It is often hard to shake the impression that companys’ ESG efforts are awash with greenwashing, not least due to the paucity of accurate measurement by companies and a lack of auditing of ESG efforts. This trickles down into any linkages between ESG and executive pay. Do you, for instance, limit the incentives to the company’s own carbon emissions or also include those of the wider supply chain?
That was the question posed by a recent study from Cambridge Judge Business School, and the researchers believe that a holistic approach is probably most effective as it strives to ensure that emissions are both measured across the supply chain and then reduced across it also.
“Unlike traditional metrics like TSR (total shareholder return), climate-linked incentives in the energy industry so far do not include evaluation against a peer group,” the researchers explain. “As the practice becomes more widespread, the scope for relative performance evaluation will increase – to better reflect management contribution rather than pay for luck”.
Climate action
The act of linking executive incentives to climate-change targets has become more popular since the 2015 Paris Agreement. Indeed, a number of high-profile firms, such as BHP and Shell have done so in recent years.
The researchers managed to discover three core principles for successfully linking executive pay to climate metrics:
- Align executive pay with corporate strategy and value creation over the long term.
- Use actionable performance measures that reflect the added value that management can bring to influence them.
- Balance incentives across multiple tasks and objectives that may compete, to prevent an excessive focus on a particular subset of tasks.
What’s more, the researchers believe that executive incentives could be formulated in a number of ways to successfully link them to climate metrics. For instance, they could be narrowly focused on certain units or apply to the whole business. They could be directly tied to carbon emissions or to the development of low-carbon products and services. Alternatively, they could apply to the absolute emissions levels of the business or the emission intensity of it. It’s important, however, that such incentives are not non-linear in design.
“Consider a sales target under which a manager receives a fixed bonus if the threshold is met at year-end and gets no bonus otherwise,” the researchers explain. “Incentives to try hard are very weak if the target looks unattainable, very strong when the target is almost reached, and zero if the sales target is locked in before the year is over.”
While a number of sectors seem to be leading the way in tying executive pay to climate change, the researchers believe this will be increasingly important for a number of sectors, and especially energy-intensive ones, such as airlines and logistics.
“In a way that would have seemed surprising even five years ago, carbon emissions are emerging as a key performance indicator,” the authors conclude. “So far, the use of climate-linked incentives involves a degree of experimentation, and there will be scope for refinement over time. This is good business practice: see what works and then make adjustments so as to avoid unintended consequences.”
