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Greener CEO pay

Caroline Flammer on why companies should use CSR contracting to tie executive compensation to social responsibility

For those in the C-suite, getting a bigger paycheck used to be simple: boost profits and keep the stock market happy. For many bosses, the formula has become more complicated—and a lot greener. In an effort to make corporate social responsibility (CSR) integral to business operations, companies have started CSR contracting, linking executive compensation to socially and environmentally responsible practices, says Caroline Flammer, an associate professor of strategy and innovation. In a 2019 study, published in the Strategic Management Journal, Flammer tracked S&P 500 companies over a 10-year period and found that the percentage of those that practiced CSR contracting increased from 12 percent in 2004 to 37 percent in 2013. Today, that figure is likely higher, says Flammer, who explains to Everett why these companies have adopted CSR contracting—and why those who haven’t, should.

Everett: What’s behind the steep increase in companies that have adopted CSR contracting?
Flammer: One factor is the increased costs and risks associated with climate change. Research has shown that stricter environmental regulation—even the threat of stricter environmental regulation—can induce firms to reduce their emissions and send a strong signal to the investors of carbon-intensive industries. Companies face stricter global environmental regulations, and they increasingly face pressure from social activist groups, customers, and their own shareholders to protect the natural environment, to improve their social impact, and to adopt a longer-time horizon in their decision-making. While the Trump administration’s skepticism has likely decreased the direct pressure on companies to improve their environmental performance, it may have amplified the pressure exerted by those activists, consumers, and shareholders.

What impact has the practice of CSR contracting had on the S&P 500 companies that have adopted it?
In five years, those companies’ firm values as measured by Tobin’s Q [a company’s market value divided by the value of its assets] increased by about 3 percent in the years following the adoption of CSR contracting. This is quite substantial, suggesting that CSR contracting is indeed a good governance practice. We also find that social and environment performance goes up, particularly with respect to community and natural environment. Companies that adopt CSR contracting decrease emissions by about 9 percent and they also are more likely to invest money into the research and development of green technologies; green innovations go up. When companies are vague about how they link compensation to social performance metrics, however, you don’t really see much of an effect.

Which industries are most likely to tie executive compensation to CSR?
CSR contracting is particularly prevalent in those industries in which the natural environment and communities are financially material to their operations—particularly the mining, transportation, electric, and gas industries, which are very emission intensive. For example, in the mining industry, it’s fundamentally important to have a good relationship with the local community.

How can socially and environmentally responsible practices benefit a company’s bottom line?
First, social and environmental practices can help companies differentiate themselves from their competitors. It can help foster innovation, enhance employee governance, improve access to government procurement contracts, and sustain competitiveness in financial crises.

As a result, it’s probably not surprising that CSR positively affects the shareholders’ perception of the company, and shareholders’ returns. The bottom line is that social and environmental practices can be very beneficial to companies, which would imply that sustainability should be an integral part of corporate governance and strategy.

“Corporate social responsibility positively affects the shareholders’ perception of the company, and shareholders’ returns.” Caroline Flammer, associate professor of strategy and innovation

You’ve said that despite the marked benefits of CSR, the practice is still not considered integral. Why is that?
One potential reason is because there is a lack of incentivizing managers to address social and environmental issues. Economic and psychological research shows that human beings tend to have an excessive preference for the present, which means that we prefer short-term rewards over long-term rewards, even if long-term rewards are substantially higher. For example, you’d probably prefer to get a present now than in 20 years, even if the present you would get in 20 years would be better.

Managers have career concerns, particularly in the US, where we don’t have long-term employment contracts. There’s a concern that you might lose your job if you don’t meet quarterly earnings expectations, for example. This increased pressure for meeting short-term performance goals leads managers to focus on the short term at the expense of the long term. It’s leading them not to act in the best interest of the company in terms of long-term value creation. So, they are not necessarily behaving in the best interest of the shareholders.

Issues like the natural environment and local communities are not in the manager’s face every day, unlike consumers and employees. So, by their very nature, the environment and communities are less salient, and so therefore the manager is less likely to be pressured by these stakeholders to take their interests into account. To address this, a board of directors can provide private incentives, such as linking executive compensation to socially and environmentally responsible practices, or to link executive compensation to long-term performance.

How should that compensation be determined?
It’s typically part of the annual incentive bonus, which has different performance goals like financial, operational, and strategic performance. For example: Intel ties its executive compensation to corporate sustainability goals, such as product energy efficiency reductions in greenhouse gas emissions and energy use. Similarly, Xcel Energy ties its executive incentives to its environmental footprint and decreases in carbon emissions.

It makes sense for these private incentives to address the interests of the stakeholders that are financially material to the company in their specific industry. There’s not much of a need to incentivize managers to pay attention to stakeholders they pay attention to anyway.

Why should future business leaders know about CSR contracting?
It's not just about philanthropy anymore: many organizations, whether nonprofit, for-profit, or pursuing both financial and social performance, try to find and create innovative products and business models that address those vital social challenges, such as climate change, food security, global health, poverty, discrimination, etc.—and, of course, to try to sustain their business over time. In fact, even if a company is purely profit-driven, business leaders should know, as the results of my study suggest, that CSR contracting helps improve the firm’s financial performance, along with its social and environmental performance. And there’s also an increased movement into socially responsible investing.

For example, if you look at the United Nations–supported Principles for Responsible Investment network, the number of signatories has exploded over the past few years. Launched in 2016, this network has grown to approximately 2,250 signatories and $80 trillion in assets under management by the end of 2018.

A recent financial innovation is corporate green bonds, which I examined in a 2018 study. Prior to 2013, this market was essentially inexistent. In 2013, there were about $3 billion issued in green bonds, whose proceeds are committed to finance eco-friendly projects, such as renewable energy, green buildings, etc. Since 2013, this market has more than doubled every year.

That’s why Questrom’s Social Impact MBA program, which used to focus on nonprofit and public management, now comprises nonprofit and for-profit companies, from start-ups to established firms, including the financial sector. Going back to these four major recent trends in the business environment—increased risk and cost of climate change, increased government regulations, increased pressure from social activist groups, and increased pressures from investors themselves—future business leaders need to be prepared to address social and environmental issues, whether in the nonprofit or for-profit sector.

This interview has been condensed and edited for clarity.