The Flaws and Limits of ESG-Based Compensation

Companies increasingly use ESG metrics in their compensation packages for CEOs. A new empirical study suggests that this practice has questionable promise and produces significant risks.

Companies have increasingly pledged support for stakeholder capitalism, but these pledges have been met with significant skepticism by some observers. The main criticism, which we have laid out in previous work, is that corporate leaders lack incentives to take into account the interests of employees, suppliers, the environment, or other stakeholders; therefore, relying on managerial discretion will not create value for stakeholders.

Partly as a response to this criticism, companies have been increasingly using ESG metrics in their compensation packages for CEOs. According to a recent report by the advisory firm Willis Tower Watson, 51 percent of S&P 500 companies use ESG metrics as part of their compensation evaluation, and the Financial Times has recently reported that the number of large companies using climate pay targets has more than doubled from 2019 to 2020.

The idea behind this trend is that corporate leaders can be incentivized to improve stakeholder welfare by tying their compensation to ESG goals. In a recently released study, “The Perils and Questionable Promise of ESG-Based Compensation,” we provide a conceptual and empirical analysis of this practice, and we expose its fundamental flaws and limitations. The use of ESG-based compensation, we show, has questionable promise and poses significant perils. 

We conducted an empirical analysis of the use of ESG compensation metrics in S&P 100 companies, which represent more than half of the entire US stock market and arguably have a significant impact on stakeholders and society at large. We found that slightly more than half (52.6 percent) of S&P 100 companies included some ESG metrics in their 2020 CEO compensation packages. These metrics focus chiefly on employee composition and employee treatment, as well as customers and the environment, but also, to a much smaller extent, communities and suppliers. 

ESG metrics are mostly used as performance goals for the determination of annual cash bonuses. However, most companies do not disclose the weight of ESG goals for overall CEO pay, and those that do disclose it (27.4 percent of the companies with ESG metrics) assign to ESG factors a very modest weight (between less than 1 percent to 12.5 percent, with most companies assigning a weight between 1.5 percent and 3 percent).

Interestingly, despite the pervasive stakeholderist rhetoric, many companies that signed the 2019 Business Roundtable Statement on the Purpose of a Corporation, and therein pledged to deliver value to all stakeholders, do not use ESG metrics in their CEO compensation arrangements. Indeed, of the 62 sample companies that signed the statement, 42 percent do not use any stakeholder-oriented incentives for their CEOs. This finding seems consistent with the view, expressed by us in previous work (see “The Illusory Promise of Stakeholder Governance” and “Will Corporations Deliver Value to All Stakeholders?),” that the Business Roundtable statement should be considered a public relations move rather than an actual redefinition of corporate purpose. 

Our empirical analysis highlights two structural limits of ESG-based compensation practices. The first limit lies in their use of a limited number of welfare dimensions of a limited number of stakeholders. Despite the promise of a new paradigm that delivers value to “all stakeholders,” and the potential breadth of companies’ stakeholders and the multiple ways their interests are affected by corporate decisions, in reality companies choose a small subset of stakeholder groups and interests on which to focus.

For example, employees care about keeping their job, the absolute level of their compensation, the relative level of their compensation compared to others in similar roles (for example, gender pay gap or racial pay gap), the relative level of their compensation compared to the highest-paid managers (for example, CEO pay ratio), health insurance and other benefits, protections in case of unemployment, health and safety, workplace culture and engagement, diversity and inclusion, and many other aspects of their employment relationship. However, most companies in our sample choose goals related to inclusion or diversity, and many focus on work accidents and illness, but none incentivizes its CEO to increase salaries or benefits, to improve job security, or to make progress on any of the other dimensions that are important for employees. 

The narrowness of ESG metrics reveals the limits of ESG-based compensation and also raises a well-known problem in the economics of multitasking. By incentivizing CEOs to improve the performance of a few narrow quantifiable metrics, companies create distorted incentives not to focus on other significant dimensions, including some hard-to-quantify dimensions. 

The second structural limit of ESG-based compensation concerns the fundamental agency problem involved in executive compensation. CEOs exert substantial influence on their boards of directors and can therefore extract significant value from their companies through excessive compensation packages. In order to mitigate this agency problem, compensation arrangements should be tied to performance and companies should disclose enough information to allow an outside observer to review and assess the meaningfulness of the performance. 

Yet almost no company in our sample uses ESG metrics that meet this standard. Most companies mention the use of ESG goals but do not disclose the relevant targets and actual outcomes, or they leave significant discretion to their boards. Among the very few companies that disclose clear and objective goals as well as actual outcomes, almost none provides sufficient contextual information allowing outsiders to review and assess the pay arrangements. 

Our analysis has significant implications for ESG-based compensation practices and the broader debate on stakeholderism. Our analysis shows that the ESG compensation trend should not be expected to produce meaningful incentives for the creation of value for stakeholders and that it poses the danger of creating vague, opaque, and easy-to-manipulate compensation components, which can be exploited by self-interested CEOs to inflate their payoffs, with little or no accountability for actual performance. 

The demand for ESG-based compensation is, explicitly or implicitly, based on the recognition that corporate executives do not have, on their own, sufficiently strong incentives to give weight to the welfare of stakeholders. We agree with this recognition; in fact, we believe that it is the fundamental weakness at the core of stakeholderism. When framed in this way, the campaign to promote and expand the use of ESG compensation metrics can be interpreted as a good-faith attempt to address this very important problem.

However, our conceptual and empirical analysis shows that the current use of ESG metrics by corporations is crucially flawed. Furthermore, it shows that such use is afflicted by certain structural problems that are difficult to address and that both significantly limit potential benefits and introduce considerable perils. Thus, we warn that the expansion in the use of ESG metrics, which stakeholderists support and that corporate leaders have incentives to embrace, would likely be counterproductive. It would likely deliver little value to stakeholders and would operate to increase executive payoffs without improving their incentives.

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