ESG Metrics in Management Compensation Systems: An Agency Theory Perspective

With growing public and policy-makers’ attention to environmental, social, and governance (ESG) disclosures, a natural question is how management compensation systems should include ESG metrics. This paper selectively reviews and discusses insights from agency theory on the design of optimal management compensation systems. Key insights are: (i) Metrics should only be included if they are incrementally informative about the manager’s effort. (ii) The relative weights on the metrics depend on their signal-to-noise ratio and on the correlation with other financial and non-financial metrics. (iii) The size of the weights on metrics cannot be interpreted as reflecting their relative importance to the firm. (iv) Attaining congruity between metrics and benefits may require a priori counter-intuitive weights on the metrics.