To cut a firm's emissions, peg its CEO's pay to climate goals

Companies that adopt ESG-linked executive pay make tangible improvements on ESG issues.
The pay package of Ben van Beurden, the chief executive of Shell, is linked in part to carbon emission targets.
The pay package of Ben van Beurden, the chief executive of Shell, is linked in part to carbon emission targets.
Photo: Sergio Moraes (Reuters)
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Companies that want to reduce their carbon footprint should pay their executives more to make that happen, according to a new working paper (pdf) by economists in California and Europe.

Drawing on survey data from more than 10,000 companies in 21 countries compiled by the proxy voting advisory firm ISS, the paper finds that a growing number of companies are linking executive compensation to the completion of environmental, social, and governance (ESG) targets—from just 1% of companies in 2011 to nearly 40% in 2021. Companies that adopted ESG-linked pay in the last couple of years include energy companies like BP and Shell, tech companies like Apple, and restaurants like McDonalds and Chipotle.

In many cases, the pressure to link executive pay to ESG goals is coming from big institutional shareholders like BlackRock and Vanguard, said Stefan Reichelstein, an economist at Stanford University’s graduate school of business and professor of business administration at the University of Mannheim, and co-author of the paper. The more shares in a company that are controlled by those firms, the more likely the company is to have ESG-linked pay, he said.

ESG-linked pay makes a difference

Moreover, those pay packages are effective, Reichelstein added. Most companies that adopted ESG-linked pay saw lower emissions and higher ESG ratings from third-party agencies within a couple of years after adoption.

The ISS survey didn’t provide comprehensive data on exactly how each such firm actually weighs ESG metrics (such as carbon footprint, or share of women in management positions). So it’s difficult to say precisely how much pay is required to achieve a specific ESG outcome. And there may be a time lag between ESG pay adoption and ESG outcomes, such that the effect of the recent uptick in adoption isn’t yet known.

Still, the paper finds that “a 1% decrease in emissions is associated with an increase in cash compensation of around 5 basis points.” Unsurprisingly, companies that specifically cited emissions performance as a pay factor were more likely to see an emissions outcome than those that set more vague ESG metrics.

Finally, meeting ESG goals doesn’t come at a cost to the companies, Reichelstein said—or a benefit: Year-to-year income of these companies was no better or worse for companies that adopted ESG pay than those that didn’t.