The winds of change were clearly blowing during the latest Institute of Corporate Directors (ICD) conference—where the need to better serve stakeholders outside the investment community was discussed as a given. As a result, it seems reasonable to ask whether executive remuneration formulas that fail to link a portion of management’s compensation to corporate social responsibility (CSR) initiatives have reached their best-before date.
Forward-looking firms, of course, have been linking executive compensation to CSR for years, especially ones with independent boards. But support for this emerging practice remains relatively weak. As The Globe and Mail recently reported, a survey of 510 business leaders found that only 41 per cent of respondents strongly agreed that performance related to environmental, social, and governance (ESG) issues should be a part of executives’ remuneration package.
The survey in question was conducted in May by the Canadian Centre for the Purpose of the Corporation. And its findings are somewhat surprising given that over 60 per cent of the same pool of management professionals actually strongly agreed that “the purpose of a corporation should be to benefit all its stakeholders, including shareholders, employees, suppliers, the communities where it operates, and the environment.”
From a governance perspective, the results are also unfortunate since research clearly shows that linking a portion of management renumeration to CSR metrics can be an effective way to improve both CSR outcomes and ratings (see “Corporate Governance and Executive Compensation for Corporate Social Responsibility” in the Journal of Business Ethics).
That said, when moving to implement this emerging compensation practice, corporate boards need to pick an approach. Amongst early adopters, research has identified two common types of CSR-contingent compensation contracts (see “CSR-contingent Executive Compensation Contracts,” a 2019 study published in the Journal of Banking & Finance).
“The key takeaway here is that moving to implement any CSR contract is a step in the right direction given the ongoing evolution in executive compensation best practices.”
Simply put, some firms take a formulistic or objective approach in which executives know in advance how much they can expect to gain by pursuing specified CSR-related activities, while other firms take a more subjective approach in which CSR-contingent compensation is subject to the discretion of compensation committees ex post.
Implementing either approach can improve a firm’s subsequent CSR ratings. But the balance of pros and cons differs depending on a firm’s industry, growth prospects, and earnings volatility. The subjective approach, for example, is often used at firms where taking a formulistic approach could result in managers being rewarded for pure luck. But subjective contracts require more trust between management and the board of directors.
Here are some key things for boards to consider when implementing CSR contracts.
The subjective approach can be more efficient when:
- firms are high-tech, risky, young, or fast-growing
- the firm is highly visible and therefore facing more public scrutiny
- implementing new, unconventional CSR projects
- project outcomes are more volatile and unpredictable
- the board can closely monitor executive effort and collusion between the board and the executives is unlikely
- information is transparent and abundant for the board to effectively conduct a subjective performance evaluation
- targets can be manipulated
- the goal is to beat competitors over the long run instead of hitting a pre-specified number in the short run
The objective approach may make more sense when:
- firms are traditional or mature in nature
- implementing conventional CSR projects or continuing existing CSR projects (so the target is clear and measurable)
- project outcomes are stable and predictable
- current CSR standings are low
- managerial effort can be quantified
- boards cannot closely monitor executives’ effort (due to lack of expertise or high cost of direct monitoring)
- collusion between the board and the executives is likely
All firms, of course, can simply try taking a conservative, objective approach to gain experience designing the reward and evaluation system, and then move to a more subjective contract if and when it makes sense to do so.
The key takeaway here is that moving to implement any CSR contract is a step in the right direction given the ongoing evolution in executive compensation best practices.
About Author
Frank Li is an Associate Professor at Ivey Business School at Western University in London, Ontario, Canada, where his research interests reside in empirical corporate finance. Professor Li has published numerous research papers and case studies, aiming to better understand the subtle but important effects of various governance mechanisms and contract designs and to identify and estimate the role of managerial attributes and preferences in determining organization structure, policy, and performance. His research—which has been featured by media outlets such as Yahoo Finance, The Globe and Mail, Financial Post and CTV News—has been supported by several Canadian federal government research funds. Professor Li has also won research awards from several world leading institutions such as the Global Finance Institute and the World Business Institute. His work experience includes various financial analyst and strategic management positions in an international bank, a personal credit company, a small pharmaceutical consulting firm, and a fortune 500 health care corporation.
Thomas Watson (Twitter: @NotSocrates) is a veteran business journalist, management consultant and communications professional with experience spanning executive education, thought leadership development, institutional storytelling, strategic communications, public and investor relations, and media production. As a Financial Post Magazine columnist and Editor-in-chief of Ivey Business Journal—one of Canada’s oldest business publications published by the prestigious Ivey Business School at Western University—Watson is recognized as an expert commentator on topics ranging from leadership and governance to managing disruption and the evolution of capitalism.
At Ivey, in addition to managing IBJ, Watson helps promote best practices in management by developing custom case studies and executive development programs. As a guest lecturer, he also shares his experience as a young VC executive who risked his career and reputation to expose the stock manipulation of a Canadian tech market darling during the dotcom boom. Watson’s insider account of this mind-blowing international scheme was featured by Canadian Business as a cover story in 2002. Entitled “The Man Who Ambushed Open Text: And How I Helped Him Do It,” Watson’s first long-form magazine article garnered comparisons to Liar’s Poker by financial journalist Michael Lewis. This led to an award-winning investigative reporting career. Highlights include: “Abandoned at the Altar,” an exclusive account of why Bay Street’s GMP Capital got cold feet when helping Ashley Madison’s corporate parent go public in 2010; “Shell Games,” an exposé of criminal boiler rooms that financed the Canadian expansion of Ben & Jerry’s during the 2008 financial crisis; “ABCP: Hunter and the Hunted,” a profile of the retail market rebellion sparked by Bay Street’s unethical marketing of high-risk asset-backed commercial paper; “The Trials and Tribulations of Brian Hunter,” an exclusive account of the 2006 implosion of the Amaranth Advisers hedge fund; and “An Apology for Eleanor Clitheroe,” a profile of the sexism and hypocrisy that derailed Hydro One’s attempt to go public with a female CEO in 2002.
Watson holds undergraduate degrees in history and political philosophy. As a graduate student, he studied journalism, political theory, international politics, public finance, and macroeconomics. Post-graduate studies included securities and market regulation.
