The relation between CSR and CEO compensation: the mediating effect of stock price returns

The relation between CSR and CEO compensation: the mediating effect of stock price returns

Bassilios Kostopoulos ¹

Thesis MSc. Finance University of Groningen Faculty of Economics and Business

Supervisor: dr. R.O.S. Zaal Co-assessor: dr. N. Selmane

Abstract

This study examines the relation between CSR and total CEO compensation through the mediating effect of corporate financial performance (CFP) measured in stock price returns. CSR is decomposed into the following three components: environmental, social and corporate governance (ESG). Using a panel data sample of all S&P 500 Index listed-firms from 2002- 2018, a direct positive relationship between social and corporate governance ESG scores and total CEO compensation was found. Moreover, no evidence of CFP’s mediation effect was established. The findings of this paper suggest that nowadays, CSR scores can be incorporated into total CEO compensation, thereby adding a new dimension to current executive remuneration schemes. This new “green” dimension of executive remuneration can be seen as complementary next to the conventional relation between CFP and total CEO compensation.

Key Words: Corporate Social Responsibility, CEO Compensation, Corporate Financial Performance, ESG, Stock Price Returns

1 b.o.v.kostopoulos@student.rug.nl S3773612

1. Introduction:

On August 19 ^th 2019, 181 out of 193 CEOs of the Business Roundtable (BRT) in the U.S.

openly rejected the conception that the only purpose of a corporation is to maximize its profits (Cohan, 2019); instead, they adopted a corporate social responsibility (CSR) oriented notion for their firms. Jamie Dimon, the CEO of JPMorgan Chase & Co. famously stated about CSR: “We are using this model to help solve critical social and economic challenges.” (Dimon, 2017)

Nowadays, numerous companies worldwide take the environmental and social effects of their business increasingly into consideration. Along with governmental organizations and NGOs, a variety of issues ought to be combated, such as reducing CO2 emissions or addressing gender equality (CEB, 2018). Firms define this responsibility as “Corporate Social Responsibility”

(CSR). CSR is described as a firm’s voluntarily commitment to take the social, economic and environmental effects of its operation into account and act ethically and responsibly (Clarkson, 1995). Alternatively, CSR is also titled as corporate citizenship, corporate conscience and sustainable responsible business (Fontaine, 2013). Based on the Thomson Reuters ASSET4 database CSR can be partitioned into the following three pillars: environmental, social and corporate governance, which are often abbreviated by the acronym ESG (Reuters, 2019). The main goal of CSR is for corporations to assume responsibility for their actions and leave a positive mark through their business activities on the environment and the public they serve, comparable to the triple bottom line (or 3P’s): people, planet and profit (Fontaine, 2013). In fact, firms have realized that they cannot ignore the environment in which they are operating in and instead have self-regulated their corporate strategies (Sheehy, 2014). As a result, firms and organizations are not only interested in maximizing their shareholders’ value, but also in addressing the prosperity and sustainability of all their different stakeholders (customers, employees, suppliers, environment, government, etc.) altogether.

CSR catalysed severe changes in corporate practices, regulations and financial strategies/guidelines (Aguilera, Rupp, Williams & Ganapathi, 2007; Barth and Wolff, 2009).

On a corporate level, the UN Sustainable Development Goals (SDGs) have been adopted by

many corporations world-wide, including also numerous Fortune 500 companies. SDGs are 17

goals established to procure economic, environmental and social sustainability globally by 2030

(United Nations, 2017). Another example, constituted specifically for the financial sector, is the

United Nations Environment Programme Finance Initiative (UNEP FI), which urges all signing

financial institutions and insurance companies to actively encompass CSR practices within their

business (United Nations, n.d.).

Additionally, investors have developed an interest in CSR practices through the implementation of investment strategies and instruments such as environmental, social and governance (ESG) investing, socially responsible investing (SRI), impact investing and green bonds. For example, impact investing targets only companies that create a positive environmental or social impact.

It is significant to note that the total assets under management (AUM) of SRI portfolios in the U.S. alone increased by 1,200% from 1995 to 2005 (Renneboog, Horst & Zhang, 2008) and that as of 2015 the total AUM of ESG portfolios has surpassed $21.0 Trillion (UN Global Impact, 2015).

Previous studies such as Akpinar, Jiang, Gomez-Mejia and Berrone (2008), Choi, Kwak and Choe (2010), Eccles, Ioannou and Serafeim (2014), Lin, Yang and Liou (2009), Orlitzky, Schmidt and Rynes (2003) and Waddock and Graves (1997) have examined the link between CSR and firms’ corporate financial performance (CFP). All studies mentioned above provided evidence of a positive relationship between CSR and a firm’s financial performance measured by stock market performance. On the other hand, it also needs to be pointed out that studies such as Aggarwal (2013), Aupperle, Carroll and Hatfield (1985) and Manescu (2011) found mixed and inconclusive evidence about the link between CSR and CFP. That said, the majority of the preceding literature which examined CSR and CFP found a positive relationship indeed (Griffin and Mahon, 1997). Consequently, it can be argued that engaging in CSR can potentially yield higher financial returns for companies.

More recently, however, a commonly-held view is that companies should also relate their CSR practices to CEO compensation (Jian and Lee, 2015). In the aftermath of the global financial crisis of 2007-2008, considerable public attention deliberated around CEO compensation (structure). A great number of arduous questions emerged, such as if CEO compensation is unjustifiably too high, if the firm’s performance corroborates it or whether if it should be (partly) linked to sustainability metrics. As a result, some companies began experimenting with CSR-contracting, thereby linking executive remuneration to sustainability measures (Ikram, Li

& Minor, 2019). Previously, companies were linking executive compensation merely to the firm’s financial performance. For instance, since 2008, Intel Corporation started attaching a small share of executive compensation to corporate sustainability factors in their annual performance bonus (Intel Corp., 2018). Henceforth, one of the precise objectives of this study is to examine whether there is a link between CSR and total CEO compensation.

Preceding literature such as Benson, Faff and Renner (2014), Cai, Jo and Pan (2011), Flammer, Hong and Minor (2019), Jian and Lee (2015), Khondkar, Eunju and Sanghyun (2018) and Stanwick and Stanwick (2001) have examined the link between CSR and CEO compensation.

Despite that, to date, none of those previous studies focused on decomposing CSR into its three

(ESG) components and connect every component separately with total CEO compensation. For example, Cai et al. (2011) and Khondkar et al. (2018) used total combined CSR scores and an aggregate CSR Index. In contrast, Stanwick and Stanwick (2001) keyed in solely on the firm’s environmental reputation. In the same vein, Benson et al. (2014) concentrated mainly on the impact that the global financial crisis of 2007-2008 had on the relationship between CSR and CEO compensation. Henceforth, the main differentiation of this study is that it will research the relation between environmental, social and corporate governance CSR scores individually with total CEO compensation. It should also be noted that all studies mentioned above employ different databases and samples (such as KLD Stats and Risk metrics database) ² and also use several time periods from the previous century. To illustrate, Benson et al. (2014) centralized their study for 1996-2010, Jian and Lee (2015) used a sample period of 1992-2011, Khondkar et al. (2018) analysed CSR data for the period 1998-2012 and Stanwick and Stanwick (2001) focused only between 1990-1991. However, this study will concentrate on 2002-2018, hence providing a more up-to-date analysis of the relationship between CSR and total CEO compensation.

This study intends to examine the relationship between CSR and total CEO compensation by introducing the partial mediation effect of CFP through stock price returns. Based upon the seminal paper of Baron and Kenny (1986), the partial mediation effect generates a third variable titled as the mediator variable, which develops the generative mechanism through which the independent variable influences the dependent variable (Baron and Kenny, 1986). The mediator variable is also known as mediating, intermediary, or intervening variable (Indiana University, 2002). In our study, the mediator variable of CFP will be the main mechanism that will effectuate the three CSR components (environmental, social and corporate governance) to influence total CEO compensation. Primarily, the partial mediation effect of CFP implies that CFP indirectly precipitates the relationship between CSR and total CEO compensation.

Therefore, the main research question that the present study will attempt to answer is the following: “Is there a relationship between CSR and total CEO compensation through the mediating effect of stock price returns?”. The main research question is represented in Figure 1 below, which also illustrates the conceptual model of this study.

2 This study will analyze CSR from the ASSET4 Database provided by Thomson Reuters Eikon

measured in ESG data. According to Bouten et al. (2017), the ASSET4 database is among the three

largest sources of CSR ratings in academic research.

CFP (Stock Price Returns)

Figure 1: Partial mediation effect of CFP towards CSR® Total CEO compensation

The study will continue by researching preceding literature and thereby developing the main hypotheses in section 2. Next, we will regress (yearly) environmental, social and corporate governance CSR scores to total CEO compensation for all S&P 500 Index listed-firms in the U.S. from 2002 until 2018. By doing this, it will be examined if there is a connection between total CEO compensation and the three underlying CSR components. Thus, research data and methodology applied to answer the hypotheses are discussed in section 3. Accordingly, the study will then proceed with presenting and analysing the results in section 4 and finish with certain concluding observations, and finally, some recommendations for future research.

2. Theory and Hypotheses Development:

2.1 CSR Definition

The definition of CSR has evolved and extended vastly over the past decades, shifting away from a legal obligation regarding socio-environmental issues into a more modern terminology, also incorporating voluntary ethical and philanthropic responsibilities (Carroll, 1999).

Importantly, Carroll (1991) expanded CSR as a pyramid of four responsibilities ranked in order of importance. Those four responsibilities (bottom-up) consist of: (1) economic responsibilities, (2) legal responsibilities, (3) ethical responsibilities and (4) philanthropic responsibilities (Carroll, 1991). With economic responsibilities Carroll (1991) implied that firms have to be profitable as a minimum baseline and with legal responsibilities that firms must always comply with the law. Furthermore, ethical responsibilities convey that firms must act ethically and avoid any negative externalities for their stakeholders (Carroll, 1991). Lastly, according to Carroll (1991) philanthropic responsibilities infer that businesses are presumed to donate resources to the communities they serve. In recent years, however, CSR has been established predominantly as a strategic requirement rather than a minimum responsibility (Werther and Chandler, 2005).

CSR (ESG) Total CEO

Compensation

The definition of CSR was developed further by Porter and Kramer (2006), who introduced strategic CSR. Strategic CSR is about incorporating CSR within a firm’s core business activities in order to achieve a competitive advantage, whereas the previous conventional CSR approaches adopted by firms were separated entirely from their core business operations (Porter and Kramer, 2006). Hence, one could argue that strategic CSR demonstrates the evolution of CSR throughout the years and also provides one of the most modern definitions of CSR.

It is imperative to note that there is no universal definition of CSR, but rather it depends occasionally on the managerial context (Davis, 1960). Conceivably, up until present time, according to Dahlsrud (2008), one of the most frequently used and hence hypothesized universally-accepted definitions of CSR is from the European Commission (EC) (2001) which defines CSR as: “a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis.” (p.5). In brief, for the remainder of this study, we will adhere to the European Commission’s definition of CSR since this is the most commonly used definition of CSR.

2.2 Stakeholder theory and its relation to CSR

Friedman (1970) stated that a firm’s only responsibility above everything is to maximize its shareholder’s value, which led to the Friedman Doctrine or shareholder theory. In essence, Friedman described that a company has no responsibility to the public/society or to the environment; a firm’s responsibility is solely to maximize shareholders’ profit. Nonetheless, later on, in 1983, Freeman expanded the concept of stakeholder theory, which was defined in his seminal paper as: “an identifiable group or individual who can affect the achievement of an organization’s objectives or who is affected by the achievement of an organizations objectives.”

(p.91) (Freeman, 1983). Most notably, in the same paper Freeman claimed that according to the Stanford Research Institute (SRI) “the organization would cease to exist” (p.89) without the support of its different stakeholders, thereby emphasizing the utmost importance for corporations to acknowledge their stakeholder’s interests.

Clarkson (1995) and Wood and Jones (1995) argued that CSR is shaped heavily by the adoption

of the stakeholder theory approach. Their main proposition is that the stakeholder theory is

crucial in terms of understanding the firm’s societal and business values since all stakeholders

are affected (in)directly by the firm’s operations and decisions.

2.3 Alternative Theory to Stakeholder Theory and its relation to CSR Institutional Theory

Another theory that influences CSR practices and can be seen as complementary to the stakeholder theory is the institutional theory. According to the institutional theory, the actions of corporations are affected by the institutional context in which they are operating within (Campbell, 2007). Scott (2004) claims that rules, norms, and routines within a context become inaugurated as official principles for social behavior, thereby shaping and establishing the institutional environment. For instance, Nikolaeva and Bicho (2011) found that if a large number of firms adopt a particular CSR reporting strategy, then all other firms in the same industry will be pressured by the institutional context to adopt the exact same strategy. Mainly, Campbell (2007) provided evidence of institutional factors that affect the implementation of CSR strategies by companies. According to Campbell (2007), companies are more likely to engage in CSR practices when faced with robust government regulations, monitoring of their CSR practices by NGOs and with an institutional environment that overall encourages CSR initiatives. Additionally, he claims that when companies are members of industrial and employee associations they are more inclined to adopt CSR practices actively.

Moreover, Windsor (2006) expounds Campbell’s statements that government regulation prompts firms to be more conscious about their community and the environment. Specifically, Windsor (2006) claims that the massive deregulations and privatizations that occurred between 1980 and 1990 in the U.S. explain a handful of the past corporate scandals evolved. Thereupon, in response to those scandals, the U.S. government strengthened regulation substantially by introducing in 2002 the Sarbanes-Oxley Act ³ (SOX). Some of those scandals include Enron’s accounting fraud which is considered as the largest accounting scandal and also as one of the largest bankruptcy filings in the corporate history of the U.S. (Harmantzis, 2004). Ultimately, the institutional theory provides evidence that a firm’s CSR strategy is indeed affected by the institutional environment it operates and most importantly by the level of government and industry regulation a company encounters. To conclude, the institutional theory is one appropriate theoretical perspective on why companies engage in CSR and one also could argue that it is one of the reasons why CSR practices often vary across industries/sectors and countries.

3 The Sarbanes-Oxley Act is a law enacted by the U.S. Congress in order to prevent fraudulent

financial reporting and management misconduct (Zhang, 2007).

2.4 The relation between CSR and CFP

When examining first the relation between CSR and CFP, there are numerous arguments that (in)directly support a positive relationship. Indirectly, one reason is that many institutional investors such as pension or mutual funds often have mandates such as ESG investing that instructs them to only invest in companies that engage in CSR. Based upon their investment policy statement (IPS), those investors are prohibited for instance, in investing in military or fossil fuel companies. A notable example is the Government Pension Fund of Norway (GPFG) which is also the largest sovereign wealth fund worldwide, which is well-known for having rejected many large companies out of its portfolio for activities that violated the fund’s environmental or social guidelines (Norges Bank, 2017).

Taking into consideration the fact that institutional investors hold large blocks of stocks and make up for most of the firm’s ownership and trading volume, losing those types of investors might negatively affect the firm’s financial performance since they are often the largest shareholders. Notably, Backus, Conlon and Sinkinson (2019) found that in 2017 more than 80%

of the S&P 500 Index was owned through exchange-traded funds (ETFs) by large institutional investors. To illustrate one’s point, if a pension fund sells the entire equity position of a firm it owns this acts as negative signaling for investors. It would negatively affect the firm’s financial performance in the following contagion mechanism: Firstly, its share price would decline due to the bulk size of the sell order. Next, if the stock price decline sustains for a prolonged period, this would harm the firm’s financing ability and subsequently, its ability to raise capital (Hua, 2018). This is so, since the firm would have to sell now more shares in order to raise the same amount of funds as it did before (Hua, 2018). Moreover, the stock price decline could have a damaging effect on the firm’s fundamentals because a lot of financial ratios such as profitability or market ratios include stock prices in their calculation (Hua, 2018). Likewise, companies with prolonged low stock prices are more vulnerable to be (hostile) taken over by other firms or even implement drastic cuts in their operations (such as firing staff), which would further hurt their public image (Hua, 2018).

Moreover, another argument supporting the positive relation between CSR and CFP is stated by Porter and Van der Linde (1995), who claim that environmental guidelines often encourage further innovation from companies. According to Minor, Brook and Bernoff (2017), innovative companies post higher profit growth and also higher net income than their counterparts.

Furthermore, one could argue that CSR initiatives that firms undertake such as community

service, charitable donations or fundraisings, increase a firm’s reputation and brand image as

this directs more news coverage and public attention towards those companies.

To illustrate, Barber and Odean (2007) developed the concept of “attention-grabbing stocks”

(p.786) and showed that due to the way that investors are “psychologically motivated” (p.805), they tend to invest in stocks they heard about more recently. Also, Rindova, Williamson, Petkova and Sever (2005) found that consumers are willing to pay higher prices for products when manufactured by companies with a good reputation. In addition, many governments offer subsidies or tax reliefs to firms that engage in eco-friendly practices, thereby reducing the firms’

variable costs while increasing their revenues. For example, the Netherlands Enterprise Agency (RVO) enacted the environmental investment allowance (Milieu-investeringsaftrek, MIA), where companies that invest in environmentally-friendly assets receive 36% total tax reduction on their profits (RVO, n.d.). Lastly, Attig, Ghoul, Guedhami and Suh (2013) illustrated that credit rating agencies assign high ratings to companies with high social performance due to the fact that CSR conveys important non-financial information to credit rating agencies in terms of the firm’s creditworthiness. This has positive implications for a firm’s financial performance, since they can reduce their financing costs (debt and equity) and in turn their cost of capital, which ultimately improves their long-term economic competitiveness (Attig et al., 2013).

There are multiple studies such as Akpinar et al. (2008), Choi et al. (2010), Dowell, Hart and Yeung (2000), Eccles et al. (2014), Lin et al. (2009), Margolis, Elfenbein and Walsh (2009), Orlitzky et al. (2003) and Waddock and Graves (1997) which show a positive relationship between CSR and a firm’s financial performance measured by stock market performance.

Akpinar et al. (2008) provided evidence of a positive relationship between a firm’s CSR and its financial performance by using monthly stock price returns. Furthermore, Choi et al. (2010) showed a significant positive relationship between CSR and CFP through means of Tobin’s Q by using a sample of 1,222 South-Korean firms. Likewise, Dowell et al. (2000) devised a significant positive relationship between a firm’s environmental standards and its stock market value using all S&P 500 Index listed-firms. Moreover, Eccles et al. (2014) with a sample of 180 public U.S. firms illustrated that companies that embrace high levels of sustainability transcend their competitors by stock market performance over extended periods of time.

Equally, Lin et al. (2009) demonstrated a positive relation between CSR and financial

performance with a sample of 1,000 firms in Taiwan across a range of risk-adjusted return

indicators. Similarly, Orlitzky et al. (2003) found a positive relationship between CSR and CFP

(with stock price returns as one measure) across thirty years of empirical data using a sample

size of 33,878 observations. In addition, Waddock and Graves (1997) employing a sample of

469 public U.S. firms identified a positive relationship between companies engaging in CSR

policies and their future financial performance by stock market performance. Besides,

Khondkar et al. (2018) found that when CEOs incorporate CSR into their firm’s business

strategy, this in turn enhances corporate performance and coordinates the firm’s interest along

with its shareholders. Lastly, Margolis et al. (2009) also found evidence of a significant positive relationship between CSR and CFP by conducting a meta-analysis of 251 studies. As highlighted previously, CSR can be constructed from the following three ESG pillars:

environmental, social and corporate governance (Reuters, 2019). Particularly, the CSR measurement based on the three ESG pillar scores leads to the first sub-hypotheses (H1a, H1b and H1c) of the study:

H1a: There is a positive relation between a firm’s environmental CSR score and its corporate financial performance (CFP)

H1b: There is a positive relation between a firm’s social CSR score and its corporate financial performance (CFP)

H1c: There is a positive relation between a firm’s corporate governance CSR score and its corporate financial performance (CFP)

2.5 The relation between CFP and total CEO compensation

In their influential study, Jensen and Meckling (1976) introduced the concept of agency theory (principal-agent problem). Classical agency theory argues that CEOs tend to pursue their own personal interests rather than to maximize shareholder’s and stakeholder’s value, thereby creating a conflict of interest. This conflict of interest occurs due to information asymmetry;

principals (shareholders) are not able to fully monitor the agent’s (CEO) performance. As a result, the agent can shirk or enjoy private benefits and perquisites at the expense of the principals’ capital. Jensen and Murphy (1990) stated that the solution to the principal-agent problem is to link the firm’s performance with CEO compensation.

In the same manner, Callan and Thomas (2012) also suggested that the best solution for the classical agency problem is attained by adjusting short-term and long-term CEO compensation to the firm’s financial performance, thus a “pay-for-performance relationship” (p. 203). They proposed that stock options and long-term incentive payouts (LTIPs) such as equity shares can truthfully encourage CEOs to achieve the firm’s financial performance metrics. Essentially, this means that e.g., if in the current fiscal year, the firm performs well (poor) financially then the CEO will be compensated with more (less) stock options and equity shares than last year, thus exhibiting a linear relationship. As Jensen and Murphy (2010) crucially point out what matters the most is how many shares of the company the CEO owns and not his/her cash compensation.

This is so since changes in the market value of the shares have a “direct and powerful feedback

effect” (p. 66) on CEOs.

Another theory affecting total CEO compensation is moral hazard, which essentially implies excessive risk-taking from the agent (CEO) under an underlying insurance mechanism provided by the principal (shareholders). Due to the separation of ownership and control in public companies the agent engages in riskier decisions for the firm, since (s)he knows that (s)he will not bear the costs of his/her decisions. A noteworthy example of the consequences of moral hazard is the global financial crisis of 2007-2008 where under the “Too big to fail” concept, financial institutions in the U.S. undertook exorbitant risks since they knew that due to their global systemic importance the government would have to bail them out eventually (Stern and Feldman, 2009; Zardkoohi, Kang, Fraser & Canella, 2016). According to Jung and Subramanian (2017), it is optimal for firms to link CEO compensation with CFP in order to induce effort and eliminate moral hazard.

By the same token, the tournament theory developed by Lazear and Rosen (1981) can also impact CEO compensation and more precisely the level of CEO remuneration. Lazear and Rosen (1981) found that with rank-order compensation schemes, the high salaries of senior management are used as an incentive for middle and line management to work harder in order to climb up the corporate ladder, otherwise if it were not for those large compensation gaps middle and line management would be unmotivated. Essentially, the tournament theory justifies high cash executive compensation based on the notion of continuous competition to high- ranked executives from managers and employees lower in the hierarchy, thereby highlighting differences in hierarchy ranking rather than in marginal productivity (Rosen, 1986). Lastly, Kolb and Moriarty (2011) also argue that CEOs have a fiduciary duty toward their shareholders and stakeholders. Under the U.S. legal system fiduciary duty is defined as an obligation to act in the best financial interests of another party with trust and confidence (LII, Cornell Law School, n.d.). Consequently, one could argue that CEOs should be compensated through a performance-based method, otherwise that would be a breach of fiduciary duty with possible reputational and legal consequences.

Over the last years, based on the theories described above, a trend emerged shifting CEO compensation away from (salary) cash into equity-based compensation (Tonello, 2017). Several boards of directors (BODs) have exploited this trend and have used increased market valuations/stock price returns to proliferate CEO compensation and revise compensation structure from cash to equity (Tonello, 2017). Between 2010 and 2016, CEO equity-based compensation for all S&P 500 Index listed-firms increased from 32% to 47.4% (Tonello, 2017).

Therefore, stock price returns have an important effect on CEO compensation, since a large

portion of the remuneration is directly associated with common stock incentive plans, equity

stock options and restricted stock grants. Typically, cash salary remains independent of any

changes in firm performance and is mostly a fixed pay for CEOs. In short, we can claim that

almost half of the CEOs pay for all S&P 500 Index listed-firms is purely based on the stock price return (i.e., financial performance) of their company as illustrated in Figure 2 below:

Figure 2: Total CEO compensation structure

Source: Equillar, CEO Pay Trends Report 2017

Furthermore, extensive preceding literature proved a positive relationship between a firm’s CFP and total CEO compensation. Baro and Baro (1990) provided evidence of a positive relation between CEO compensation and firm financial performance (using stock returns) for a sample of 83 U.S. banks. Likewise, Ozkan (2009) found a positive relationship between total CEO compensation and CFP (using shareholder returns) between 1995-2005 for 390 U.K. firms in the FTSE All-Share Index. Similarly, Jensen and Murphy (1990) also found a positive relationship between total CEO compensation and a firm’s financial performance with a sample of 2,213 CEOs across twelve years of data. Equivalently, Abowd (1990) also showed a positive relationship between total CEO pay and a firm’s financial performance by using a sample of more than 16,000 executives at 250 U.S. companies. Besides, Lewellen, Loderer, Martin and Blum (1992) also illustrated a positive relationship by analyzing the compensation of a firm’s three highest-paid executives to the differences in stock returns. In a similar vein, Elston and Goldberg (2003) also found a positive relationship between CFP and total CEO compensation with a sample of 91 German companies from 1970 to 1986. Finally, Firth, Fung and Rui (2006) provided evidence of a positive relationship between CFP and CEO pay for public Chinese non- state companies. Thus, there is abundant evidence supporting the positive relationship between CSR and CFP, which in turn establishes the main mechanism (higher equity-based returns) for developing the (indirect) positive relationship between CSR and total CEO compensation.

Salary Bonus Stock Options Other Bonus,

Stock, 49% 23%

Salary, 13%

Options, 12%

Sample CEO compensation structure of S&P 500 Index firms

Other, 3%

Conclusively, plenteous research studies ratify both a CSR-CFP positive relationship based on stock market performance and, on the grounds of this, a positive relationship funneled through increased stock price returns between CFP and CEO compensation as well. Conclusively, higher stock price returns constitute the main mechanism that corroborates the positive relation between CSR and total CEO compensation. In summation, taking into account that bonuses, equity shares and stock options can transmit a firm's financial performance to total CEO compensation, this leads to the second hypothesis (H2) of the study:

H2: There is a positive relation between a firm’s CFP and its total CEO compensation

2.6 The relation between CSR and total CEO compensation

As already mentioned in the introduction, certain companies such as Intel Corporation began experimenting with linking their CSR performance to their executives’ compensation (CSR- contracting). Based on agency theory, one could argue that integrating non-financial performance measures such as CSR metrics directly in CEO compensation increases the value of CEO compensation contracts (Holmstrom, 1979). This is due to the fact that non-financial performance measures disclose further information about an agent’s performance and effort (Holmstrom, 1979) and can be used as a supplement along with financial measures in executive compensation contracts. The main argument is that even though financial performance measures do a good job in evaluating CEO competencies, they still, however, do not reflect the advantages of a firm’s long-term strategies such as investing in product development or new growth opportunities (Bushman, Dai & Zhang, 2016).

Moreover, one could argue that traditional financial measures such as accounting earnings or stock price returns can be noisy ⁴ in the short-term at times, hence considering other additional non-financial performance measures that further divulge CEOs performance would be optimum and fair (Holmstrom, 1979; Lambert and Lacker, 1987). In most instances, the investments of companies in social and environmental projects typically only succeed in the long-run (Eccles et al., 2014). As a result, non-financial performance measures signify long-term value creation and therefore make a strong case for attaching them in CEO compensation contracts (Flammer et al., 2019). In greater detail, Flammer et al. (2019) recommend that firms offer incentives based on their environmental and social targets as measured by CSR. By doing this, gradually more CEOs would be directed to espouse a long-term horizon in their efforts and performance (Flammer et al., 2019). Consequently, CEOs would increasingly take on longer-term

4 In the context of financial markets, noise refers to short-term stock market transactions that are not

indicative of fundamental analysis and that can unpredictably affect stock prices (Verma and Verma,

2007).

stakeholder initiatives, enhancing firm performance and inevitably increasing firm value (Flammer et al., 2019).

Eccles et al. (2014) found that companies that encompassed environmental and social policies outperformed their counterparts in the future in terms of stock market and accounting performance. CSR-contracting helps to avoid CEOs “short-termism” (p.1101) and incentivizes CEOs to focus on stakeholders that contribute to long-term value creation instead of shareholders who maintain a short-term horizon (Flammer et al., 2019). In summation, one could argue that compensating a CEO based on the firm’s financial performance is still based on the old notion of Friedman’s shareholder theory. Nowadays, if firms want to engage in CSR and serve all their stakeholders interests actively, then there needs to be a link between total CEO compensation and CSR performance.

In addition, a corporate governance concept directly affecting the relationship between CSR and CEO compensation could be increased shareholder activism. Shareholder activism is defined as using equity ownership in a corporation to influence management to change certain policies (Lin, 2015). Methods of shareholder activism include private discussions with the firm’s BoD (Board of Directors), drafting proposals and voting at the shareholder meetings, public press releases/speeches or proxy fights (Lin, 2015). Case in point, activist shareholders could pressure BoDs of companies in order to ameliorate environmental practices or community relations and embrace a long-term orientation (Flammer and Bansal, 2017).

As a response, BoDs could introduce CSR-contracting in order to motivate CEOs to achieve the firm’s CSR goals. Therefore, the central monitoring system for ensuring that companies do truly engage in CSR initiatives would be linking firms’ CSR performance with CEO compensation. This system is similar to the financial performance remuneration scheme, where CEO compensation is based mainly on the firm’s financial performance through the alignment of equity shares and stock options. As a result, if CEOs do not deliver as projected on CSR performance, they would observe a reduction in their pay (and vice versa), hence a linear relationship comparable to the CFP-CEO compensation. Taking into account that 49% of total CEO compensation for an S&P 500 Index listed-firm is based merely on the firm’s stock price, the potential loss in CEO pay would be extravagant (almost half of their pay).

Grewal, Serafeim and Yoon (2016) found that the number of shareholder proposals on

sustainability issues increased steadily from 1997 to 2012 and consisted of ca. 40% of all total

proposals filed in 2013 across a sample of 2,665 shareholder proposals. Moreover, they also

found that the percentage of votes supporting ESG strategies almost tripled from 8% in 1999 to

21% in 2013. In addition, O’Rourke (2003) provided evidence that there is an increasing trend

of shareholder groups that actively propose and vote on shareholder meetings on CSR issues.

Namely, some of the world’s largest hedge funds such as Blue Harbour Group, ValueAct or as of recently AQR Capital have fully incorporated CSR into their investing strategies as pressure was exerted heavily by their own activist shareholders (Financial Times, 2017).

At present, there is only a small number of previous studies that provide evidence of a direct relationship between CSR and CEO compensation. However, they either focus solely on firms in environmentally-sensitive industries or focus only on the firm’s environmental or social CSR performance. As a result, their empirical results are in some measure limited and therefore provide recommendations and leave space for further research. Two recommendations that this study addresses are that first we use a broad sample with different industries and secondly that we divide CSR into its three main ESG components and examine every ESG component individually.

Berrone and Meja (2009) found that companies laboring in polluting industries which reach all their environmental performance objectives tend to pay their CEOs accordingly. Using a sample of 469 U.S. companies based on total emissions across seven years of data (1997-2003), they inaugurated that companies in polluting industries incorporate environmental performance as a measure for CEO remuneration. This reveals that eco-sensitive firms that successfully achieve all their environmental goals increase their CEOs compensation correspondingly (Berrone and Meja, 2009). Besides, Riahi-Belkaoui (1992) found that executive pay is driven by the firms’

financial and social performance by using a sample of 155 U.S. firms with cross-sectional data from 1986. Moreover, Stanwick and Stanwick (2001) found that CEO compensation is positively related to a firm’s environmental reputation. Furthermore, Hong, Li and Minor (2016) found that companies with more shareholder-friendly corporate governance are more likely to link CSR to CEO compensation. Lastly, Flammer et al. (2019) found among others that CSR contracting increases a firm’s social and environmental strategies and also helps them to be more environmentally innovative. Having said that, Flammer et al. (2019) constructed a KLD Index by adding up the number of CSR strengths without decomposing CSR into its three different components. Similar to the first sub-hypotheses developed in the study, the three pillars of ESG can measure a firm's CSR. In summation, this leads to the following three sub- hypotheses (H3a, H3b and H3c):

H3a: There is a positive relation between a firms’ environmental CSR score and its total CEO compensation

H3b: There is a positive relation between a firms’ social CSR score and its total CEO compensation

H3c: There is a positive relation between a firms’ corporate governance CSR score and its

total CEO compensation

2.7 The mediating effect of CFP

Aside from the direct mechanisms between CSR and total CEO compensation described above, there is also an indirect mechanism that explains this relationship. Based on the aforementioned studies (Akpinar et al., 2008; Choi et al., 2010; Eccles et al., 2014; Lin et al. 2009; Orlitzky et al., 2003 and Waddock and Graves, 1997) it can be argued that engaging in CSR can potentially increase a firm’s CFP measured in stock price performance, which in turn can culminate in higher stock price returns for the firm. Subsequently, higher stock prices resulting from a firm’s commitment in CSR increase CEO compensation, since (s)he can achieve larger capital gains through the common stock incentive plans or exercise his/her equity stock options at a profit once the stock price rises above the call option’s strike price (in the money exercise). On top of that, some CEOs also collect cash or equity dividends in case their company pays out distributions to shareholders, which also augments their total remuneration.

The hypothesized positive relationship between CSR and CFP which, if held true influences total CEO compensation can be depicted as a partial mediation effect. Baron and Kenny (1986) defined the mediator variable as the main mechanism that causes the independent variable to influence the dependent variable. In essence, the partial mediation effect implies that the relationship between the independent variables and the dependent variable is explained by adding a third variable, the mediator variable. The partial mediation effect indicates that the independent variable influences the mediator variable, which in sequence also affects the dependent variable. Accordingly, in our study the partial mediation effect implies that there is a positive indirect relation between CSR and total CEO compensation on the condition that there is a positive influence of CSR on CFP. If, for example, CSR is found not to have a relation with CFP, then the partial mediation effect would not apply. This implies that the indirect relation between CSR and total CEO compensation, which is generated through CFP’s partial mediating effect can be described as a conditional effect. Therefore, the mediation effect of CFP leads us to the last hypotheses (H4a, H4b and H4c) of this study:

H4a: The positive relation between a firm's environmental CSR score and its total CEO compensation is mediated by CFP

H4b: The positive relation between a firm's social CSR score and its total CEO compensation is mediated by CFP

H4c: The positive relation between a firm’s corporate governance CSR score and its total

CEO compensation is mediated by CFP

3. Data and Methodology:

3.1. Data sources and variable description

Our sample from the Thomson Reuters ASSET4 database contains yearly ESG observations for all S&P 500 Index listed-firms from 2002 until 2018. Previous studies examining CSR such as Chatterji, Durand, Levine and Touboul (2015) and Ioannou and Serafeim (2012) also utilized this database. The ASSET4 ESG database provides ESG information and financial data analysis for 4,500 public firms worldwide and is considered one of the most frequently used databases for CSR research (Ioannou and Serafeim, 2012). Moreover, total yearly CEO compensation (structure) data were obtained for all S&P 500 Index listed-firms from 2002 to 2018 from Wharton Research Data Services (WRDS) and more specifically from the Execucomp database.

The S&P 500 Index includes the 505 largest stocks in the U.S. by market capitalization among other things. The reason behind choosing this index is that most firms listed in the S&P 500 are very well data-documented and that this index is a diversified representation of the U.S. economy since it covers almost 80% of all market capitalization in the U.S. (S&P Global, n.d.). Lastly, due to some missing observations out of the total of 505 stocks in the S&P 500 Index, the final sample reduced to 497 stocks.

Total CEO compensation structure

The dependent variable of this study is total CEO compensation measured in U.S. dollars.

Although total CEO compensation often varies by firm, industry, firm size and laws and

regulations it is a mixture of five elements: salary (cash), bonuses, equity shares (restricted stock

grants), equity stock options (call options) and employee benefits (perquisites). Salary is a fixed

amount paid over a CEO’s tenure, whereas bonuses depend on performance metrics and are

typically awarded as a lump-sum payment semiannually or at the end of a fiscal year. Then,

equity shares (restricted stock grants) and equity stock options which are defined as long-term

incentive plans (LTIPs) are based on firm performance. Equity shares are granted to CEOs

through their own contributions and employer-matching contributions only after a specific

length of time is completed. Executives must vest the equity shares through their retirement

plans or their employee stock options plans (ESO). Next, (call) stock options give CEOs the

right (but not the obligation) to buy the firm’s shares up until a specified expiration date at a

pre-determined price (i.e., strike or exercise price) which can be below, at or above the current

stock’s price. Finally, perquisites are benefits that CEOs enjoy while holding their position such

as housing, car allowances or paid travel expenses. Accordingly, total CEO compensation can

be partitioned between cash- and equity-based CEO compensation. Below a detailed list of total

CEO compensation structure from Execucomp available via WRDS is provided:

Cash-based CEO compensation:

• Salary - (S)

• Bonus - (B)

• Other Annual - (O)

Equity-based CEO compensation:

• Restricted Stock Grants - (RSTKGR)

• LTIP Payouts – (LTIP)

• Options Granted – (OPTION AWARDS)

• All Other Total - (AOT)

Finally, based on the information provided above, total CEO compensation is calculated as follows:

!"#$% '() '"*+,-.$#/"- = 1 + 3 + ) + 41!564 + 7!89 + :)! + )9!8); :<:4=1

CSR

The data on the firms’ CSR are obtained from ASSET4 ESG database provided by Thomson Reuters Eikon and measured in ESG scores. A firm’s yearly total ESG score consists of three pillars: (yearly) environmental ESG-scores, (yearly) social ESG scores and (yearly) corporate governance ESG-scores. Essentially, these three ESG pillars measure a firm’s total CSR performance in those respective three categories ⁵ . The environmental ESG-score (ENVSCORE) is calculated from the following three categories: resource use, emissions and innovation (Reuters, 2019) with a total pillar weight of 34%. Likewise, social ESG scores (SOCSCORE) are measured from the following categories: workforce, human rights, community and product responsibility with 35.5% as total pillar weight (Reuters, 2019). Moreover, the corporate governance ESG-score (CGVSCORE) focuses on the following three categories: management, shareholders and the firm’s CSR strategy with the remaining pillar weight of 30.5%. The ESG- scores range from 0 (lowest score) to 100 (highest score).

Mediator variable of CFP

In line with other studies examining CSR-CFP such as Choi et al. (2010), Galbreath (2006), Lee and Park (2010), Mertzanis, Basuony and Mohamed (2018) and Rodriguez-Fernandez (2015) ROE (return on equity) is used for measuring a firm’s CFP. ROE is calculated by dividing a firm’s net income by its shareholder’s equity and reveals a firm’s profitability compared to its equity. ROE was chosen over ROA and Tobin’s Q because ROA is already used as a control variable (as will be shown in the next section) and because Tobin’s Q is used mainly as a valuation measure rather than a profitability ratio (Buckingham, 2012).

5 For more detailed information, please refer to Table A of the appendix.

Control Variables

Based on previous studies, a number of control variables that could influence total CEO compensation are selected. The list of control variables this study will utilize is the most relevant both from a theoretical and also from an empirical perspective.

-Total Assets

According to Baker, Jensen and Murphy (1988) and Smith and Watts (1992), larger corporations in terms of size tend to pay their executives more than their smaller counterparts, hence a positive relation between CEO compensation and firm size. This is in line as well with Rosen (1982), where he found that larger firms tend to hire more talented executives who in turn augment total-factor productivity (TFP) and hence those firms pay their executives more.

Therefore, firm size is controlled by using the natural logarithm of total assets as performed by Cai et al. (2011), Jian and Lee (2015) and Flammer et al. (2019).

-Return on assets (ROA)

As stated in section 2, total CEO compensation is positively related with corporate financial performance (CFP). In accordance with the studies of Benson et al. (2014), Cai et al. (2011), Flammer et al. (2019) and Jian and Lee (2015), the financial ratio of ROA is applied in order to control for the effect of firms’ prior financial performance on CEO compensation. ROA illustrates how profitable a firm is proportional to its total assets and is calculated by dividing a company’s net income over its total assets.

-Leverage (D/E Ratio)

Leverage is also known as the debt-to-equity (D/E) ratio and is calculated by dividing total liabilities over total shareholders’ equity. Leverage is used in order to control for a firm’s risk.

Firms that operate in volatile industries/sectors such as in the energy or technology sector are more likely to pay their CEOs higher (Banker and Datar, 1989 and Lee, Lev & Yeo, 2008). The classical risk-return tradeoff in finance can also explain the positive relation between risk and compensation. Therefore, firm risk is controlled with leverage as also done in Benson et al.

(2014), Cai et al. (2011), Flammer et al. (2019), Jian and Lee (2015), and Khondkar et al.

(2018).

-Capital Expenditures (CapEx)

Capital Expenditures (CapEx) illustrate how much money a company is investing in

maintaining or upgrading its physical assets such as infrastructure, plants, property and

equipment (PP&E). It is calculated by adding the change in PP&E with the current depreciation

expenses. Trueman (1986) provided evidence that the higher the CapEx of a firm is, the higher

its market valuation will be by investors. Similarly, McConnell and Muscarella (1985) found

that announcements of increases (decreases) in CapEx are linked with significant positive

(negative) stock returns. Therefore, with CapEx a firm’s CFP is controlled as in the study of

Khondkar et al. (2018).

-Board Independence

Board Independence is the percentage of independent directors within a firm’s board. Weisbach (1988) and Rosenstein and Wyatt (1990) found that companies that have independent (outside) directors on their board than firms with inside directors perform better financially. Therefore, in line with the studies of Benson et al. (2014), Cai et al. (2011) and Jian and Lee (2015) board independence measured in percentage terms controls for firm performance.

-CEO Duality

CEO Duality refers to the situation where the CEO is also simultaneously the chairman of the board of directors. Lee et al. (2008) state that CEO Duality increases rent-seeking behavior by CEOs in the executive compensation structure. In addition, Core, Holthausen and Larcker (1999) found that CEOs earn excessive remuneration when they are also the chairman of the board. Finally, the study of Khondkar et al. (2018) controlled for CEO Duality.

3.2 Methodology

Following Baron and Kenny’s (1986) paper on the mediation effect, three models were constructed. Furthermore, Baron and Kenny (1986) stated that a mediation effect arises only when the following conditions are met: Firstly, the independent variable must influence the mediator variable in the first model. Next, the mediator variable must affect the dependent variable in the second model. Lastly, the independent variable must also affect the dependent variable in the third model. In this study, the first model (CSR® CFP) will test hypotheses H1a, H1b and H1c. Then, model 2 (CSR and CFP® total CEO compensation) will test hypothesis H2 and H4a, H4b and H4c. Lastly, model 3 (CSR® total CEO compensation) will test hypotheses H3a, H3b, H3c. For instance, if H4a, H4b and H4c hold true (or one of them) this will provide evidence of CFP’s mediation effect. However, if H3a, H3b and H3c hold true (or one of them), then a direct link between CSR and total CEO compensation is established.

In order to avoid any autocorrelation between the independent variables and to ensure that the

current CSR scores and total CEO compensation are not influenced by past scores, lagged

independent variables of a one-year period are used. In similar vein, in order to address any

heteroscedasticity issues robust standards errors are utilized. Moreover, the variables of total

assets and capital expenditures had very large values; thus, in order to see if the values of those

two variables are normally distributed the Shapiro-Wilk W test was performed. For both

variables the p-values were lower than the significance level (i.e., 5%), resulting therefore in

non-normal distributions. In order to address the non-normal distributions, the natural logarithm

for both variables was taken as also the studies of Cai et al. (2011), Jian and Lee (2015) and

Flammer et al. (2019) did. The general specification for the estimated models can be presented

as follows:

> _?@ = A _? + B _@ + C _D 1A"E, _?@ + C _F 4)( _?@ + G _H I _H?,@KD

L HMD

+ N _?@

Where > _?@ is the dependent variable (CFP; total CEO compensation), 1A"E, _?@ is the firm’s CSR score (environmental, social and corporate governance), 4)( _?@ is the return on equity and has mediation effect between firms’ CSR score and its total CEO compensation, I _H?,@KD is the matrix of control variables ROA, log(Total Assets), D/E Ratio, log(Capital Expenditures), Board Independence and CEO Duality, A _? and B _@ are individual and year fixed effects, and N _?@ is the error term. Moreover, our panel data sample is unbalanced due to some missing observations over some years. However, this is reasonable because the S&P 500 Index does not contain a fixed constituents list, but rather companies are being added or removed continuously due to new initial public offerings (IPOs), delisting’s of firms’ and new mergers and acquisitions (M&As). Since we have panel data, the Hausman test was performed in order to determine whether fixed effects (FE) or random effects (RE) are appropriate. Fixed effects are more appropriate for this study and also for the sample from the S&P 500 Index than random effects, since we assume that differences among entities (companies in our study) do not influence our dependent variable (Torres-Reyna, 2007). On the other hand, random effects are more suitable when dealing with differences among entities that influence the dependent variable (Torres- Reyna, 2007). The results of Hausman test (H0: Use random effects) are presented in table 1 below. The last test suggests a marginal case with p-value=0.1902. Therefore, fixed effects are employed for all the models, which is the consistent for the given cases.

Table 1: Hausman Test

Dependent Variable Model chi2 Prob.>chi2 Consistent

estimator

ROE Environmental ESG Score 1713.50 0.0000 FE

Social ESG Score 6521.57 0.0000 FE Governance ESG Score 30.39 0.0845 FE Total CEO Compensation Environmental ESG Score 47.85 0.0007 FE

Social ESG Score 40.55 0.0064 FE

Governance ESG Score 26.44 0.1902 RE

3.3 Descriptive Statistics

Table 2 below provides the summary statistics for the variables used in this study.

Table 2: Descriptive Statistics

This table shows the summary statistics for all 11 variables used in this study. Total CEO compensation is calculated by adding together cash- and equity-based compensation. ROE is return on equity. ROA is the return on assets and is calculated by diving net income over total assets. D/E Ratio illustrates debt divided by equity and measures leverage. Capital expenditures show how much a firm spends towards its property, plant and equipment. Board Independence measures the fraction of independent directors within a firm’s board. CEO Duality occurs when the CEO is simultaneously also the Chairman. Lastly, ROE, ROA, D/E Ratio and Board Independence are measured in percentage.

Variable Obs Mean Std.Dev. Min Max

ROE 6456 15.95 160.68 -11982.72 895.41

Total CEO Compensation 7700 10032.36 8976.35 0.00 156077.90

Environmental ESG Score 6011 55.87 22.42 4.77 98.88

Social ESG Score 6011 59.14 19.59 4.90 99.04

Governance ESG Score 6016 56.88 21.05 2.82 99.06

Log (Total Assets) 7908 23.26 1.58 17.49 28.60

ROA 7762 6.14 8.23 -105.78 102.29

D/E Ratio 7640 149.51 809.67 0.00 32244.78

Log (Capital Expenditures) 7648 19.59 1.63 12.22 24.36

Board Independence 5971 80.22 13.25 0.00 100.00

CEO Duality 6035 0.75 0.44 0.00 1.00

There are no problems or issues apparent when examining the descriptive statistics in Table 2.

Intriguingly, total CEO compensation has a minimum value of 0. Primarily, this occurs when CEOs are also the (co-) founders of the firm and are not compensated symbolically as a way of showing their dedication to the firm and how aligned they are to the company’s success.

Moreover, all ESG scores are closely ranged together, hence one could argue that most firms in the S&P 500 Index try to balance their CSR equally across its three different components.

Intriguingly, a minimum ROE value of -11982.72% was identified, which is negative and illustrates that this firm’s shareholders are losing money. In similar vein, as illustrated in Figure 3 below, in 2009, the mean of ROE decreased by almost 20% presumably due to the global financial crisis of 2007-2008. Also, the average D/E ratio (leverage) for all S&P 500 Index firms is 149.51%, which is rather high and it signifies that firms use more debt than equity to finance their operations. Furthermore, board independence is also high, illustrating that ca. 80%

of a firm’s board directors are independent (outsiders). It is important to note that the variable

of CEO Duality operates as a dummy variable. This is so since CEO Duality equals to 1 if the

CEO is also the chairman of the board and 0 if the CEO is not the chairman of the board at the

same time. Finally, as depicted in Figure 4, the mean of total CEO compensation had an upward

trend over the period 2002-2018. There was only a small decrease which occurred in 2009,

likely due to the 2007-2008 global financial crisis.

3.4 Correlation Matrix

Table 3, illustrated on the next page, displays the correlation matrix (Pearson r correlation) for the dependent, independent and control variables employed in this study. The correlations between environmental, social and governance ESG scores are slightly high, however this is anticipated since Thomson Reuters Eikon calculates all ESG scores in a very similar manner.

Likewise, companies tend to invest equally in all three CSR categories, thereby generating a

balanced CSR score. Moreover, independent ESG scores are used separately in our regressions

thus, those high correlations do not pose any threat to our model. Besides, a multicollinearity

issue usually arises if the correlation is above 0.90 (Franke, 2010). Based on this, the high

correlation of Log (Capital Expenditures) with D/E ratio can be overlooked. Apart from this,

all other correlations are moderate-sized; therefore, our sample avoids the effect of

multicollinearity. Following our correlation matrix, we can proceed without any problems with

the estimation of our results.

Table 3: Matrix of correlations

This table shows the correlations (Pearson r correlation) between total CEO compensation, individual ESG scores and control variables.

Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

(1) Total CEO compensation 0.018

(2) Environmental ESG Score 0.031* 0.238*

(3) Social ESG Score 0.015 0.249* 0.685*

(4) Governance ESG Score 0.012 0.096* 0.446* 0.429*

(5) ROA 0.040* 0.044* 0.009 0.044* -0.0141

(6) Log (Total Assets) 0.006 0.358* 0.401* 0.396* 0.288* -0.163*

(7) D/E Ratio -0.045* 0.008 -0.009 -0.007 -0.026* -0.052* 0.045*

(8) Log (Capital Expenditures) 0.014 0.257* 0.439* 0.392* 0.276* -0.0217 0.705* 0.041*

(9) Board Independence 0.002 0.047* 0.215* 0.248* 0.459* -0.024 0.158* -0.031* 0.114*

(10) CEO Duality 0.019 0.013 0.038* 0.088* -0.055* 0.055* 0.049* -0.021 0.058* 0.026

*** p<0.01, ** p<0.05, * p<0.1

24

4. Results and Discussion:

4.1 Estimation Results

Table 4 (model 1) below provides the regression results for the relationship between CSR and CFP and more specifically for H1a, H1b and H1c.

Table 4: Utilizing a sample with all S&P 500 Index listed-firms between 2002-2018, it is examined whether there is a positive relationship between environmental, social and governance ESG scores with corporate financial performance (CFP). The dependent variable of CFP is measured by ROE. Environment, social and governance ESG scores are the independent variables. ROA stands for return on assets and D/E ratio stands for debt over equity and measures leverage. Lastly, CapEx stands for capital expenditures.

ROE ROE ROE ROE ROE ROE

Control variables

1.109*** 1.109*** 1.109*** 1.172*** 1.170*** 1.131***

ROA _$%& (0.247) (0.247) (0.247) (0.269) (0.268) (0.264)

-3.700* -3.700* -3.700* -2.850 -2.968 -3.282 '()(T. Assets) _$%& (2.048) (2.048) (2.048) (2.023) (2.009) (2.034)

-0.0104 -0.0104 -0.0104 -0.0110 -0.0110 -0.0110 D/E Ratio _$%& (0.00862) (0.00862) (0.00862) (0.00857) (0.00858) (0.00858)

-0.859 -0.859 -0.859 -1.490 -1.458 -1.534 '()(CapEx) _$%& (1.502) (1.502) (1.502) (1.496) (1.456) (1.510)

0.0198 0.0198 0.0198 -0.00164 -0.00138 -0.00712 Board Indepen. _$%& (0.0592) (0.0592) (0.0592) (0.0585) (0.0587) (0.0650)

-1.692 -1.692 -1.692 -1.688 -1.608 -1.547 CEO Duality _$%& (2.907) (2.907) (2.907) (3.154) (3.142) (2.978)

121.2*** 121.2*** 121.2*** 119.1** 119.7** 125.5**

(46.79) (46.79) (46.79) (49.86) (48.92) (49.59) Independent Variables

Environmental ESG _$%& -0.0933

(0.0591)

Social ESG _$%& -0.0623

(0.0620)

Governance ESG _$%& 0.00982

(0.0613)

Year FE Yes Yes Yes Yes Yes Yes

Observations 4,461 4,461 4,461 4,147 4,147 4,150

Number of ID 474 474 474 471 471 471

R2 0.076 0.076 0.076 0.085 0.084 0.083

Adj. R2 0.0714 0.0714 0.0714 0.0798 0.0794 0.0782

Difference in Adj. R2 0.0046 0.0046 0.0046 0.0052 0.0046 0.0048

F test 4.550 4.550 4.550 4.387 4.360 4.394

df (20,473) (20,473) (20,473) (21,470) (21,470) (21,470)

*** p<0.01, ** p<0.05, * p<0.1

When looking at Table 4 (model 1), the first thing observed is that the control variable of ROA is significant at the 1% level among all regressions. In addition, as one would expect, the adjusted R- squared increases slightly with the addition of independent variables. In the first three regressions containing only the control variables, the adjusted R-squared is 0.0714. In contrast, in the last regression which contains both control and independent variables, the adjusted R-squared is 0.0782.

That means that the last regression explains 7.82% of the variations in the dependent variable (CFP).

Based on Table 4, there is no mediation effect since CSR is not found to be significant related with CFP and thus, therefore, H4a/b/c do not hold true. In similar vein, H1a/b/c do not hold as well.

Table 5 (models 2 and 3), illustrated below, shows the results for the relationship between CSR and CFP and total CEO compensation through the mediation effect of CFP measured in ROE for H2 and H3a/b/c. Consistent with the previous findings, in table 5 the control variable of ROA is also significant for all regressions. Similarly, the control variable of Log (Total Assets) is also significant across all regressions. Therefore, those control variables appear to have a predictive power for total CEO compensation. Importantly, in model 3 (CSR® total CEO compensation) we observe that the coefficients of social and corporate governance ESG scores are positive (18.69 and 19.37) and significant at the 10% and 5% level, respectively. This statistical significance indicates that there is a direct positive relation between social and corporate governance CSR scores with total CEO compensation. Consequently, H3b and H3c hold true, whereas H3a does not hold true. Thus, those results provide evidence that a firm’s social and corporate governance practices have a direct effect (without mediation) on total CEO compensation.

In addition, the coefficient of ROE is not significant, hence there is no relation between CFP and total

CEO compensation. As a result, H2 does not hold true. Lastly, in the regression set of model 2 (CSR

and CFP® total CEO compensation) the social and corporate governance CSR scores remain

significant, however in this case both are significant at the 1% level. In model 3 also the

environmental ESG is significant, however only after when ROE is included in the regression.