The Hidden Risk in ESG Harmonization

Three-quarters of S&P 500 companies now tie part of their CEO’s pay to environmental, social and governance (ESG) metrics. They typically include carbon emissions, workforce diversity and worker safety, among others. Their justification is straightforward: If shareholders want corporations to take climate change and social responsibility seriously, firms should pay their leaders for achievements on these dimensions.

This practice is encouraged by boards and large institutional investors. Many regulators are now trying to standardize the underlying metrics so that investors can compare firms on a common basis.

In a recent paper, my co-author Nicolas Sahuguet and I asked a simple question: If executives understand how the metrics tied to their pay are calculated, how will they actually respond? The answer points to an unintended consequence of the push for harmonizing ESG measures. 

Opportunistic behaviour

Critics including Lucian Bebchuk at Harvard and Alex Edmans at London Business School have argued that tying executive compensation to specific ESG metrics invites executives to game the incentive scheme by hitting the target while missing the point.

Executives who know how a carbon-intensity score is calculated do not need to actually reduce their firm’s environmental impact to improve that score. They can outsource emissions-heavy production to external suppliers or shift the firm’s activities toward those that improve relevant metrics without changing its underlying environmental impact. None of this requires fraud, only an understanding of how the scoring system works.

We model this formally, taking into account a manager’s understanding of how the metric is constructed and how it responds to their decisions. This provides a more nuanced picture of ESG-linked pay: It is sometimes second-best optimal, but never without cost. Because the manager games whatever metric is used, ESG bonuses inevitably distort their decisions by diverting resources toward investments that improve the score rather than those that improve underlying outcomes.

The board accepts this distortion only when the alternative is worse, which is only the case when it genuinely wants the firm to do more for the environment or for stakeholders than what would maximize its stock price. If shareholders already reward social performance through the stock price, as they increasingly do, equity-based pay is already providing adequate incentives. Adding ESG bonuses is then doubly counterproductive. They distort investment decisions through gaming, and they push the firm to over-allocate resources to ESG activities beyond what either shareholders or the board actually want.

This helps explain why the sensitivity of CEO pay to ESG metrics is usually small, sometimes surprisingly so, even in firms that have made serious public commitments to environmental or social goals. This is not necessarily window dressing: the board keeps this sensitivity low precisely to limit the distortion.

How should ESG be measured?

The more fundamental question is how ESG performance should be measured. Today, several major rating providers, including MSCI, Sustainalytics, S&P Global and Bloomberg rate the same firms differently, even when they assess the same dimension of ESG performance. An influential paper found that the average correlation between major ESG ratings is around 0.54, far below the near-perfect agreement between credit rating agencies. The same firm can look like a sustainability leader based on one provider’s score and a laggard based on another’s.

This divergence is widely perceived as a problem, and the standard prescription is harmonization. Regulators have moved decisively in that direction. The International Sustainability Standards Board, set up by the International Financial Reporting Standards Foundation in 2021, issued its first two global standards in 2023. Around 40 jurisdictions have now adopted the standards or taken formal steps toward doing so. The European Union went further by adopting the ESG Ratings Regulation, which regulates ESG rating providers. In 2024, the Canadian Sustainability Standards Board released its sustainability disclosure standards.

The common wisdom is that convergence on a common standard is unambiguously desirable. But our paper suggests that harmonization would have negative unintended consequences. When several raters use different methodologies, gaming becomes harder: What improves one score may not improve another. An executive who knows that Provider A weights one set of indicators, Provider B weights different ones, and Provider C weights different ones still cannot easily satisfy all three without genuinely improving underlying performance. 

A single official measure provides every CEO with a clear target to optimize against. Once the methodology is public and predictable, the divergence between hitting the metric and improving underlying performance widens. For harmonization to be a net improvement, the unified standard would need to be of much higher quality than the patchwork it replaces, by a factor that scales with the number of providers being consolidated. 

The central premise driving the harmonization push, that disagreement among raters is a flaw to be regulated away, deserves more scrutiny than it has received. Disagreement has costs, but it also has benefits. By limiting the manager’s ability to game the metrics, it allows firms to provide more effective incentives on various ESG dimensions. Regulators should consider preserving the discipline associated with multiple independent metrics. 

A version of this essay was published by The Conversation.