Introduction

This research explores the effectiveness of implicit and explicit contracts in linking executive compensation to environmental and social (ES) performance targets. The study highlights how these contractual structures impact corporate ES outcomes. Explicit contracts, which rely on measurable targets and fixed links to compensation, are compared to implicit contracts, which rely on subjective evaluation. Data was collected from over 52,000 firm-year observations of publicly listed US firms from 2006 to 2021.

Prevalence Of ES pay

The use of ES Pay schemes increased significantly over time, from 6.5% of firms in 2006 to 25.7% in 2021. Explicit contracting rose slightly, from 30.1% of ES Pay schemes in 2006 to 43.5% in 2021. S-related targets, such as diversity and safety, were more prevalent than E-related targets, with 25.6% of firms including S targets compared to 12.4% using E targets by 2021.

ES pay contracting structure

Explicit contracts, which use quantitative targets and fixed compensation links, accounted for 40.7% of ES Pay schemes. Implicit schemes, relying on qualitative targets and discretion, represented 59.3%. Targets with precise metrics, such as emissions reductions, were more likely to use explicit contracts (65%). Implicit contracts were preferred for vague metrics like community engagement (16.3% explicit).

ES pay targets

The most common S targets were talent management (52.6%) and employee safety (44.3%). Common E targets included emissions reduction (3.6%) and waste management (1.9%). Over time, targets for emissions and diversity increased, with emissions-related targets rising from 0.9% in 2006 to 12.9% in 2021. Safety-related targets declined slightly during the same period.

Effectiveness Of ES pay schemes

Explicit ES Pay schemes demonstrated stronger performance for measurable targets. For example, firms with explicit emissions targets showed a 41% reduction in GHG emission intensity, whereas implicit schemes had no measurable impact on emissions. Implicit schemes were more effective for vague targets. Talent scores, for instance, were 8.5% higher in firms with implicit schemes compared to those without such targets.

ES pay and CEO compensation

The study found that CEO compensation was, on average, 2.9% higher in firms using ES Pay compared to those without it. This increase was primarily driven by firms using implicit contracts for hard-to-measure targets. Explicit contracts had no significant impact on overall executive pay.

ES pay and financial Pperformance

No evidence suggested that ES Pay schemes negatively impacted financial performance. Firms with ES Pay schemes exhibited similar return on assets (ROA) and stock returns compared to those without ES Pay. Explicit and implicit contracts also showed no discernible difference in financial outcomes.

Recommendations

The study recommends that firms match the structure of ES Pay schemes with the measurability of targets. Explicit contracts are suited to clear metrics, such as emissions, while implicit contracts are effective for broader goals, such as community engagement. Increased transparency and standardisation in ES Pay schemes are also suggested to ensure their effectiveness and comparability.

Conclusion

This research highlights the importance of tailoring ES Pay schemes to the nature of performance metrics. Explicit contracts work best for quantifiable goals, while implicit contracts excel with qualitative objectives. These findings are relevant for stakeholders, compensation committees, and regulators aiming to incentivise sustainable corporate practices effectively.