Companies are increasingly using ESG metrics in CEO compensation packages. New empirical research suggests that this practice has dubious promise and creates significant risks.
Corporations are increasingly pledging their stakeholders to support capitalism, but these pledges have been met with significant skepticism by some observers. A major criticism I have presented in previous research is that corporate leaders lack incentives to consider the interests of employees, suppliers, the environment, or other stakeholders. Therefore, reliance on management discretion does not create value for stakeholders.
In response to this criticism, companies are increasingly using ESG metrics in CEO compensation packages. According to a recent report by advisory firm Willis Tower Watson, 51% of S&P 500 companies use his ESG metrics as part of their pay evaluations, and the Financial Times recently published a report on large companies using climate change pay targets. reported more than double the number of From 2019 to 2020.
The idea behind this trend is that corporate leaders can incentivize stakeholder well-being by tying compensation to ESG goals. A recently published study, “The Risks and Questionable Promises of ESG-Based Compensation,” provides a conceptual and empirical analysis of this practice, revealing its fundamental flaws and limitations. The use of ESG-based rewards has dubious prospects and poses significant risks.
S&P 100 companies account for more than half of all US stock markets and probably have a significant impact on stakeholders and society at large. We found that just over half (52.6%) of S&P 100 companies are including some ESG metrics in their 2020 CEO compensation packages. These indicators focus primarily on employee composition and employee treatment, as well as customers and the environment, but also communities and suppliers.
ESG metrics are primarily used as performance targets to determine annual cash bonuses. However, most companies do not disclose the weighting of ESG targets to overall CEO compensation, and those that do (27.4% of companies with ESG metrics) give very modest weightings to ESG factors. (between less than 1% and 12.5%). , most companies assign a weight between 1.5% and 3% of him).
Interestingly, despite stakeholder rhetoric prevalent, it signed the 2019 Business Roundtable Statement on Corporate Purpose, in which it committed to delivering value to all stakeholders. Many companies do not use ESG metrics in their CEO compensation arrangements. In fact, of the 62 sample companies that signed the statement, 42% do not use stakeholder incentives for their CEOs. This finding seems to be consistent with views we have expressed in previous research (“The Fantastic Promise of Stakeholder Governance” and “Do Companies Provide Value to All Stakeholders? ). More than a real redefinition of corporate purpose.
Our empirical analysis highlights two structural limitations of ESG-based compensation practices. The first limitation lies in using a limited number of welfare dimensions for a limited number of stakeholders. Despite the promise of the new paradigm to deliver value to “all stakeholders”, the potential breadth of a company’s stakeholders, and the different ways in which stakeholder interests are affected by company decisions , in practice, companies select a small subset of stakeholder groups and interests. concentrate.
For example, employees care about keeping their jobs. their absolute level of compensation, their relative level of compensation compared to other employees in similar roles (e.g., gender pay gap or race pay gap), relative remuneration levels, etc. Highly paid managers (such as CEO pay ratios), health insurance and other benefits, unemployment protection, health and safety, workplace culture and engagement, diversity and inclusion, and many other aspects of the employment relationship. However, most companies in our sample chose goals related to inclusion or diversity, many focused on occupational injuries and illnesses, but asked their CEOs to increase salary and benefits or increase employment. Nothing encourages us to improve our stability or make progress in any of the other aspects. important to employees.
The narrowness of ESG metrics exposes the limitations of ESG-based rewards and also raises well-known problems in the economics of multitasking. By incentivizing CEOs to improve performance on a small number of limited, quantifiable metrics, companies are skewed incentivized not to focus on other important dimensions, including some that are difficult to quantify. produces
“Our analysis suggests that ESG remuneration trends should not be expected to create meaningful incentives for stakeholders to create value and risk creating ambiguous, opaque and manipulable remuneration components. It shows what it brings.”
A second structural limitation of ESG-based compensation relates to the underlying agency issues involved in executive compensation. Because CEOs wield so much influence over the board, they can extract more value from the company through over-the-top compensation packages. To mitigate this agency problem, compensation arrangements should be tied to performance and companies should disclose sufficient information to allow external observers to see and assess the implications of performance.
However, very few companies in our sample use ESG metrics that meet this criteria. Most companies mention his use of ESG targets, but either fail to disclose relevant targets and actual results, or give the board considerable discretion. Among the very few companies that disclose clear, objective goals and actual results, few provide enough contextual information to allow outsiders to review and evaluate salary arrangements.
Our analysis has important implications for the broader discussion of ESG-based compensation practices and stakeholderism. According to our analysis, ESG compensation trends should not be expected to create meaningful incentives for stakeholders to create value, and risk creating ambiguous, opaque and manipulable compensation components. It shows that there is a – Concerned CEOs inflating profits with little to no accountability for their actual performance.
The demand for ESG-based compensation is based, explicitly or implicitly, on the recognition that corporate management alone does not have strong enough incentives to focus on stakeholder well-being. We agree with this perception. In fact, we believe that is the fundamental weakness at the core of stakeholderism. Given this, campaigns promoting and expanding the use of ESG reward metrics can be construed as a sincere attempt to address this very important issue.
However, our conceptual and empirical analysis shows that the current use of ESG metrics by companies is seriously flawed. Moreover, such use indicates that it suffers from certain structural problems that are difficult to address, severely limit potential benefits, and pose considerable hazards. The growing use of ESG metrics, which are endorsed by the public and have incentives for corporate leaders to adopt them, is likely to backfire, he warns. It likely delivers little value to stakeholders and works to increase executive compensation without improving incentives.
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