Over the past two decades, regulators, lawmakers, and stakeholders have increasingly urged companies to give greater weight to the broader interests of society alongside traditional financial goals. As a result, a notable percentage of firms – 64 percent of the top 250 U.S. companies in 2023 – have included ESG and other non-financial corporate responsibility metrics in their executive incentive plans[1]. Nonetheless, little is known about what prompts a firm to include non-financial corporate responsibility targets in executive compensation contracts. Finding out more is important because scholars[2] and stakeholders[3] have expressed concerns that non-financial targets, which are susceptible to manipulation and difficult to verify, may serve as a façade, potentially enabling managers to secure higher payouts and extract undue gains at shareholders’ expense.

In a recent study, we examine the role of industry-specific risks and propose that a firm’s choice to include non-financial metrics in executive incentive plans is a strategic response to heightened regulatory scrutiny and reputational concerns within a firm’s industry. We use the frequency of violations of federal and state laws pertaining to non-financial responsibility issues in an industry to serve as a proxy for within-industry regulatory scrutiny and reputational concerns.

On the one hand, increases in such violations may indicate a misalignment between industry practices and expectations of society, potentially leading to intensified regulatory oversight and interventions. As these industry-wide consequences can adversely affect the overall performance of all firms in the industry, non-violating firms have strong incentives to adopt strategies that mitigate the economic and reputational costs associated with such misconduct. The inclusion of non-financial responsibility metrics in executives’ annual bonuses can be particularly useful from this point of view as it aligns managers’ efforts with stakeholders’ expectations while signaling to outsiders the firm’s commitment to risk management. On the other hand, if the short-term financial benefits of non-compliance outweigh the costs – such as lower product prices boosting competitive advantage – firms may overlook the broader negative impacts and may not respond to non-financial violations within an industry.

Moreover, a firm’s unique market position or diversification might shield it from the reputational damages typically associated with industry-wide misconduct, thereby leaving firms with little incentive to adjust their executive incentive plans. Furthermore, as non-financial targets are easy to manipulate and hard to verify, the inclusion of non-financial metrics can represent a window-dressing strategy or a means through which managers can earn higher payouts and extract rents at the expense of shareholders. Taking these diverging views into account, we examine the effect of industry-wide regulatory scrutiny and reputational risks on the design of compensation contracts. Our sample covers corporate non-financial violations and executive annual bonus plans with available vesting metric details in S&P1500 firms between 2006 and 2019.

First, we examine the prevalence of non-financial violations within an industry and the use of non-financial metrics in executive bonuses among our sample firms. Over our sample period, on average, approximately 38 percent of those firms were implicated in non-financial violations, with ESG violations related to environmental, employee safety, and governance issues constituting the majority. The annual rate of ESG violations rose from 33 percent in 2006 to 38 percent in 2019, primarily due to a surge in social violations, which increased from 24 percent to 34 percent over the period, while environmental and governance violations remained relatively stable. Mining, construction, utilities, retail trade, and oil and gas industries showed the highest incidences of ESG violations.

Notably, the trends in incorporating non-financial responsibility targets are similar to the trends in non-financial violations. During our sample period, on average, about 21 percent of firms incorporated at least one non-financial metric into their annual bonuses, with social targets being the most prevalent (40 percent) followed by customer (23 percent) and product-market goals (20 percent). Our data indicate that the use of these metrics increased overall from 18 percent in 2006 to 26 percent in 2019, particularly in industries with significant environmental and regulatory challenges such as mining and utilities, where non-financial metrics predominantly addressed ESG concerns.

Our further analysis indicates that firms are more likely to include non-financial metrics in annual bonuses when there is a higher frequency of non-financial violations within an industry. Specifically, these adjustments are primarily driven by responses to ESG violations, especially environmental and social, rather than other types of non-financial violations. These results support our prediction that firms tailor their pay-for-performance policies to promote executive accountability on responsibility targets and demonstrate a commitment to responsible management. To ensure these findings are in fact influenced by industry-specific violation frequencies and not merely by the overall intensity of regulatory scrutiny, we conducted several sensitivity tests, including a placebo analysis with firms randomly assigned to different industries. The results of these tests consistently support our initial conclusions.

We next explore conditions that increase the likelihood of adjustments to executive annual bonus plans in response to non-financial violations. Economic theories propose that firms whose products are similar to competitors’ offerings rely more on corporate reputation and customer loyalty as key drivers of revenue. As a result, these firms, facing stiff competition due to low product differentiation, are particularly sensitive to reputational risks and adverse publicity. Supporting this notion, our findings indicate a stronger relationship between the frequency of non-financial violations and the inclusion of responsibility metrics in firms facing intense competition and low product differentiation. We further find that the influence of industry-specific violations is amplified by external governance pressures such as peer compensation practices, shareholder activism, and media scrutiny.

Our study demonstrates that increased regulatory scrutiny and reputational risks within an industry can significantly influence executive incentive plans. This evidence has important practical implications for policymakers and regulators, revealing a previously undocumented externality: the incorporation of responsibility targets into executive compensation as a consequence of enforcing ESG regulations.

ENDNOTES

[1] Cook, F.W. & Co. Inc. 2023. Use of Environmental, Social and Governance Measures in Incentive Plans. F.W. Cook Publishing.

[2] Bebchuk, L. A., and R. Tallarita. 2022. The perils and questionable promise of ESG-based compensation. Journal of Corporate Law, 48: 37.

[3] Temple-West, P. & Xiao, E. (2023, August 27). Investors warn ‘fluffy’ ESG metrics are being gamed to boost bonuses. Financial Times. https://www.ft.com/content/25aed60d-1deb-4a41-8f39-00c92702b663.

This post comes to us from professors Francesca Franco and Claudia Imperatore at Bocconi University and Mariya Ivanova at the Stockholm School of Economics. It is based on their recent article, “Executive Bonus Adjustments to Industry Non-Financial Violations.”