Shifting the focus: Implications of increasing ESG compensation on firm performance

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Journal Title

Journal ISSN

Volume Title

School of Business | Master's thesis

Authors

Date

2024

Department

Rahoituksen laitos

Major/Subject

Mcode

Degree programme

Finance

Language

en

Pages

78

Series

Abstract

ESG-linked objective metrics in executive compensation contracts are increasingly being adopted as a tool to harmonize and align the interests of stakeholders and incentivize decision-makers to consider ESG issues alongside conventional financial targets. While previous research has investigated the firm outcomes of engagement in the practice of ESG compensation, the findings regarding the impact on firm performance and value creation have been contradictory. In our thesis, we study how changes in the weighting of ESG-linked metrics within executive compensation schemes influence firm performance. Diverging from earlier studies that primarily employ a binary variable to indicate firm engagement in ESG compensation to any extent, we introduce a novel and refined variable, measuring the year-to-year changes in the relative share of compensation metrics tied to ESG objectives. We assess the implications on firm ESG performance, operative financial performance, and investor sentiment through fixed-effects OLS regressions. Our study spans 13,331 firm-year observations of North American publicly traded companies from 2010 to 2021. We find statistically and economically significant evidence on the association between the proportion of ESG-linked compensation metrics and developments in ESG ratings, especially those driven by environmental and holistic ESG objectives covering multiple of ESG areas. Contradicting the recent concerns of investors related to “fluffy” ESG targets shifting executives’ focus away from growth and profitability, we find no significant relation between increases in the share of ESG-linked metrics and subsequent developments in relative sales growth and gross profit margins. Additionally, our research identifies a significant positive impact on short-term stock returns for institutionally owned firms following the announcements of ESG-favorable changes in executive compensation schemes. Firms that increase their focus on emissions reduction through compensation contracting experience higher returns also on a year-to-year basis, regardless of the level of institutional ownership. Comparing the results of our refined ESG compensation variable with the binary variable, our findings indicate that assessing the relative change in the weight of ESG-linked compensation metrics provides a more informative perspective on firm outcomes resulting from changes in executive compensation than merely determining whether a firm practices ESG compensation or not.

Description

Thesis advisor

Kaustia, Markku

Keywords

ESG, compensation contracting, agency theory, managerial decision-making, non-financial targets, firm performance

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Citation

Permanent link to this item

https://urn.fi/URN:NBN:fi:aalto-202402182438

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[gradu] Kauppakorkeakoulu / BIZ