The Perils and Questionable Promise of ESG-Based Compensation

Abstract

With the rising support for stakeholder capitalism and at the urging of its advocates, companies have been increasingly using environmental, social, and governance (ESG) performance metrics for CEO compensation. This Article provides a conceptual and empirical analysis of this trend, and exposes its fundamental flaws and limitations. The use of ESG-based compensation, we show, has at best a questionable promise and poses significant perils.

Based partly on an empirical analysis of the use of ESG compensation metrics in S&P 100 companies, we identify two structural problems. First, ESG metrics commonly attempt to tie CEO pay to limited dimensions of the welfare of a limited subset of stakeholders. Therefore, even if these pay arrangements were to provide a meaningful incentive to improve the given dimensions, the economics of multitasking indicates that the use of these metrics could well ultimately hurt, not serve, aggregate stakeholder welfare.

Second, the push for ESG metrics overlooks and exacerbates the agency problem of executive pay, which both scholars and corporate governance rules have paid close attention. To ensure that they are designed to provide effective incentives rather than serve the interests of executives, pay arrangements need to be subject to effective scrutiny by outsiders. However, our empirical analysis shows that in almost all cases in which S&P 100 companies use ESG metrics, it is difficult if not impossible for outside observers to assess whether this use provides valuable incentives or rather merely lines CEO’s pockets with performance-insensitive pay.

The current use of ESG metrics, we conclude, likely serves the interests of executives, not of stakeholders. Expansion of ESG metrics should not be supported even by those who care deeply about stakeholder welfare.

This paper is part of a larger research project of the Harvard Law School Corporate Governance on stakeholder capitalism and stakeholderism. Other parts of this research project include The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita, Will Corporations Deliver Value to All Stakeholders? by by Lucian A. Bebchuk and Roberto Tallarita, For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita, Stakeholder Capitalism in the Time of COVID by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita, Does Enlightened Shareholder Value Add Value? by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita, and How Twitter Pushed Stakeholders Under The Bus by Lucian A. Bebchuk, Kobi Kastiel, and Anna Toniolo.

Keywords: corporate purpose, corporate social responsibility, stakeholders, stakeholder governance, stakeholder capitalism, compensation, corporate governance, ESG

JEL Classification: D22, G34, G38, K22, M12