In this recent academic study, Social Responsibility Criteria in Executive Compensation: Effectiveness and Implications for Firm Outcomes, the authors examined the impact of the integration of elements of corporate social responsibility, such as environmental and social performance, into executive compensation performance criteria.  In the decision-making process, executives tend to gravitate toward the achievement of short-term goals and to respond more readily to more prominent direct stakeholders, such as customers and shareholders. But CSR metrics typically have a long-term pay-off and involve less direct stakeholders, such as the environment and the local community.  The question is: is the inclusion of CSR performance metrics in executive comp programs effective to motivate executives to achieve those longer-term CSR goals, engage with CSR stakeholders and enhance long-term value creation?

The authors attribute the tendency of individuals to favor the short-term to a well-established characteristic of “intertemporal decision-making” known as “hyperbolic discounting,” that is, “an excessive preference for the present, preferring short-term rewards over long-term rewards, even if the latter are substantially higher.” For executives, this tendency is compounded by various short-term pressures, such as analyst expectations for quarterly earnings and short-term compensation. For example, an academic study has shown that “three quarters of senior American corporate officials would not make an investment that would benefit a company over the long run if it would derail even one quarterly earnings report.”  (See this PubCo post.) As a result, management tends to pay more attention  to “salient stakeholders,” such as shareholders and customers, that have more direct claims focused on short-term performance, as opposed to stakeholders that might be less salient but financially material to the company in the long run, such as the environment and local communities, which depend on the advocacy of others.

One way to redirect management attention to long-term value creation, the authors theorize, is to link financial incentives to long-term performance criteria through “CSR contracting,” the integration of CSR metrics into executive comp targets.  However, it has not been clear whether the adoption of  non-financial performance measures, such as CSR metrics, for executive comp was an effective governance tool, particularly where the comp lacked substance (e.g., the proportion of comp affected was too small) or was  merely symbolic (effectively, a PR strategy rather than a financial incentive).  In addition, compared to financial performance measures, completion of CSR targets can be difficult to quantify and track, with the result that the incentive may be phrased in vague terms, providing no clear guidance to executives.

To conduct the study, the authors looked at CSR performance metrics in comp disclosure reported in proxy statements of  S&P 500 companies over a 10-year period (2004-2013), which included 4,533 firm-year observations. Linking pay to social and environmental performance is a relatively new trend, the authors assert, but an increasing one; in 2004, only 12% of S&P 500 companies used these performance factors, but, by 2013, the percentage had increased to 37%. These CSR metrics included community, compliance with ethical standards, corporate social responsibility, diversity, employee well-being, energy efficiency, various environmental factors such as environmental compliance or environmental projects, greenhouse gas emissions reductions, health, performance relative to a corporate responsibility index, product safety, reduced injury rates, safety, and sustainability.

Then, using various established indices, the authors measured the outcomes. The authors found that the adoption of CSR metrics led to “i) an increase in long-term orientation; ii) an increase in firm value; iii) an increase in social and environmental performance; iv) a reduction in emissions; and v) an increase in green innovations.” For example, following the adoption of CSR contracting,  the study showed an increase in firm value of  3.1%, which the authors characterize as “economically large.”

Moreover, the authors found that the results were more pronounced when the CSR incentive was specified (instead of vague) and proportion of CSR-related comp was larger. The authors contended that these findings support their “theoretical arguments that CSR contracting enhances the governance of a company by incentivizing managers to adopt a longer time horizon and shift their attention towards stakeholders that are less salient, but contribute to long-term value creation.”

What’s the bottom line? The authors found that inclusion of CSR performance metrics  mitigates “corporate short-termism and improves business performance,” including significant increases in firm value that foreshadowed a “large and statistically significant” increase in operating profits that materialized within three years.  The authors suggest that the study highlights “a new lever in executive compensation that boards of directors can use to influence managerial incentives.”

Why is this the case? Viewing stakeholder engagement as an integral part of corporate governance, the authors theorize that inclusion of these metrics  “helps direct management’s attention to stakeholders that are less salient but financially material to the firm in the long run, thereby improving a firm’s governance as well as its impact on society and the natural environment.” That is, these factors can improve long-term value creation “because in the long term, social and environmental issues become financial issues.”

Posted by Cydney Posner