Research

How to make incentives for corporate social responsibility pay off

Clinical Assistant Professor of Finance Atif Ikram shares his research on incentivizing corporate social responsibility and its effects on boards of directors, executives, shareholders, and other stakeholders.

By Jane Larson

2020-03-16

Executives have long been rewarded for hitting stock-price targets or turning red ink into black. More and more, though, companies are building incentives into compensation contracts to encourage executives to pay attention to corporate social responsibilities (CSRs) ranging from a clean environment to customer satisfaction to high ethical standards.

Atif Ikram, clinical assistant professor of finance, wanted to know more about the percentage of companies offering CSR-contingent contracts to their executives, the types of companies offering them, and whether the incentives produced the hoped-for results. His team also wondered which school of thought was right about why firms offer CSR incentives — the stakeholder view that CSR incentives are designed to align executives’ interests with those of shareholders and others, or the critics’ view that such incentives are just examples of managerial power.

The most fundamental question was if these compensation contracts are granted, are they geared toward stakeholders and better governance? Do they constitute an optimal way to construct contracts? Or is it the exact opposite, where managers have this sort of self-serving agenda in which they are trying to find an easy way to give themselves all these different types of bonuses?

– Atif Ikram, clinical assistant professor of finance

Some previous studies had looked at how firms that include non-financial measures in compensation contacts fare compare to those that don’t. However, these studies had primarily used firm-level data, precluding any insight into how such contracts influence behavior at the executive level. The novelty of Ikram’s paper lay in focusing exclusively on CSR-related variables in compensation contracts using executive-level data.

In their study, Ikram and colleagues from the University of Western Ontario and Northwestern University found that the tendency to grant CSR contingencies in contracts varied across industries, and that the contingencies and type of contract usually were based on issues important to the company’s industry. They also found that CSR contingencies were more common in companies with strong boards of directors than in firms where managers held more power. Further, the study showed companies saw their corporate social standings rise after they offered executives incentives to meet such goals.

Ikram’s team started by collecting data from proxy statements of all the S&P 500 firms over the five years from 2009 to 2013. Then they tracked whether the firms tied executives’ compensation to corporate social responsibility goals, how objective these contracts were in tying compensation to specific CSR-related milestone, and whether the objectivity (or lack thereof) had a differential impact on firms’ corporate social standing.

Social responsibility incentives gaining popularity

We were somewhat surprised by how popular CSR-contingent contracts are becoming, Ikram says. Although most of the S&P 500 firms produced annual reports touting their social responsibility achievements, more than 40% of firms put their money where their mouths were. From 42% of firms in 2009 to 48% in 2013, companies offered their executives financial incentives to achieve CSR goals — especially goals that are important to their industries.

For example, the team found that mining, oil, and utility companies tended to offer incentives related to safety, health, and the environment. Retailers often focused on customer satisfaction, and financial institutions made ethics and corporate culture a priority. Other goals companies set included employee satisfaction, diversity, and corporate citizenship, and sustainability.

The team also found it encouraging that boards of directors with better governance — that is, larger boards with independent directors and in competitive industries — were more likely to make corporate social responsibilities part of executives’ contracts than were boards co-opted by a handful of insiders in less competitive industries. “We were measuring good governance in different ways, and overall the results seem to suggest the same thing: Better governance translates into an improved tendency for firms to grant these contracts,” Ikram says.

The team also studied whether the contracts set objective measures for the CSR goals an executive was to meet, or whether the contracts allowed for a more subjective determination of whether goals were met. They expected and found that firms facing uncertain economic outcomes would favor subjective contracts, and those with more certain outcomes would tend toward objective contracts.

“Overall, our results support this idea that firms know what they’re doing, they’re trying to improve firm value by granting these contracts, and they’re aware of what kind of contracts they want to offer, keeping in mind their economic environment,” Ikram explains.

They also found that objective contracts worked better when they related to measurable metrics such as safety, health, the environment, and customer satisfaction. Subjective contracts were more effective with goals whose impact is harder to measure, such as diversity or ethics, and with boards practicing good governance.

Contracts a cause, not effect, of higher CSR ratings

Finally, they looked at whether the contracts caused companies’ corporate social standing rankings to rise, or whether already-strong corporate social standing caused companies to offer the incentives. They found that CSR-contingent contracts correlate with corporate social standing, as ranked by an independent vendor that rates the CSR performance of publicly traded firms. Regardless of whether the contracts were subjective or objective, the researchers found that setting CSR goals in contracts caused companies’ rankings to go up in subsequent years.

Though their study covered data only up to 2013, Ikram thinks the share of firms including CSR goals in executives’ contracts is still rising. “There is a lot of pressure on firms to do this right now anyway,” he says. “I think a lot of your access to capital markets is kind of influenced these days by how your corporate social standing is, and I think firms and executives are realizing they, at the very least, need to signal this strong commitment toward CSR by actively tying CSR to compensation.”

The next step in this research, he says, could be in the emerging area of climate finance. Researchers could look at corporations’ social responsibility goals related to climate change and see what measures, including incentives, firms are using to try to achieve those goals.

The bottom line

Ikram says his team’s research holds these takeaways for various stakeholders:

• Boards of directors — Tying executives’ compensation to social-responsibility milestones has an impact on a company’s corporate social standing. That said, compensation committees should recognize that not all the CSR metrics are relevant to all industries, so focus on including in contracts the ones that are most important to the company’s industry. “If improving your corporate social standing is something that you care about, which a lot of boards of directors do, you should try to give the right incentives to your management to do that,” Ikram says. If a company operates in a steady, certain environment, consider contracts with objective goals; if it operates in a volatile, uncertain environment, subjective contracts may be more useful.
• Executives — You might think financial measures are all that’s important but realize that broad-based measures that take care of all stakeholders are important in the long run. “If you know that customer satisfaction or employee satisfaction is important for your business, be a little more open-minded and more receptive to being paid to achieve along those lines as well, rather than just focusing on financial performance metrics or share price,” Ikram says.
• Shareholders — You might think that CSR incentives are merely self-serving for executives, but the study shows otherwise. Such incentives can indicate better governance, do improve corporate social standing, and encourage executives to take long-term views. When you vote on members of boards of directors, consider voting for candidates who can make the board more independent and who can put good CSR-contingent contracts in place.
• Other stakeholders — Activist groups can find that CSR goals mean the groups aren’t alone in their fights. “Corporations can play their part as well if the incentives are right,” Ikram says. “I think in this climate, where people are increasingly aware, corporations can play a major part in achieving these goals related to sustainability.” Activists can keep up the pressure, and they can partner with corporations on common goals. Customers and employees also are stakeholder groups with a lot of power. They can pressure corporations when they don’t like certain policies, and they do have a voice with companies that value customer or employee satisfaction metrics.

Finance