Environmental, Social, and Governance Coverage of Rating Agencies and Executive Compensation

SYNOPSIS

This study examines how coverage by environmental, social, and governance (ESG) rating agencies influences executive pay structures. We find that when a firm begins to be rated by ESG agencies, its executive compensation becomes more sensitive to ESG performance and less sensitive to traditional financial performance. Our analysis identifies three key mechanisms driving this change: ESG raters (1) mitigate information asymmetries, (2) substitute for weak internal ESG governance, and (3) amplify external stakeholder pressure. The effect is stronger for firms in industries with poor ESG performance and for firms operating under heightened external scrutiny. Additional evidence shows that ESG rating coverage is positively associated with the adoption of explicit ESG-linked compensation provisions. Taken together, the results demonstrate that ESG rating coverage serves as a potent external governance mechanism that increases the importance of ESG outcomes in executive compensation.

Data Availability: The data used in this study are available from the public sources identified in the article.

JEL Classifications: G18; G38; K33; L21; M12; M41; M48.