The Perils and Questionable Promise of ESG-Based Compensation.

• Author: Bebchuk, Lucian A.

Table of Contents I. Introduction 39 II. The Stakes 42 A. The Rise of Stakeholderism 42 B. The Demand for ESG Metrics 44 C. The Questions 47 III. ESG Metrics in S&P 100 CEO Compensation 47 A. ESG-Based Compensation in S&P 100 Companies 47 B. The Use of ESG Metrics 48 IV. Narrow Dimensions and the Multitasking Problem 52 A. The Breadth of Stakeholder Interests 52 B. The Narrowness of ESG Metrics 54 C. The Multitasking Problem 61 V. Outside Reviewability and the Agency Problem 63 A. Agency Problem and the Importance of Outside Reviewability 63 B. Three Key Requisites for Effective Outside Reviewability 66 C. Outside Reviewability of ESG Metrics 68 VI. The Perils of ESG-Based Compensation 74 List of Tables Table 1. CEO Compensation in S&P 100 Companies 49 Table 2. Stakeholder Groups and Interests in ESG Metrics 55 Table 3. Dimensions of Stakeholder Welfare in ESG Metrics 57 Table 4. Outside Reviewability of ESG Metrics 70 I. INTRODUCTION

A heated debate is taking place on how to create a more inclusive capitalism that serves not only the interests of shareholders but also those of other "stakeholders," including employees, consumers, suppliers, communities, and the environment. According to an increasingly influential view, companies can accomplish this goal by moving away from the traditional shareholder primacy model and shifting toward a new conception of corporate purpose. This stakeholder governance view (in short, "stakeholderism") recommends that corporate leaders be given enhanced discretion to take into account the interests of all stakeholders, not only shareholders. (1)

In response to skepticism about whether corporate leaders have adequate incentives to create value for stakeholders, some supporters of stakeholderism have posited that corporate leaders can be incentivized to improve stakeholder welfare by tying their compensation to environmental, social, and governance (ESG) goals. Based on this view, not only have compensation consultants been busy developing ways to incorporate ESG metrics into executive compensation, but many companies have been using such metrics in their pay arrangements, and supporters of stakeholderism have been urging an expansion of this practice. (2) This trend is based on the idea that ESG-based compensation carries the promise of creating effective incentives for CEOs and top executives to improve the welfare of stakeholders and reduce their companies' negative externalities. Reacting to the increased use of ESG metrics, the SEC recently requested comments on what companies should tell investors about the use of such metrics. (3)

This Article provides a conceptual and empirical analysis of the use of ESG metrics in executive pay. We conduct a detailed investigation of the current use of ESG metrics in S&P 100 companies and examine the extent to which expansion of these practices may or may not be beneficial. Our analysis identifies two structural problems with ESG metrics, which we show to be difficult to solve and which severely limit the benefits of this practice. We conclude that the use of ESG-based compensation has a questionable promise and poses significant perils.

In particular, we warn that using ESG metrics threatens to reverse the progress achieved in the past few decades in making executive pay more transparent, more sensitive to actual performance, and more open to outside oversight and scrutiny. We explain that encouraging and expanding the use of ESG-based compensation might give self-interested executives a powerful tool to increase their payoffs without creating meaningful value for stakeholders while potentially diluting executives' incentives to deliver value to shareholders.

Our analysis is organized as follows. Part II discusses the recent rise of stakeholderism and the increasing demand for stakeholder-oriented governance arrangements. Many prominent corporate leaders and advisers, as well as influential business interest groups, such as the Business Roundtable and the World Economic Forum, have publicly announced a redefinition of the purpose of the corporation--namely, from shareholder primacy to stakeholder governance--and have pledged to deliver value to all stakeholders. (4)

In particular, Part II discusses the growing trend of including ESG goals in executive compensation packages, presented as an effective tool to incentivize CEOs and top executives to take into account the interests of stakeholders and create value for them. (5 ) This trend is partly due to well-intentioned (but, as we explain, mistaken) support from investors and business leaders genuinely interested in improving the treatment of stakeholders. However, it might also be driven by corporate leaders who recognize that ESG-based compensation can serve their private interests.

The growing use of ESG-based compensation raises two important questions for corporate governance and the debate on stakeholderism. The first is whether the current practices of ESG-based compensation produce meaningful incentives to increase stakeholder welfare. The second is whether the current limits of ESG-based compensation can be improved and, if so, to what extent. (6)

Part III provides an overview of the companies in our sample and their use of ESG compensation metrics. We chose to focus on the 97 U.S. companies included in the S&P 100 index, as they represent more than half of the entire U.S. stock market and arguably have a significant impact on stakeholders and society at large. (7) We found that slightly more than half (52.6%) of these companies included some ESG metrics in their 2020 CEO compensation packages. These metrics focus chiefly on employee composition and employee treatment, as well as customers and the environment, but also, to a much smaller extent, communities and suppliers.

ESG metrics are mostly used as performance goals for determining annual cash bonuses. (8) However, most companies do not disclose the weight of ESG goals for overall CEO pay, and those that do disclose it (27.4% of the companies with ESG metrics) assign a very modest weight to ESG factors (between less than 1% to 12.5%, with most companies assigning a weight between 1.5% and 3%).

Part IV discusses the first structural limit of ESG-based compensation. ESG metrics inevitably focus on a limited number of welfare dimensions of a limited number of stakeholders. Despite the promise of a new paradigm that delivers value to "all stakeholders," the potential breadth of companies' stakeholders, and the multiple ways their interests are affected by corporate decisions, companies choose a small subset of stakeholder groups and interests on which to focus. (9)

The narrowness of ESG metrics reveals the limits of ESG-based compensation and also raises a well-known problem in the economics of multitasking. By incentivizing CEOs to improve the performance of narrow quantifiable metrics, companies create distorted incentives to neglect other significant but hard-to-quantify dimensions. (10)

Part V examines the second, and fatal, limit of ESG-based compensation. CEOs exert substantial influence on their boards of directors and can therefore extract significant value from their companies through excessive compensation packages. In order to mitigate this agency problem, compensation arrangements should be tied to performance, and companies should disclose enough information to allow an outside observer to review and assess the meaningfulness of the performance. (11)

Yet almost no companies in our sample use ESG metrics that meet this standard. Most companies mention using ESG goals but do not disclose the relevant targets and actual outcomes, or they leave significant discretion to their boards. Among the very few companies that disclose clear and objective goals and actual outcomes, almost none provide sufficient contextual information allowing outsiders to review and assess the pay arrangements. (12)

Part VI sets forth our conclusions on ESG-based executive compensation and the implications for the broader debate on stakeholderism. (13) Our analysis shows that the ESG compensation trend should not be expected to produce meaningful incentives for the creation of value for stakeholders and that it poses the danger of creating vague, opaque, and easy-to-manipulate compensation components, which self-interested CEOs can exploit to inflate their payoffs, with little or no accountability for actual performance.

2. THE STAKES

   In this Part, we discuss the recent spread of stakeholderism and, in particular, the increasing adoption of ESG metrics in executive compensation arrangements as a tool to incentivize corporate leaders to give weight to the interests of stakeholders, not only of shareholders. The study of this phenomenon and its actual efficacy, we argue, is important for assessing the promise of stakeholder governance.

   1. The Rise of Stakeholderism

      For decades, corporate law scholars have debated whether directors should serve only shareholders or also other constituencies, such as employees, customers, suppliers, or society at large. (14) Recently, however, this longstanding debate on the purpose of the corporation has taken a new form. On the one side, advocates of stakeholderism suggest that corporate leaders be given enhanced discretion to consider the interests of stakeholders, not only of shareholders, when making business decisions. (15) Stakeholderism thus encourages reliance on managerial discretion to produce corporate decisions that may increase the welfare of stakeholders.

      On the other side, critics of stakeholderism believe that corporate leaders lack the incentives to sacrifice shareholder value in order to benefit stakeholders (the "agency critique" of stakeholderism). (16) Therefore, they worry that relying on managerial discretion and corporate leaders' pledges to serve stakeholders would not produce significant benefits for stakeholders; rather, it would harm stakeholders by worsening the economic...