The Use of ESG Ratings in Corporate Compensation Plans: Promises and Pitfalls

Should executive compensation be tied to third-party sustainability ratings?

Charlie Cregan, J. Andrew Kelly, and J. Peter Clinch examine the growing practice of linking executive pay to ESG ratings in « The Use of ESG Ratings in Corporate Compensation Plans: Promises and Pitfalls ».

The authors analyse public reports from 60 large firms (30 airlines and 30 banks) to assess whether third-party ESG rating scores are reliable and meaningful benchmarks for bonuses.

Their conclusions include:

• ESG metricscontribute only ~1.5-3% of total CEO compensation (occasionally up to 12.5%), even though 90% of institutional investors now endorse including ESG goals in pay packages.
• Out of 60 major airlines and banks studied, only one bank (MUFG) and three airlines (e.g. Japan Airlines, easyJet, Ryanair) tied executive incentives to external ESG rating improvements.
• Even sophisticated investors struggle to judge if a chosen ESG rating is a relevant compensation indicator because many ESG scores fail to align with actual outcomes.
• Improving ESG ratings can be much easier than sustainability metrics: a cynical view suggests executives could meet sustainability targets on paper without making substantive concrete changes.
• Managers may manipulate ratings-based incentives by cherry-picking a favorable provider where the company already scores well or engaging in strategic disclosure to lift their scores without real performance gains.

The paper suggests verifiable metrics aligned with strategy makes incentives effective and defensible while involving third-party ratings can obscure analysis and erode shareholder trust if pay rewards don’t reflect real progress.

These findings rely mainly on the banking and airline industries and may not generalise to sectors with different sustainability challenges or less investor scrutiny.

It should be noted the trend of linking pay to ESG ratings is quite new, with only four firms in the sample adopting it so far. With such a small pool of examples, insights are only preliminary and do not allow to identify long-term outcomes

The authors relied on public disclosures, where some companies did not reveal which ratings or how heavily they influence pay, meaning the study could only assess what firms chose to report.