Should companies link Executive Pay to Corporate Purpose?

Amid the movement to value companies beyond profit and share price, there is a debate on whether to do the same with the pay packages of top executives, incorporating non-financial performance criteria into incentive plans. Should “purpose” be one of them?

We recently conducted a global survey of boards of directors to gauge views on issues related to purpose, culture and strategy. A remarkably high number of board directors -- 89% -- reported that their company had an explicit statement of purpose. They also said they believed the CEO was the chief figure in shaping purpose, more than the board itself or than other employees.

However, the need to link executive pay to corporate purpose (henceforth “purpose pay”) is not immediately obvious. To begin, one could argue that caring about people and the planet is a “must”, and thus should not be subject to variable remuneration. A related argument is that executives already have powerful non-monetary incentives to fulfill their firms’ purpose in the form of social pressure, reputation, and the like. Others might argue that purpose statements can tend toward the vague and aspirational whereas pay packages are overwhelmingly concrete, requiring reliable metrics. Finally, if purpose is about “finding profitable solutions for the problems of people and the planet”, one could argue that the fulfilment of corporate purpose will eventually show up in the financial metrics currently used in compensation contracts.

The discussion around incorporating environmental, social and governance (ESG) criteria in executive compensation can provide useful insights into the possibility of “Purpose Pay”.

In a recent study on ESG pay, we looked at nearly 4,400 publicly traded firms in 21 countries. We found that the practice of linking compensation to ESG goals had jumped to 38% of firms in 2021 from just 1% a decade earlier – a sign that incorporating novel metrics is possible.

We examined three potential reasons for companies to base executive compensation arrangements on ESG metrics. These rationales are interrelated and not mutually exclusive.

The first reason relates to incentive contracting. To the extent that ESG metrics are viewed as leading indicators of future financial performance and potential risks, existing agency models provide an efficient contracting rationale for ESG-linked pay (ESG Pay), even if the firm’s shareholders preferences are purely pecuniary.

A second potential reason to adopt ESG Pay is aligning managerial objectives with the interests of select stakeholder groups, including the firm’s shareholders. If the firm’s current or prospective shareholders have an intrinsic (i.e., non-pecuniary) preference for improvements in ESG related outcomes, the adoption of ESG Pay may serve as a mechanism for aligning the objectives of management with owners’ preferences. Note that this rationale does not necessarily imply that higher ESG performance leads to higher financial performance.

A third potential rationale for ESG Pay is that the decision to tie managerial compensation to ESG outcomes may strengthen the credibility of a company’s existing disclosures and pledges to improve its ESG outcomes.

The results of our tests suggest that each of the three rationales can explain part of the variation in ESG Pay adoption. In exploring two additional factors which may affect the adoption of ESG Pay, we find support in the data that the decision to adopt this practice is affected by individual perceptions, specifically personal opinions and expectations about ESG outcomes and/or ESG Pay, as well as peer effects. We do not find that ESG Pay is related to abnormal CEO compensation, but this does not necessarily mean that this compensation practice is on average optimal for shareholders.

We also explored the potential consequences of the implementation of ESG Pay. While our tests are descriptive (establishing causality is not possible given the limitations of our data), we found evidence consistent with the notion that ESG pay can be instrumental in improving sustainability performance. For example, our results suggest that, when companies include emission-specific metrics in their pay packages, they exhibit a subsequent decrease in their CO2 emissions.

In contrast, we did not find that the introduction of ESG Pay was followed by stronger financial performance. If, anything, the results pointed in the opposite direction. One explanation is that improving ESG performance is costly from a financial perspective. An alternative explanation is that improved ESG performance will yield long-term financial benefits, not yet captured in earnings and/or stock prices.

It is not difficult to see the likely connections between ESG pay and “Purpose Pay”. Similar to ESG metrics, a measure of purpose could be a leading indicator of future financial performance. Of course, this assumes that purpose really means “producing profitable solutions to the problems of people and planet, not profiting from producing problems”. Just as ESG criteria have been criticized for being overly broad and amorphous, a measure of purpose could be noisy and manipulable. Like ESG Pay, “Purpose Pay” would require a clear definition of the underlying concept of purpose, along with well thought-out and transparent metrics and targets. Otherwise we run the risk of “purpose-washing”.

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By Gaizka Ormazabal, IESE Business School.

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