ESG targets in executive pay plans too easy to hit?

Here’s this note from Nawar Alsaadi:

This fascinating piece of research by Adam B. Badawi at the University of California and Robert P. Bartlett at Stanford Law School provides great insights on how corporate boards and executives establish fuzzy and easy to beat ESG targets.

Although the paper mentions a rise in executives ESG incentives from 37% in 2013 to 63% within the S&P 500 companies, the vast majority of the ESG objectives tied to these incentives are vague and easy to beat. Here is a key passage from the paper, “while executives miss all of their financial targets 22% of the time in our sample, we show that this outcome is exceptionally rare for ESG-based compensation. Only 6 of 247 (2%) firms that disclose an ESG performance incentive report missing all of the ESG targets.” (chart above).

The authors goes on to explain as to why this is the case, “whereas financial metrics used in executive compensation plans are typically tied to publicly available accounting or market metrics, ESG metrics are more likely to focus on less transparent operating measures, such as those relating to carbon emissions, workplace conditions, or hiring and promotion practices.”

And it is not that executives are not missing ESG targets, but they are supposedly exceeding them in 76% of the cases compared to 44% for financial targets (chart below). Interestingly enough, when ESG targets are tied to obligatory reporting obligations such as those required by the EPA, OSHA or EEO-1, they are missed at a much higher rate. Said another way, when ESG incentives are real and are tied to measurable, transparent, targets, CEOs fail to meet them by an order of magnitude more. This is another validation as to why we need robust ESG disclosure regulations.

Finally, despite the easy ESG pay pocketed by these executives, the overall impact on a CEO’s expected annual compensation is typically small (3% or less). This largely due to the fact that ESG incentives are over-weighted towards short-term incentives plans (96.5%) which tend to represent a smaller portion of overall CEO pay. Considering the long term nature of many ESG and sustainability issues, the short term focus of these ESG targets is another indictment of what I like to call “ESG Incentives Theater.”

The unfortunate reality is that many companies use ESG incentives as a facade, setting low, opaque ESG targets and praising executives for meeting them, all to create the illusion of strong ESG leadership. Sustainable investors must apply greater scrutiny to these targets and insist on clear, measurable ESG goals. It’s crucial to stop rubber stamping executive pay plans and accepting companies’ vague ESG references in proxy statements as sufficient progress.