By Gaizka Ormazabal and Igor Kadach (IESE Business School)
BlackRock CEO Larry Fink recently said he’s stopped using the term “ESG” because the acronym for environmental, social and governance criteria has become “weaponized” by both the left and the right.
“I don’t use the word ESG any more, because it’s been entirely weaponized … by the far left and weaponized by the far right,” Reuters quoted Fink as saying at the Aspen Ideas Festival in June. He clarified, however, that his commitment to the underlying issues remains unchanged.
ESG is becoming yet another battleground in the U.S. culture wars. Despite that, our research shows that linking ESG goals to executive compensation is an increasingly common practice globally and can serve as a useful potential tool for improving environmental performance.
The research, carried out with Shira Cohen of San Diego State University and the University of Mannheim’s Stefan Reichelstein, looked at nearly 4,400 publicly traded firms in 21 countries. We found 38% of companies had incorporated ESG factors into contracts in 2021, compared to just 1% in 2011.
Even though it has become a political flashpoint in the U.S., it’s the country where adoption was the lowest. Only 16.5% of U.S. firms studied tied compensation to ESG goals, compared to 44% in the U.K. and 59% in France.
The practice was more common in countries with stricter ESG regulations and greater public sensitivity towards environmental and social issues. And at a firm level, it was more prevalent among larger firms and those with higher emissions, including oil producers, utilities and automakers. Those are the same firms that in the future may have to pay a higher cost for emissions and face greater public scrutiny over their environmental track record.
Why ESG Pay Is On The Rise
Why are the companies doing it? For several overlapping reasons. One of them was tied to companies’ future expectations. ESG metrics are viewed as leading indicators of future financial performance and potential risks: companies that take them seriously now will likely do better in the future.
Another reason was linked to investors and other stakeholders. Folding ESG metrics into executive compensation agreements is associated with engagement, voting and trading by institutional investors such as BlackRock. Companies may be adopting ESG pay in order to align their management objectives with those of shareholder groups, who in turn may fear losing sustainability-minded clients if they don’t press their investments for specific climate measures.
As calls for climate action strengthen, ESG pay also brings companies’ objectives in alignment with other stakeholders, internalizing some environmental externalities. For example, a company that makes hitting a pollution-reduction target part of its executive compensation package is internalizing the issue among corporate decision makers who might otherwise be focused on financial performance. Financial performance may eventually be lifted, but it’s unlikely to be an immediate boost. The benefits may also be indirect, in the form of creating greater loyalty among environmentally conscious customers.
ESG pay can also have an important signaling effect, showing that a company’s commitment to sustainability runs deep. A corporate pledge to reduce pollution will be viewed with less skepticism and accusations of greenwashing if executives also get paid more if they do better by the planet.
Outcomes For Companies with ESG Pay
But does ESG pay actually make a difference in firm performance? We find that, when structured right, it can have meaningful impact. When companies include emission-specific metrics in their executive compensation packages, they also report a subsequent decrease in their CO2 emissions. Here, the devil is in the details: the metric must be specific and measurable, and the expected outcome as well.
ESG ratings have come under fire recently for their inconsistency, and there is a need to standardize criteria and measurements. But just as ratings agencies play a fundamental role in global debt markets, it’s reasonable to expect that ESG ratings will play a role in green finance. Our research found that companies that incorporated ESG pay received higher ESG ratings.
And the bottom line? Companies looking for immediate financial returns as a result of ESG pay will be disappointed. ESG pay didn’t produce stronger financial performance and if, anything, the results may point in the opposite direction. The reasons could be many, but it could be that the ESG performance will yield long-term financial benefits, not quickly captured in earnings and/or stock prices.
Much of the criticism of ESG criteria has focused on their ambiguity. ESG can be defined to include everything from a company’s energy use, to employees’ volunteer activities, to diversity policies. But the scope may be reason to advance in more standardized definitions and greater precision, rather than to abandon it. Companies wishing to incorporate ESG targets into executive compensation should be transparent in the specific goals and outcomes. They must understand that it forms part of a longer-term vision of the company. There may be compelling reasons to adopt ESG pay – but short-term profit is not one of them.
Gaizka Ormazabal and Igor Kadach are professors in the Accounting and Control Department of IESE Business School.
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