In the Nation's Interest
What Gets Measured Gets Done
Seven years ago, after the fall of Enron and WorldCom, President Bush called for a "new ethic of personal responsibility in the business community-an ethic that will increase investor confidence, make employees proud of their companies and regain the trust of the American people." Recently, President Obama outlined a number of principles meant to correct the errors that precipitated the financial crisis and guide future regulatory reforms. Principle five reads: "We must demand strict accountability, starting at the top. Executives who violate the public trust must be held responsible."
President Obama is no doubt correct to call for greater responsibility, just as President Bush did seven years earlier, and just as CED has done here, here, and here. It is entirely appropriate to hold executives accountable for unethical and irresponsible behavior. The political system is seeking to restore public trust, if not assuage populist anger, by reining in executive compensation and strengthening regulation. But while preaching from the bully pulpit and regulating from government agencies may be part of the solution, they are not the best responses to the problem.
A better solution can be derived from the old adage, "What Gets Measured Gets Done." Business management science has long held that people respond when results are measured-especially when their pay is tied to those measurements. In other words, encouraging corporations to revise their pay-for-performance criteria to include well-articulated measures of responsible environmental, social, and governance (ESG) performance might go a long way to elicit desired behavior from corporate managers.
In our view, the benefits of ESG performance measures should gain greater prominence amidst the financial crisis. In a crisis born partly of short-term thinking, and especially an unhealthy obsession over short-term financial results, ESG performance criteria may help to reorient a firm's focus toward long-term value creation. According to a recent McKinsey survey, 83 percent of respondents say that market pressures are causing their companies to recognize the importance of ESG performance indicators.
ESG performance measures can sometimes better signal future financial performance than can strictly financial indicators, such as quarterly earnings per share. Most CEOs already seem cognizant of this fact: Of chief executives surveyed, 78 percent reported that financial indicators alone do not adequately capture their company's strengths and weaknesses. In the same survey, 85 percent of respondents believed that environmental programs bear positively on shareholder value over the long run. Social programs received a positive rating by 74 percent of respondents.
Tying executive compensation to ESG performance measures anchors the company's performance to an ethic of integrity and responsiveness to public concerns, among other benefits. ESG objectives act as a counterweight to the pressure on executives constantly to meet short-term share-price targets. Such pressure encourages a race to the bottom: executives look for ways to cut costs at every corner, even if doing so compromises societal interests; management is led to blur ethical lines at the expense of public trust. But when boards expressly make clear that concerns about ethical standards and societal interests are backed up by compensation policies, short-term pressures can be abated.
Opponents will undoubtedly argue that it's difficult to develop metrics of ESG performance. That's true, to an extent. But data are available. And compensation incentives could be amended to encourage management to address long-term strategic goals, including environmental, social, and governance goals. It is not especially difficult to solicit customer satisfaction feedback via surveys. It's not terribly difficult to measure carbon emissions or compliance with recognized national and international labor standards. Specific targets, for example for research and development investments, can be established and their achievement measured.
Some metrics may not be as easy to develop, but the development of ESG metrics of success would be well worth the effort-remember, what gets measured gets done. These outcomes also need to be independently verified. Of course doing so will entail some costs. But corporate leaders should see the value of such expenditures. Finally, we would argue for incorporating some qualitative information into performance evaluations. Not everything that can be done can be measured objectively. Ethical behavior, for example, may be demonstrated when something is not done, such as a bribe not made or taken, rather than when something measurable is accomplished. Subjective evaluations have a role to play, and they should not be avoided just because they involve personal judgments rather than observable events.
Boards of directors can play a key role in helping a company to get ahead of the curve, to step outside of day-to-day pressures, and to think strategically about the long-term interests of the corporation. Directors are uniquely placed to ask tough questions about how a corporation's strategy interacts with societal concerns that form the landscape in which the business operates and to develop appropriate incentives for company executives to deal constructively in that landscape. They also establish compensation benchmarks and pay-for-performance measures. They have it in their power to insist that at least a portion of executive pay is tied to ESG and ethical indicators.
Our hope is that shareholders and other stakeholders will encourage directors to act, so future Presidents don't need to echo Presidents Bush and Obama, and again call for a new era of business responsibility.
Commentaries are the views of the authors and do not necessarily represent policies of the Committee for Economic Development.