In the last few years, there has been an increase in the proportion of socially and environmentally responsible shareholders. These shareholders are not solely concerned with the profits generated by a firm. Instead, they also care about its social and environmental impact. Some empirical studies have already established that this has implications for firms’ stock market valuations: all else equal, more socially or environmentally responsible firms will trade at a premium.[1]
In the context of corporate governance, a significant aspect to consider is how corporate owners can align their interests with those of self-interested professional managers. While linking the manager’s compensation to profits or stock returns can help align interests when financial performance is at stake, the challenge lies in achieving alignment when the firms social and environmental performance also holds significance.
It has been pointed out that firms tend to set easily achievable targets for social and environmental objectives so these “incentives” are ineffective and merely allow managers to inflate their pay. However, investors who invest in hundreds or thousands of firms do not have the time or expertise to analyze each of these firms’ annual ESG reports and draw the necessary implications. Therefore, to meet investor demand, several ESG (Environmental, Social, and Governance) rating agencies now provide ESG ratings and scores for companies in which corporate performance on a range of ESG indicators is quantified.
In a recent paper, Nicolas Sahuguet and I consider interest alignment in this context. We consider a firm owned by socially responsible shareholders who would like to incentivize corporate managers to invest in social and environmental projects according to their preferences. To this end, they can make managerial compensation contingent on several performance measures: the firm’s profits, stock price, and ESG scores as provided by ESG rating agencies.
One might think executive compensation will be contingent on the firm’s ESG scores if its shareholders are socially responsible, but this is too simplistic. ESG scores are standardized measures of ESG performance that can easily be gamed by executives. Also, the stock price already incorporates social and environmental incentives to the extent that stock market investors care about these issues. Consequently, a manager with stock price-based incentives already has social and environmental incentives. Moreover, these incentives for ESG investments are “better” than those provided purely based on ESG scores. This is because stock market investors are aware of ESG scores’ imperfections and adjust stock prices accordingly, thus mitigating the impact of imperfect ESG scores. In sum, stock prices reflect investors’ best assessment of the firm’s ESG output.
We show that managers will receive compensation contingent on their firm’s stock price and ESG scores if their long-term shareholders are more socially responsible than investors who set the stock price by trading. On the contrary, if the firm’s shareholders are less socially responsible than stock market investors, then managers will receive compensation contingent on the stock price and the firm’s profits. Profits-based compensation allows for attenuating the social and environmental incentives embedded in the stock price. Intuitively, a manager who maximizes a stock price set by highly socially responsible investors would invest “too much” in ESG-related projects from the perspective of the firm’s shareholders. Finally, when the firm’s shareholders and stock market investors have the same social preferences, managers will simply receive equity-based compensation. In this case, the compensation contract is very simple – even though incentives are provided over multiple dimensions, which usually requires multiple performance measures.
We also analyze what happens when social preferences vary across dimensions of ESG. For example, the firm’s shareholders and the board might care more about the firm’s carbon emissions but less about its top-management diversity than stock market investors. In this case, the manager’s contract can be more complex. It can include stock price-based compensation, earnings-based compensation to discourage excessive investments in top-management diversity (from the board’s perspective), and compensation contingent on the firm’s ESG score on carbon emissions to encourage related investments (carbon capture, green technologies, etc.) above the level that would maximize the stock price. Once again, using performance measures other than the stock price arises when ESG preferences are heterogeneous across economic agents and dimensions of ESG.
Finally, we analyze the outcome with multiple sets of ESG scores provided by multiple ESG raters. When the noise in ESG scores is uncorrelated and identically distributed across ESG raters, we show that the distorting effect of ESG scores vanishes as the number of scores increases. Intuitively, if scores are constructed differently, it is harder for a manager to game multiple scoring methodologies than a single methodology. Thus, even though the heterogeneity of ESG ratings is often criticized because it reflects disagreement between ESG raters, it can be useful from a corporate governance perspective. However, we also show that the availability of additional ESG scores is not always beneficial if the noise in ESG scores is positively correlated across ESG raters. Indeed, gaming mitigation is minimal in this case, while highly noisy scores distort incentives even more.
In summary, by incorporating the specific characteristics of ESG scores in a standard principal-agent model of corporate governance with socially responsible shareholders, our model provides some guidance for the design of social and environmental incentives for corporate executives.
Pierre Chaigneau is an Associate Professor of Finance at the Smith School of Business at Queen’s University.
Nicolas Sahuguet is a Professor of Business Economics at HEC Montreal.
This post was adapted from their paper, “Executive Compensation With Socially Responsible Shareholders,” available on SSRN.
[1] Hartzmark and Sussman, 2019, Barber, Morse, and Yasuda, 2021, Bauer, Ruof, and Smeets, 2021, Heeb et al., 2023
