Executive Compensation and Corporate Sustainability: Evidence from ESG Ratings

Can executive compensation incentivise the wrong behaviours?

Chen Zhu, Xue Liu, Dong Chen, and Yuanyuan Yue explore whether higher executive compensation improves corporate ESG ratings in their article « Executive compensation and corporate sustainability: Evidence from ESG ratings ».

They use data from 28,306 observations of Chinese A-share listed companies from 2012 to 2021 and fixed-effects regressions, PSM, instrumental variables and mediating-effect models to conclude:

• Higher executive compensation is consistently associated with better ESG ratings, and the relationship remains significant across various tests to a robust and positive link.
• Year-to-year increases in executive pay also raise ESG performance in the year following the increase, which confirms both levels and variations in compensation can influence sustainability performance.
• Three channels explain this indirect effect: executive pay raises green innovation efficiency, strengthens environmental information disclosure, and improves financial performance.
• When management shareholding is high, the positive effect of pay on ESG weakens, suggesting an « entrenchment effect ». Conversely, a higher proportion of independent directors strengthens the link through more effective oversight.
• Sustainability gains hold only when compensation remains within a reasonable range , as overpay is significantly associated with lower ESG ratings.

This article suggests investors may integrate compensation structures into governance assessments by evaluating whether pay packages promote long-term ESG investment rather than entrenchment.

Compensation committees could embed green innovation and environmental disclosure metrics into executive pay while ensuring incentives remain proportionate and balanced to avoid overpay issues.

Regarding the limitations of this study, it should be noted ESG ratings rely on Huazheng data, which may differ from international frameworks and constrain cross-country comparability.

Additionally, the analysis does not incorporate granular compensation components beyond cash pay, limiting assessment of how equity-based incentives interact with ESG performance.