In new research, Michal Barzuza, Quinn Curtis, and David Webber create a framework explaining why CEOs have powerful incentives to promote ESG, why these incentives are distinct from those of shareholders, why they are powerful despite the lack of governance mechanisms, and why they are at times excessive or skewed.

Chief executive officers bear significant non-diversifiable personal risks from environmental, social, and corporate governance (ESG) setbacks, potentially jeopardizing their job security and future career trajectories. Consequently, these risk-averse CEOs may embrace ESG, not only in response to shareholder pressure, but also defensively as a means of self-protection. This CEO-centric ESG agency dilemma is pivotal in shaping the trajectory of ESG and in devising policies to calibrate CEO incentives.

The rising social demand for ESG, recent examples and studies suggest, has pushed firms to embrace ESG goals. Following the murder of George Floyd and the Black Lives Matter protests beginning in spring 2020, firms increased the proportion of minority directors by 120%. Boycott campaigns led firms to pull out of Russia in response to its invasion of Ukraine in February 2022. Index funds’ campaigns have pushed firms to diversify their boards and reduce carbon emissions. Some studies claim corporations’ adoption of ESG goals is little more than greenwashing and tokenism, but many firms have nevertheless demonstrably met shareholders’ ESG demands.

Understanding the effect of ESG demand and how it alters corporate actors’ incentives is crucial to ESG predictions and policy recommendations. In our article “The Millennial Corporation: Strong Stakeholders, Weak Managers,” we develop a theory of ESG as a product of social demand. We analyze the effects that the changing social landscape in which key stakeholders—employees, customers and investors act on their social preferences in their economic lives—has on the incentives of corporate players.

Our framework shows how the demand for ESG has created significant, and sometimes skewed, incentives that drive CEOs, investment managers, and activist hedge funds to adopt ESG policies. The article highlights five channels that influence corporate leaders to champion ESG:

1. CEO Personal Risk: Boycotts, Cancel, Walkouts and ESG Negative News

Risk of Termination: CEOs face personal risks from negative ESG occurrences, such as bad publicity, walkouts, boycotts, and deteriorating ESG ratings. These events amplify the chances of CEOs losing their positions, especially when they are highly broadcast, and have an adverse effect on their future job prospects.

Undiversifiable risk: Unlike shareholders, who can diversify their investments across various companies, a CEO has only one career. Thus, boycotts are more costly for a risk-averse CEO than for a diversified investor.

Mitigation Costs Not Borne by CEO: While the risk of negative repercussions from ESG failures is borne personally by the CEO, the costs of investing in ESG initiatives are shouldered by the company and its shareholders. This dynamic can lead to CEOs choosing to invest heavily and perhaps excessively in ESG.

These three factors separately and combined contribute to a CEO ESG agency problem: For risk-averse CEOs, the primary concern becomes minimizing personal risks related to ESG failures, even if the measures taken differ from both conventional value maximization and the optimal ESG preferences of socially oriented shareholders.

2. Investment Managers’ Incentives: ESG stewardship To Attract Investors

Index fund managers (BlackRock, State Street, and Vanguard) can leverage ESG activism to differentiate their offerings and attract socially inclined investors. The Big Three voted against boards based on lack of diversity and climate disclosure. These fund managers may exert excessive ESG stewardship that prioritizes investment flows over shareholder value. Their activism adds another layer of ESG-oriented pressure on managers and boards.

3. Activist Hedge Funds: Leverage on ESG Goals To Gain Board Seats

Activist hedge funds capitalize on ESG themes in their activist campaigns to win the index funds votes for their director candidates. Thus, managers face additional pressure from activist hedge funds to promote ESG goals. Following the success of Activist investment firm Engine No. 1 in placing three directors on ExxonMobil’s board by leveraging ESG goals, law firms have distributed client memos encouraging firms to look for weaknesses in their ESG policies and disclosure . Thus, managers have further incentives to promote ESG to avoid being targeted by activist hedge funds.

4. ESG Regulation

The growing demand for ESG has indirectly empowered ESG-centric regulations. The call for greater transparency in lobbying activities and the shareholder-driven demand for ESG disclosures have fortified such regulations, exemplified by the Security Exchange Commission’s Proposed Climate Disclosure Rule. The proliferation of ESG practices and disclosure also facilitates financial regulation by tilting the cost benefit analysis in favor of pro-ESG regulations.

5. Market Pressure

Firms are experiencing increasing demands from employees, consumers, and investors to exhibit their commitment to social and environmental objectives. This commitment is seen as vital for talent acquisition, consumer attraction and loyalty, and investor interest. This channel, however, depends on the extent to which managers are incentivized by market value. We believe that the channels that impose personal risk on managers are more significant in influencing CEO investments.

Further predictions and Implications of ESG

These five channels, separately and combined, incentivize CEOs, investment managers, and activist hedge funds to promote ESG. The analysis produces unique predictions and welfare and policy implications.

One of these predictions is that firms are less likely to respond to ESG demands when they possess high market power or when their manager has superstar power. For example, Jeff Bezos at Amazon or Elon Musk at Tesla have both resisted pushes for ESG enhancements. Second, our analysis suggests that ESG considerations will play a diminished role when negotiating change in control transactions, such as in the sale of Twitter. In the final period of the firm’s life, the CEOs lose their position in any case, and ESG issues no longer have the same bite.

Our framework also shows that the ESG demand can force firms to account for costs on third parties and the environment that have been traditionally externalized. Since relying solely on regulations to safeguard environmental and employee rights can be problematic, this is a potential advantage of the rising demand for ESG. ESG’s benefits however need to be balanced with its potential costs, like managerial overreaction or it being disregarded during firm sales.

Lastly commentators have suggested different mechanisms to incentivize CEOs and boards to promote ESG goals. Former Chief Justice of the Delaware Supreme Court Leo Strine argued that ESG should be in the realm of board risk oversight. Following the Delaware Supreme Court’s line-of-oversight decisions holding that boards should monitor mission-critical risks, we think that it is more than likely that some parts of ESG will fall within this realm. Oliver Hart and Luigi Zingales argued that managers should maximize shareholder welfare rather than returns, and they propose different mechanisms to achieve that goal. We do not have a strong position on these proposals, but we believe that social demand will continue to drive change even without reforms to existing law. Even within current legal frameworks, ESG can continue to rise, since strong incentives are already in place, and everyone is on the same page—managers, board members, index fund managers, activist hedge funds, and regulators.

Addressing ESG Critiques

Some view ESG as smoke and mirrors and others as wholly beneficial. The truth is mixed. On the one hand, it has become clear that ESG policies have led to consequential corporate actions. At the same time, it is also clear that ESG is not optimal, but rather infused with noise, problematic rating systems, and what sometimes seems to be excessive responses from firms, managers, investment managers, and policy makers. Our study’s insights highlight the theoretical motivations behind ESG adoption but also reveal the potential misalignments, especially between CEOs and shareholder interests.

Our analysis suggests that ESG is neither all smoke and mirrors nor yet another tool developed by management to justify entrenching mechanisms that preempt desirable ESG regulations and provide no value to stakeholders. We do not disagree that in the past managers had no incentives to cater to stakeholders and accordingly adopted the rhetoric of social responsibility to fend off accountability. However, we argue that this time the external social pressures impelling the rise of ESG has created powerful incentives for managers that will likely produce real value to stakeholders. Indeed, the progress on board diversity and climate commitments (even if imperfect) illustrates the distinction between past and present. 

Furthermore, most of the evidence relied upon by proponents of the managerial entrenchment view comes from M&A transactions. Yet, as explained above, firm sales create a final period problem, where managers are no longer exposed to the risks of being fired in response to poor ESG performance.

Second, ESG critics also point to a lack of effective commitment mechanisms as evidence that ESG is all talk. For example, they argue that ESG-based compensation schemes are poorly designed. Similarly, they show that firms that committed to the Business Roundtable Statement promising to deliver value to all stakeholders in a firm’s activities, not just shareholders, did not update their governance guidelines or their bylaws to reflect this commitment. Yet, we believe that these examples have limited explanatory power. Since under our analysis demand pressures managers, there is no need for these mechanisms to further incentivize managers and boards.

Finally, our analysis suggests that the rising demand for ESG is likely to facilitate, rather than preempt, desirable ESG regulation, as evidenced Nasdaq diversity listing standards, the SEC’s proposed climate disclosure mandate, the rising pressure from shareholder and index funds on firms to disclose their lobbying expenses, and the extent to which these expenses are consistent with their commitment to the Paris climate agreement. Pressure on firms to disclose lobbying expenses weakens opposition to ESG regulation, and the proliferation of ESG practices facilitates financial regulation’s cost-benefit threshold by reducing the wherewithal required for implementation and raising the costs of ignoring shareholder demand.

Our analysis has implications also for the view of ESG proponents that ESG maximizes long-term firm value. Our analysis suggests that while the incentives created by social demand are forceful, they are also skewed, can sometimes be excessive, and may not only be about firm value.

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.