How climate change can be addressed through executive compensation

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 70-80% of respondents have identified ESG priorities and developed ESG implementation plans. However, only 48% 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%) of respondents indicate that they believe ESG is a key contributor to strong financial performance.

Though 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% of respondents ranked the environment – including climate change – as their leading ESG priority now; and 43% anticipated it will remain number one 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 programmes, and the incorporation of new climate-action metrics into such programmes.

Rising demand for sustainable solutions

The drive to make companies more climate resilient and sustainable started with institutional investors, which have long been 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 now 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.

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 approximately 11% of the top 350 European companies have CO2 emissions linked to their incentive plans, only 2% of US S&P 500 companies have it.

As we look forward, nearly four out of five (78%) survey respondents plan to change their use of ESG priorities in executive incentive plans over the next three years, with 40% 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 programmes, executives acknowledge the need to address climate risk.

According to a 2019 survey by the United Nations (UN) and Accenture, 71% 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% of CEOs are implementing sustainability into their operations, which is 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%), identifying (48%) and defining (47%) performance metrics, and establishing time periods to affect meaningful change (35%).

Given these responses, it is fair to assume that the lack of standardised 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.

Since every industry is different, the metrics to incentivise climate action need to be customised 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 then start to consider the linkages to their executive compensation programmes.

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.

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 (e.g. 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 (i.e. one- or three-year performance periods) and performance as a variable (i.e. 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 (e.g. CO2 emission reduction of 50%) 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.

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 advisors 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 sceptics, focus on the bottom line

For boards and management that are a little more suspect of climate sustainability, consider the fact that climate-related measures can provide a return on investment through reduced energy consumption and waste in addition to the goodwill of stakeholders like 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 has always been an effective tool to foster innovation. Now we must marshal its power to encourage the march toward a climate resilient future.