Business managers, particularly at poorly governed firms, are likely exploiting “less transparent ESG metrics” to set targets in ways that are likely to be achieved, either to enhance their compensation or to appease institutional investors and other stakeholders who demand greater ESG accountability, according to research published by the European Corporate Governance Institute (ECGI).
Researchers from the University of California, Berkeley, and Stanford University assessed the use of ESG targets in executive compensation plans and found meeting ESG-based targets “is not associated with improvements in ESG scores” and the presence of ESG-linked compensation “contributes to more opposition in say-on-pay votes”.
Additionally, some 63% of S&P 500 firms include an ESG component in their executives’ compensation, according to their findings, and the vast majority of these incentives are part of an annual incentive (AIA) plan, rather than part of a long-term equity incentive (LTI) plan.
While executives were found to miss all of their financial targets 22% of the time in the sample, the researchers were able to show that this outcome was exceptionally rare for ESG-based compensation – just six of 247 firms that disclosed an ESG performance incentive report missing all of their ESG targets.
Adam Badawi and Robert Bartlett – co-authors of the paper – wrote the inclusion of performance goals such as sustainability and diversity within executive compensation plans “may have been a response to institutional investor demand for better ESG performance”. But, while there are some indications that this demand is pulling back from a high point, the widespread adoption of these performance measures “raises several questions about their use”.
As well as applying ESG targets only to the company’s AIA plan, rather than the more substantial LTI plan, the authors also expressed concerns over the level of difficulty in achieving specified targets.
They cite two challenges in establishing performance goals. Firstly, ESG metrics “are more likely to focus on less transparent operating measures, such as those relating to carbon emissions, workplace conditions or hiring and promotion practices”. This lack of transparency “impairs the ability to assess the difficulty of an ESG performance target relative to past performance and to verify that the target has been achieved”.
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Secondly, given the direct relationship between management compensation and achieving performance targets, the authors note that “it should hardly be surprising if managers were to use less transparent targets to set targets that are easy to achieve”. Such incentives, they continued, may also be amplified to the extent companies adopt ESG performance measures to satisfy investors who expect a company to outperform its ESG goals.
ESG overperformance, the researchers therefore conclude, is likely related to “governance deficiencies” rather than exceptional ESG outcomes.
‘No panacea’ to performance pay out discrepancies
In sharing the research, Alex Edmans (pictured), professor of finance and London Business School, said the implication is not that we should have more financial targets, but have fewer bonuses and instead “pay the CEO predominantly with long-term equity”. According to Edmans, this could incentivise a CEO to improve all relevant performance dimensions, not just those in their bonus contract.
However, Morningstar Sustainalytics’ director of stewardship research and policy, Lindsey Stewart, added, while he tends to agree with Edmans that increasing the proportion of executive pay aligned to truly long-term outcomes for equity owners is a desirable goal, “it’s not a panacea”.
“The paper raises some interesting questions, and the idea that non-GAAP performance metrics, ESG-related or otherwise, may trigger payouts to executives for less-than-extraordinary performance is certainly not a new one. Yet, even over the long term, not everything at a company that influences its performance and valuation ends up baked into the share price. And there’s always the question of whether paying a CEO with long-term equity actually prompts management to seek an expedient, if not necessarily optimal, M&A deal in the short term, triggering quick payouts of ‘long-term’ incentives. If any of this was easy, we’d have found the answer by now!”
