Should executives be paid for their ESG performance?
Last Monday, I wrote about the finding that better ESG metrics only increase company valuations if a company has above-average profitability. That implies that companies that focus too much on improving their ESG metrics might not reap the benefits of this focus comes at the expense of traditional financial metrics. This week, I want to continue down this road and look at what happens when executive compensation is linked to ESG targets, not just financial targets.
Shira Cohen from San Diego State University and her colleagues looked at the executive compensation plans of more than 9,000 companies across the developed world and what impact executive compensation linked to ESG targets has. By now, linking executive compensation to ESG goals is becoming mainstream. In their global sample, some 40% of companies had executive compensation linked to ESG goals and in Europe, by my estimate, we have crossed the 50% threshold. In particular companies in sectors that are the focus of ESG investors like oil & gas, utilities, mining, and transport tend to have executive compensation linked to ESG goals, but other sectors are catching up.
The good news is that linking executive compensation creates improving ESG metrics over time. What gets measured gets done, as they say. Companies that link executive compensation to a reduction in greenhouse gas emissions see their greenhouse gas emissions drop faster and by larger increments than companies that don’t. In fact, companies where executive compensation is not linked to greenhouse gas reduction targets don’t on average reduce their greenhouse gas emissions, even if executive compensation is linked to other ESG goals. That is not necessarily a bad thing since greenhouse gas emissions reductions are not always the most important ESG goal a company can have. Yes, they are important for large emitters, but if you are running an accounting firm, your greenhouse gas footprint is quite small and essentially consists of travel and commuting emissions.
Looking beyond greenhouse gas emissions if executives were compensated for other ESG goals like improving their ESG rating, these metrics improved over time and again faster than if the executives were not compensated for ESG goals.
Ok, that’s great. Executives who are incentivised to improve the ESG credentials of a company do improve them. But what about the financial metrics?
And here is the bad news. Companies that introduced ESG targets in the executive compensation saw their profitability (measured again as Return on Assets, ROA) shrink slightly in the short term. If the executives had a specific greenhouse gas reduction target, the ROA tended to drop by 1%, a statistically and economically significant decline. Companies that did not have a greenhouse gas emissions target saw their ROA decline, but by so little that it was not statistically significant and indistinguishable from zero.
What this shows, in my opinion, is that too big a focus on ESG goals can distract executives and harm corporate profitability in the short run. Of course, improving the right ESG metrics will improve profitability over time. There is ample evidence that increasing diversity increases profitability or that reducing greenhouse gas emissions increases investments in modernisation and productivity-enhancing measures which in turn increase profitability. But these measures come at a short-term cost even if in the long-term they are beneficial.
And this points to two very important lessons to heed for executives and the directors who set their incentives:
Don’t shock the system: Don’t focus on ESG goals too much. Because there are costs associated with focusing on ESG goals in the short term, the change should be gradual and balanced with the overall financial health of the company. Move too fast and you reduce profitability. Move too slow and you will be left behind by your competitors who are moving faster. It’s a delicate balance.
Focus on the right ESG goals: Because achieving ESG goals require time and money, executive compensation should only be linked to ESG goals that have a demonstrable effect on the profitability and revenues of a company. This is where a materiality assessment is important. Every company must understand which ESG metrics have the biggest influence on the company. Only link ESG compensation to these ESG metrics, even if that means ignoring measures that are commonly emphasised by the press like greenhouse gas reduction.