ESG-linked pay: What does the research say?

The PRI strongly believes that ESG-linked pay can be an important tool to drive value and better sustainability performance. However, given that some of the early academic studies such as Cordeiro and Sarkis (2008) and Berrone and Gomez-Mejia (2009) had failed to establish a strong link between ESG-linked pay and improved sustainability performance, we were keen to see if subsequent research had supported or reversed this finding.

The studies examined as a part of this review signalled strongly that ESG-linked pay is indeed value-enhancing for companies. Abdelmotaal and Abdel-Kader (2016), analysing a sample of 212 firms in the FTSE 350 between 2009 and 2011, found ESG-linked pay to be positively associated with shareholder returns, measured as profit before tax divided by shareholders funds. Furthermore, Flammer et al. (2019), studying S&P 500 companies over 2004-2013, established causal evidence that the adoption of such pay practices leads to an increase in firm value, long-term orientation and improves the firm’s ESG performance. The study by Ikram et al. (2019), assessing a similar sample (S&P 500 firms from 2009-2013), affirmed these conclusions - firms with ESG-linked pay have better MSCI KLD ESG ratings.

Considering the strong academic evidence behind the effectiveness of ESG-linked pay, let’s turn to when we can expect ESG-linked pay to be a priority for companies.

Prevalence of ESG-linked pay

We would expect to see more examples of ESG-linked pay where companies are looking to prove a point around their commitment to sustainability. This could be companies that already have a strategic focus on sustainability i.e. those that have good record of ESG performance and are incentivising further improvements by tying their executive rewards to these factors. This could also be companies that are embedding ESG-linked pay for signalling ESG commitment i.e. those that want to be perceived as sustainable because the industries in which they operate are vulnerable to stakeholder pressure or regulatory changes.

There is empirical evidence that supports this hypothesis. For instance, a paper from Eccles et al. (2014) looked at 180 US companies and found that firms that had adopted sustainability policies voluntarily by 1993 were more likely to integrate ESG-linked pay by 2009. Al-Shaer and Zaman (2019) assessed a sample of FTSE 350 firms from 2011-2015 and found that incorporation of ESG-linked pay increases with the presence of sustainability committees, sustainability reporting assurance and when a company operates in a sustainability-sensitive industry (i.e. oil and gas, chemicals, mining, utilities, forest and paper products, beverage, tobacco, and aerospace and defence industries).

Furthermore, a couple of recent studies have found a correlation between the strength of corporate governance and ESG-linked pay. Hong et al. (2016) analysed the executive compensation contracts of the top five executives in S&P 500 firms for the year 2013 and found that firms with better corporate governance^[1] are more likely to incorporate ESG-linked pay, and these firms have greater MSCI KLD scores on average. Ikram et al. (2019) assessed a sample of S&P 500 firms over 2009-2013 and concluded that the likelihood of firms granting ESG-linked pay increases with better governance and decreases with executive power and entrenchment in the status quo.

Interestingly, the academic literature also points to determinants of adoption that may be less obvious. For instance, one of the earlier research papers from Ittner et al. (1997) assessing 300 plus US-based firms across 48 industries found that the weight allocated to non-financial measures in executive pay is higher in innovative, quality-orientated companies. The positive correlation between growth opportunities and the extent of integration of non-financial performance measures in pay is also verified in another study from Schiehll and Bellavance (2009) that assessed 184 firms listed on the Toronto Stock Exchange. This correlation may be particularly relevant for companies that rely on intangible assets such as brand value and human capital and where non-financial measures could prove to be a better signal of value than traditional, backward-looking measures.

Using ESG factors in a downturn to boost pay

There are concerns that some companies may integrate ESG into pay for reasons such as pay padding or greenwashing.

The above-mentioned Ittner et al. study found that firms use non-financial metrics in pay when financial performance measures are poor reflections of factors that drive firm value (for example, when accounting returns are volatile, or when the correlation between financial and accounting returns are low). This could mean that the integration of non-financial factors into pay could become more commonplace in times of financial crisis. Kolk and Perego (2014) warn against this trend, particularly when measures can be manipulated or non-financial targets can be easily achieved. The study looked at Dutch multinational companies that started to use sustainability criteria for executive bonuses in 2009, following the financial crisis when traditional financial metrics were under greater scrutiny. The authors argue that incorporation of ESG-linked pay in these scenarios may be one way of advancing managers’ interest and ratcheting realised pay.

A need for more academic research

The incorporation of ESG measures in executive pay is becoming more common; however, the academic research analysing these practices remains relatively preliminary. For instance, many of the papers surveyed as part of the literature review have a narrow timeframe and / or small sample size in terms of firms covered, or fail to establish causal links. The authors therefore call for analyses with broader scope and more recent international and cross-country data.

Further reading

Abdelmotaal, H., & Abdel-Kader, M. (2016). The use of sustainability incentives in executive

remuneration contracts: Firm characteristics and impact on the shareholders’ returns. Journal of Applied

Accounting Research, 17(3), 311-330.

Al-Shaer, H., & Zaman, M. (2019). CEO compensation and sustainability reporting assurance:

Evidence from the UK. Journal of Business Ethics, 158(1), 233-252.

Berrone, P., & Gomez-Mejia, L. R. (2009). Environmental performance and executive compensation:

An integrated agency-institutional perspective. Academy of Management Journal, 52(1), 103-126.

Eccles, R. G., Ioannou, I., & Serafeim, G. (2014). The impact of corporate sustainability on

organizational processes and performance. Management Science, 60(11), 2835-2857.

Flammer, C., Hong, B., & Minor, D. (2019). Corporate governance and the rise of integrating corporate

social responsibility criteria in executive compensation: Effectiveness and implications for firm

outcomes. Strategic Management Journal, 40(7), 1097-1122.

Hong, B., Li, Z., & Minor, D. (2016). Corporate governance and executive compensation for corporate

social responsibility. Journal of Business Ethics, 136(1), 199-213.

Ikram, A., Li, Z. F., & Minor, D. (2019). CSR-contingent executive compensation contracts. Journal

of Banking & Finance, 105655.

Ittner, C. D., Larcker, D. F., & Rajan, M. V. (1997). The choice of performance measures in annual

bonus contracts. Accounting Review, 231-255.

Kolk A. and Perego P., (2014). Sustainable bonuses: Sign of corporate responsibility or window

dressing? Journal of Business Ethics, 119(1), 1–15.

Schiehll, E., & Bellavance, F. (2009). Boards of directors, CEO ownership, and the use of non􀀀

financial performance measures in the CEO bonus plan. Corporate Governance: An International

Review, 17(1), 90-106.