How to make the link between executive compensation and the climate
The trend is clear.
Boards considering specific climate-related goals, or even those considering tying more environmental measures to bonuses, face a number of dilemmas.
Companies, Grogan says, must first design their ESG strategy, which will help determine the appropriate goals executives need to meet to earn their bonus. The next challenge is to identify quantifiable measures that can be applied to these targets. Third, boards must set the goal âso that there is appropriate leewayâ, which makes achieving the goal neither too easy nor too difficult for senior executives. This is no small feat given the lack of historical data. In the case of profit goals, there are years of data that show the likelihood that they can be achieved. But, since companies don’t have as much experience setting environment-related goals, “it’s actually quite difficult to predict how they might change over time,” says Grogan.
Boards of directors are also grappling with the expectations of various investors.
Passive investors with high influence are generally less aggressive in their demands for the inclusion of climate measures in executive compensation. For them, climate action tends to be more of a checkbox, argues Robinson. Passive funds simply need to be able to assure their clients that they are taking climate issues seriously.
On the other hand, large pension or retirement funds, which invest over periods of 30 or 40 years, see climate change as an existential threat to their portfolios. These investors, like activist investors, demand more than ticking boxes.
In addition to the different sources of capital, the types of climate goals chosen by boards of directors will depend on their investment strategies and the estimated time frames over which the returns will be generated. A resource company that builds a mine with a 40-year time horizon may need to opt for more important climate-related measures than a retailer investing in stores in order to achieve the desired results.
Then there is the question of quantum. What proportion of an executive’s remuneration should be linked to environmental or climate measures? If there are too many individual metrics used to determine the size of the bonus, the weight of each will be too low to influence behavior.
Grogan argues that no single measure should account for less than 10 percent of the pie that is used to determine an executive’s short-term incentive payout. Ideally, the figure would be closer to 20 percent.
âIt goes back to the principle that incentive pay isn’t meant to be rewarding [executives] for each metric or responsibility that is part of [their] job. It’s really about outperformance and creating shareholder value. Therefore [the challenge] try to determine the five or six main parameters most closely related to these results. The five or six measures would relate to both financial and non-financial measures, âsays Grogan.
Robinson argues that individual metrics must be 30 percent of salary in order to drive behavior change, but adds that many investors will be happy with a 5 percent component.
Rather than paying incentives to executives who achieve certain climate-related goals, some companies take a so-called bridging approach. Management must achieve a certain goal before they can access their bonus. The bar for passing through the gangway is usually set quite low, but Robinson notes that at least this “catches the attention of management.”
Fast food retailer Collins Foods will introduce an ESG component to its bonus plan for the first time this year. Under the proposed program, which is largely secret, ESG metrics will make up 15 percent of the total scorecard, alongside a customer satisfaction metric (also 15 percent) and a revenue target. (70 percent).
Consistent with the group’s goals of reducing greenhouse gas emissions by 25% “soon” and increasing the amount of waste diverted from landfills by 25%, Collins is using measures in areas such as as energy consumption, water waste and cooking oil upcycling.
âWith a short-term incentive plan, you can change things around the edges, but you won’t be encouraged to invest a lot of capital. “
– Michael Robinson, Guerdon Associates
The structure of each leader’s bonus measures will depend on the areas over which they have control. âThe trick is to adapt these things as much as possible to make them relevant,â President Robert Kaye said. The board, he said, needed to calculate the company’s emissions and analyze exactly where Collins, Australia’s largest KFC franchisee, could make a difference to the environment.
âEverything has to be measurable. You have to look at it in a very analytical way. This will involve big structural changes, âKaye said.
Kaye thinks the overall 15% ESG component is important.
âWhen you come out of a weak base, it will all be quite significant. This will highlight the direction, âhe said.
Ultimately, boards and investors may need to address the link between climate-related goals and long-term incentive plans.
Unlike many of their offshore counterparts, Australian companies tend to limit ESG and climate measures to short-term incentive plans.
In the UK, around one in five FTSE 100 companies have ESG measures in their long-term incentive plans. Among blue-chip Australian companies, the equivalent figure is one in 20. The rejection of the prudential regulator’s proposal to include non-financial goals in long-term executive bonuses after the Hayne Royal Commission demonstrated the preference of Australian shareholders for companies to focus strictly on financial metrics when it comes to long-term compensation.
AGL Energy also proposed, last June, to include carbon transition indicators in its long-term incentive plan for key executives. Key proxy advisor Institutional Shareholder Services urged clients to vote against the plan and ultimately the energy company was struck by a strike against its compensation report.
On the other hand, says Robinson, many boards would prefer to link inventive long-term plans to climate action, because of the need to invest in reducing emissions, the return on which will be in long-term investments. many years.
âThe only way to do it realistically is in a long-term incentive plan. With a short-term incentive plan, you can tweak things around the edges, but you won’t be encouraged to invest a lot of capital, âsays Robinson.
âA long-term incentive plan really encourages you [to opt] for lasting improvement, which means you need to invest some capital on a sustainable basis.
âThe dynamics of this are always quite interesting. Investors should understand that the return on investment will not be as quick on this capital as others [investments], but if you’re looking at long-term survival, you probably have to, âsays Robinson.