How climate change can be addressed through executive compensation
Author: Nidia Martínez
How climate change can be addressed through executive compensation
Mon, 02/08/2021 - 00:44
Environmental, social and governance (ESG) issues are increasingly becoming incorporated across all aspects of organizations, including business strategies, operations and product/service offerings.
Recent global research of boards of directors by Willis Towers Watson found that 70 to 80 percent of respondents have identified ESG priorities and developed ESG implementation plans. However, only 48 percent have fully incorporated ESG into their businesses, indicating that organizations are at different stages in their ESG journeys. While the most cited reason for taking ESG actions is that they see it as the right thing to do, over three-quarters (78 percent) of respondents indicate that they believe ESG is a key contributor to strong financial performance.
Although many organizations have adopted ESG principles, executives and boards could do more to meet the demands of institutional investors, customers, employees and other stakeholders especially in regard to climate change risk.
Some 41 percent of respondents ranked the environment — including climate change — as their leading ESG priority; and 43 percent anticipated it will remain No. 1 in three years.
A particularly effective way to advance ESG principles is through redefining responsible leadership. And one of the most useful tools in prompting leaders to address climate change and make their organizations more sustainable is through compensation and incentive programs, and the incorporation of new climate-action metrics into such programs.
Rising demand for sustainable solutions
The drive to make companies more climate resilient and sustainable started with institutional investors, long aware of climate risk. Consumer awareness, likewise, has grown significantly as climate change becomes more apparent in their daily lives amid news stories about extreme weather, such as wildfires.
Many consumers are more conscious than ever when choosing brands whose policies meet their own interests. For some, this attitude carries over as a factor in the companies they choose to work for, further encouraging organizations to incorporate climate action and sustainability, among other ESG criteria, to help attract and engage the best talent.
Only 48% of CEOs are implementing sustainability into their operations.
Despite this backdrop, many boards have not incorporated climate awareness into their organizations yet. Analysis of company public disclosures conducted by Willis Towers Watson shows that while about 11 percent of the top 350 European companies have CO2 emissions linked to their incentive plans, only 2 percent of US S&P 500 companies have it.
As we look forward, nearly four out of five (78 percent) survey respondents plan to change their use of ESG priorities in executive incentive plans over the next three years, with 40 percent looking to introduce ESG measures into long-term incentive plans and nearly one-third looking to increase the prominence of environmental measures.
Executives acknowledge need for climate action
Despite the lack of environmental and climate metrics in executive compensation and rewards programs, executives acknowledge the need to address climate risk.
According to a 2019 survey by the United Nations (UN) and Accenture, 71 percent of CEOs believe that — with increased commitment and action — business can play a critical role in contributing to the UN’s Sustainable Development Goals. Yet only 48 percent of CEOs are implementing sustainability into their operations, consistent with the findings from Willis Towers Watson’s research as noted earlier.
Our research found that the most common challenges cited when incorporating ESG metrics into executive compensation plans include setting targets (52 percent), identifying (48 percent) and defining (47 percent) performance metrics, and establishing time periods to affect meaningful change (35 percent).
Given these responses, it is fair to assume that the lack of standardized climate change metrics is holding back the wider adoption of including climate action in executive compensation. Furthermore, every business has a measurable carbon footprint. Therefore, boards can make reducing that footprint — with the ultimate goal of reaching carbon neutrality — a metric for their organizations and incorporate it into executive compensation.
As every industry is different, the metrics to incentivize climate action need to be customized by sector, as highlighted through the industry-specific standards provided by the Sustainability Accountability Standards Board or other climate change disclosure frameworks such as the Task Force on Climate-related Financial Disclosures (TCFD).
As organizations refine their climate change strategies and disclosures, they can start to consider the linkages to their executive compensation programs.
Multiple ways to link executive pay to climate action
As indicated by our research, more boards will be linking relevant climate action measures to executive incentive plans over the next few years. There are a few ways to make the connection, ranging from underpins to modifiers to short-term incentive (STI) plans to key performance indicators (KPIs) within long-term incentive (LTI) plans to standalone hyper-long-term incentive plans.
An underpin (or minimum funding threshold) is most appropriate in the case of a company with meaningfully high CO2 emissions that newly introduces climate sustainability metrics. It should include a threshold or basic level of CO2 emissions required for some payout under other incentive plan metrics to occur.
An individual performance rating modifier can be tailored to an individual's role and improve line-of-sight for more qualitative or strategic climate change objectives, but it may not promote collaboration by participants to achieve a common material goal.
Plan modifiers are standalone metrics that consider the "how" and the "what." A modifier allows for the entire STI or LTI award payout to be increased or decreased by a certain percentage. If the underlying target is met, then no modification would be made and the underlying STI or LTI award would be made based on the other metrics.
KPIs provide a direct measure that reinforces the importance of climate change and usually are easily communicated, quantifiable objectives. A more highly weighted metric requires clear linkages to funded metrics, but the KPI needs to have a material weighting to demonstrate its importance to plan participants and external stakeholders.
KPIs in LTI plans introduce standalone climate change metrics that are most appropriate if there is a longer time horizon to produce measurable results (such as carbon emission reductions). A drawback, however, is the length of performance period may dilute momentum to achieve sustainability results, the key drivers of LTI plan performance, and could de-emphasize financial/market performance.
Standalone incentive plans are separate from other incentive plans, with the sole purpose of measuring sustainability performance and reducing climate risk (such as a hyper-long term that aligns with the sustainability strategy). Such plans encourage participants to take a longer-term view of performance, but they may be difficult to communicate or viewed as duplicative of other incentives.
Because most CO2 emission reduction targets tend to have longer-term horizons, the typical annual and three-year incentives may not be directly aligned with these goals. Nonetheless, even short-term incentives can have a significant impact in terms of corporate culture. But to encourage longer-term decision making (for example, a target period of 10 years) often associated with large capital investments, and to emphasize its prominence, companies could introduce a separate, hyper-long-term incentive plan focused solely on CO2 emission reductions.
Modern incentive plans are based on time as a constant (such as one- or three-year performance periods) and performance as a variable (achievement of threshold, target, stretch goals). However, a hyper-LTI could allow a different variation, in that the performance goal could be treated as constant (CO2 emission reduction of 50 percent) and time could be treated as the variable. Thus, encouraging early achievement of goals via incentive upside, and conversely punishing delayed achievement of CO2 reduction targets with an incentive downside.
Climate-related measures can provide a return on investment through reduced energy consumption and waste in addition to the goodwill of stakeholders such as investors, customers and employees.
Implementing such incentive arrangements may not be straightforward. Companies will need to consider whether and how best to rebalance other components of pay, how to deal with disclosures of mega-LTI grants, and ensure that targets are sufficiently stretched so that proxy advisers do not perceive these plans to have soft targets as way of boosting executive pay. Large institutional investors have supported proposals for long-term alignment between CO2 emissions and incentives, provided that the quantum and opportunity are properly calibrated, and mechanics are carefully laid out.
To convince skeptics, focus on the bottom line
For boards and management that are a little more suspect of climate sustainability, consider that climate-related measures can provide a return on investment through reduced energy consumption and waste in addition to the goodwill of stakeholders such as investors, customers and employees.
As the World Economic Forum’s January 2019 publication on effective climate governance for boards sets out, monetary incentives for senior management teams should be tied to long-term organizational goals that contribute to resilience and prosperity over time. There is little to prevent linking climate-risk and opportunity-related factors to compensation if they are material to an organization’s long-term sustainability, value creation and risk mitigation.
Executive compensation always has been an effective tool to foster innovation. Now we must marshal its power to encourage the march toward a climate resilient future.
This story was originally published by GreenBiz and can be accessed here.