More and more companies are paying bonuses to executives in the pursuit of sustainability. Driven by an ever-growing attention to global issues, more than three-quarters of the large, listed companies in Europe and North America now use environmental, social and corporate governance (ESG) measures in determining executive bonuses.
In addition, almost two-thirds of companies in Europe and the United Kingdom now include environmental criteria as part of their executive incentive programs.
Normally annual cash bonuses represent approx 24 percent of the average CEO salary. Because bonus payments are contingent on achieving specific performance goals, their influence on the actions of managers is usually more direct.
Although such incentives can improve a company’s ESG performancethey also offer managers the opportunity to receive larger bonuses under the illusion of ‘doing good’. There is always a risk that executives will manipulate performance data to obtain bonuses.
Exploring ESG incentives
We noticed for the first time that in 2015 a significant number of managers received bonuses for achieving ESG goals. In 2020, more than 43 percent of managers at the 500 largest listed American companies had ESG incentives.
Because the use of ESG incentives is relatively new, we suspected they were open to misuse and decided to investigate. Us recent research examines how ESG incentives influence annual bonuses for top executives.
Because these major companies are required to disclose information about how they pay their top executives, we used new artificial intelligence to examine these companies’ documents.
In our analysis, we took into account how much money we expected managers to make, how much power they had over their company’s board of directors, whether or not they used ESG incentives, and whether there were a variety of corporate governance mechanisms (such as sustainability committees) existed. in situ.
The good news and the bad news
Our research shows that managers generally do not appear to use their power to achieve higher compensation through ESG incentives. That’s the good news.
The bad news, however, is that not all executives use their power for good. Some executives appear to be using their power to extract higher bonuses from ESG incentives. This seems to happen mainly in environmentally sensitive sectors (e.g. mining or oil and gas) or in companies that have other corporate governance mechanisms in place, such as sustainability committees.
It is possible that stricter supervision may be needed in certain sectors, or even in some corporate governance mechanisms may be more for show than for governance. For example, board members should ensure they have the requisite knowledge to have meaningful conversations about the use of ESG incentives in compensation plans.
They may also need to implement additional checks and balances to better monitor, control and advise management on the use of these incentives, especially in relation to the selection of ESG performance measures.
Why does this matter?
Key stakeholders such as the Canadian Coalition for Good Governancestandard typesetters such as the International Sustainability Standards Council and rating agencies such as MSCI advise organizations to include ESG objectives in executive compensation plans. The goal is likely twofold: measuring what matters and providing incentives for executives to move their organizations toward sustainability.
However, the link between ESG incentives and sustainability is not so clear. We still need to learn more about using ESG incentives to apply them properly. Furthermore, companies often equate their ESG focus with sustainability, but the two are not the same.
An ESG focus is a focus on how environmental, social and governance factors influence the company’s financial performance, while a sustainability focus is a focus on how the company impacts society and the environment. Think of it like the difference between a selfie and a landscape photo: one looks inward (ESG) and the other looks outward (sustainability).
There is limited evidence that awarding bonuses based on ESG criteria automatically translates into better corporate sustainability. While there some evidence that they might beit’s too early for a definitive answer.
ESG factors focus on risks and opportunities that impact financial performance, not necessarily those related to planetary sustainability. In fact, no research to date links a company’s ESG performance to planetary sustainability.
While ESG incentives can help a company mitigate the risk of investor or regulator intervention, they do not necessarily translate into sustainability performance. We cannot reiterate this enough: a focus on ESG is a focus on risk and opportunity management, not on sustainability.
Our research reminds boards, executives, regulators and standard setters that one-size-fits-all is rarely appropriate and that these incentives can be abused if we don’t look closely at what’s happening.