Can investors successfully advocate for improved ESG outcomes at their portfolio companies? We examine whether the introduction of say-on-pay (SOP) laws provides investors with a way to increase the extent to which executive compensation is tied to ESG metrics and whether doing so, in turn, improves a firm’s ESG performance.

Surveys have found that investors value firms’ commitment to sustainability and social issues.  For example, a recent survey of 325 investors internationally by PwC found that 79 percent of investors agreed with the statement, “ESG risks are an important factor in investment decision-making” (The Economic Realities of ESG, PwC 2021). While there is significant evidence of investor demand for ESG, there is less evidence about how investors can successfully advocate for improved ESG outcomes at their portfolio companies.

Concurrent with the rise in investor demand for ESG performance are changes to compensation. Firms are increasingly linking a portion of executive compensation to ESG metrics (e.g., greenhouse gas emissions goals, diversity metrics) (we refer to this as “ESG contracting”). A study of European firms found the percentage of companies employing ESG contracting increased from 3 percent to 34 percent from 2008 to 2021 (Aligning Pay, People and Planet, Diligent Institute 2021). But is the unprecedented movement into ESG contracting a serious effort to improve ESG performance or merely “greenwashing”?

We use the staggered adoption of SOP laws around the world as the laboratory for our study. Those laws require companies to hold a shareholder vote (typically annually) on executive compensation. Research has shown that SOP laws provide some ability to impact changes in core aspects of executive compensation such as pay levels. Our attention is on ESG contracting.

Using a sample of firms from 36 countries, 14 of which adopted SOP laws at various times during our sample period of 2004 to 2016, we find a 35 percent increase in the use of ESG contracting after SOP laws were adopted in the countries where those companies are based. These results are concentrated among firms for which shareholders are likely to have more influence on management, including those with more institutional ownership or an independent compensation committee. In addition to finding that firms incorporate ESG-related compensation policies or tie compensation specifically to the achievement of sustainability targets, we find that executive pay is also more sensitive to environmental performance after SOP adoption. This latter result does not require specific data on compensation contracts, but instead, uses an indirect approach to document greater pay-for-ESG performance sensitivity. These results support the hypothesis that SOP adoption provides a mechanism through which investors can encourage ESG contracting.

We next consider the influence of SOP adoption on ESG performance. While the inclusion of ESG metrics could encourage executives to invest more in ESG activities, it is possible that, on average, ESG contracting is greenwashing – firms claiming to be concerned with ESG without changing their behavior. For example, if only a small portion of total pay is tied to ESG metrics, it might not provide sufficient incentives to change behavior, or ESG goals within the contract (e.g., emissions targets) could be set at easily achievable levels without requiring a change in strategy or behavior. We find that firms’ overall ESG scores, as well as the “environmental” and “social” components individually, increase after SOP adoption. To help understand whether improvements in ESG performance are the result of changes in ESG policies, we evaluate whether firms are more likely to adopt policies on reducing CO2 or other toxic emissions. Indeed, we find that ESG contracting is tied to improvements in specific environmental policies. Our evidence is consistent with SOP leading to meaningful changes in ESG policies and inconsistent with these changes representing “greenwashing”.

We perform additional tests to support the idea that compensation contracting represents a key mechanism enabling investors to demand and generate improvements in ESG performance. In response to SOP, some firms add ESG contracting metrics, which in turn results in efforts by executives to improve ESG performance. However, it is possible that interactions between the board and the CEO, and not ESG contracting, is driving our results. For example, concurrent with, but unrelated to, the adoption of SOP in a country, boards might be more likely to impress upon the CEO that continued employment is contingent on improved ESG performance. This would lead to an improvement in ESG performance but not be due to ESG contracting. As we cannot observe these actions, we cannot fully rule this out. However, it is not likely the explanation behind our findings since we find that improvement in ESG performance is concentrated in the countries where more firms adopted ESG contracting after SOP.

Our study provides new insights on whether and how investors can express their preference for ESG performance. Our findings suggest that SOP laws, by empowering investors to influence ESG-contracting, provide them a way to change firm behavior and translate their preferences into performance.

This post comes to us from professors Andrea Pawliczek at the University of Colorado at Boulder, Mary Ellen Carter at Boston College, and Rong (Irene) Zhong at the University of Illinois at Chicago. It is based on their recent paper, “Say on ESG: The Adoption of Say-on-Pay Laws and Firm ESG Performance,” available here.