For years, shareholder activists have argued that the best way to get corporate executives to manage their assets for the public good is to pay them to do it – by linking their compensation to positive social and environmental activities, such as increasing diversity and reducing carbon emissions.
Today, 72% of S&P 500 companies include environmental, social and governance (ESG) metrics in determining executives’ pay, says the Semler Brossy Consulting Group. Of the 2024 Corporate Knights Global 100 companies, 79% have sustainability pay links.
But the ESG backlash south of the border continues to grow. In the U.S., a report from Pleiades Strategy finds that Republican lawmakers in 37 states introduced 165 pieces of legislation in 2023 to discourage companies and investors “from considering commonplace risk factors in making responsible, risk-adjusted investment decisions.” The good news, according to Pleiades: only 22 laws and six resolutions passed in 2023, and “the bills that became law were often heavily revised to weaken core provisions and minimize costs.”
Defenders of ESG metrics were put on the back foot again when the Financial Times quoted an asset manager calling companies’ ESG targets “fluffy.” The story charged that “investors are worried the [ESG] metrics are being gamed to increase payouts.” Its examples include Southwest Airlines, where a disastrous 2022 holiday season that saw cancellation of 16,000 flights didn’t stop senior executives from garnering bonuses, and CBRE, a real estate firm whose CEO failed to meet key financial objectives but still earned US$4 million in bonuses by achieving five other strategic goals, such as improving team diversity and boosting employee engagement.
One executive of Boston-based State Street Global Advisors told the Times they were skeptical of using ESG metrics to determine executive compensation: “Oftentimes they are very subjective, fluffy and easily gamed.”
So does tying compensation to ESG targets work? A study released last summer by researchers at Stanford University found that firms that link executive bonuses to emission-specific metrics do decrease their carbon dioxide emissions. They also tend to see improvements in their ESG performance, as measured by third-party ratings. The study found no evidence so far that this practice affects organizations’ financial performance or share price.
A similar study released in 2023 by two business professors at Concordia and Carleton universities took a bolder tack, asking whether ESG-based bonuses result in S&P 500 executives receiving excess pay. Using artificial intelligence to identify normal pay ranges and outliers, the researchers found that use of ESG-based bonuses produced a 32% reduction in excess annual cash bonuses, “implying ESG incentives are an effective corporate governance tool.”
However, they did spot sectors where boards and shareholders should remain on high alert: companies in environmentally sensitive industries such as mining or oil and gas, where management teams were determined to have greater influence on the board. They may “need to put additional checks and balances in place to better monitor, control and advise management on the use of these incentives, especially with respect to the selection of ESG performance metrics,” said Sprott School of Business’s Leanne Keddie and Concordia’s Michel Magnan.
A recent report from Harvard Law Review suggested some best practices for companies treading the ESG path: take time to develop meaningful performance data; adopt targets that are “material, durable, and auditable”; and test your ESG operating goals for a year or two before linking them to pay, to ensure their relevance and hone your methodology.
In Canada, the Institute of Corporate Directors has actively promoted ESG-linked executive pay for more than a decade. “Successful incentive programs require robust planning and metrics and verification systems,” says Gigi Dawe, the institute’s VP of policy and research. “There’s lots of new information out there to help set standards, so I think we are going to get better at it.”
