EXECUTIVE COMPENSATION IN A SUSTAINABLE ORGANIZATION: AN AGENCY AND STEWARDSHIP PERSPECTIVE

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EXECUTIVE COMPENSATION IN A SUSTAINABLE

ORGANIZATION:

AN AGENCY AND STEWARDSHIP PERSPECTIVE

by

Arjan de Groot

University of Groningen

Faculty of Economics and Business

September, 2011

Drouwenerstraat 3a 9503 AV Stadskanaal Phone number: 00316 41853793 E-mail address: A.de.Groot.14@student.rug.nl

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PREFACE

This thesis is the final product of my master study in business administration at the University of Groningen. With this thesis, I hope to successfully finish my master. I started at the University of Groningen in the September 2009, joining a pre-master program after graduating at the Hanze University of Applied Science in Groningen. In July I succeeded the pre-master program and was allowed to start with my master.

During the first semester of the program I was actively thinking about interesting topics for my thesis. In one of the lectures of the Field course Organizational & Management Control (O&MC) an article about sustainability was introduced (Stubbs and Cocklin, 2008). This article was based on two cases of organizations that did business in a sustainable and different manner. These two cases made me curious and I started to study sustainability in more depth.

On a certain moment I was reading an article of Lubber (2010) regarding sustainability. She argued that there are serious calls for sustainability, however most organizations neglect these calls. Lubber argued that executive compensation is one of the tools that could be used to get executives and organizations into sustainability. This argument made me thinking and I was wondering „how‟ compensation could weave sustainability in an organization. I decided that this problem should be the starting point of my master thesis. Now, the final product is lying before you and I hope you enjoy reading.

I like to thank my supervisor, Dr. J.S. Gusc, for all her support during the process of writing my thesis. I am thankful for all the enthusiasm, critiques and good questions and ideas she gave to me; they really helped me further completing my thesis. In addition I like to thank my friends with whom I meet to discuss possible thesis themes and with who I extensively discussed my thoughts. Even more I like to thank those friends who critically read my thesis and gave me valuable comments on my work. Finally I like to mention that I enjoyed working on this thesis, especially study the differences between sustainable and neoclassical organizations and, between the agency and stewardship theory. To study an object like executive compensation from all this different perspectives was very interesting. Yours sincerely

Arjan de Groot

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ABSTRACT

These days there are serious calls to improve organizational sustainability; however, most organizations neglect them and maintain focusing on increasing shareholder value. Consequently social and environmental objectives stay subordinate. Lubber (2010) proposed that executive compensation could be used as a tool to weave sustainability into an organization. However, to do this, new business models and innovative executive compensation schemes are needed. The purpose of this study was to come to an innovative form of executive compensation that fosters sustainability. This is tried by complementing executive compensation that is primarily agency based, with elements from the stewardship theory. The study consists two phase, first an explorative literature study and second an empirical examination of the theoretical findings. The explorative literature study found that sustainable organizations vary from neoclassical organizations and that these variations result in differing perspectives with agency based executive compensation.However, stewardship elements can complement to deal with these differing perspectives. Ultimately the executive compensation package transforms to a more fixed, flat and longer-term oriented package. The empirical phase points out, that sustainable organizations have a more stewardship based executive compensation package and confirm the theoretical findings. To do this empirical analysis, executive compensation figures from sustainable and regular organizations are compared. The compensation figures are derived from the SEC‟s (Security Exchange Commission) database and a sample of sustainable organizations is derived from the Dow Jones Sustainability Index U.S.

Key words: Executive compensation; Sustainability; Sustainability Business Model; Agency Theory; Stewardship Theory

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1. INTRODUCTION

1.1. Introduction

This first section aims to introduce the topic of this thesis and the initial motive to execute a study about executive compensation in sustainable organizations. In addition the identified problem, the research objective and research question are introduced. Moreover, this section explains the domain of research.

1.2. Initial motive

Despite a global financial meltdown tied to reckless risk-taking and governments forced to ride to the rescue, Mindy Lubber, president of Ceres1, argued that most organizations will continue paying executives in ways that foster short-termism at the expense of sustainability (Lubber, 2010). According to Lubber (2010) two things should be done to enhance sustainability in organizations:

1) New business models have to be implemented;

2) Innovative executive compensation packages have to be implemented.

At present, the dominant business model of organizations seems to be drawn on neoclassical economic theory (Stormer, 2003, p. 283) which objective is to maximize shareholder value. In the view of Lubber (2010) executive compensation packages are a good mechanism to make executives motivated to achieve organizational objectives related to sustainability. However, nowadays, executive compensation practices seem to be mainly grounded on the agency theory. In accordance to this view, executive compensation is used to align the interests of shareholders and executives and hence, executives are motivated to enlarge shareholder value. Executives are rewarded to achieve organizational objectives which are mainly oriented financially. Consequently social and environmental objectives are subordinate (Stubbs and Cocklin, 2006, p. 103). This is in congruence with Lubber‟s claim that new business models are needed to make organizations behave in favour of sustainability. Based on the above mentioned discussion, the following problem was identified: Despite a need for sustainability, at present, most organizations maintain executive compensation practices that aim to increase shareholder value, as opposed by the nowadays dominant business models, and thus, do not optimally contribute to the need for sustainability.

In this paper, one of the few business models that does concern about sustainability, the Sustainability Business Model, of Stubbs and Cocklin (2008) will be discussed. This model aims to shape sustainability concepts as the driving force of the organization and its decision making. Due to the primary focus on sustainability the Sustainability Business Model fits with Lubber‟s call for business models that enhance sustainability.

As mentioned above, at present, executive compensation seems to be based on the agency theory. To comply with Lubber‟s call that innovative compensation packages should be used to enhance sustainability, this paper will discuss the stewardship theory as a complementary theory to executive compensation. This theory has e.g. been used in a study of Le Breton-Miller and Miller (2009) to study family businesses. These authors argued that the stewardship theory is complementary to the agency theory when studying family businesses. This study aims to investigate if the stewardship theory could complement the agency theory for executive compensation in a sustainable organization.

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1.3. Problem statement

This paper examines executive compensation in a sustainable organization and will contribute to the understanding of executive compensation in sustainable organization in an agency and stewardship perspective. Furthermore, an empirical comparison is executed between sustainable organizations‟ and regular organizations‟ executive compensation in practice. The reason is to find evidence for the application of theoretical results in practice. Summarizing, this study discusses agency based executive compensation in a sustainable organization, and examines what elements do not respond in a sufficient way to a sustainable organization and how stewardship elements could possibly complement to a form of executive compensation. This paragraph discusses the research objective, the research questions and sub questions.

1.3.1. Research objectives

Resulting from the theorem of Lubber (2010) that executive compensation is a good mechanism to motivate executives to enhance organizational sustainability; this study aims to raise an understanding about executive compensation in sustainable organizations.

The Sustainability Business Model of Stubbs and Cocklin (2008) will be applied to develop a distinction between regular and sustainable organizations‟ approach regarding executive compensation. This study analyse executive compensation by both the agency and the stewardship theory. First, the agency theory is selected because it seems to be the dominant governance theory in executive compensation literature. Second, the stewardship theory is selected because it has differing views and is assumed to be complementarily to the agency theory. This result in the following research objective:

Derive an understanding of how elements from the stewardship theory could complement agency theory based executive compensation to motivate executives to perform on behalf of the needs of sustainability.

This objective ultimately has to deliver insights about executive compensation in organizations with new sustainable business models so that they can optimally contribute to the need for sustainability.

1.3.2. Research question and sub questions

Based on the above mentioned research objective the following research question is formulated: How can, elements derived from the stewardship theory complement to agency based executive compensation in such a way that executives in sustainable organizations are motivated to reach organization‟s sustainability objectives.

To answer to the research question, four sub questions are formulated. First, this study develops a theoretical understanding and subsequently it tests this understanding in practice. Consequently the first three sub questions are theoretical and the fourth sub question is practical:

1) What evidence literature provides to assume that nowadays executive compensation is based on agency theory?

2) What are the differences between sustainable and neoclassical organizations regarding executive compensation?

3) How can, stewardship elements complement agency based executive compensation in sustainable organizations?

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7 Lubber (2010) claimed that nowadays dominant business models neglect sustainability and that new business models and innovative compensation schemes are needed to weave sustainability into the organization. Sub question one is developed to derive an understanding about how that dominant business model looks like and if the executive compensation practices, as applied in the dominant business model are agency based. The second sub question has to clear out how sustainable organizations differ from neoclassical organizations in respect to executive compensation. Based on this examination there could be analysed how the current paramount model of executive compensation fits in a sustainable organization. The third sub question has to answer how stewardship theory elements could complement to the executive compensation package in sustainable organizations to increase organizational sustainability. The aim of the fourth sub question is to test the theoretical findings in practice.

1.4. Research domain

This paper is based on the U.S. context for which the underlying reasoning will be addressed in this paragraph. First, the reason to base this study on one national setting is that in corporate governance several institutional factors influence corporate governance outcomes in countries (Dennis and McConnell, 2003, p. 18). By concentrating on one national setting a correction for specific national institutional factors is not necessary. In addition the majority of corporate governance research, including executive compensation studies, is based on the U.S. (Dennis and McConnell, 2003, p. 18). Moreover, as in other liberal market economies the U.S. has relatively large proportions of minority shareholders that are protected by relatively high disclosure requirements (Aguilera and Jackson, 2003, p. 453). This results in the mandatory disclosure of executive compensation figures of all publicly traded organizations. Consequently, the data is reliable and easily available.

1.5. Key findings

This study found that when organizations apply a business model that is based on sustainable principles the application of agency based executive compensation result in various differing perspectives between the business model and executive compensation. To be able to deal with this executive compensation packages should be complement by elements of the stewardship theory because they are better able to comply with the differing dimensions of a sustainable organization. Moreover, this study found empirical evidence that in practice sustainable organizations apply executive compensation packages that are based on stewardship principals.

1.6. Preview of the organization of the paper

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2. RESEARCH DESIGN

The study consists of two phases; the first phase is theoretical and discusses executive compensation in an agency and stewardship perspective in the setting of a sustainable organization. This section is devoted to introduce the research design as used in the theoretical phase of this study. In section seven the methodology related to the empirical phase of the study will be introduced.

2.2. Literature review

The research type applied in phase one could be classified as exploring research. At present, there has been done a lot of research regarding executive compensation in an agency perspective (e.g. Bebchuk and Fried, 2003; Murphy, 2002; Jensen and Murphy, 1990; Jensen and Meckling, 1976). In addition there has been done research about agency based executive compensation in sustainable organizations (Frye, Nelling and Webb, 2006; Mahoney and Thorne, 2005). However, the field of executive compensation based on stewardship theory in a sustainable organization is a niche that is relatively unexplored. Therefore, an explorative approach has been applied in this study. Explorative research is the initial research conducted to clarify and define the nature of a problem but does not provide conclusive evidence. Thus, the end product of this literature phase should be hypotheses. This implies that new research issues have to be defined. An explorative study could be executed by literature search, experience survey, focus groups or case study. For this study there is chosen for a literature search. Hart (2005, p. 119) identified the literature review study as a study that is able to explore an issue or argument. This study aims to explore the argument of Lubber (2010) that despite the need for sustainability, most organizations maintain executive compensation practices that foster short-termism at the expense of sustainability and that this can be alleviated by the introduction of new business models and innovative compensation packages. In addition a literature review could be applied to develop new knowledge based on existing knowledge.

To be able to answer the research question and develop hypotheses, literature from different perspectives has been consulted. To answer the first sub question it has to be analysed what the paramount form of executive compensation is and if this is based on agency theory. Literature for this sub question will be based on executive compensation from an agency perspective. To answer the second sub question literature about sustainability and sustainable business models will be consulted. This literature, together with the literature findings of the previous sub question will identify the relevant differences between sustainable and neoclassical organizations regarding executive compensation; and thus, will answer sub question two. The third sub question aims to answer how executive compensation based on the stewardship theory make executives motivated to achieve sustainable objectives in a sustainable organization. To develop an answer, literature regarding the stewardship theory will be consulted.

2.3. Literature selection

To acquire the relevant literature to answer the sub questions and ultimately the research question an extensive literature search will be executed based on the five steps of a literature search as described by Blumberg, Cooper and Schindler (2008, pp. 114-119). These five steps are:

1) Define the research question;

2) Identify key terms relevant to the research question by consulting textbooks;

3) Apply these key terms in searching databases to identify specific secondary sources; 4) Locate and review specific secondary sources for relevance;

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9 The research question and the associated sub questions are introduced in section one. Based on these questions key terms are defined by the consultation of textbooks.

The first key term that has been defined was executive compensation. This is a term frequently applied in management accounting and has been identified as the typical outcomes of performance evaluations (Ferreira and Otley, 2009, p. 273). For this study Merchant and Van der Stede (2007) is consulted as a source to define key terms regarding executive compensation. These key terms are: executive compensation; executive compensation package; fixed compensation; variable compensation; long-term compensation; short-term compensation; base salary; annual bonus; stock based compensation; stock options; extrinsic motivation; intrinsic motivation.

The basis of the literature regarding the second term, agency theory, is derived from Eisenhardt (1989). This article is selected as a source to find relevant literature about the agency theory because it is perceived as a very extensive review of the agency theory. The following key terms are identified for the agency theory: agency theory; pay-for-performance; agency problem; Wiseman and Gomez-Mejia.

The alternative governance theory, the stewardship theory is the third term and has been described extensively in the article of Davis, Schoorman and Donaldson (1997). Davis and Donaldson introduced the stewardship theory already in 1989 but the article of 1997 has been applied as a basis article due to its more extensive review of the stewardship theory. Key terms related to stewardship theory are: stewardship theory; stewards; Theory Y.

The literature regarding the fourth term, sustainable business models, is derived from two sources: Stubbs and Cocklin (2008) and Sharma and Starik (2002). Stubbs and Cocklin is applied to develop a basic understanding of sustainability in an organization and Sharma and Starik (2002) is a textbook about research in sustainability. Key terms related to sustainability are: sustainability; CSR; corporate social responsibility; definition sustainability; sustainability and compensation.

After selecting the key terms, the third phase includes the search for scientific articles based on the key terms in the following databases, ordered by usage:

1) EBSCO Host Business Source Premier;

2) Purple Search of the Library of the University of Groningen; 3) Google Scholar.

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2.4. Methodology

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3. THE DOMINANT PARADIGM IN EXECUTIVE COMPENSATION

Executive compensation is a widely discussed management accounting topic that frequently been addressed in the discussion about sustainability (e.g. Frye, Nelling and Webb, 2006; Mahoney and Thorne, 2005). Lubber (2010) made serious calls for increasing sustainability by organizations and argued that innovative executive compensation packages could weave sustainability into an organization. Despite this, Lubber (2010) notes that organizations maintain executive compensation practices that neglect sustainability. This section‟s goal is to derive an understanding about how literature sees these executive compensation practices. The findings of this section could be applied in the following section to understand why nowadays executive compensation neglect sustainability. Subsequently the fifth section aims to find if nowadays executive compensation could be complemented with elements of the stewardship theory so that it is able to weave sustainability into an organization.

The expectation is that these executive compensation packages are based on the principals of the agency theory what is the dominant model of governance (Davis, Schoorman and Donaldson, 1997, p. 20). Executive compensation in an agency perspective is a topic discussed in wide variety of studies (e.g. Bebchuk and Fried, 2003; Murphy, 2002; Jensen and Murphy, 1990; Jensen and Meckling, 1976). This section aims to answer the following sub question:

What evidence literature provides to assume that nowadays executive compensation is based on agency theory?

To be able to answer sub question one, a theoretical understanding has to be developed about the dominant paradigm of executive compensation. Paragraph 3.2 presents the dominant business model and its relation with executive compensation in an agency perspective. Paragraph 3.3 discusses the executive compensation package and this section will be concluded in paragraph 3.4.

3.2 The dominant business model and the relation with executive pay in an agency view At present the dominant model of the firm draws on neoclassical economic theory (Stubbs and Cocklin, 2008, p. 116; Brickson, 2007, p. 864). In this model shareholders‟ and organization‟s values are aligned around maximizing financial outcomes (Sundaram and Inkpen, 2004, cited Stubbs and Cocklin, 2008, p. 116). In fact organization‟s objective is to maximize shareholder value and executives are appointed to realise this. The relationship between the executive (agent) who have to perform on behalf of the shareholders (principals) is an agency relationship.

Although in an agency relationship, the executive have to perform in behalf of the shareholder, this behaviour is not taken for granted. This is due to the agent‟s self-serving behaviour, based on Theory X (McGregor, 1960 cited Donaldson and Davis, 1991, p. 51); a founding theory underlying agency thinking. Due to agent‟s self- interest there is no goal congruence between owners of the organization and the executives; so, there exists an agency problem (Eisenhardt, 1989, p. 58). In addition agents have an information advantage resulting in information asymmetry. Besides the problem of risk sharing is an additional problem in an agency relationship (Wiseman and Gomez-Mejia, 1998). Agents are more risk averse compared to principals who are able to diversify their risks. To accommodate the agency problem and make agents behave in a manner that is beneficial to the organization, agents should be compensated to behave in organization‟s interests; this is the relation between the business model and executive pay in an agency perspective.

3.3. The executive compensation package

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12 compensation elements are depicted because the agency theory does not left room for intrinsic compensation; this is due to agents‟ focus on extrinsic tangible rewards (Davis, Schoorman and Donaldson, 1997, p. 27). The division of the extrinsic compensation elements in fixed and variable compensation is widely used and is also applied by the Security and Exchange Commission. Organizations that are listed in the U.S. are obliged by the Security and Exchange Commission to disclose executive compensation figures regarding the CEO, CFO and three other most highly ranked executives in the Security and Exchange Commission‟s database. This database will be consulted in the empirical section of this study to gather executive compensation data. The components of the executive compensation package will be discussed briefly; first, fixed compensation and subsequently variable compensation.

FIGURE 1

A model of executive compensation

(source: Van Herpen, 2007, p. 39; Murphy, 1998, pp. 9-23)

Fixed executive compensation

Fixed compensation contains mainly base salary; other elements are e.g. retirement programs. Fixed compensation, as the primary part of fixed compensation, is an important element of the compensation package because it is the minimal pay that will be rewarded. In addition the level of the base salary has important implication for executive‟s variable compensation. Most variable components of the executive compensation package are measured as a percentage or a multiple of base salary (Murphy, 1998, p. 9).

Variable executive compensation

While the payment of fixed compensation is guaranteed, the payment and the level of the variable compensation depend on executive‟s performance. Executive‟s performance is measured by various, primarily financial oriented measures, that are enumerated by Carton and Hofer (2006, pp. 230-231); as presented in table 1. Rewarding variable compensation to executives depending on executive‟s performance could be seen as Jensen and Meckling‟s (1976) performance. The aim of pay-for-performance is to align the interests between agent and principal.

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13 regarding financial metrics as sales, net profits or operating income; like the performance measures enumerated in table 1. Compensation elements with a period longer than one year can be identified as long-term compensation (Merchant and Van der Stede, 2007, p. 396). Stock based compensation has in general a period longer than one year and could be defined as long-term. Organizations increasingly pay their executives stock and stock options. Rewarding stock based compensation to executives makes executives, shareholders. Haugen and Senbet (1981) assume this will align executive‟s objectives with the organization. In addition Jensen and Murphy (1990, cited Sundaramurthy and Lewis, 2000, p. 399) value stock ownership as an internal bonding mechanism, dealing with goal conflict by tying executives‟ rewards to firm performance. Next to these beneficial elements of stock ownership, rewarding executives with ownership rights also provides executives more freedom to pursue their own objectives (Dennis and McConnel, 2003, p. 3).

TABLE 1

Financial performance measures for high-performance organizations

Profitability ROA, ROE, ROS, ROI

EBITDA return on investment Operating margin

Growth Growth rate of sales

Growth rate of operating expenses Growth rate of total assets

Cash flow Operating cash flow to equity

Economic value Residual income return on investment

Cost of equity capital Cost of equity capital

Market Price-to-book ratio

(source: Carton and Hofer, 2006, p. 231)

3.4. Conclusion

This paper started with a claim that nowadays dominant executive compensation practices neglect sustainability. This paper aims to find out why and how elements from the stewardship theory could be added to come to an innovative compensation package that is able to create a perspective of executives regarding sustainability that makes them aiming to reach organization‟s sustainability objectives. However, it seems that nowadays executive compensation practices neglect sustainability; this section‟s objective is to derive an understanding about how literature sees executive compensation. This is important to be able to find in the following section why executive compensation neglect sustainability. It was expected to find a dominant perspective that sees executive compensation based on the assumptions of the agency theory. Based on this, the sub question that should be answered in this section is:

What evidence literature provides to assume that nowadays executive compensation is based on agency theory?

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14 that does not left room for intrinsic motivation what makes nowadays application of variable compensation a typical agency mechanism.

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4. AGENCY BASED EXECUTIVE COMPENSATION IN A SUSTAINABLE

ORGANIZATION

As introduced in the section three, organizations that draw their business models on neoclassical economic theory primary aim to increase shareholder value. In the view of Lubber (2010) these organizations neglect sustainability. According to Freeman and Gilbert (1992 cited Stubbs and Cocklin, 2008, p. 103) these organizations perceive social and environmental objectives as subordinate. In addition, according to Stubbs and Cocklin (2008, p. 103) the neoclassical economic theory is limited in its ability to address social and environmental objectives. Because the perceived drawbacks of business models drawn on neoclassical economic theory regarding sustainability, Stubbs and Cocklin (2008) developed the Sustainability Business Model. This business model aims to deal with sustainability and is discussed in this section. Using the Sustainability Business Model, this section aims to identify the differences between neoclassical and sustainable organizations regarding executive compensation. By doing so, an understanding about agency based executive compensation in sustainable organizations can be developed to understand why agency based executive compensation neglect sustainability. The following sub question should be answered in this section: What are the differences between sustainable and neoclassical organizations regarding executive compensation?

To be able to answer the sub question first an understanding about sustainable organizations has to be developed. Paragraph 4.2 will point out what is meant by sustainability and will be followed by paragraph 4.3 that enumerates the differences between organizations applying a sustainable business model compared to organizations drawing their business model on neoclassical economic theory. Paragraph 4.4 deals with the implications of applying neoclassical agency based executive compensation in a sustainable organization. The sub question will be answered in the concluding fifth paragraph.

4.2. Definitions of sustainability

The literature about sustainability is rife with attempts to define sustainability (Robinson, 2004 cited Stubbs and Cocklin, 2008, p. 103). During the years there where many attempts to define sustainability, partly due to the fact that the subject has been examined in differing disciplines including biology, ecology, economics, ethics, sociology and political science (Faber, Jorna and Van Engelen, 2005, p. 2; Sharma and Starik, 2002, p. 4); this study has an economic focus.

Frequently definitions of sustainability are drawn on the principals of the Brundtland Commission (Haugh and Talwar, 2010, p. 385; Faber, et al., 2005, p. 14) who defined sustainability as follows (WCED, 1987):

“Sustainability means meeting the needs of the present without compromising the ability of future generations to meet their own needs”.

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16 “Sustainability means that our economic system should be managed so that we live off the dividend of our resources, maintaining and improving the asset base”.

Repetto‟s view (1985) of sustainability differs from the Brundtland Commission‟s because Repetto argues that the environment is changing by stating “maintaining and improving the asset base”. This view implies that, when there is a certain amount of resources, man have to live from its dividends and aim to maintain the amount or even increase it for future generations. However, also this definition is oriented very broad.

A definition that suits better with the objective of this paper is developed by Stubbs and Cocklin (2008) and is based on the three pillars of sustainability: economic, social and environmental sustainability. Nowadays there is a growing consensus that sustainability is grounded on these three pillars (Stubbs and Cocklin, 2008, p. 119; Haugh and Talwar, 1981, p. 385). Economic sustainability is vital for organizations‟ corporate financial success and survival. Social sustainability embodies the humanitarian context of business. Environmental sustainability focuses on various aspects, e.g. the impact of business on the quality and quantity of natural resources, the environment, global warming, ecological concerns and waste management. This study applies Stubbs and Cocklin‟s (2008) three pillar definition of sustainability:

Sustainability means focusing on being profitable as well as on improving the welfare of stakeholders and minimizing environmental impact.

This definition is better applicable at a business level compared to the Brundtland and Repetto definitions. This makes Stubbs and Cocklin‟s (2008) definition better applicable to this study. This definition is based on an alternative worldview than the neoclassical economic theory; the Ecological Modernization. This view differs from the neoclassical economic theory by: the longer-term perspective; the strive for more equitable distribution of resources across generations; the focus on economic, social and environmental sustainability; and the stakeholder perspective (Stubbs and Cocklin, 2008, p. 106).

4.3. Differences between the sustainable and neoclassical organization

Neoclassical organization‟s primary aim to increase shareholder value and sustainability is subordinate. However, when an organization is sustainable, social and environmental concerns are part of the three pillars and are approximately equally important as economic sustainability. This different organizational focus asks for other business models. Stubbs and Cocklin (2008) made a unique contribution to literature by making one of the few attempts to develop a sustainable business model at an organizational level; most studies had a broader scope. The Sustainability Business Model developed by Stubbs and Cocklin (2008) is a business model in which sustainability concepts shape the driving force of the organization and decision making. This business model is examined to identify differing perspectives between sustainable organizations and neoclassical organizations.

Shareholder versus stakeholder perspective: neoclassical organization are concerned about satisfying shareholder needs; however, also other stakeholders make organizational claims. These claims are perceived as subordinated to shareholder interests by neoclassical organizations. However, sustainable organizations do value other stakeholder‟s claims. In fact, sustainable organizations do concern about shareholder‟s interests but also aim to identify, balance and respond to stakeholder needs (Stubbs and Cocklin, 2008, p. 115).

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17 Cocklin, 2008, p. 106). A sustainable organization aims to do things because they are the right thing to do, and because it is smart in an ethical and economic point of view.

Short-term versus long-term focus: the time-frame of sustainable and neoclassical organizations differs. As argued by Stubbs and Cocklin (2008, p. 114) neoclassical organizations have a short-term financial perspective while sustainable organizations have a long-term focus towards value creation through sustainability initiatives. This long-term perspective of sustainable organizations is longer than the „more than one year‟ long term perspective as defined by Merchant and Van der Stede (2007, 396). This long-term could be defined as „between generations‟ (Howarth and Norgaard, 1992, p. 476). Thus, when a neoclassical organization is talking about long-term it is a different term than when a sustainable organization will do.

4.4. Implications of sustainability for agency based executive compensation

When organizations draw their business models on the neoclassical economic theory, an agency based form of executive compensation will fit. However, when organizations comply with the Sustainability Business Model, this would result in differing perspectives: from shareholder to stakeholder orientation; from financial focus to the three pillar perspective; and from short-term to long-term orientation. This paragraph discusses the implications of sustainability for agency based executive compensation.

Executives of sustainable organizations do not solely have to achieve shareholder objectives but should also care about other stakeholder‟s interests. This influences the agency relationship because executives have to make decisions that are in best interest of shareholders and other stakeholders. The issues resulting from this agency based executive compensation in sustainable organizations is that different interests need to be advocated while in the traditional setting the executive will be rewarded primarily based on the performance regarding shareholders‟ financial objectives. In general an agent does not have a stakeholder orientation.

The key element of agency based executive compensation is pay-for-performance. It could be questioned if pay-for-performance is flexible enough to fit in a sustainable organization. In literature there is evidence that just like in neoclassical organizations, there is a relationship between executive‟s pay and performance (Frye, Nelling and Webb, 2006, p. 452). However, this relationship is less sensitive; the sensitivity was measured by comparing share price performance with compensation. This lower sensitivity could be explained by the conception of sustainable organizations that pay-for-performance is redundant to motivate executives and a tendency to direct financial resources to sustainable investments instead of increasing executive pay. This view of sustainable organizations conflicts with agents‟ self-interest, aiming to increase extrinsic financial needs. However, according to Frye et al. (2006) executives in sustainable organizations derive utility from their contribution to the organization‟s social responsibility and have an intrinsic motivation; theoretically an agent would not behave like that. An alternative explanation for the less sensitive pay-for-performance relationship is that sustainable organizations do not measure their performance solely by financial performance; the previous paragraph stated that sustainable organization have an orientation towards the three pillars of sustainability instead of a solely financial orientation.

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18 should be clearly lower compared to neoclassical organizations. This long-term view contradicts with the short-term orientation that an organization in an agency view advocates (Davis et al., 1997, p. 32). Because a sustainable organization cares about stakeholders and flat compensation structures are effective in promoting stakeholder welfare (Tirole, 2001 cited Frye et al., 2006, p. 452), sustainable organization‟s executive compensation would have a flatter structure. This implies that it is beneficial to establish compensation package with relatively a high level of fixed compensation. This thought is in congruence with test results from Frye et al. (2006, p. 450) who found that the level of base salary in sustainable organizations is higher compared to neoclassical organizations.

The goal of this section was to determine the differences between sustainable and neoclassical organizations with respect to executive compensation; in which perspectives this two types of organizations differ, and to what implications this result for executive compensation. This paragraph provides an answer to the second sub question:

What are the differences between sustainable organizations and neoclassical organizations regarding executive compensation?

This section identified three perspectives in which neoclassical and sustainable organizations differ that could lead to implications for executive compensation: (1) a stakeholder instead of a shareholder focus; (2) an orientation towards economic, social and environmental sustainability objectives instead of solely financial objectives; and a longer-term perspective. Because a sustainable organization has to comply with these different perspectives, an executive compensation package should be able to enable executives concentrating on these perspectives. Lubber (2010) argued that agency based executive compensation is unable to fulfil this objectives and this section find five arguments underpinning this statement.

First, the relationships of an executive in a sustainable organization are more complex due to the shareholder and stakeholder perspective. There is no typical agency relationship where the agent has to perform services on the principals‟ behalf. This has important implications for executive compensation because in the agency based situation agents are compensated to behave in principals‟ interests. Maintaining a situation where executives are primarily rewarded to increase shareholder value jeopardize the interests of the other stakeholders. To be sustainable an organization must take the interests of other stakeholders like e.g. employees, residents and environmental organizations seriously and cannot neglect them. Thus, it would be hard to maintain a situation where the executive will solely be rewarded to advocate shareholder interests in a sustainable organization.

Second, in sustainable organizations not only the complexity of the executive‟s relationships is higher, also the objectives that have to be advocated for the differing relationships differ. While in neoclassical organizations executive‟s performance is primarily measured by financial performance measures as depicted in table one, sustainable organizations also care about non-financial performance. This is due to the fact that not all stakeholders are as financially oriented as shareholders in an agency view are; not all social and environmental objectives could be measured financially. For agency based executive compensation this is an implication that is hard to deal with due to its financial orientation.

Third, related to the objectives, the orientation of stakeholders and agents is not comparable. In a neoclassical organization both agents and shareholders aim to increase their personal financial gains; both have an extrinsic focus. However, the focus of stakeholders is not always extrinsic and could also intrinsic while agents still are motivated extrinsically.

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19 However, the relation between pay and performance in sustainable organizations is less sensitive. Relations in sustainable organizations are more based on trust instead of control. This result in an issue regarding agency based executive compensation that aims to compensate for the agency problem by pay-for-performance. This non-financial and intrinsic view conflicts with the agency view. In addition the reliance of trust instead of control conflicts with the model of man applied by the agency theory. Fifth, the timeframe differs between sustainable and neoclassical organizations. The time-frame for sustainable organizations has a „between generations‟ long-term view instead of a „longer than one year‟ long-term view. This influences the executive compensation in that respect that the compensation and organizational objectives have a longer-term view. Especially short-term bonus systems would not be favourable to sustainable organizations. This has implications for agents who have a short-term focus.

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5. STEWARDSHIP THEORY AND EXECUTIVE COMPENSATION IN A

SUSTAINABLE ORGANIZATION

Section four illustrated that agency based executive compensation had differing perspectives compared to sustainable organizations: a stakeholder instead of shareholder orientation; three pillars perspective instead of financial focus; and long-term instead of short-term orientation. To deal with the differing perspectives some authors complement the agency theory with other theories like the stewardship theory as done by Le Breton-Miller and Miller to study family businesses (2009, p. 1174). They were complementing the agency theory with stewardship elements because agency perspectives reduce organizational and social reality to rationales that ignore social forces and relationships and view human as self-interested, opportunistic and greedy. Another reason to complement the agency theory with additional theories is because it overlooks the diverse identity of shareholders (Aguilera and Jackson, 2003, p. 449). For example, pension funds have differing interests to invest compared to more risk taking investment funds. Another reason to complement the agency theory is because it overlooks interdependencies among other stakeholders in the organization and it has a narrow scope to the institutional environment influencing corporate governance; like the claim for sustainability. As Le Breton-Miller and Miller (2009), this study will complement the agency theory with the stewardship theory. The aim is to add stewardship elements to the executive compensation to deal with the differing perspectives between agency based executive compensation and sustainable organizations. This section aims to answer the third sub question:

How can stewardship theory complement agency based executive compensation in a sustainable organization?

To answer the second sub question this section will first produce an understanding of the stewardship theory. The stewardship theory will be discussed and used as a theory, alike the agency theory in the previous section, to study executive compensation in a sustainable organization. In paragraph two the concept of the stewardship theory will be introduced briefly. In the following third paragraph the differing views of the stewardship theory compared with the agency based executive compensation regarding executive compensation will be discussed. The fourth paragraph will discuss stewardship assumptions in executive compensation for sustainable organizations. Based on the previous paragraphs, the fifth and concluding paragraph examines if stewardship based executive compensation in a sustainable organization could complement agency based executive compensation and answers sub question three.

5.2. The stewardship theory

The stewardship theory was introduced by Donaldson and Davis (1989) as an alternative to the agency theory; later they perceived stewardship theory as an addition to the agency theory (Donaldson et al., 1997, p. 21). While the agency theory has its roots in economics, the stewardship theory is rooted in sociology and psychology.

The primary difference between agency and stewardship theory is the view of man. In the stewardship theory the view of man is based on McGregor‟s (1960 cited Donaldson, 1990, p. 377) Theory Y. This model of man regards the assumptions of the economic view as limitations and leads to a intrinsically motivated man behaving as a collectivist (Sundaramurthy and Lewis, 2003, p. 399; Donaldson et al., 1997, p. 28).

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21 While an agent has the primary obligation to serve the shareholder, a steward strives to be beneficial to all stakeholders (Le Breton-Miller and Miller, 2009, p. 1171). When alignment is lacking between shareholders and stakeholders the steward make decisions that are best for the group; resulting in satisfying most organizational stakeholders.

Stewards need high levels of autonomy to maximize their contributions because they can be trusted and thus, control can be regarded as a limiting factor lowering steward‟s motivation (Davis et. al, 1997, p. 25). Stewardship theorist focus on structures that facilitate and empower rather than those that monitor and control.

The management philosophy in a stewardship perspective is involvement oriented. This approach emphasizes self-control and self-management (Lawler, 1992, cited Davis, et. al 1997, p. 32). Trust is a crucial aspect of the involvement-oriented approach and will be enhanced in relationships based on personal power. Subsequently a stewardship view advocates a long-term perspective and aims to achieve performance enhancement.

Stewards are collectivists, avoid conflict and confrontation, have a very positive stance to harmony and prefer long-term relationships. Stewardship organizations are more likely to have a low power distance resulting in decentralization, a high level of consultation in decision making and differences in salary and perquisites are minimized.

5.3. Different views of stewardship theory to executive compensation

The stewardship theory differs from the agency theory because of its different view of man. Consequently it is expected that executive compensation based on the stewardship theory will differ from executive compensation based on the agency theory. This paragraph will examine those differences.

When applying agency based executive compensation, agents will be compensated for the agency problem; the need to do this with a steward is lower. One of the reasons why there is an agency problem is that agents and principals have no goal congruence. The relationship with a steward and a principal is different because stewards have a higher level of goal congruence. This could be underpinned by the statement of the previous paragraph that stewards will favour pro-organizational and collective behaviour. Even when steward‟s and principals‟ interests differ the steward is expected to realise organizational objectives. In addition compensating stewards for an agency problem as done by agency based executive compensation will be less attractive to a steward. The compensation is primarily extrinsic and financial while a steward has an intrinsic focus. Due to this intrinsic focus compensating for the agency problem by pay-for-performance would have less effect to a steward. The stakeholder view of the stewardship theory is an important determinant in steward‟s compensation package. To promote stakeholder welfare it is preferable to apply a flat compensation structure (Tirole, 2001). This influence both the fixed and variable part of the compensation package. First, the fixed part of the compensation package will be relatively higher. This is because fixed compensation is flatter. Second, the variable part of the compensation will be more focussed on the long run. This assumption is also in line with the longer-term perspective of the stewardship theory. Because the variable package has a longer-term perspective it will become less volatile; resulting in a flatter compensation structure. This is in congruence with the findings of Frye et al. (2006, p. 450) who argue that sustainable organizations favour restricted stock compensation. This form of stock compensation has a longer term focus.

5.4. Stewardship assumptions of executive compensation in a sustainable organization

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22 paragraph discuss the stewardship assumptions of executive compensation in a sustainable organization. The first point where a sustainable organization differs from a neoclassical organization is its focus that is not solely to achieve shareholder objectives but achieve economic, social and environmental results. In theory this will fit with a steward due to the stakeholder view of stewards. Stewards should be able to advocate shareholder‟s and stakeholder‟s interests and mediate between them to come to the best to all solution when interests differ.

In a sustainable organization the relation between pay and performance is less sensitive and has been seen as redundant. When this sensitivity is lower, a stewardship focus will be preferable because a steward will favour pro-organizational and collective behaviour and his or her interests are in congruence with organization‟s objectives; there is less reason to establish a high level pay-for-performance system. Stewards make use of self-control and the relationship between a steward and principal is based on trust instead of control. In addition sustainable organizations reflect a tendency to direct financial resources to sustainable investments instead of increasing executive compensation; this is in line with steward‟s intrinsic motivation. Stewards do good because they want to do and their objectives are more aligned because they identify themselves with the organization. The lower pay-for-performance sensitivity in a sustainable organization aligns with the stewardship theory.

As argued in section four, the composition of the executive compensation package itself differs between neoclassical and sustainable organizations. Sustainable organizations have a longer-term view what perfectly aligns with steward‟s long-term perspective. Both stewards and sustainable organizations will favour a compensation package without short-term variable compensation.

This paragraph is the concluding paragraph of the fifth section and of the theoretical part of this study. This fifth section developed an understanding about adding stewardship elements to complement agency based executive compensation in sustainable organizations. The third sub question will be answered:

How can, stewardship elements complement agency based executive compensation in sustainable organizations?

Pay-for-performance isn‟t a bad mechanism, it is applied in practice frequently and is supported by various authors (e.g. Murphy, 2002, 1999; Jensen and Meckling, 1973) however, this paper aims demonstrates that towards sustainability, stewardship elements should be added to complement agency based executive compensation. The reason is the differing perspectives of a sustainable organization: there is a stakeholder instead of a shareholder orientation; organizational objectives are directed towards ecological, social and environmental sustainability instead of solely increasing shareholder value; and there is a long-term instead of a short-term orientation. These differing perspectives disturb the normal setting in agency based executive compensation where pay-for-performance mechanism are applied to compensate executives to deal with the agency problem. This section provided four arguments that demonstrate why agency based executive compensation should be complemented with stewardship elements

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23 Second, in sustainable organizations agent‟s objectives are more diverse and complex. Due to a differing perspective of sustainable organizations to draw their objectives on economic, social and environmental sustainability instead of solely economic shareholder objectives, an executive have to deal with more separated targets. In a neoclassical organization, executive‟s objectives are mostly related to increasing shareholder value. However, in sustainable organizations not all objectives are financial but could also be non-financial. These non-financial objectives conflict with the financial form of performance measurement (table 1) as applied in agency based executive compensation and contradicts with agent‟s financial orientation. Adding stewardship elements would help to deal with this differing perspective of sustainable organizations because a steward has a more intrinsic orientation and would be better capable to deal with non-financial organizational objectives.

Third, in line with the second argument, when a sustainable organization has less financial oriented objectives, the relation between pay and performance is less sensitive. Consequently pay-for-performance, as one of the most important elements in agency based executive compensation, is less powerful in sustainable organizations. This is an issue because pay-for-performance is applied for compensating executives to deal with the agency problem. Adding stewardship elements could help to deal with this differing perspective. A steward is perceived to have a higher level of goal congruence and identification with the organization. Consequently, compensating, to handle the agency problem is less relevant because the agency problem is smaller. Besides that, the effect of pay-for-performance to stewards would be less because of their intrinsic motivation.

Fourth, sustainable organizations have a differing perspective of time. Sustainable organizations view long-term as „between-generations‟ long-term while neoclassical organizations perceive long-term as longer than one year. To deal with this differing perspective it is wise to complement agency base executive compensation with stewardship elements because of agent‟s short-term orientation; a steward has a longer-term orientation.

These four arguments illustrate that adding stewardship elements to agency based compensation in sustainable organizations would be wise to make executive compensation better able to deal with the differing perspectives of a sustainable organization. These theoretical findings confirm Lubber‟s (2010) claim that for sustainability, innovative executive compensation packages are needed. However, it is questionable how this innovative compensation packages should look like. Answering this question would answer the third sub question.

Just like an agency based executive compensation package there should be a fixed and variable part. The first thing to take into account is the lower pay-for-performance sensitivity compared to neoclassical organizations. Because pay-for-performance does not have the effect to stewards as it has to agents, a sustainable organization would direct a lower part of their compensation package to variable pay. Consequently the fixed compensation, and thus the base salary, of sustainable organization‟s executives will be proportionally higher; measured as a percentage of the total compensation package. In addition because sustainable organizations emphasize the importance of all stakeholders, and stakeholder welfare will be improved by flat compensation structures, executive compensation will show a flatter structure over the years. This is an additional argument why the share of base salary will increase. Next to that it has important implications for the variable compensation. Over a multiple year period, the variable compensation will be flatter; this also weakens the relation between pay and performance. Variable compensation itself consists of short-term and long-term elements. Because the long-term orientation the proportion of short-term variable compensation will be lower in a sustainable organization. Thus, a sustainable organization will reward a lower proportion of its executive compensation package as annual bonuses.

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6. HYPOTHESIS DEVELOPMENT

After concluding the theory in phase one, this section starts with the, as by Hart (2005, p. 199) defined, traditional part of the study. The theoretical phase explored complementing agency based executive compensation with stewardship elements in sustainable organizations. The study found that, theoretically, stewardship elements complement agency based executive compensation in sustainable organizations because it is better able to deal with the differing perspective of a sustainable organization because: it is better able to deal with stakeholder interests and non-financial objectives; is less dependent on pay-for-performance; and has a longer-term orientation.

Phase two aims to perform an empirical analysis about the applicability of adding stewardship elements in sustainable organization‟s executive compensation. Because in section five it is discussed how an executive compensation package would look like when stewardship elements are added, it is possible to analyse the compensation packages of sustainable organizations to identify stewardship elements. Due to the fact that standard executive compensation packages and those influenced by stewardship theory theoretically differ, it is possible to identify the application of stewardship elements in executive compensation by analysing the monetary part of the compensation. This stance is comparable to other studies of executive compensation in sustainable organizations; e.g. Berrone and Gomez-Mejia, 2009; Frye, Nelling and Webb, 2006; Mahoney and Thorne, 2005. The empirical phase of the study aims to answer the fourth sub question:

Do sustainable organizations have executive compensation packages that are more like stewardship based executive compensation packages?

Answering the sub question will contribute to the findings in the theoretical phase by providing practical evidence to underpin the findings and could confirm Lubber‟s (2010) claim that innovative compensation package are needed for sustainability. Analysing executive compensation packages in sustainable organizations provides an understanding about the addition of stewardship elements in sustainable organization‟s executive compensation packages. To analyse executive compensation in sustainable organizations in a stewardship perspective makes this study delivering a unique contribution to the current studies of executive compensation in sustainable organizations (e.g. Frye, Nelling and Webb, 2006; Mahoney and Thorne, 2005). The following paragraph of this section will discuss the developed hypothesis. In section seven the methodology will be discussed and test results will be presented.

6.2. Hypothesis development

Four hypothesis are developed based on the expectations regarding the composition of by stewardship theory influenced executive compensation package as discussed in the previous section. As introduced in the literature phase, an executive compensation package in general includes base salary, annual bonus, stock and stock options, and others. The hypothesis examine the composition of the compensation package. This is in line with Sapp (2008) who argued that when analysing executive compensation, the focus should be on the composition because the composition of the package determines how organizations are managed.

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26 be proportionally higher. The lower use of pay-for-performance in sustainable organizations is based on self-control, trust and goal alignment in sustainable organizations. This result in the following hypothesis:

Hypothesis 1: The share of base salary in a compensation package compared to the variable share will be higher in a sustainable organization compared to a regular organization. Annual bonus: the annual bonus is a short-term variable form of compensation. The expectation is that this form of compensation will be applied more in a regular organization. This expectation is based on two arguments. First, a sustainable organization has a longer term perspective that is between generations. This long-term is longer than a long-term view of a regular organization that is generally defined as more than one year. Thus, the time frame of executive compensation is expected to be adjusted accordingly and in that respect a sustainable organization will be less willing to apply a short-term variable compensation. Second, when a sustainable organization has a more stewardship like perspective, stewards have just like sustainable organizations a longer term view compared to agents. Because an annual bonus is a short-term compensation component and both stewards and sustainable organizations have a longer term view, and agents have a short-term perspective there could be expected that the proportion of annual bonuses in a compensation package for sustainable organizations will be lower than for regular organizations. The following hypothesis is developed: Hypothesis 2: The proportion of the annual bonus in a compensation package of a sustainable

organization is lower than for regular organization.

Stock and stock options: the stock and stock options in an executive compensation package are defined as long-term compensation components. In a regular organization these components are important pay-for-performance elements. However, in sustainable organizations this element should have a major share of the total compensation package because the long-term orientation. Because in both sustainable and regular organizations stock based compensation is an important element of the executive compensation package two measures are developed to analyse the characteristics of the payment of stock based compensation to find evidence for stewardship elements in sustainable organizations instead of comparing proportionally. The two measures are derived from the literature phase and will be discussed in succession:

1) The flatness of the compensation structure; 2) The pay-for-performance sensitivity.

The flatness of the compensation structure should be higher in sustainable organizations because it is effective in promoting stakeholder welfare and strengthens the long-term perspective. It is expected that sustainable organizations favour flatter compensation structures compared to regular organizations. Over multiple years of flat compensation of stock and stock options will be less volatile. This flat structure fits the steward who is willing to advocate the shareholders and have a long-term view. This resulted in the following hypothesis:

Hypothesis 3a: The volatility of stock based compensation in sustainable organizations is lower than for regular organizations.

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27 Hypothesis 3b: The correlation between share price and stock based compensation is lower for

sustainable organizations than for regular organizations.

The reason to focus on the correlation between share price and stock based compensation is to identify the sensitivity. Pay-for-performance has been used to make executives achieving the organizational objective of increasing shareholder value. An agent will be rewarded to increase shareholder value and the correlation between share price and stock based compensation should be higher.

The level compensation: it is expected that the level of the total compensation package of a sustainable organization is lower than for a regular organization. This is because stewards favour intrinsic motivation and derive utility from their contribution to the organization‟s social responsibility (Frye, Nelling and Webb, 2006, p. 452). Next to that in regular organizations, monetary incentives are used to align the interests of executives and shareholders. However, because executives in sustainable organizations have a better alignment of interests an organization could make fewer costs to overcome this misalignment.

In literature there exist alternative approaches to pay-for-performance; like tournament pay. The tournament pay founded by Lazear and Rosen (1981) have a better acceptance of CEO compensation compared to pay-for-performance and include a gradual construction of the organizational compensation structure. The expectation is that due to stewardship perspectives, a sustainable organization will have a lower difference between CEO compensation and average worker compensation and thus a more gradual construction. This results in the following hypothesis:

H4: The ratio CEO to average worker compensation is lower in a sustainable organization compared to a regular organization.

EXECUTIVE COMPENSATION IN A SUSTAINABLE ORGANIZATION: AN AGENCY AND STEWARDSHIP PERSPECTIVE