Should the pay of top executives be linked not just to the performance of the company in the stock market or other quantitative/financial goals, but also to whether the company meets environmental, social, and governance (“ESG”) goals? Lucian A. Bebchuk and Roberto Tallarita raise some doubts in “The Perils and Questionable Promise of ESG-Based Compensation” (Journal of Corporation Law, Fall 2022).

Bebchuk and Tallarita focus on the actual behavior of the 97 US companies in the S&P 100–which together represent over half the total value of the US stock market. They write:

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. 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%).

It is notable to me that if you hear a large company announcing that it has tied executive bonuses to environmental, social, and governance goals, it typically determines 1.5-3% of the executive bonus. Bebchuk and Tallarita look at what specific goals are mentioned in corporate reports:

Despite the potential richness and intricacy of a company’s stakeholders and their interests, ESG metrics used in the real world are inevitably limited and narrow. … Most companies use metrics linked to employee composition and employee treatment, and many use metrics connected to consumer welfare and environmental issues (especially carbon emissions and climate change). Very few companies, however, consider their impact on local communities, and only two companies use metrics linked to supplier interests.

Furthermore, with respect to each of these groups or interests, ESG metrics focus on a narrow subset of dimensions that are relevant for stakeholders. … [F]or each stakeholder group or interest, companies choose to give weight to specific dimensions that represent only part of what stakeholders care about. With respect to employees, for example, most companies choose goals related to inclusion or diversity, and many focus on work accidents and illness, but none incentivizes its CEO to increase salaries or benefits or to improve job security. With respect to community, many companies focus on trust and reputation, but almost none chooses incentives linked to reducing local unemployment or to distributing free products or services to disadvantaged residents. …

[S]takeholder welfare is multi-dimensional. However, some of these dimensions are easier to pin down and measure, while others, equally important, are difficult to measure. Consider, for example, the welfare of employees. Employees are interested in receiving a good salary, avoiding accidents and illnesses, and keeping their job: these goals are relatively easier to measure and assess. However, employees are also interested in being treated fairly, developing good professional relationships with supervisors and peers, growing professionally, and other factors that are very hard to measure. …

The narrowness of ESG metrics is an empirical fact and also a theoretical necessity. No compensation package could exhaustively identify and incentivize goals that address all of the interests and needs of all individuals and groups affected by a company’s activities. The very act of identifying a measurable goal and designing a metric to assess the achievement of that goal requires the choice of some specific dimension and measure and, therefore, the rejection of other potential dimensions and measures. Business leaders have embraced stakeholderism by promising win-win scenarios in which companies deliver value to shareholders and all stakeholders. The reality, however, is that companies choose only a few groups of core stakeholders and focus on a limited number of aspects of their welfare.

One response to these sorts of concerns is the “at least” defense. At least the firms are making a public statement in response to broader concerns. At least some firms may be trying a little harder along these lines. At least some broader social concerns might be addressed. Maybe the glass is only 1.5% to 3% full, but at least it’s not 100% empty. At least it’s a start.

However, a primary concern over executive pay for some decades now has been about overly cozy relationships between corporate executives and boards of directors, in which top executives get excessive pay over what their performance would actually deserve. Linking pay to stock prices or other financial performance is clearly not a perfect measure, but it’s at least an anchor for executive pay. If executives were to get a significant share of their pay based on the announced commitments they make about ESG concerns, or about subjective judgements on the extent to which they have achieved these goals, then it again becomes possible for cozy relationships between board members and executives to lead to higher pay: “Sure, the company had a dramatic decline in production and sales last year, but as a result, we also reduced carbon emissions, so the CEO gets a raise.” Moreover, if executives have incentives to re-jigger corporate resources toward more measurable social goals, but potentially at the expense of less measurable goals, there is no guarantee that the overall goals of making corporations more socially conscious will be met.

A similar set of themes arise in concerns over “Diversity Washing,” which refers to companies that make public announcements about their commitment to diversity, but don’t actually do much about it. Andrew C. Baker, David F. Larcker, Charles McClure, Durgesh Saraph and Edward M. Watts discuss the issue in a European Corporate Governance — Finance Working Paper (# 868/2023, January 2023).

The authors have detailed data on gender and racial diversity of the employees for over 5,000 US public companies. They also have company statements filed with Securities and Exchange Commission that discuss their diversity, equity, and inclusion policies (specifically, annual reports, current reports, and proxy statements. In addition, they have measures of firm misconduct related to diversity issues, as well as the rankings that firms have received about their diversity programs. Thus, they can look at whether firms that talk a good game about diversity actually walk the walk, and also whether firms that talk a good game get rewarded for what they say, rather than what they do.

It turns out that there is an overall positive correlation between the talking at the doing, but the correlation is a mild one, because of firms that they call “diversity washers.” They write:

We provide large-sample evidence showing many firms have significant discrepancies between their disclosed commitments to diversity and their actual hiring practices. Consistent with such firms making misleading commitments to DEI, we find diversity washers have less workplace diversity, experience future outflows of diverse employees, and are subject to higher diversity-related fines. Despite these negative DEI outcomes, we show diversity washers receive higher ESG scores from commercial rating organizations and attract more investment from ESG-focused institutional investors, suggesting these disclosures mislead outside stakeholders and investors.

My focus here has been on practical problems that arise when corporations seek to put a priority on ESG goals. But at a deeper level, I have qualms over whether it is a good idea for corporations to have such goals. Different institutions are good for different purposes. We don’t expect hospitals to educate fourth-graders, we don’t expect universities to produce smartphones, and we don’t expect churches to install dishwashers. It seems to me quite possible to support the idea that corporations should be focused on earning profits, and also to support both government and nongovernment efforts to define and pursue environmental and social goals. For prior posts on the general subject, starting points are: