The Advisors' Blog

I’ve blogged a few times about the downsides of adding ESG metrics to incentive plans – here’s a write-up of why long-term shares might be a better mechanism for motivating ESG behavior, and here’s a post about how ESG metrics can be particularly dangerous when it comes to things like employee safety. Now, Harvard Law profs Lucian Bebchuck & Roberto Tallarita are out with this empirical analysis to highlight flaws of ESG-linked compensation. They identify these two primary limitations:

1. 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. They risk distorting CEO incentives.

2. ESG compensation poses the danger of creating vague, opaque, and easy-to-manipulate compensation components, which can be exploited by self-interested CEOs to inflate their payoffs, with little or no accountability for actual performance.

The professors are skeptical that ESG pay programs could evolve enough to overcome these problems, even if designed with an eye towards being clear, objective, comprehensive, transparent and standardized. Their current conclusion is that:

Shareholders and those who care about stakeholder welfare should not support maintaining or expanding current practices for using ESG metrics. Existing practices and their expansion should not be regarded as a positive development for those who are concerned about stakeholder protection. They serve the interests of executives but not those of shareholders or stakeholders.

Companies that are resisting the push to incorporate ESG metrics in pay programs may want to add some of these talking points to their engagements and proxy statements.

Companies that have or are planning to add ESG metrics should consider how to overcome these objections – e.g., by improving transparency and limiting discretion. Comp committees and advisors should also thoroughly consider and remain on the lookout for “unforeseen consequences” of these incentives. A lot of investors are on the ESG bandwagon right now, but they’ll be at your doorstep complaining if things go south.

– Liz Dunshee