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E-MailMarco Dell’Erba is a Professor of Law at University of Zurich, and Suren Gomtsyan is an Assistant Professor of Law at LSE Law School. This post is based on their recent paper.
The rise of responsible capitalism has driven significant changes in corporate governance, including the integration of ESG (environmental, social, and governance) metrics into executive compensation. This trend has gained rapid adoption among major corporations worldwide, with compensation committees increasingly embedding ESG targets into pay structures. Studies show a steep increase in the share of companies that incorporate ESG metrics in the design of executive pay. As a result, the large majority of S&P 500 companies link a portion of executive incentive compensation to the achievement of ESG metrics. The proportion of publicly traded companies incorporating ESG metrics into executive pay is larger in the UK’s FTSE 100 index and in other European countries.
Support for this trend is coming from different corners: financial regulators, prominent compensation consultants, investors, and academics. For instance, one of the proposals in the climate change framework of the Basel Committee on Banking Supervision encourages banks to review their pay and bonus structures to make sure that they are consistent with long-term goals on dealing with the climate change. Similarly, Willis Towers Watson, a global professional services company, advocates using executive compensation to align the interests of executives with employees and other stakeholders. PwC, a consulting and audit firm, goes even further, advocating the use of ESG metrics not only in the pay of executive directors but for other employees as well. Investor pressure is also on the rise. Several major UK and European investment management groups – such as Allianz Global Investors, Cevian Capital, Amundi Asset Management, AXA Investment Managers, DWS Investments, and Legal & General Investment Management – urge corporate boards to add ESG metrics in executive pay design.
This practice, however, raises significant doubts and important questions. Can use of ESG metrics in executive remuneration be effective in changing the behavioural incentives of executive directors? Can a standard best practice approach work in every company? Or does the effectiveness of pay related ESG metrics depend on specific circumstances, such as the overall design of compensation related incentives, the company’s core business, its business model, and internal governance? In the latter case, ESG metrics need to be used sparingly and not every company needs them. Related to this, and moving towards a normative perspective, should regulatory rules, industry best practice norms, and investor voting and engagement policies promote blanket demands for the inclusion of ESG metrics in the structure of executive compensation for all companies? These are questions at the very center of the ongoing debate on the use of ESG metrics in executive remuneration.
Our article challenges the effectiveness and necessity of universally applying standard ESG metrics in compensation structures and aims to construct a framework for a more contextual and nuanced application of ESG-linked executive compensation. The analysis highlights the limitations of ESG objectives unrelated to shareholder value and demonstrates the limited circumstances where some company specific ESG objectives can drive rapid changes in targeted performance by drawing attention to these objectives.
First, we review various challenges that the use of ESG measures in compensation face to show that an ESG measure is effective for achieving quick and meaningful improvements in targeted performance. However, the attainment of this short-term goal does not necessarily translate into better overall financial performance or more responsible corporate behaviour in the long-term. As a further extension of this conclusion, aggregate ESG measures must be avoided because they fail to highlight specific areas that require immediate improvements and encourage reflective behaviour aimed at maximising the score of the aggregate measure.
Second, we develop a framework for assessing the impact of pay-linked ESG metrics to show that the conditions for the effective use of ESG metrics in executive compensation are narrow. In addition to the need to overcome the challenges of measuring ESG goals, the selected ESG measure must align and not compete with the core financial incentives included in the executive compensation plan. By contrast, ESG targets related to corporate externalities are likely to fail unless the entire compensation plan is reformed so that the reduction of externalities – not financial performance – becomes its core focus. Accordingly, ESG measures can be used to improve performance on a material aspect of corporate strategy where a company needs a significant and visible change in a short timeframe.
Third, a key implication of our framework is that pay-linked ESG measures are not a universal solution for every company. ESG metrics that can work effectively may be irrelevant for some companies; adding others for the sake of having ESG metrics in pay may lead to waste and inefficiencies like any poor corporate governance arrangement. Moreover, the widespread adoption of ESG metrics and the need to oversee their use can dilute shareholder resources and direct attention away from companies that need those metrics the most. This means that a standard approach to the use of ESG metrics in pay must be avoided.
These findings question the evolving practice of a uniform integration of ESG metrics in compensation plan design of all companies and urge regulators, institutional investors, and corporate boards to adopt a more tailored, focused, and selective strategy in integrating ESG metrics into executive pay.
