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Research shows that executives holding company shares are of tangible detriment to their companies’ ESG performance. By Gianfranco Gianfrate of EDHEC Business School.
When, in 1970, the American economist Milton Friedman penned his famous op-ed in the New York Times, proclaiming that “the only responsibility of corporations is to make profits”, he pitched money-making against environmental, social and governance (ESG) principles.
For decades, corporate leaders have been fixated on generating profits, often to the detriment of ESG issues, and without thinking of their company’s or employees’ long-term futures.
However, a tectonic shift from shareholder primacy to stakeholder primacy is underway. There is, nonetheless, a major hurdle yet to overcome: executive ownership and the negative impact it has on sustainability goals in the corporate world.
Two colleagues and I recently examined executive ownership in publicly traded companies in the US, and we found that when a CEO has a personal stake in a company’s financial success, ESG goals – while perhaps openly stated on the company’s website and in investor relation materials – are often set aside.
CEO compensation at the root of the problem
A company’s success is linked to the CEO’s ability to lead their team and manage complex economic scenarios effectively, so it makes sense to compensate a business leader based on how well or poorly they perform. But when boards of directors reward a CEO for their performance with shares in the company, our research shows that the CEO can become too focused on making sure those shares gain value – and this can have negative effects on our communities and our planet.
We collected firm-level sustainability data (environmental and social) from 742 US corporations and reviewed their key performance indicators (KPIs). We merged this data set with one comprising executive ownership information for the same firms from 2002 to 2019 and found that executive ownership leads to a 13.1% drop in ESG performance.
These findings should be used to reject, once and for all, the theory that executives with a financial stake in a company will pursue sustainability goals as part of their overall leadership duties. Indeed, when the paycheque they receive is not tied directly to ESG goals and their achievement of them, increasing shareholder value will always take precedence.
Why boards and investors should care
Recent studies suggest that firms with strong ESG ratings are relatively resilient to financial crises. For example, scholars who studied the performance of firms during the 2008 financial crisis found that the stock returns for those active in ESG were significantly higher than for those that were less active. Given these results, some colleagues and I decided to examine global corporate performance during the initial wave of the Covid-19 virus.
More specifically, we looked at whether firm-level ESG ratings were positively associated with abnormal stock returns and negatively associated with credit spread changes during the first quarter of 2020. In an analysis of more than 6000 stocks in 63 different countries, we found that US firms focused on sustainability goals were more likely to deliver a risk-adjusted strategy that allowed them to ride out the pandemic.
More often than not, these firms performed well on the stock market despite the effects of the pandemic and witnessed less strain on their credit default spread (a popular measure of firm creditworthiness).
Our findings were particularly striking for the US, where our data showed that a superior corporate sustainability footprint can protect a firm’s value despite impressive disruption from outside sources. One reason for this, we believe, is that the US government was slower to respond to the virus’ spread than some governments in Europe, where there is, in general, a broader and deeper social safety net.
a superior corporate sustainability footprint can protect a firm’s value despite impressive disruption from outside sources
My academic colleagues and I were impressed by these results because they provide proof of the broader good that can be realised when firms focus on ESG goals. These goals consider the communities in which company employees and their families live.
In the early days of Covid-19, some businesses in the US provided immediate aid to their employees (access to masks and hand gel, medical advice, etc.). Although the initial stress of the situation was intense, once these firms were able to stabilise the health and safety of their workforce, they were able to more quickly shift back to serving their clients and making money.
Since ESG protects companies from external shocks that are getting more frequent and severe (i.e., climate-related disasters, pandemics and war), boards of directors, as well as investors, should think about sustainability as a critical piece of corporate strategy, not as a ‘nice to have’. Corporate ESG should also matter for bond investors and lenders for the same reason, which is why they too should advocate for sustainability goals and not just year-over-year profit gains.
Greener paydays ahead
In recent years, some prominent public company executives have had a small portion of their compensation linked to ESG goals – about 5% to 15% of total pay – and this trend is catching on. According to Farient Advisors, a US firm that provides counsel on executive compensation, 240 of 416, or 58%, of S&P 500 companies releasing proxies in 2022 have used ESG measures.
Remuneration packages should feature material ESG measures and should target both reasonable and challenging KPIs. If the ESG measures chosen are too loose or ambiguous, we can’t expect true accountability from corporate leaders. Boards and investors need to push executives to do more for society and the planet. If they don’t do this, even ESG-focused remuneration packages are at risk of ‘greenwashing’ or ‘social washing’.
Indeed, it’s getting too late for leniency. If boards and investors don’t take appropriate action and refocus executive pay, they could invite backlash from angry and disappointed consumers and perhaps sanctions from government and industry watchdogs. Today, there’s waning patience for Milton Friedman’s ‘profit is king’ mentality and a growing body of proof that corporate sustainability is critical to future success – for CEOs, boards and investors.
Gianfranco Gianfrate is a Professor of Finance at EDHEC Business School and a Research Director at EDHEC-Risk Climate Impact Institute.
