Harvard Law Study Challenges the Use of ESG Metrics in Executive Pay

As policy makers and governance experts debate the need to move beyond a singular focus on shareholders toward a model that serves multiple stakeholders, companies are responding by incorporating non-financial metrics into their pay plans. Specifically, metrics focused on Environmental, Social and Governance (ESG) issues are becoming increasingly common in executive incentives. Advocates point to the signaling function of incentives, sending a message that companies are taking the interests of all stakeholder groups seriously. However, in a recent study Harvard Law professors Lucian Bebchuk and Roberto Tallarita argue strongly against the use of ESG metrics in executive incentives, saying, “The use of ESG-based compensation, we show, has at best a questionable promise and poses significant perils.”

Based on a review of the 2020 CEO pay packages of companies in the S&P 100, the authors identified what they characterize as two “structural” problems inherent in the use of ESG metrics in executive pay plans:

• ESG metrics attempt to tie CEO pay to partial interests of a limited subset of stakeholders. They assert this is not the case with shareholders, whose interests they claim are captured by one metric. (While not explicitly stated, that metric is presumably Total Shareholder Return). As a result, a focus on narrowly defined ESG metrics could unintentionally reduce overall stakeholder welfare.
  
  
• ESG metrics as currently used in incentives exacerbate the agency problem of executive pay because they are not subject to effective scrutiny by outsiders. Specifically, they do not have clear and objective goals; the outcomes are not typically disclosed; and companies do not provide enough context so that the level of rigor of the goals can be assessed.

Based on these inherent limitations, Bebchuk and Tallarita conclude that the expansion of ESG into incentives is counterproductive, weakening shareholder oversight and allowing executives to “cherry-pick” vague metrics that enable higher pay without any corresponding benefits to stakeholders. They further argue that the use of ESG metrics could even erode the progress that has been made in strengthening the pay-for-performance relationship and enabling effective shareholder oversight. Given the level of pressure and engagement by multiple stakeholders on ESG issues, it remains to be seen how much interest this study will generate as boards evaluate whether and how to use incentive compensation to drive a focus on the interests of a broader group of stakeholders.