The Advisors' Blog

This blog features wisdom from respected compensation consultants and lawyers

July 1, 2021

ESG Metrics: Beware “Unintended Consequences”

In the past year, S&P 500 companies rapidly changed their executive compensation to incentivize diversity, worker health & safety, and other ESG metrics. In some cases, the metrics were added as one-time modifiers to individual payouts, and in many cases – particularly for D&I – the metrics were added to formulaic plans. This 10-page Semler Brossy memo catalogues many of the changes.

What we don’t know yet is whether these changes to comp plans will effectively motivate actions that support the long-term, sustainable performance that investors want. As I blogged yesterday, pay-for-performance already has some flaws. And just as ESG metrics are becoming mainstream, this WSJ piece from London B-School Prof. Alex Edmans argues that, except in a few unique circumstances, we may be barking up the wrong tree with these new incentives as well. Here’s an excerpt:

These unintended consequences might be even worse for ESG than financial targets. One challenge is that, for financial performance, only a couple of measures might be relevant. But ESG performance is multifaceted. Companies have a responsibility to many stakeholders—employees, customers, suppliers, the environment, communities and taxpayers—and for each stakeholder, many dimensions are relevant. Either the contract includes only a couple of ESG measures and the CEO ignores others, or it includes most of them and the contract becomes so complex that it loses any motivational effect.

A second problem is measurement. For a financial target such as earnings-per-share, there’s consensus on how to measure it. But that isn’t the case for an ESG metric. Should ethnic diversity be captured by the number of minorities on the board, in senior management, or in the workforce—or other factors such as the ethnic pay gap, or the proportion of minorities who get promoted from each level? Even ESG-rating agencies disagree significantly on how to measure ESG performance, so any measure might be perceived as unfair or ignore important dimensions.

The solution, Professor Edmans says, is to pay CEOs like owners – with long-term shares. That’s something that Norges Bank, which manages Norway’s huge sovereign wealth fund, has been saying since 2017 (here’s their policy, which I’ve blogged about a few times). Professor Edmans says that companies can get the benefit of motivation – without the risk of manipulation – simply by setting & reporting on ESG goals. CEOs are a competitive bunch!

It goes without saying that not everyone agrees with Professor Edmans’ take. If we’re locked into the pay-for-performance system – and existing financial goals are at odds with ESG – it makes sense to even the playing field and emphasize the strategic importance of these metrics.

Liz Dunshee