Aligning Pay with Social and Financial Performance
caroline flammer is an Associate Professor of Strategy & Innovation at Boston University’s Questrom School of Business.
Published January 19, 2020
It’s so accepted that you never think about it: From sales agents to corporate executives, financial incentives serve as a basic tool to motivate employees. Specifically, financial incentives are almost universally used to align employees’ interests with those of their employers — a fix for what economists call the “principal-agent problem.” Traditionally, the ultimate goal of for-profit enterprises is to maximize shareholder return.
With statements of corporate purpose beyond profits now rising in popularity, however, more boards are adding corporate social responsibility (CSR) criteria to executive pay packages. Traditionalists, following the classic argument offered by Milton Friedman, bemoan the attention spent on multiple stakeholders as they believe it wastes resources by undermining corporations’ responsibility to maximize the value of capital. But they’re missing an important connection between social and financial performance.
CSR Incentives Matter
The practice of linking executive pay to social and environmental targets (e.g., CO2 emissions reduction, employee satisfaction targets, compliance with ethical standards in developing countries) is known as “pay for social performance” or “CSR contracting.” Apart from anecdotal accounts, little is known about this governance practice and its effectiveness. My collaborators Bryan Hong and Dylan Minor and I shed light on this rising governance practice in a recent article in the Strategic Management Journal. Using data for the 500 largest firms from 2004 to 2013, we documented that the use of CSR contracting for the top executives of the firm has become increasingly common. CSR contracting was used by only 12.1 percent of S&P 500 in 2004; by 2013 the comparable figure was 36.7 percent.
CSR contracting is especially prevalent in emissions-intensive industries. For example, in its 2019 proxy statement, Valero Energy — a Fortune 500 manufacturer of transportation fuels and other petrochemical products — reported that 13.3 percent of its CEO’s annual incentive bonus is based on the achievement of health, safety and environmental goals.
Most importantly, we also found that the incentives did what they were meant to do. That is, following the adoption of CSR contracting, companies increased their CSR engagement — we estimate by about 6 percent. This increase is driven by higher CSR engagement benefiting the natural environment and local communities as opposed to customers and employees. This suggests that CSR contracting shifts managers’ attention toward stakeholders that might affect the company’s bottom line in the long run, but not necessarily in the short run. Managers pay attention to customers and employees every day, so they’re attentive to those interests, regardless. As such, CSR incentives are not needed. Not so for the environment and local communities.
Absent long‐term incentives, executives tend to underinvest in long‐term projects to the detriment of the company and shareholders along with society and the natural environment.
This suggests that CSR contracting helps address corporate short-termism. There is considerable evidence that managers tend to overweight the short term in their decision making because it pays them to do so. A survey by John Graham, Campbell Harvey and Shiva Rajgopal published in the Journal of Accounting and Economics is striking: the researchers found that more than three-quarters of the surveyed executives would prefer not to invest in valuable long-term projects if doing so would prevent them from meeting short-term performance targets. Similarly, in a previous study, my coauthor Tima Bansal and I found that corporate short‐termism hampers businesses success — absent long‐term incentives, executives tend to underinvest in long‐term projects to the detriment of the company and shareholders along with society and the natural environment.
In this vein, our results suggest that CSR contracting is part of the solution to mitigate managerial myopia since it gives managers incentives to take into account stakeholders that are financially material in the long run. Consistent with this interpretation, we find that companies tend to adopt a longer-term orientation and undertake long-term investments that help transition to a lower carbon economy following the adoption of CSR contracting.
Implications for Firm Value
A commonly used measure for firm value is Tobin’s Q — defined as the market value of a firm divided by the replacement cost of its assets. It is appealing in our context because it captures the efficiency by which firms convert investments into expected profits, discounted to their present value. We found that firms’ Tobin’s Q increases by about 3 percent following the adoption of CSR contracting.
Among companies that have adopted CSR contracting, on average about 4.2 percent of executive compensation is linked to CSR performance. Not surprisingly, the increase in firm value is stronger (in both economic and statistical terms) when more pay is linked to CSR performance. In fact, we do not find significant results if CSR-based compensation represents a low share of the overall compensation. This suggests that the symbolic adoption of CSR contracting does not affect firm outcomes; it is only effective when it is substantive.
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Our study has clear implications for boards of directors. Because of managerial myopia, managers tend to ignore stakeholders who are financially material in the long run but are less obviously salient in the short run (such as the natural environment and local communities). CSR contracting helps bridge this governance gap by making managers pay more attention to these stakeholders. It turns out that this increased attention isn’t merely virtue signaling. Indeed, by paying more attention to all their stakeholders, managers can increase firm value and shareholders come out ahead. Thus, CSR contracting is a “win-win” that not only benefits society and the natural environment but also contributes to companies’ long-term financial performance.