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.