Executive compensation and corporate sustainability: Evidence from ESG ratings (2024)

2.1. Executive compensation and corporate ESG ratings

Executive compensation encompasses various forms of compensation received by executives from the company, including direct or indirect, explicit or implicit, and monetary or non-monetary components. Currently, two predominant perspectives exist regarding the factors that influence executive compensation contracts: the "optimal contract theory" and the "management power theory." The "optimal contract theory," rooted in the principal's viewpoint, asserts that the principal can design an effective executive compensation contract to incentivize executives to work diligently while curbing the agent's self-interest. Thus, the executive compensation contract serves as a mechanism to mitigate the agency conflict between the principal and the agent [10,11]. In contrast, the "management power theory" is an agent-based theory. According to this perspective, rational managers are primarily motivated to maximize their own interests rather than the interests of the company and its shareholders. The inherent weaknesses of the board of directors, the managerial market, the control market, and the capital market allow managers to wield substantial influence over the formulation and implementation of executive compensation contracts, enabling them to seek personal gains by manipulating these contracts [12]. Consequently, executive compensation contracts themselves become part of the agency problem. Existing literature predominantly revolves around the "optimal contract theory" and the "management power theory," considering various factors such as the type of controlling shareholders [13], firm production [14], executive tenure [15], stock market performance [16], internal and external corporate governance environment [17], and the comparability of accounting information.

ESG Ratings is a measure of a firm's sustainability, and academic discussions on this topic can be broadly categorized into two aspects: economic consequences and influencing factors. Regarding economic consequences, the primary focus lies in examining the impact of ESG Ratings on various financial indicators such as financial performance, share price volatility, financing constraints, firm value, and firm efficiency. There is a positive correlation between ESG ratings and firms' financial performance, and this positive effect is stable in the long run [18]. During the COVID-19 pandemic, portfolios with higher ESG scores showed greater resilience [19]. Socially Responsible Investment (SRI) foundations adjust their portfolio weights based on a company's relative ESG rating [20].Companies with higher ESG ratings have lower debt financing costs and are more influential in stakeholder-oriented unsystematic equity setups [21].ESG ratings have a positive impact on listed companies' value and can significantly improve a firm's Tobin's Q [22]. Non-linear relationship between corporate ESG activities and corporate efficiency [23].

Additionally, ESG Ratings has been shown to have various positive effects, including the reduction of corporate risk, the enhancement of customer relationship stability, the inhibition of true surplus management activities, and the reduction of equity costs [[24], [25], [26]]. These positive impacts on firm operations and capital market performance can serve as motivators for firms to prioritize and improve their ESG Ratings. In terms of influencing factors, studies have been conducted to examine comprehensive ESG Ratings with regard to corporate organizational structure, industry heterogeneity, management characteristics, and company size. Companies with social responsibility committees exhibit higher ESG ratings [27]. Companies operating in sensitive industries such as tobacco, alcohol and polluting industries are motivated to improve their ESG ratings [28]. Materialism plays a role in shaping individual value systems, and companies led by materialistic CEOs tend to have lower CSR scores and fewer strengths, resulting in lower ESG ratings [29]. There is a significant positive correlation between firm size and ESG ratings, which can be explained by the concept of organizational legitimacy [30].

According to the theory of incentive compatibility and optimal contract theory, although both incentives and supervision can address the conflict of interest between the two parties in the principal-agent relationship, incentives hold greater advantages due to the associated costs incurred by supervision. An effective compensation contract, serving as an incentive mechanism, can mitigate the agency conflict between shareholders and executives, aligning the interests of both parties. Well-designed compensation contracts can satisfy both management participation constraints and incentive compatibility constraints, thus helping to mitigate the moral hazard problem of agents under information asymmetry [31]. Meanwhile, there has been increasing domestic and international attention to the Environmental, Social, and Governance (ESG) concept in recent years, making ESG ratings a mainstream evaluation criterion for publicly listed companies globally. ESG factors are playing an increasingly significant role in the operation and performance of enterprises, drawing heightened interest from stakeholders such as investors, consumers, employees, and regulatory bodies.

As the ESG development paradigm gains increasing prominence, a growing number of companies are incorporating ESG performance indicators into the evaluation systems for executive compensation [[32], [33], [34], [35], [36]]. Under such a compensation design, it can heighten the executives' focus on long-term sustainability, curb their short-term opportunistic behaviors to a certain extent, and thereby encourage executives to consider environmental, social, and governance (ESG) factors in investment and business operational decisions. This, in turn, aligns the incentives of executives with the sustainable development of the enterprise. Drawing on stakeholder theory, in scenarios where enterprises prioritize ESG institutional construction and ESG performance, compensation incentives can enhance the alignment of executives' decision-making with the values of stakeholders. This alignment facilitates the enterprises' strategic decision-making that adheres to the principles of sustainable development, based on a long-term value orientation. Consequently, executive compensation incentives are likely to improve a company's ESG performance.

Based on the preceding analysis, this paper proposes the following hypothesis.

2.2. The mediating role of green innovation efficiency, environmental information disclosure and financial performance

3.1. Sample and data sources

This study focuses on the inclusion of all A-share listed companies in the Shanghai and Shenzhen markets in China between 2012 and 2021 as the primary subject of investigation. A total of 40,766 initial observation samples were obtained from 5072 listed companies. To align with the research objectives, the following treatments were applied to the samples: (1) exclusion of samples from the financial, insurance, and capital market service industries, (2) exclusion of ST-labeled samples, (3) exclusion of samples with missing data, and (4) application of tailoring at the 1% and 99% levels for all continuous variables. Ultimately, 28,306 observation samples were obtained. All data were obtained from the CSMAR database, the Wind database and the CNRDS database.

3.2. Variable definition

3.3. Model setting

To investigate the relationship between executive overcompensation and corporate ESG Ratings, the following benchmark regression model is set in this paper:

In order to further investigate the impact of changes in executive compensation on changes in corporate ESG performance, this paper constructs the following model:

To examine whether executive compensation affects corporate ESG Ratings through mediating variables, the following mediating effect test model is constructed:

where the dependent variable ESGi,t represents the ESG Ratings of firm i in year t, while ΔESGi,t denotes the difference between the ESG performance of firm i in year t and that in year t−1. The explanatory variable Payi,t represents the executive compensation received by firm i′ s executives in year t, and ΔPayi,t−1 represents the change in executive compensation received by firm i's executives in year t−1. The intercept term is denoted by α0 and Controlsi,t refers to the control variables. λi is the individual fixed effect, μt is the year fixed effect, and εi,t is the random error item. The coefficients α1 represents the effect of executive compensation on corporate ESG Ratings. If the coefficient α1>0 and statistically significant, it indicates that the executive overcompensation has a positive association with the ESG Ratings of the company, supporting research Hypothesis 1.

Mediatei,t represents the mediating variables, including social responsibility (CSR), internal control (IC), and financial performance (ROE). According to the three-step test for mediating effects, the mediation effects are examined as follows: in the first step, The impact of executive compensation on corporate ESG Ratings is significant, indicating that the coefficient α1 in model (1) reaches a significant level. In the second step, the impact of executive compensation on the mediating variables is significant, indicating that the coefficient β1 in model (2) reaches a significant level. In the third step, the simultaneous effects of executive compensation and mediating variables on corporate ESG Ratings are tested. In model (3), when the coefficient γ2 of the mediating variable is significant while the coefficient γ1 of executive compensation is not significant, the mediating variable fully mediates the relationship. When both the coefficient γ2 of the mediating variable and the coefficient γ1 of executive compensation are significant, the mediating variable partially mediates the relationship.

4.1. Descriptive statistics

Table 2 presents the descriptive statistics for the main variables. In terms of the ESG Ratings of firms (ESG), the sample exhibits a mean of 6.469 and a median of 6.000. These values suggest an overall favorable ESG Ratings among the firms. Furthermore, the standard deviation of ESG Ratings is 1.174, indicating a substantial variation in ESG Ratings levels across firms. Regarding executive compensation (Pay), the mean value is 14.467, with a minimum of 12.820 and a maximum of 16.404. These findings align with previous literature on the subject. Firm size (Size) demonstrates a mean value of 22.251 and a standard deviation of 1.299, implying significant differences in size across firms. The mean value of gearing (Lev) is 0.432, indicating a generally strong solvency among companies. For the variable Dual, the mean value is 0.282, and the standard deviation is 0.450, suggesting that the phenomenon of having the same person as the chairman and general manager is relatively common in supervisory companies. The mean value of Growth is 0.174, indicating that companies, on average, maintain a high level of revenue growth.

Table 3 shows the correlation coefficients between the variables, and it can be seen that the correlation coefficient between Pay and ESG is 0.211,and presents a significance at 1% level. It indicates that there is a significant positive correlation between executive compensation Pay and corporate ESG performance.

Table 4 shows the Variance Inflation Factor (VIF), it can be seen that the average VIF is 2.96, and the VIF of each variable is less than 2, which indicates that there is no significant problem of multicollinearity, and the results of this study can more reliably explain the effect of the independent variables on the dependent variable without being significantly affected by multicollinearity.

4.2. Baseline regression results

Table 5 presents the regression results, which have been adjusted using cluster-robust standard errors to address the issue of within-group correlation in the sample. We adjusted for clustering at the enterprise level using the cluster variable (firmid) to ensure the accuracy and robustness of the results. All standard errors in the table have been adjusted for clustering. column (1) presents only the regression results of executive compensation (Pay) and firms' ESG performance (ESG), column (2) reports the regression results controlling for industry and year, which show that the regression coefficients of executive compensation (Pay) are all significant at the 1% level. The regression results imply that there is a significant positive relationship between executive compensation and firms' ESG performance, indicating that the higher the compensation given to executives, the better the firms' ESG performance will be, controlling for other variables.

Columns (3) and (4) show the results of regressing the change in executive compensation (ΔPayt-1) in the previous year on the change in corporate ESG performance in the current year. The results show that the regression coefficients of the change in executive compensation (ΔPayt-1) in the previous year are significant at the 5% and 1% levels, respectively, and it appears that the change in executive compensation (ΔPayt-1) in the previous year significantly improves the change in corporate ESG performance in the current year. Hypothesis 1 is verified. Regarding the control variables, the regression coefficient of firm size (Size) is significantly positive at the 1% level, indicating that the larger the firm size, the more importance the firm attaches to ESG performance. The regression coefficient of Lev is significantly negative at the 1% level, indicating that the higher the corporate debt ratio, the worse the ESG performance of the firm. The regression coefficient of Dual is significantly negative at the 1% level, indicating that the ESG performance of enterprises with the same chairman and general manager is worse than that of enterprises with different chairmen and general managers, which may be due to the fact that the decision-making of this enterprise is mainly decided by a single person and lacks the necessary supervision, and will be under-invested in ESG. The regression coefficient of Board size (Board) is significantly positive at the 1% level, indicating that the larger the board size, the more complex the mutual monitoring among directors, and the better the ESG performance of the firm. The regression coefficient of firm growth (Growth) is significantly negative at the 1% level, indicating that firms with faster growth in operating income may devote more resources to the development of corporate performance and thus have poorer ESG performance. The regression coefficient of company value (TobinQ) is significantly positive at the 1% level, indicating that companies with higher company value have better ESG performance.

4.3. Robustness test

In the robustness test, this paper conducts a substitution of the explanatory variables by introducing the logarithm of the total annual salary of directors and supervisors (Pay1) and the corporate ESG Ratings score data provided by Bloomberg Consulting (ESG1) for the benchmark regression analysis. This substitution is carried out to ensure the reliability and robustness of the paper's findings.

As depicted in columns (1) and (2) of Table 6, the substitution of the explanatory and explanatory variables does not alter the positive correlation observed between executive compensation and corporate ESG Ratings. This outcome aligns with the results obtained in the previous study, thereby enhancing the consistency and robustness of the findings.

4.4. Endogeneity test

4.5. Mechanism test

Table 11 presents the regression results for equation (3) and equation (4). Within this table, columns (1) and (2) exhibit the test results regarding the mediating effect of the transmission path "Executive Compensation - Green innovation efficiency - Corporate ESG Ratings." Columns (3) and (4) demonstrate the test results concerning the mediating effect of the transmission path "Executive Compensation - Environmental information disclosure - Corporate ESG Ratings." Lastly, columns (5) and (6) showcase the test results pertaining to the mediating effect of the transmission path "Executive Compensation - Financial Performance - Corporate ESG Ratings." The findings suggest that green innovation efficiency, environmental information disclosure, and financial performance partially mediate the relationship between executive compensation and corporate ESG Ratings. This implies that executive compensation enhances corporate ESG Ratings by elevating the levels of green innovation efficiency, environmental information disclosure, and financial performance, thereby confirming Hypothesis 2 in this study.

Moreover, to ensure the robustness of the mediating effect test results, the Bootstrap method was employed in this study to evaluate the regression results presented in Table 11. As depicted in Table 12, the estimation coefficients for both the direct and indirect effects of the mediating variables, namely green innovation efficiency (GIE), environmental information disclosure (EDI), and financial performance (ROE), exhibit statistical significance at the 1% level. Furthermore, the 95% confidence intervals' upper and lower limits do not encompass zero. The proportions of indirect effects for the mediating variables are 8.45%, 28.07%, and 24.55%, respectively. Notably, environmental information disclosure yields the highest proportion of indirect effect, followed by financial performance.

5.1. Heterogeneity analysis

5.2. Excess executive compensation and corporate ESG ratings

The previous article discussed the impact of executive compensation on corporate ESG Ratings and concluded that executive compensation contributes to corporate ESG Ratings. However, the concept of executive overcompensation highlights the notion that executives are paid more than what may be considered reasonable, often exceeding the fair value of their work and performance, and extending beyond the realm of corporate performance-based decisions. Academically, two main perspectives exist regarding executive overcompensation. One perspective argues that excessive executive compensation has a positive effect on firm value and can effectively address agency problems [58]. The other perspective views excessive executive compensation as a means for executives to prioritize their own interests at the expense of shareholders [59]. According to the "managerial power hypothesis," excessive managerial compensation reflects the power of executives and leads to increased agency costs. Executive compensation contracts contain performance noise, and executives may be motivated by self-interest to engage in unethical behavior in order to receive excessive compensation [60].Additionally, executives often justify their compensation by increasing the linkage between pay and performance, frequently resorting to earnings management [61]. Even with supervisory mechanisms in place, supervisors may still collude with agents to obtain excessive compensation by sharing the benefits of collusion [62]. Subsequently, the paper delves into investigating the impact of executive overcompensation on corporate ESG Ratings. The calculation process for executive overcompensation is outlined as follows:

where CEOpayi,t is the actual absolute compensation received by executives, the Overpayi,t is the excess compensation of executives, and Expectedpayi,t is the expected executive compensation. Sizei,t illustrates the company size, measured using the logarithm of total assets at the end of the year. ROAi,t signifies the performance of the listed company, measured by the return on assets. IAi,t represents the company's intangible assets ratio. Zonei,t denotes the dummy variable of region. The regression equation (6) is initially estimated using the sample data to obtain the regression coefficients. Then, these estimated coefficients are multiplied by the corresponding factors determining compensation to derive the expected executive compensation. Finally, in equation (7), the actual executive compensation is subtracted from the expected executive compensation to obtain the unexpected executive compensation. When Overpayi,t is greater than 0, it represents the excess compensation received by the company's executives.

Table 14 presents the regression results examining the relationship between executive overpay and corporate ESG Ratings. The coefficient of executive overpay (Overpay) is found to be significantly negative at the 5% level. This suggests that there is a negative association between executive overpay and corporate ESG Ratings. In other words, as the level of executive overpay increases, the corporate ESG Ratings tends to worsen. These findings indicate that, under certain circ*mstances, it is important to control executive compensation incentives within an appropriate range in order to enhance the firm's ESG Ratings. It further implies that excessive executive overpay can have detrimental effects on corporate ESG Ratings.

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