The Advisors' Blog

Last spring, Liz shared a Bloomberg article describing the more “critical eye” that investors and the media are casting toward ESG incentives, saying, “there’s evidence to suggest the add-on is being used to enable bigger remuneration packages without leading to any meaningful [ESG] improvement.” A recent research paper suggests there’s reason for concern.

In “ESG Overperformance? Assessing the Use of ESG Targets in Executive Compensation Plans,” Adam Badawi (UC Berkeley) and Robert Bartlett (Stanford Law School) audited S&P 500 companies’ 2023 proxy statements to assess the use of ESG metrics and, most importantly, NEOs’ performance against those metrics. Here’s what they found (from their HLS blog summary):

Financial targets are nearly always hard targets that are tied to measures such as revenue and profitability. In general, they appear to be set at levels that are not easy to hit, which would explain why executives missed all of their financial targets 22% of the time in our sample.

ESG targets, it appears, get set in a different way. We find that, of the 247 firms that disclose an ESG performance incentive, only 6 of them reported missing every target. That is, 98 percent of them met at least one ESG target. Similarly, we find that 44% of firms met or exceeded all of their financial targets while 76% of firms met or exceeded all of their ESG targets.

They then tried to analyze what’s causing this. Are NEOs just ‘knocking it out of the park’ when it comes to ESG improvement? It’s hard to say for sure, but that seems unlikely.

Using three different measures of ESG performance, we find no statistically significant association between attaining ESG performance goals and improvements in ESG scores. We next examine whether there is an association between whether a company meets or exceeds all of its ESG targets and the level of shareholder support that executives receive during the annual say-on-pay vote. Here we do find a statistically significant negative association.

But what does it all mean? They go on:

This evidence is consistent with the theory that ESG targets are set at levels that reflect weak corporate governance. That is, they may be set at levels that are low to allow executives to reap their rewards even if ESG performance is not particularly strong. … 

Motivating better ESG performance benefits from setting award thresholds and the amount of compensation at high levels. But doing so poses the risk that executives will miss the targets, which may indicate to the outside world that managers are not prioritizing ESG values. … [F]irms may have responded to this dilemma by setting ESG incentive targets at levels that are designed to be achieved.

Take note! If companies are setting ‘softball’ ESG goals, this will continue to be a pain point for investors, who will demand better transparency around target metrics and executives’ performance against them.

– Meredith Ervine