United States: Are There Best Practices For Linking Executive Compensation To Climate Goals?

In this new paper, Feet to the Fire: How Should Companies Tie Executive Compensation to Climate Targets?, from the Rock Center for Corporate Governance at Stanford, the authors looked at how some companies bolstered their commitments to climate action—the authors refer to it as "institutionalizing" their climate goals and commitments—by including climate-related metrics in executive compensation plans and agreements. The authors observed that, increasingly, even in the absence of regulation, companies have made voluntary pledges to reduce their carbon emissions. Citing MSCI, the authors report that about "half of large, publicly traded companies have established carbon emissions targets, and a third have pledged to achieve net zero emissions by 2030 or 2050." But is there anything to these promises? Have any of these carbon reduction objectives been fully integrated into the company's strategy, operations or corporate culture? One way that some companies have sought to realize their climate goals is by tethering them to a measure of compensation. These climate metrics can function as both a signal of seriousness to the public and a mechanism for bringing accountability. In employing climate metrics as performance conditions in compensation programs, are there best practices to effectively achieve the kind of "institutionalization" that the authors advance?

According to the authors, often, "corporate carbon reduction programs are essentially a black box," allowing investors little insight into "programs companies have implemented, the milestones targeted, and the resources and dollar amounts committed." With incidents of greenwashing on the rise, does the public know, the authors ask, what investments these companies have made to achieve these goals or how the company plans to achieve them? Instead of investors trying to suss out the extent of a company's commitment from sustainability reports, the authors point investors to companies' executive compensation plans as a signal: "if a company prioritizes an objective—strategic, financial, operational, or otherwise—it will compensate the executive team for pursuing that objective. (As one study of corporate culture succinctly puts it: 'People will invariably do what you pay them to do.')" But if companies do not include climate metrics as components of comp, the authors ask, does that mean that they are not really serious about their climate commitments?

How pervasive are climate-related metrics as part of performance comp? A survey by Willis Towers Watson showed that, among companies in the S&P 1500, 56% conditioned a portion (typically about 20%) of the annual bonus on achievement of ESG metrics, and 8% included ESG metrics in the long-term bonus. But WTW also found that, among the S&P 500, only 12% used climate-related or environmental metrics in the annual bonus, with just 2% including them as a component of the long-term bonus.

According to research cited in the paper, using climate or sustainability metrics to determine executive compensation has been an effective tool, with companies registering higher ESG scores and profitability, as well as lower emissions without an impact on operating performance or share price. Another paper established that shareholders of a sample of oil and gas companies who otherwise might oppose carbon reduction targets found them to be more palatable when included as targets for executive comp. Some research, however, showed a negative impact on shareholder and stakeholder outcomes as a result of "a dual-mandate that allows management to sidestep accountability to either objective. The authors note this risk can be lessened through the use of clear, objective, and standardized metrics." Other research made the point that nondiscretionary ESG incentives were currently "too insignificant to materially influence behavior," affecting, on average, only 1.1% of total comp.

Rather than presenting primarily survey data, the paper offers a narrative, in a more anecdotal style, that recounts information elicited through conversations with chief sustainability officers and senior executives at seven "world-class" companies about their implementation of carbon-reduction programs. From these conversations, the authors ascertained that the programs varied significantly across companies in structure, prioritization and support from leadership, nature and rigor of targets, the level of investment in data systems, the extent of integration of climate goals with strategy and planning, and financial incentives for achievement of goals. The authors learned that companies approached the issue of institutionalizing climate goals from different starting points, but, in general, compensation was considered "a central means of signaling the importance of climate objectives and holding executives accountable for achieving them."

As the data above suggested, the authors found that the companies interviewed generally included climate objectives in the annual bonus program rather than the long-term incentive program. Why? Since climate goals tend to be long-term in nature, that might seem somewhat anomalous. The authors found that, because LTIPs typically represent a greater proportion of comp and include only two or three performance targets, the annual programs were perceived as more appropriate for climate metrics; including carbon reduction goals in the LTIP would "significantly raise the prominence of these goals." The companies used various structures to design their programs, with a focus on simplicity to clearly convey to employees the link between the climate objectives and pay. The authors also detected a trend toward attributing more significance to climate goals by assigning increasing weight to those metrics. The authors found that up to several thousand employees, from senior leaders to plant managers or supply chain managers, could be eligible for climate-related bonuses.

The authors identified two key considerations in setting goals: the type of metric and how rigorous the target should be—whether goals should be stretch or clearly within reach. With regard to emissions, most of the companies used Scopes 1 and 2 goals, which are within the company's control, as opposed to Scope 3, which is usually not. (In most cases, reducing Scope 3 emissions would require companies to change the behaviors of suppliers and customers.) Metrics selected ranged from qualitative to science-based, i.e., targets that "provide a direct path to reducing emissions in line with the Paris Agreement goals." Targets could also be gross reduction targets or net targets (i.e., reduced by offsets. See this PubCo post and this PubCo post.) Targets could be either straight-line reductions annually or take a "hockey-stick" approach.

Metrics were typically tailored based on the 'job function and level of authority" of the employee, with more senior leaders "responsible for organizational or divisional goals; employees farther down the organization are given metrics that roll up in support of these." The companies interviewed used outside firms "to vet targets and benchmark against peers." Structuring the metric was also part of the exercise, with choices including discrete quantitative metrics, scorecards (which include a mix of quantitative and qualitative metrics), modifiers (where the primary metrics, generally financial performance, are adjusted based on the level of achievement of the modifier goal), and entirely discretionary metrics.

The authors indicated that learning how to break down long-term climate goals into annual increments can be challenging, a process that requires companies to learn over time and through "repeated effort... how efficiency programs, sourcing programs, and technology translate into emission reductions....The objective in goal setting is to establish a glidepath whereby annual reductions lead to the achievement of long-term goals." According to the authors, "[t]argets for the first five to seven years focus on the transition to renewable energy and gross energy reductions in production and supply. Beyond this, there is general acknowledgement that technological innovation (outside the company) is going to be required for companies to achieve their long-term pledges." But the possibility of missing annual goals that affect the long term can be troubling.

Creating employee buy-in can be a multi-year process, the authors were told. Typically, implementation was phased in with the most senior executives, after initial testing of the utility/efficacy of various metrics outside of the compensation context. Interestingly, the authors found that internal resistance to the inclusion of climate metrics was not about the value of addressing climate change, but rather what the authors viewed as the "practicality of tying pay to climate." To illustrate, they pointed to examples such as board members concerned about the cost of the initiatives, engineers concerned about the impact on product quality and marketers skeptical of the veracity of professed customer interest in environmentally friendly products. Other factors cited were generational splits and company financial difficulties. Companies sought to address this resistance through incremental commitments and framing the importance of climate objectives rather than emphasizing efficiency goals.

Companies told the authors that they needed to implement new systems to collect and calculate climate data—specifically, one system for business units to report raw data and another separate system for calculations and reporting to the sustainability officer. The authors indicated that system "separation improves the integrity of reporting." For the most part, the companies interviewed considered auditing "critical to ensuring the reliability of data. An audit of climate metrics forces the company to think rigorously about how to measure climate performance and, in the words of one company, 'makes the results indisputable.'"

In terms of oversight, the companies reported that multiple board committees were highly engaged and that the full board looked at sustainability "within the broad context of ESG and strategy," as well as "the rigor of goals, whether climate goals are a distraction to other business objectives, the operating and investment requirements to achieve climate targets, progress, and results." Current issues before these boards were "whether to include climate or environmental goals in the LTIP and whether and how to move to science-based targets." Another issue for boards was the nature of any "legal risk that might arise from not achieving their stated objectives."

The authors found that most stakeholders viewed these companies' climate efforts positively—employees, suppliers, institutional investors with an ESG mandate as well as the broader investment community, and local communities and customer groups.

The authors made best-practice recommendations in three areas:

Leadership. To be effective, the company's commitment to carbon reduction must be "genuinely embrace[d]" by leadership as "integral," not secondary, to the company's strategic and financial objectives—a component of strategy, budgeting and ultimately corporate culture. To help overcome any resistance, the authors advised that the company clearly articulate, through the ranks, why the company has committed to carbon reduction goals.

Metrics. The authors advised that climate targets were most effective if "few in number, low in redundancy, and largely quantifiable." They learned that "the most successful companies adopt science-based targets because of their demonstrable link to net-zero emission goals," break down long-term climate goals into "clearly achievable" annual increments that "map to quarterly, annual, and multi-year budgets and are supported by granular plans for capital allocation and procurement." Investment in new data collection and analytical systems will be required. Reporting should be consigned to "a small team of experts to ensure consistency and accuracy," and the results should be audited.

Compensation. The authors concluded that the most effective climate programs fully align the company with its commitments by making climate metrics a component of comp for executives and senior managers. In particular, they contended, the most successful companies include climate metrics as part of their LTIPs to better align the timing goals and payouts, using achievement of annual bonus targets to build confidence that long-term goals will be met. The authors advocated that comp for achievement of climate goals "should constitute a material part of at-risk compensation to encourage performance." In addition, they advocated transparent reporting of interim and long-term targets so that the board and shareholders can "monitor progress and hold the company accountable."

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