An increasing number of companies are paying bonuses to executives in the pursuit of sustainability. Driven by an ever-growing focus on global issues, more than three-quarters of large, publicly traded companies in Europe and North America now use environmental, social and corporate governance (ESG) metrics when determining executive bonuses.
In addition, nearly two-thirds of companies in Europe and the United Kingdom now include environmental criteria as part of their executive incentive schemes.
Typically, annual cash bonuses represent about 24 per cent of a typical CEO’s pay. Since bonus payments depend on the achievement of specific performance goals, their influence on executives’ actions tends to be more immediate.
While such incentives can enhance a firm’s ESG performance, they also present an opportunity for executives to obtain bigger bonuses under the illusion of “doing good.” There is always a risk of executives manipulating performance metrics to gain bonuses.
Examining ESG incentives
We first noticed that a significant number of executives were being paid bonuses for achieving ESG goals in 2015. By 2020, more than 43 per cent of executives from the largest 500 publicly traded U.S. firms had ESG incentives.
Since the use of ESG incentives is relatively new, we suspected they might be susceptible to abuse and decided to investigate. Our recent study examines how ESG incentives impact yearly bonuses for top executives.
Since these large companies are required to disclose information on how they pay their top executives, we used novel artificial intelligence to examine these companies’ documents.
In our analysis, we took into account how much money we expected executives to make, how much power they had over their firm’s board of directors, whether they used ESG incentives or not and whether a variety of corporate governance mechanisms (like sustainability committees) were in place.
The good news and the bad news
Our study found that overall, executives do not appear to be leveraging their power to get higher compensation through ESG incentives. That’s the good news.
The bad news, however, is that not all executives are wielding their power for good. Some executives seem to use their power to obtain higher bonuses from ESG incentives. This seems to happen particularly in environmentally sensitive industries (mining or oil and gas, for example) or in firms that have other corporate governance mechanisms in place, like sustainability committees.
It’s possible that tighter oversight is needed in certain industries or even that some corporate governance mechanisms may be more for show than for governance. For instance, board members should ensure they have the requisite knowledge to engage in meaningful conversations about the use of ESG incentives in compensation plans.
They may also need to put additional checks and balances in place to better monitor, control and advise management on the use of these incentives, especially with respect to the selection of ESG performance metrics.
Why does this matter?
Key stakeholders like the Canadian Coalition for Good Governance, standard setters like the International Sustainability Standards Board and rating agencies such as MSCI advise organizations to include ESG goals in executives’ compensation plans. The objective, presumably, is twofold: to measure what matters and provide executives with incentives to move their organizations toward sustainability.
However, the connection between ESG incentives and sustainability is not so clear-cut. We still need to learn more about the use of ESG incentives to be able to apply them properly. Moreover, firms often equate their ESG focus with sustainability, but the two are not the same.
A focus on ESG is a focus on how environmental, social and governance factors affect the financial performance of the firm while a focus on sustainability is a focus on how the firm affects society and the environment. Think of it as the difference between a selfie and a landscape photo — one looks inward (ESG) and the other outward (sustainability).
There is limited evidence that awarding bonuses based on ESG criteria automatically translates into improved sustainability for a company. While there is some evidence they might, it’s still too early for a definite answer.
ESG factors focus on risks and opportunities that affect financial performance, not necessarily those that are connected to planetary sustainability. In fact, there is no work to date that we are aware of that connects a firm’s ESG performance to planetary sustainability at all.
While ESG incentives may help a firm mitigate the risk of investors’ or regulators’ intervention, they don’t necessarily translate into sustainability performance. We cannot reiterate this enough: a focus on ESG is a focus on risk and opportunity management, not sustainability.
Our research is a reminder, to boards of directors, executives, regulators and standard-setters, that one-size-fits-all is rarely appropriate and without looking closely at what is happening, these incentives can be abused.