Stock prices already force executives to think green and ratings can be gamed

Photo by Waldemar on Unspash

The ESG (environmental, social, and governance) investment framework is a much livelier topic than it really ought to be. It ought to be boring.

Institutional investors, who know an ill wind when they feel one, are clearly concerned that climate change and lax corporate governance will imperil the value of their holdings. The prospect of stranded assets and Enron-level scandal can have that effect.

Investors have been pushing for an independent standardized way of rating ESG that would help them compare the performance of publicly traded businesses on, say, carbon emissions or diversity targets. ESG serves that purpose, albeit as an imperfect and ever-evolving rating tool.

Yet, for some, ESG rating by investors is “a dangerous political agenda masquerading as altruism” that may constitute a hub-and-spoke (or even Chinese!) conspiracy. It’s some grotesque result of a woke agenda?—?at the very least a scam.

You can only begin to understand this reaction by viewing ESG not as a tool for rating but as a tool for alignment. It is one means by which investors can align the priorities of senior management teams of companies in their portfolios with the investors’ concerns for sustainability and good governance. By trading stocks, they bake these concerns into the share price, a metric guaranteed to get any CEO’s attention.

The same logic can hold for corporate boards. If ESG is an alignment tool for institutional investors, surely it can be the same for board directors. Boards have long incorporated share price into compensation packages to focus executive attention on boosting short-term profits and mitigating losses. They could certainly incorporate ESG into executive compensation to align executives on non-financial outcomes as well.

Many corporate boards agree. According to one survey, 77 percent of major companies across North America and Europe include ESG metrics in their executive incentive plans (from 69 percent in the U.S. to about 90 percent in Europe and the UK).

This type of ESG uptake is yet one more alarming proof point for conspiracists and culture warriors. Yet the use of ESG in executive compensation even worries many supportive experts. It has been suggested that, at best, it is ineffective or, at worst, it leads to unintended consequences. There are not only the challenges of designing robust ESG metrics but also the problem of incorporating them into complex compensation packages weighed down by cross-cutting incentives.

Signals from stock prices

Pierre Chaigneau, for example, is a Canadian academic who has extensively studied the economics of executive compensation. While he agrees that ESG reports and ratings, imperfect though they are, provide material information for investors, he says ESG-based compensation is generally unnecessary for boards to align their executive leaders to ESG-related outcomes.

This is his thinking: If institutional investors are already making decisions on buying or selling a stock partly based on ESG ratings?—?which many now do?—?then ESG considerations are already embedded in the share price of public companies. Therefore, company boards could use stock price-based incentives in their executive compensation with some confidence that ESG considerations would be part of those incentives?—?like a carrot that does double duty as a lure for savvy business acumen and community-minded leadership. A study he conducted based on game theory showed how this could work.

In another study, Chaigneau showed that even if corporate board directors were focused solely on short-term financial returns, with no regard for longer-term ESG concerns, their executives with share price-based incentives would still pick up the signal from institutional investors that green concerns needed to be taken seriously.

In fact, his research shows that executive compensation doesn’t have to be particularly sensitive to ESG ratings for executives to be motivated to make investments supportive of ESG.

Some boards, of course, may still opt to incorporate ESG-related targets in their executive compensation plans. If they feel pressure to do so, Chaigneau has two pieces of advice: One, use full ESG ratings (that are based on hundreds of measures) rather than cherry-pick a handful of measures that show the company in the best light. And two, use metrics from more than one ESG rating firm. If a board is serious about outcomes and isn’t just engaged in greenwashing, it must guard against executives gaming the incentives associated with ESG measures for their personal benefit.

This is not as far-fetched as you may think. The ESG ratings industry is fragmented with raters taking different approaches to the measurement, scope, or weighting of data. ESG raters are transparent regarding how they derive their ratings, making it easier for executives to anticipate and game their company’s numbers if they are sufficiently motivated. They can choose to invest in certain technologies or initiatives that pump up their company’s ESG rating (and potentially their compensation), even if the company’s actual ESG performance doesn’t improve.

A study Chaigneau conducted with Nicolas Sahuguet showed that, if needed, it would be far better for boards to base their compensation schemes on data from multiple ESG rating firms rather than just one. Their study, which simulated various scenarios, showed that increasing the number of ratings used for managerial compensation purposes improved the social and environmental impact of the firm, and that the distorting effect of ESG ratings weakened as the number of ratings grew.

Intuitively, this makes sense: It is harder for a manager to game multiple rating methodologies than to game a single methodology.

An incentive for the times?

This type shrewd approach to mitigating one of the vulnerabilities of ESG-based compensation is a welcome contribution to a field that is still in its infancy. It is not at all certain, however, that ESG ratings will ever be an effective direct incentive for senior executives or improve the social impacts of corporate activities.

Yes, a great many organizations are adopting some form of ESG-based executive compensation. But the motive for doing so likely has more to do with keeping up appearances or responding to investor pressure rather than pursuing a deeply-felt strategic goal. As well, most ESG-based executive compensation is geared to short-term outcomes (via annual bonuses) rather than rewarding more visionary leadership (via long-term equity instruments).

The other unknown is the power of the signal. So far, the incentives built into executive compensation plans to advance ESG goals are dwarfed by the incentives to maximize share value. A recent study of companies with leadership positions in the Business Roundtable, an industry group that has embraced ESG, showed that explicit, non-discretionary ESG incentives are “economically insignificant relative to executives’ incentives to maximize share value arising from shares owned outright and unvested or unexercised equity-based compensation.”

Will that change going forward? And, if not, will the ESG signal that is already embedded in share prices be a sufficiently powerful incentive for executives, as Chaigneau’s research suggests? Or maybe this is all a dangerous political agenda masquerading as altruism, and we’ll soon wake up from this nightmare and see the light.

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Why ESG Ratings Have No Place in Executive Compensation was originally published in DataDrivenInvestor on Medium, where people are continuing the conversation by highlighting and responding to this story.

ESG, SDG, CER, GRI, FSC, LCA, WELL sustainability, compensation, esg, governance, ceo Read More 

Alan Morantz