Pierre Chaigneau and Nicolas Sahuguet
Review of Finance, Volume 29, Issue 3, May 2025, Pages 779–818, https://doi.org/10.1093/rof/rfaf012
How can corporate executives be motivated to generate both financial and social value? One approach is to integrate Environmental, Social, and Governance (ESG) performance metrics into executive compensation plans. Currently, 75% of S&P 500 companies have adopted this practice. It is largely supported by investors, with many institutional investors endorsing ESG-based compensation as a way to promote social and environmental impact.
However, some scholars argue that using environmental and social performance metrics in executive pay leads to unintended consequences. These criticisms include: (1) “gaming” the incentive scheme, where executives improve ESG metrics without necessarily improving real-world ESG outcomes, and (2) the difficulty of evaluating ESG performance due to the lack of agreement on ESG measurement.
To address these concerns, the paper presents a principal-agent model in which a socially responsible board designs the compensation contract of a manager who understands how ESG metrics are constructed, and can therefore game incentive schemes that rely on these metrics. The model considers both profit-driven incentives and ESG-based incentives. Key findings include:
- Gaming Behavior: When ESG metrics have a low quality, executives may focus on improving ESG scores rather than making genuine social or environmental improvements. To mitigate this effect, incentives based on ESG metrics are low-powered.
- Stock Price Influence: Some investors factor ESG performance into stock valuation. If stock price maximization already encourages environmental and social performance, then ESG-based compensation is unnecessary.
- Incentive Design: ESG-based incentives should only be used when the board’s preferred level of ESG investment exceeds what maximizes the stock price.
- ESG Scoring Diversity: Having multiple ESG rating agencies with independent scoring methodologies can help minimize gaming opportunities. Indeed, it is harder for a manager to game multiple scoring methodologies than to game a single methodology. However, if additional ESG scores are of low quality or highly correlated with existing ones, they may worsen gaming distortions rather than mitigate them.
- Empirical Trends: The paper suggests that a rise in socially responsible investing (SRI) should reduce the reliance on ESG-based compensation. This can explain the apparent paradox that ESG-based incentives have recently grown despite declining investor interest in ESG funds. This could be due to firms maintaining their ESG commitments independently of investor sentiment.
Finally, the paper challenges the notion that ESG-based incentives increase firm value. Companies adopting ESG incentives may do so to improve stakeholder relationships or mitigate externalities rather than for financial returns. This aligns with a broader view of corporate responsibility in which fiduciary duties extend beyond profit maximization to incorporate stakeholder interests.