the environment. Including ESG metrics among executives’ KPIs is a way for firms’ owners to let stakeholders know that management is paying attention to such issues.

Aligning the goals of senior management with stakeholders can result in organisations reaping the rewards from an improved corporate image and stronger loyalty among customers. There is also the potential that the company’s shares will become more attractive to certain investor groups.

Some institutional investors, such as BlackRock, have urged businesses to become transparent regarding their sustainability agendas, specifically as these agendas relate to financial uncertainty resulting from climate change. When investors consider the looming threat of an impending climate crisis, portfolios become more selective and unsustainable practices are viewed as financially risky.

However, the potential benefits for companies that affirm their commitment to CSR has led to concerns of “window-dressing”, or “greenwashing”, activities. This tends to occur in organisations whose owners and boards of directors see little benefit in improving ESG scores beyond enhancing the firm’s reputation. They would like to be perceived as responsible without having to walk the talk.

This sort of behaviour can be difficult to detect in the context of ESG pay schemes, as the way progress on ESG targets is measured, in order to make the decision whether bonus pay is deserved, often varies from company to company. Furthermore, outside observers are rarely able to access information on the relative weights given to different metrics in executive compensation schemes.

The opaqueness and subjectivity of what goes on within firms means we have to look at their impact on the environment and the communities they operate in if we are to find out whether ESG pay schemes are effective at improving companies’ CSR.

Crunching the numbers

In joint work with colleagues from the IESE Business School in Spain and a colleague from San Diego State University, we conducted empirical tests on data taken from the ISS Executive Compensation Analytics database to determine what factors contribute to businesses adopting ESG pay for executives. Our study covered a sample of 4,395 public firms from 21 countries, over a period spanning 2011 until 2020.

Our findings show that adopting ESG pay schemes is associated with firms receiving on average more favourable ESG scores from external rating agencies. These companies also tend to experience more tangible improvements in their carbon dioxide emissions. These patterns are especially pronounced in countries which are generally perceived as more ESG sensitive, in particular those within the European Union.

Both of these findings indicate that, for the most part, introducing ESG metrics as KPIs for executives translates into improved ESG performance for the company. It also suggests that most companies do not merely engage in window-dressing when they adopt ESG Pay practices.

As for executives, as long as they deliver on the ESG metrics, they stand to benefit from the introduction of ESG pay as well. We found that, after factoring in the impact of a firm’s accounting and stock price performance, executives at firms with higher external ESG ratings and reduced carbon dioxide emissions are rewarded with higher bonuses. However, these benefits are not observed by executives in organisations that have not adopted ESG pay schemes.

The effect on shareholder wealth is less clear-cut. We did not find a significant link between adopting ESG pay schemes and improved return on assets. This finding is consistent with the notion that some investment groups are insistent on firms making progress on ESG targets and are willing to accept lower returns as a consequence.

In terms of what contributes to firms deciding to adopt ESG pay, engagement with any of the three largest institutional investors – BlackRock, State Street, and Vanguard – tends to improve the likelihood of this happening. From gathering information on the role played by investor groups, we also observed that investors generally tilt their portfolios in favour of firms that already have ESG pay schemes in place.

Location was another important factor. Not only do firms with ESG pay schemes in place achieve better ESG ratings in “sensitive” countries, companies across the board are more likely to introduce sustainability targets to executives’ KPIs. Indeed, in many of these countries, some form of ESG reporting is already mandatory for businesses. Companies in environmentally burdensome industries, for example, those with high levels of carbon emissions or chemical waste, also tended to have a higher ESG Pay adoption rate.

Aside from national and sector-specific pressures, at the level of individual companies, we found that larger organisations with higher volatility were more likely to add ESG criteria to executive compensation schemes. So too are corporations that have already made public commitments to sustainability.

The reason that larger firms are more likely to adopt ESG pay schemes for executives than smaller businesses is partly due to the significant costs of implementing ESG strategies. Added to this is the fact that big corporations have far greater visibility, thereby increasing the chances that they will be subjected to ESG activism and regulatory pressure.

Taken as a whole, the role of ESG pay seems effective at encouraging executives to allocate more time and attention on pursuing their company’s ESG targets. While the internal processes for assessing performance and awarding bonuses remain somewhat opaque to outsiders, the majority of companies that adopt ESG metrics as KPIs also experience subsequent improvements in these metrics.

ABOUT THE AUTHOR

Professor Stefan Reichelstein is the Director of the Mannheim Institute for Sustainable Energy Studies and a Professor of Business Administration at the University of Mannheim.