No. 237: Performance Substitutability in ESG Pay

This study examines how the substitutability of ESG performance for financial performance in executive compensation contracts is associated with firm outcomes. Using hand-collected compensation data for large German firms, we distinguish between high-substitutability contracts, in which strong ESG performance can compensate for weak financial performance, and low-substitutability contracts, which restrict this trade-off. The positive association between ESG pay and ESG performance is significantly stronger for high- than low-substitutability contracts. Following Germany’s implementation of the Second Shareholder Rights Directive, post-ARUG-II ESG-performance changes are more positive among high- than low-substitutability adopters. Evidence for a corresponding financial-performance trade-off is weaker. Additional analyses show that high-substitutability contracts are more likely to include quantifiable and collectively applied ESG metrics, with both features positively associated with ESG performance. Our findings highlight the importance of how ESG and financial performance interact within compensation contracts rather than simply whether ESG metrics are included.