by Shira Cohen, Igor Kadach, Gaizka Ormazabal, andStefan Reichelstein
Recent years have witnessed a rapidly growing interest in the role that
Environmental, Social and Governance (ESG) criteria play in shaping the
decisions of major corporations. In a recent paper,we provide initial
systematic evidence of the use of ESG performance metrics in executive
compensation contracts in a broad international sample.
The practice of including ESG metrics in executive compensation schemes
(henceforth referred to simply as “ESG pay”) raises two broad sets of questions.
First, what are the firm characteristics, such as geographic location, industry or
ownership structure, and board composition, that tend to make firms more
prone to adopt the practice of ESG pay? Second, what are the economic
consequences of this practice, specifically with regard to subsequent financial
performance, ESG performance, and executive compensation? Our paper
provides systematic evidence on the determinants of ESG pay adoption and the
economic consequences associated with this practice.
Our empirical tests are based on a sample of 4,395 public firms from 21
countries, spanning the period from 2011 to 2020. We first document that the
share of firms indicating that some ESG metrics are used as Key Performance
Indicators (KPI) for their executives has grown from 3% in 2010 to 25% in 2020.
In other words, the large-scale use of ESG pay is a new phenomenon.
In terms of the determinants of ESG pay, the data in our sample indicate that
this practice is more common among firms with higher stock price volatility and
lower short-term accounting performance (but not lower stock market
performance).
Beyond firm fundamentals, several external factors appear to make firms more
prone to the adoption of ESG pay. At a macro level, the inclusion of ESG
metrics in compensation contracts is more common in countries that are
generally perceived to have higher ESG sensitivity, which includes the
possibility that some dimensions of ESG reporting are already mandatory in
these countries. At the firm level, we observe that the practice of ESG pay is
associated with firms that have a higher share of institutional ownership. We
also document that this practice is more common among firms that make public
environmental commitments and those that have higher ESG ratings to begin
with. Finally, ESG pay is also related to certain board characteristics, notably
the percentage of independent directors and the percentage of female directors.
Our next set of tests explores the potential consequences of adopting ESG pay.
We find some evidence that the inclusion of ESG metrics is associated with a
decrease in carbon emissions and an improvement in ESG ratings. These
patterns are more pronounced among countries with higher ESG sensitivity,
specifically countries within the European Union. We also find that after
controlling for accounting and stock price performance, executives of firms exhibiting higher ESG ratings and lower emissions receive higher variable compensation. This impact on executive compensation does not apply to firms that do not condition their compensation arrangements on ESG variables.
The effect of ESG pay on shareholder wealth is less clear-cut. We find no
positive association with financial outcomes, such as return on assets, and even
find a decrease in stock returns after the adoption of ESG pay. However, when
analyzing investors’ reaction to ESG pay, we find that funds tend to tilt their
portfolios towards firms that do rely on ESG pay. These findings are consistent
with the general perception that some investment groups are insistent on
attention to ESG criteria, but also willing to trade improvements in those
dimensions for lower returns (Pastor et al., 2020; Riedl and Smeet, 2017;
Barber et al., 2021).
We also take a more detailed look at the link between institutional investors and the implementation of ESG pay. While institutional investors are often seen as playing a potentially crucial role in the current efforts to transition towards more sustainable economic practices, there is an ongoing debate on the growing influence of large asset management companies. To that end, we first repeat our analysis of the determinants of ESG pay by breaking down institutional ownership in various ways. Our results indicate that the association between ESG pay and institutional ownership is stronger for larger institutions and foreign investors. We further corroborate these results with an instrumental variables approach to isolate exogenous variation in institutional ownership. Finally, we collect data on engagements by the three largest institutional investors (i.e., Blackrock, State Street, and Vanguard) and find that their engagements tend to increase the likelihood of a particular firm implementing ESG pay.
Taken together, our findings suggest that the inclusion of ESG metrics in
executive compensation packages cannot be dismissed as a mere public
relations move. We conclude that ESG pay is a response to the increasing need
to complement traditional firm-level financial performance metrics, especially in
the current context of managing ESG-related risks and opportunities. Our
evidence suggests that the implementation of ESG compensation metrics is
strongly related to sources of external pressure, including the country the firm is
headquartered in as well as institutional shareholder influence. However, in
contrast to the conjecture that ESG pay primarily serves window-dressing
purposes, our results suggest that the adoption of ESG pay likely has tangible
implications not only for managerial incentives but also for multiple outcome
variables.
References
Barber, B.M., Morse, A. and Yasuda, A., 2021. Impact investing. Journal of
Financial Economics, 139(1), pp.162-185.
Cohen, S., I. Kadach, G. Ormazabal, S. Reichelstein (2022), “Executive
Compensation Tied to ESG Performance: International Evidence, ECGI
Working paper. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4097202
Pástor, Ľ., Stambaugh, R.F. and Taylor, L.A., 2021. Sustainable investing in
equilibrium. Journal of Financial Economics, 142(2), pp.550-571.
Riedl, A., Smeets, P., 2017. Why do investors hold socially responsible mutual
funds? Journal of Finance 72, 2505-2550.
Shira Cohen is an Assistant Professor at San Diego State University, Igor Kadach is an Assistant Professor at IESE Business School, Gaizka Ormazabal is a Professor at IESE Business School, CEPR & ECGI, and Stefan Reichelstein is a Professor at the Mannheim Institute for Sustainable Energy Studies, Universität Mannheim, and Graduate School of Business, Stanford University.
The views, opinions and positions expressed within all posts are those of the authors alone and do not represent those of the Program on Corporate Compliance and Enforcement or of New York University School of Law. The accuracy, completeness and validity of any statements made within this article are not guaranteed. We accept no liability for any errors, omissions or representations. The copyright of this content belongs to the authors and any liability with regards to infringement of intellectual property rights remains with them.