With the rising support for stakeholder capitalism and at the urging of its advocates, companies have been increasingly using ESG metrics for CEO compensation. In a recently released study, The Perils and Questionable Promise of ESG-Based Compensation, we provide a conceptual and empirical analysis of this practice, and we expose its fundamental flaws and limitations. The use of ESG-based compensation, we show, has questionable promise and poses significant perils.
Based partly on an empirical analysis of the use of ESG compensation metrics in S&P 100 companies, we identify two structural problems. First, ESG metrics commonly attempt to tie CEO pay to limited dimensions of the welfare of a limited subset of stakeholders. Therefore, even if these pay arrangements were to provide a meaningful incentive to improve the given dimensions, the economics of multitasking indicates that the use of these metrics could well ultimately hurt, not serve, aggregate stakeholder welfare.
Second, the push for ESG metrics overlooks and exacerbates the agency problem of executive pay, which have received closed attention from both scholars and policymakers. In particular, we warn that the use of ESG metrics threatens to reverse the progress achieved in the past few decades in making executive pay more transparent, more sensitive to actual performance, and more open to outside oversight and scrutiny.
To ensure that they are designed to provide effective incentives rather than serve the interests of executives, pay arrangements need to be subject to effective scrutiny by outsiders. However, our empirical analysis shows that in almost all cases in which S&P 100 companies use ESG metrics, it is difficult if not impossible for outside observers to assess whether this use provides valuable incentives or rather merely lines CEOs’ pockets through performance-insensitive pay. Encouraging and expanding the use of ESG-based compensation, we explain, gives self-interested executives a powerful tool to increase their payoffs without creating any significant incentives to deliver value to either stakeholders or shareholders.
The current use of ESG metrics, we conclude, likely serves the interests of executives, not of stakeholders. Expansion of ESG metrics should not be supported even by those who care deeply about stakeholder welfare.
Below is a more detailed account of our analysis:
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