ESG-Linked Compensation, CEO Skills, and Shareholder Welfare

Should boards reward CEOs for meeting ESG goals?

Swarnodeep Homroy, Taylan Mavruk, and Van Diem Nguyen explore whether tying CEO pay to ESG targets aligns with shareholders’ interests and how CEOs’ skill sets factor in in « ESG-Linked Compensation, CEO Skills, and Shareholder Welfare ».

The authors hand-collected detailed data on executive compensation contracts for Swedish firms, identified which CEOs had ESG performance metrics in their bonuses, and classified CEOs as « generalists » or « specialists ».

They then examine if ESG-linked pay appears in settings where it might not automatically increase shareholder wealth and conclude:

• ESG targets constitute a modest part of CEO bonuses, are not easier to achieve than financial targets, and may sometime be conflicting: CEOs who meet their ESG goals often miss some financial targets.
• ESG-linked pay is about 5% more likely in firms with strong governance, who adopt ESG incentives to ensure managers pursue broader stakeholder goals responsibly and mitigate agency concerns.
• Generalist CEOs with broad skill sets who have the versatility to juggle multiple and potentially conflicting objectives are 6.3% more likely to have ESG-linked targets in their pay.
• The presence of ESG pay is especially evident in firms where shareholders’ wealth and ESG utility diverge, like the ones facing high demand uncertainty and where pursuing ESG might not directly increase profits.
• ESG-linked pay correlates with better ESG performance, as assessed by higher ESG ratings, but only under the right conditions: specifically, strong governance and a generalist CEO at the helm.

This article shows boards use ESG-linked bonuses to produce ESG outcomes that shareholders value as part of total shareholder welfare, not necessarily to boost immediate shareholder wealth.

Without explicit sustainability incentives, firms might under-deliver on ESG issues that investors care about, even when these targets can align with financial performance.

That said, the study focuses on correlational analyses on a small sample of Swedish firms and relies on disclosed ESG performance metrics and third-party ESG ratings, which have their own shortcomings.