In today's corporate world, there's a lot of buzz about linking executive pay to Environmental, Social, and Governance (ESG) metrics. One specialist recently trumpeted: "Companies have crossed the Rubicon in integrating environmental, social and governance performance." The idea does indeed sound great: reward leaders for steering companies toward sustainable and ethical practices. But are these ESG incentives genuine, or are they just for show?
A recent study we published, entitled "All Hat and No Cattle? ESG Incentives in Executive Compensation," attempts to answer this very question. The research delves into executive compensation data from 674 executives across 73 major European firms between 2013 and 2020. The findings are quite revealing. Here are just a few:
- By 2020, 60% of the companies studied had incorporated ESG goals into their executive pay structures, suggesting that ESG-linked pay is indeed on the rise. However, in most cases, these ESG metrics are purely discretionary, and firms do generally not commit whether and to what degree ESG performance will actually enter executive pay. Binding (non-discretionary) ESG goals carry a weight of less than 5% in bonus calculations, and realized ESG performance explains less than 1% of variation in executive pay.. In contrast, traditional financial metrics influence a whopping 87% of short-term pay variations
- In industries like finance, where ESG objectives aren't directly linked to financial outcomes, the inclusion of ESG metrics often appears more symbolic than substantive. This raises concerns about potential "greenwashing," where companies project an image of sustainability without meaningful action.
- Sectors with significant environmental impacts, such as energy, utilities, and manufacturing, tend to assign more weight to ESG metrics. This approach better aligns executive rewards with sustainable outcomes compared to industries where the environmental impact is less direct.
- Specialized positions like Chief Human Resources Officers (CHROs) and Chief Technology Officers (CTOs) often lack relevant ESG metrics. For example, a CHRO is not more likely to have an ESG goal related to employee satisfaction than the CEO of the same company. In other words, firms do not seem to tailor these ESG metrics to the tasks and responsibilities of different executives. Instead, they seem to emphasize ESG goals for their most visible leaders, like CEOs, possibly as a strategy to appear more environmentally conscious.
Impact Versus Optics
These insights prompt us to question if companies are genuinely committed to integrating ESG principles into their core strategies, or are they merely paying lip service to appease stakeholders? Indeed, our research indicates that while the adoption of ESG metrics in executive compensation is on the rise, their actual influence remains limited. This disparity suggests that many firms might be more focused on the optics of sustainability rather than driving genuine impact.
The 81-page study also highlights the importance of industry context. We illustrate this by studying firms in two camps. Companies in sectors with direct environmental impacts are more likely to implement meaningful ESG targets. Those in the energy and utilities or in the industrial & materials sector face strict regulations and rising carbon prices, meaning real ESG efforts - like reducing emissions - translate into financial benefits. Other companies, in the industrial & materials sector, have embedded ESG into compensation structures in a more binding way, ensuring that sustainability is a key driver of executive performance.
In contrast, we found that firms in industries where the link between ESG and financial performance is less evident may adopt ESG metrics more superficially. In the financial services sector, some major companies have added only soft ESG-linked targets, without any real commitment to include them in the calculation of payout. Such observations may raise concerns that these purely discretionary targets may be more about optics than impact. Our research comes at a time when ESG practices are under increasing scrutiny from regulators and investors. The European Union, for instance, has been ramping up its regulatory framework around sustainable finance, pushing for greater transparency and accountability. Investors, too, are becoming more discerning, seeking out companies that demonstrate genuine commitment to ESG principles rather than those that merely tick the boxes.
The implications of this study are significant for corporate governance. If ESG metrics in executive compensation are to drive real change, companies need to ensure that these metrics are substantial, measurable, and directly tied to performance outcomes. This approach would genuinely motivate executives to improve environmental and social performance and thereby enhance the credibility of corporate ESG commitments. While the integration of ESG metrics into executive compensation is a step in the right direction, there's still a long way to go.