CEO compensation in global companies is increasingly tied to ESG objectives that by their very nature are soft, qualitative, and potentially hard to verify. Are ESG metrics another manifestation of CEO power?
In principle, contracts that link executive compensation to shareholder wealth should be the most effective way to align managers’ incentives with shareholder interests. While existing theories have focused on shareholder value maximization without fully considering shareholders’ environmental and social (E&S) preferences, optimal contracts may not change significantly as firms’ stock prices already reflect the preferences of marginal investors who would sell their shares if dissatisfied with corporate policies. For this reason, the growing emphasis on E&S targets in executive compensation has raised concerns that this trend reflects CEO power, primarily serving executive interests in ways that are not transparent to stakeholders.
Our recent paper provides new insights into this debate through an extensive analysis of compensation targets in the executive contracts of 10,636 listed companies worldwide. We find that ESG metrics are not special, and that CEO compensation includes many different types of metrics. Specifically, boards routinely subordinate executive compensation to various operational metrics, such as sales expansion, cost reduction, efficiency, project completion, or capital structure, which go well beyond stock returns and profits.
Our analysis reveals several key findings about compensation structure, performance metrics, and their role in shareholder communication. First, companies with E&S metrics also disclose market, financial, and operating performance metrics. More importantly, firms that disclose more metrics award their executives more equity-based compensation, which is crucial to aligning managerial incentives with shareholder interests. In addition, ESG metrics are more widely used when conventional signals of managerial performance, such as stock returns and profits, are highly volatile and noisy, which is consistent with the theory of optimal contracts. However, we also observe that contracts tend to emphasize ESG metrics in areas where companies have recently performed well.
While this would suggest that ESG metrics may be a way for boards to increase CEO payouts, we do not observe that ESG metrics are associated with higher excess pay, even though companies with operating and market metrics tend to pay their CEOs more. In addition, ESG metrics do not affect the sensitivity of compensation to financial and non-financial performance. These findings do not support the conjecture that ESG metrics are a manifestation of CEO power.
Perhaps most revealing, we find that metrics are often used in the early years of a CEO’s tenure, when there is more uncertainty about the CEO’s strategy and skills. In addition, the arrival of sophisticated outside blockholders, who may have strong views about corporate strategy, is also correlated with increased metrics usage. Based on this evidence, we conjecture that all metrics, and E&S metrics in particular, serve as a communication tool to explain to shareholders the level and structure of CEO compensation and, more broadly, the corporate strategy.
To test this conjecture, we analyze shareholder voting patterns and the incidence of shareholder proposals. We start by considering shareholders’ votes on the companies’ compensation policies, the so-called “say-on-pay” votes. We find that companies using more metrics in executive contracts receive a higher proportion of votes supporting their compensation packages, even after controlling for stock market performance, E&S performance, and total executive pay. Furthermore, companies whose contracts specify more metrics face lower shareholder dissent on management proposals. Thus, it appears that when boards communicate with shareholders through the use of metrics, shareholders’ opposition to compensation and other proposals is substantially lower. Consistent with such an interpretation, we observe an increase in the number of metrics featured in CEO contracts following periods of high shareholder dissent on say-on-pay proposals.
Further evidence supports the conjecture that pay metrics increase shareholder awareness of corporate strategy. Firms using E&S metrics are less likely to receive E&S proposals from shareholders, regardless of the firms’ actual E&S performance. Moreover, companies with more metric types and a higher number of metrics are less likely to receive shareholder proposals, and especially shareholder proposals opposed by management. This evidence reinforces the conclusion that metrics help boards effectively communicate corporate strategy to shareholders.
Overall, our analysis suggests that the recent rise in E&S metrics represents more than just a trend in compensation design – it reflects a broader shift toward using executive contracts as a tool for improving communication with shareholders increasingly interested in sustainability issues.
Nickolay Gantchev is a Professor of Finance at Warwick Business School, University of Warwick, a Research Fellow at the Centre for Economic Policy Research (CEPR), and a Research Member at the European Corporate Governance Institute (ECGI)
Mariassunta Giannetti is the Katarina Martinson Professor of Finance at the Stockholm School of Economics, a CEPR research fellow, and a research member and fellow of the European Corporate Governance Institute (ECGI).
Marcus Hober is a PhD candidate in Finance at the Stockholm School of Economics.
