This study contributes to the literature in several ways. First, it contributes to the literature on incentive contracting. Linking executive compensation to ESG performance represents an evolution of the well-known practice of aligning executive pay with financial outcomes. Compensation mechanisms are designed to motivate executives to act in shareholders’ best interests, primarily through financial incentives that enhance shareholder wealth (Bebchuk and Fried 2003; Jensen and Murphy 1990). We show that incorporating ESG metrics as part of the executive compensation framework reflects a broader understanding of value maximization that includes sustainability and corporate responsibility. Our results suggest that, just as equity-based compensation and bonuses have been used to align executives’ actions with financial goals, the integration of ESG criteria serves to align executives’ decisions with the growing importance of environmental, social, and governance concerns. In line with these findings, Flammer et al. (2019) also demonstrate that CSR contracting mitigates corporate short-termism, enhances business performance, and drives improvements in environmental and social outcomes, particularly regarding local communities and the environment. Their research underscores how CSR contracting can refocus management’s attention on long-term, financially material stakeholders, thus improving both governance and a firm’s societal and environmental impact.

Second, this study extends the literature on the consequences of CEO incentives, including the impact of their political affiliations, by investigating the underlying motivations that drive executives’ pursuit of ESG achievements. Studies have investigated how CEOs’ political ideologies (ranging from conservative to liberal) shape their approach to corporate social responsibility (CSR), revealing that a CEO’s political orientation can significantly influence their organization’s CSR activities (Chin et al. 2013; Markoczy et al. 2023). Such findings highlight that the political beliefs of CEOs, reflecting their core personal values and convictions, have profound effects on their management styles and, by extension, on their companies’ engagement in sustainability and social responsibility initiatives. Our study contributes to the existing literature by examining the consequences of CEO incentives, specifically, the impact of direct compensation and political ideology, on a company’s ESG performance.

Finally, our study contributes to the literature on corporate governance, with a particular focus on the effect of increased board independence in shaping executive compensation frameworks. Boards composed predominantly of independent directors noted for their impartiality and extensive experience, are considered proficient in crafting compensation schemes that align executive behaviors with shareholder interests. This alignment is expected to ensure that governance mechanisms extend beyond financial performance to encompass sustainable and socially responsible practices. Board independence, while crucial for effective governance, may not necessarily enhance the financial benefits derived from strong ESG performance. This analysis highlights that the role of board independence in influencing financial outcomes through ESG practices is complex and possibly overshadowed by broader environmental and economic conditions.

The significance of Environmental, Social, and Governance (ESG) matters has dramatically increased in recent years, driven by the global push for corporate social responsibility and the interconnected nature of global economies. Initiatives such as the United Nations’ Principles for Responsible Investment in 2006 and the Paris Agreement in 2015 have set a global precedent, urging companies and investors to incorporate ESG factors into their decision­ making process.

This shift is also accentuated by the adoption of ESG disclosure mandates and guidelines by numerous stock exchanges worldwide, reflecting a broader commitment to sustainability. A total of 130 stock exchanges worldwide have become signatories to the Sustainable Stock Exchange Initiative (SSEI). Among these exchanges, 34 have mandated ESG (Environmental, Social, and Governance) disclosure for listed companies, while 72 exchanges have developed guidelines pertaining to ESG disclosure (SSEI 2024).

The ESG performance of companies is progressively becoming a key metric for assessing their dedication to environmental conservation and social accountability. ESG considerations are factored into assessments of ESG performance, wherein a company’s ESG score indicates its level of environmental and social awareness. A strong ESG performance by a company not only signifies its commitment to social and environmental responsibility but also contributes to reducing information asymmetry and market volatility. Furthermore, businesses with high ESG ratings are less susceptible to litigation risks due to their initiatives aimed at mitigating environmental harm (Chen et al. 2023).

The board of directors fulfills a dual function, simultaneously overseeing the firm’s management and offering guidance on critical strategic decisions. This dual role allows the board to both scrutinize managerial actions and contribute expert advice on essential corporate matters. The principal function of the monitoring segment of the board is to elucidate information controlled by the CEO, whereas the advisory segment is tasked with identifying and acquiring incremental information pertinent to decision-making (Baldenius et al. 2014).

Prior research (Cornett et al. 2008; Ryan and Wiggins 2004) supports the prevalent belief that the independence of a board of directors enhances shareholder welfare. Independent directors possess a better bargaining position over the CEO, leading to a compensation structure that is more closely aligned with the objectives of shareholders. In a scenario where the shareholders’ objective is to enhance sustainability performance, a more independent board can facilitate a closer alignment of shareholder objectives with those of the CEO through equitable compensation agreements. Thus, our third hypothesis posits a three-way interaction: ESG compensation moderates the effect of ESG performance on financial performance, contingent upon the strength of the board of directors. Specifically, the hypothesis suggests that the presence of strong board independence will amplify the effect of ESG compensation on the relationship between ESG performance and financial performance. This implies that a more independent board plays a crucial role in moderating the relationship, creating a dynamic interaction among ESG compensation, ESG performance, and board strength.

H3: ESG compensation moderates the effect of ESG performance on Financial Performance if the company has a strong Board of Directors.

The summary statistics presented in Table 2 provide a comprehensive snapshot of the sampled firms, indicating varied practices and outcomes in environmental, social, and governance (ESG) efforts. The average ESG performance score of 56.732, with a broad range from 40 to 77.8, highlights the disparity in ESG practices among firms, reflecting varied commitment levels and execution strategies. Notably, approximately 22% of companies incorporate ESG metrics into their compensation schemes, suggesting an emerging trend to align executive incentives with sustainability goals. The average financial performance (Return on Assets) is 0.134 (13,4%). The political orientation variable, with an average of 0.338, suggests that a significant portion of executives may favor policies supportive of ESG principles, which could influence corporate strategies toward sustainability. Board independence is notably high, with a mean score of 0.733, suggesting that the governance structures of most firms support unbiased decision­ making and oversight, a crucial factor in effective ESG integration.

Untabulated pairwise correlations, presented in Table 3, reveal several nuanced relationships among financial performance and ESG performance, compensation, and governance variables. Financial performance shows a statistically significant positive correlation with ESG performance (0.040), suggesting that higher ESG scores might enhance financial outcomes. However, there is a moderate negative correlation between financial performance and ESG Compensation (-0.129), indicating that the integration of ESG metrics into compensation might slightly detract from financial outcomes, potentially due to the upfront costs or strategic adjustments involved in ESG initiatives. A strong positive correlation between ESG Compensation and ESG Performance (0.391) confirms the effectiveness of ESG-oriented compensation policies in boosting ESG outcomes. Furthermore, the slight positive correlation between Political Orientation and ESG Performance (0.079) suggests that leadership with pro-ESG values modestly favors better ESG practices.

We have also conducted an analysis of the differences in mean and median values, the results of which are presented in Table 4. All variables show significant differences in means and medians for firms with ESG Compensation (ESG Compensation = 1) versus those without (ESG Compensation = 0).

The first hypothesis of this study examines the moderating role of ESG compensation in the relationship between ESG performance and financial performance. It explores whether tying executive compensation to ESG targets influences the extent to which sustainability outcomes translate into financial success. In analyzing the effects of ESG Compensation on ESG Performance, the results in model (2) of Table 5 indicate a positive and significant relationship. Specifically, the inclusion of ESG targets in executive compensation significantly enhances ESG performance, with a coefficient of 4.2850 at a 1% significance level. Additionally, the model reveals that larger firms exhibit superior ESG performance, as indicated by a positive and significant coefficient for Firm Size (1.855 at p < 0.01). However, the Book to Market ratio shows a negative association with ESG performance, suggesting that firms perceived as undervalued by the market may focus less on sustainability initiatives. Other factors like Board Size and the use of Big 4 auditors also positively influence ESG performance, indicating that better governance and stringent auditing standards correlate with improved ESG outcomes. Other variables such as Leverage and CEO Duality do not significantly affect ESG performance, highlighting that financial structure and executive governance might not play a decisive role in ESG dynamics within this model. The inclusion of Year and Industry Fixed Effects significantly increases the explanatory power of the model (Adjusted R-squared of 0.586), suggesting that controlling for these factors provides a more accurate depiction of the variables impacting ESG performance. This analysis underscores the effectiveness of ESG-focused compensation in enhancing a firm’s sustainability performance, especially when adjusting for industry and temporal influences.

Building upon the theoretical underpinnings previously discussed, we next investigate the relationship between ESG Performance and Financial Performance in models (3–4) of Table 5. Our results indicate that there is a statistically significant positive relationship between ESG Performance and Financial Performance, evidenced by a coefficient of 0.013 at a 1% significance level. This suggests that higher ESG scores are associated with better financial outcomes, potentially due to improved reputation, customer loyalty, and operational efficiencies driven by sustainable practices.

Finally, we explore the moderating role of ESG Compensation on the relationship between ESG Performance and Financial Performance in Models (5–6) in Table 5. Our results reveal that ESG Performance continues to have a positive and significant effect on Financial Performance, at a statistically significant at the 1% level, indicating that ESG performance is positively associated with financial outcomes. However, ESG Compensation alone does not show a significant direct effect on Financial Performance, suggesting that the mere presence of ESG-linked compensation schemes does not automatically enhance financial metrics. Furthermore, the interaction term between ESG Performance and ESG Compensation does not exhibit significance. This absence of a significant moderating effect could imply several explanations. Firstly, it may be that the structure and specific conditions of ESG-related incentives are too complex or not aligned closely enough with the financial goals to make a measurable impact on financial outcomes. Secondly, the direct benefits of high ESG performance, such as increased market appeal and operational efficiencies, might already provide significant financial benefits, thus rendering the additional motivational boost from ESG-linked compensation redundant. As a result, we must reject H1, as our analysis does not support the hypothesis that ESG Compensation influences the impact of ESG Performance on Financial Performance.

These results underscore the need for careful design and implementation of ESG incentives within corporate compensation strategies, emphasizing that not all ESG-linked compensation schemes may effectively enhance financial outcomes. They highlight the importance of understanding the broader organizational and economic context in which these incentives operate to ensure they drive meaningful impact.

Next, we delve into the role of ideology in enhancing ESG performance, specifically examining how the political orientation of executives might interact with ESG Compensation to influence sustainability outcomes. The results for Models 1 and 2 presented in Table 6 show that ESG Compensation and Political Orientation both have positive and statistically significant effects on ESG Performance with coefficients of 3.629 and 1.090, respectively, suggesting that both the presence of ESG-related incentives and the political leaning of executives towards sustainability individually enhance ESG performance. However, the interaction term between ESG Compensation and Political Orientation, although positive, is not statistically significant. This outcome suggests that while both ESG Compensation and a supportive political ideology positively influence ESG performance, their combined effect does not significantly exceed their individual contributions. The lack of a significant interaction effect could indicate that while ESG incentives are effective on their own, aligning them with the political orientation of executives does not necessarily compound their effectiveness. This outcome might reflect the robustness of ESG Compensation structures in motivating sustainability efforts irrespective of executives’ personal ideological alignments, or it could highlight that the effect of political orientation is already embedded within the direct impacts of ESG Compensation and does not additionally enhance it when combined.

We then investigate the interaction between ESG Performance and Political Orientation on Financial Performance. The findings in Models 3 and 4 are consistent with the idea that ESG Performance positively impacts Financial Performance, suggesting that better ESG practices contribute to improved financial results. This aligns with the broader narrative that sustainable practices can enhance a company’s reputation, operational efficiency, and market positioning, which in turn may boost financial performance. Political Orientation, however, has a statistically significant negative effect on Financial Performance. This indicates that executives with a pro-ESG political orientation might prioritize long-term sustainability goals over short-term financial gains. The interaction term between ESG Performance and Political Orientation is both positive and statistically significant, suggesting that the financial benefits of ESG practices are stronger in firms where the executives’ political orientation is supportive of ESG initiatives. This interaction implies that in companies led by executives with a pro-ESG political orientation, the financial benefits of ESG practices are enhanced, potentially due to a more effective integration of these practices into the firm’s core business strategies. However, it is important to note that this effect is reported at the aggregate level and is not split by specific political affiliation (e.g., Democrat or Republican CEOs). Therefore, the result reflects a broader trend where pro-ESG political orientation generally amplifies the financial benefits of strong ESG performance.

Finally, we investigate the interaction between ESG Performance, ESG Compensation, and Financial Performance, with a focus on the political orientation of CEOs to determine if a CEO’s support for ESG practices, as indicated by their political ideology, enhances the financial benefits of these practices. To examine this, we split the sample between firms led by Democratic-leaning CEOs and Republican-leaning CEOs in the four models presented in Table 6. Models 5 and 7 represent firms with Democratic-leaning CEOs (presumed to support ESG practices), while Models 6 and 8 focus on firms with Republican-leaning CEOs.

In Models 5 and 7, ESG Performance shows a positive and statistically significant effect on Financial Performance in firms with Democratic-leaning CEOs (coefficients of 0.024 and 0.025, both p < 0.01), suggesting that ESG practices enhance financial outcomes when executives align with sustainability goals. However, in Model 8, with Republican-leaning leadership, the effect of ESG Performance is much weaker and statistically insignificant (coefficient = 0.006), indicating that ESG practices have a less pronounced financial impact under such leadership.

The t-test for the difference in the coefficients of the interaction effect between ESG Performance and ESG Compensation in Models 5 and 6 (Democratic vs. Republican CEOs) yields a p-value of 0.368, and in Models 7 and 8, the p-value is 0.176. Both p-values are greater than 0.05, indicating that the interaction effect does not significantly differ between Democratic-leaning and Republican-leaning CEOs. This suggests that the combination of ESG Performance and ESG Compensation has a similar impact on financial performance, regardless of CEO political orientation, leading to the rejection of Hypothesis 2.

In conclusion, while both ESG Compensation and Political Ideology independently contribute to better ESG Performance, the interaction between ESG Performance and ESG Compensation does not significantly enhance financial outcomes differently across leadership ideologies, leading to the rejection of the hypothesis that CEO political alignment with ESG amplifies the financial be­nefits of these practices.

In this section, we evaluate the role of monitoring by examining the interaction between ESG Compensation and Board Independence on ESG Performance. First, results in Table 7 show that the impact of Board Independence on ESG Performance, while significant in Model 1 (coefficient of 1.402), lose their significance in Model 2 (coefficient of 0.343). This suggests that the positive influence of board independence observed in the less controlled model may be confounded by industry­-specific or temporal factors, which when controlled for, diminish its apparent impact. Furthermore, the interaction between ESG Compensation and Board Independence again shows a significant negative effect in Model 1, while not significant in Model 2, implying that when accounting for year and industry-specific variations, the negative moderating role of board independence on the effectiveness of ESG Compensation does not persist.

Next, we examine the potential moderating effect of Board Independence on the relationship between ESG Performance and Financial Performance. The results in Table 7 show that for models 3 and 4, while ESG Performance has a consistently positive impact on Financial Performance (coefficient of 0.016), the direct influence of Board Independence is not significant (coefficient of -0.002). Moreover, the interaction between ESG Performance and Board Independence also lacks statistical significance, suggesting that the presence of a stronger board does not significantly alter the financial returns from ESG practices when industry and temporal factors are accounted for. The results indicate that board independence, while crucial for effective governance, may not necessarily enhance the financial benefits derived from strong ESG performance.

Finally, we evaluate the influence of board independence on the relationship between ESG Performance, ESG Compensation, and Financial Performance. The dataset is split into two groups: firms with a more independent board (Models 5 and 7) and firms with a less independent board (Models 6 and 8), to assess the differential impacts. The t-tests for the difference in coefficients for the interaction terms across these models are not statistically significant, suggesting that board independence does not meaningfully alter the financial returns from ESG initiatives through compensation structures, and thus, rejecting our third hypothesis.

The analysis also reveals that, when controlling for year and industry fixed effects (Models 7 and 8), ESG Performance consistently shows a positive and statistically significant impact on Financial Performance. In Model 7, where firms have a more independent board, the coefficient is 0.013 (p < 0.05), while in Model 8, with less independent boards, the coefficient is 0.012 (p < 0.1). These findings suggest that a more independent board may slightly enhance the effectiveness of ESG practices in improving financial outcomes, likely due to stronger oversight and a greater focus on sustainability initiatives. However, the difference in the coefficients between firms with more and less independent boards is not large enough to suggest that Board Independence plays a substantial or moderating role in this relationship.