No. 237: Performance Substitutability in ESG Pay

This study examines how the substitutability of ESG performance for financial performance in executive compensation contracts relates to firm outcomes. Using hand-collected data, we distinguish between high-and low-substitutability contracts. In high-substitutability contracts, executives can receive bonuses for ESG performance alone. In low-substitutability contracts, ESG bonuses are contingent on meeting financial thresholds. We find that, on average, ESG pay improves ESG performance. However, this effect is concentrated among highsubstitutability contracts, whereas low-substitutability contracts show no significant improvement in ESG performance. We also find that high-substitutability contracts are associated with weaker short-term financial performance, whereas low-substitutability contracts preserve financial outcomes. A mediation analysis shows that high-substitutability contracts are more likely to include quantifiable and collectively applied ESG metrics, which partially explains their positive association with ESG performance.