Opinion

Incentivising ESG: What does it really take? 

Pressure on companies to commit to ESG has so far led mostly to box-ticking. A rethink on what to expect – and how this can be achieved – is now crucial.

The current state of ESG efforts by corporations is disappointing but understandable. Investors pressurise them into what amounts to a box-ticking, virtue-signalling exercise – and it shows. 

Nevertheless, if we accept the premise that ESG exists to help confront real-world problems, we need to incentivise business to solve these problems. What will it take?

Take the case of fast-food giant McDonald’s, which stakeholders have long called on to improve its diversity. In February 2021, McDonald’s announced it would tie executive compensation to annual increases in the share of women and minorities in senior leadership. These new ‘human capital’ measures, among others, will influence 15 per cent of executive bonuses. 

This may sound good – until you read reports that the company had been practising a form of redlining with Black franchise owners. McDonald’s was accused of pushing them to the least favourable locations, required them to make unrealistic renovations, and burdened them with harsher grading and inspections. The company denied any wrongdoing and settled claims that it had treated Black franchisees less favourably. 

What encouraged that behaviour? Was there any relationship between the lack of diversity in senior leadership and this litigation? More broadly, why should executives be given bonuses for meeting intrinsic goals that ought to be central to any company’s values and mission? 

That last question is particularly pressing because big corporations have enthusiastically embraced ESG incentives recently. In 2022, 69 per cent of S&P 500 companies reported ESG metrics in their proxy statements, up from 52 per cent a year earlier. Analysis from PwC published in a Harvard Law School Forum post shows the most common metric is diversity and inclusion, with customer satisfaction and employee safety coming a close second. 

The wrong focus?

Declaring diversity an ESG target rather than a baseline expectation appears to be a self-serving strategy to generate positive PR. Targeting senior leadership also makes it likely that a company will focus here, at the expense of equally critical issues such as franchisee selection, the supplier base and overall wages.  

It’s easy to see why companies have stampeded en masse into ESG incentives. Critics consistently claim executives are excessively rewarded for managing to boost short-term shareholder value. Imposing ESG incentives also answers calls to take the reality of power and influence inside corporations seriously; if ESG is relegated to a siloed sustainability team with no budget or influence, it will quickly become an empty reporting exercise. 

By contrast, leaders who are formally incentivised to meet non-financial goals might just transform their organisations. More importantly, investors and boards like the idea. A 2021 survey by ISS found that more than half of investor respondents support specific, measurable and transparent non-financial ESG metrics, with a third recommending they should be tied to longer-term compensation. In its Annual Corporate Directors Survey the same year, PwC found that 94 per cent of boards favour non-financial goals in executive compensation plans.

Numerous potential hazards arise when you introduce financial rewards for meeting non-financial targets, however. To take one striking example, executives at Marathon Petroleum got a bonus for reducing carbon emissions in the same year – 2018 that the company was fined for a major oil spill.

It’s unclear whether compensation is a better lever than recruitment or promotion criteria, for example. Another hazard is mixing quantitative and qualitative targets; we need qualitative targets to reward how the outcome is achieved, but they are easily manipulated. Meanwhile, there are many ways to hit a quantitative target that miss the point. You can reduce your carbon emissions by closing a factory and laying off thousands of people. You may have heard of Goodhart’s law: when a measure becomes a target, it ceases to be a good measure – that is, it will become corrupted, because the process is now worth gaming.

Driven by fear

All this would be hazardous enough, but the current state of ESG makes it particularly ripe for this kind of maladaptation. For investors, the point of measuring ESG is to seek directly comparable data that can be used to design portfolios and ultimately, to generate higher returns. In response, companies are herding together into an undifferentiated mass. 

In the Harvard post, PwC explicitly suggests that no board wants to be first or last, so benchmarking against peers is the way to go. This is a fear-driven, risk-averse approach by which companies design ESG metrics so they won’t lose funding or public face. 

Why is all this happening? One issue is that we are like drunks looking for car keys under the streetlamp because that’s the only place that is illuminated and that we can see. A metric that is well developed or easy to measure, even if it isn’t important or suitable to your organisation, is effectively the streetlight. 

An even bigger issue is that these early efforts are revealing our lack of consensus on the ultimate purpose of ESG efforts. Companies don’t know if they are trying to incentivise innovation to solve societal challenges or to penalise ethical failures that create negative externalities and financial risk. So they do neither, and huddle together to avert investor scrutiny.

A better approach

What would a better approach look like? Companies would not simply provide additional bonuses for meeting ‘human capital’ measures at the executive level and then hope these magically trickle down. They would instead agree that diversity is essential to its purpose and strive to meet customer, supplier and employee expectations over the long term. 

Executives could then do what they were hired to do: bring new ideas to the table, assess the risks of their actions and lead others. They should be asked to create plans for how their division or function can address the diversity imperative, and encouraged to compete with each other and test micro innovations. 

Division leaders could create plans to increase the diversity of employees, franchisees and suppliers; ensure that perpetuating harassment and discrimination results in meaningful penalties; and measure stakeholder satisfaction, as well as progress against quantitative targets. 

This would encourage executives to learn about diversity and apply the best ideas to the business they are responsible for. They might also recruit rank-and-file employees to contribute their ideas and effort. 

Business leaders could agree that responsible environmental stewardship is their ultimate goal. This target could be met through a combination of reduced emissions and community social and environmental goals. We don’t yet know what creative efficiencies or mitigation strategies might materialise if talented executives were incentivised to create – and held responsible for administering – solutions that meet practical demands. Executives in an organisational system set up to demand such approaches are likely to respond with the intensity we need in solving our biggest challenges. 

Identify core issues

If companies really want to incentivise ESG, they should identify a very small number of core strategic issues – one is ideal, and more than three inadvisable – that are important enough to generate both long-term financial performance and positive societal impact (known as ‘double materiality’). Executives should then be encouraged to innovate and compete to meet these imperatives. 

While it is fine to measure and evaluate interim performance, the financial rewards of such innovation should manifest in the creation of long-term shareholder value. If executives already have well-designed and long-term financial performance goals, there should be no need to introduce additional bonuses or metrics. Meanwhile, moves to dump externalities (the medical costs of opioid and tobacco addiction are great examples) on the wider society can be treated as the management failures they are, and penalised appropriately. 

It’s time for investors to stop pressuring corporations into empty box-ticking. Instead, they should recognise that the stakes are high, and commit to push companies to do what they are designed for: innovating and improving our lives.

Alison Taylor is adjunct professor at NYU Stern School of Business and executive director of its Ethical Systems research platform; Brian Harward is lead research scientist at Ethical Systems.



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