Tying CEO pay to climate metrics seen as increasing accountability to investors, but no consensus on optimal approach.
The practice of incentivising CEOs to deliver on climate change commitments through remuneration is in its infancy, with many firms struggling to identify appropriate metrics or balance short- and long-term goals.
“Once a company has committed to net zero and established its interim decarbonisation targets, the clear next step should be to tie those goals to CEO pay,” Melissa Walton, Executive Compensation and Say on Climate Research Associate at As You Sow, told ESG Investor.
Research published by the shareholder advocacy non-profit last week highlighted that a number of major US companies either have no linkage between CEO pay and climate metrics, or do not tie remuneration to climate performance metrics at a level likely to achieve alignment with limiting climate change to 1.5°C.
As You Sow analysed the 2021 CEO compensation packages of 47 US companies targeted by the investor-led Climate Action 100+ engagement initiative, focusing on whether they included a 1.5°C-aligned climate metric, a measurable climate metric paired with measurable pay, or a measurable climate metric in a long-term incentive plan.
Eighty-nine percent of the assessed companies received ‘D’ or ‘F’ grades for their climate-related pay incentives, as they failed to include “rigorous quantitative climate-related metrics with measurable –pay-out or long-term incentive components”, the report said. Six companies had linked a quantitative climate incentive to CEO compensation, but just one of these was focused on emissions reductions.
Companies assessed include Walmart, Delta Air Lines, Coca Cola and ExxonMobil.
More drastic decarbonisation is needed by corporates, according to recent research by environmental disclosure platform CDP and consultancy Oliver Wyman. It noted that Group of Seven (G7) companies’ current emissions reduction targets set the G7 on a path to 2.7°C of warming by 2050.
In comparison, 51% of EU-based companies have set decarbonisation targets that are aligned with the Science-based Targets Initiative (SBTi), which has “cooled” the temperature pathway of the European economy by 0.3°C since 2021, down to 2.4°C of warming.
Confusion, commitments and clawbacks
“It’s understandably challenging for companies, because this is about combining two very confusing topics – executive compensation and climate metrics,” said Walton.
As You Sow found that several climate metrics were in use by firms, but it was rarely clear how they related to CEO pay, including proportion of remuneration. “We don’t want a high-quality climate metric to be tied to a negligible amount of pay, because that’s not going to be sufficiently incentivising. On the flip side, we don’t want a low-quality qualitative climate metric tied to a big pay-out,” Walton added.
Companies that can demonstrate their commitment to the net zero transition through credible, transparent and measurable climate metrics tied to their executive remuneration schemes are going to be at a competitive advantage, said Ken Kuk, Rewards Practice Leader at investment consultancy firm WTW.
“It will show investors that these companies are more prepared for the long term,” he said.
As well as incentivising CEOs to take action on climate, this can help investors hold companies accountable on their short- to medium-term decarbonisation progress, Kuk and Walton said.
Tessa Younger, Head of Engagement at Pensions and Investment Consultants (PIRC) and Engagement Services Manager for the UK’s Local Authority Pension Fund Forum (LAPFF), told ESG Investor: “There should be a clawback of bonuses and variable pay where poor environmental performance causes demonstrable harm to the company’s reputation or social licence to operate.”
The right lever
It’s important that climate metrics tied to executive pay are fairly scaled to incentivise CEOs to take action in the short-term, said WTW’s Kuk.
Many firms have set 2030 decarbonisation targets in line with the UN’s calculation that global emissions need to be cut by 45% by 2030 if net zero by 2050 is to be possible.
“It’s difficult to tie net zero – a goal that’s still decades away – to a typical CEO reward scheme, which is between one and three years,” Kuk said. “Companies need to figure out how to equate progress and be very transparent about it to investors. It’s unlikely that net zero can be achieved in three years.”
Walton noted that alternative approaches are being discussed, such as introducing a five to ten-year climate-focused metric as part of companies’ remuneration schemes, to help incentivise CEOs in their succession planning to make sure their replacement is equally committed to decarbonisation.
However, a number of companies are still in the progress of “figuring out what a net zero transition really means to them”, Kuk said, pointing out that complexities around of measuring Scope 3 emissions will have an impact on the scope of short to medium-term decarbonisation metrics connected to CEO pay.
“Climate is also competing with a number of different ESG priorities, and there are hundreds of related metrics to choose from. Companies need to determine what is most material to their business.”
In 2021, 52% of S&P 500 companies included ESG metrics in compensation, the As You Sow report said, increasing to 69% in 2022.
“There isn’t yet enough data to really show whether CEO pay is the right lever to most effectively incentivise companies to transition to net zero, but it is the lever being increasingly used, so it’s important that companies go about this the right way,” said Walton.
“The ultimate goal is for all US companies across heavy-emitting sectors to link CEO pay to a quantitative and 1.5°C-aligned climate metric.”
As You Sow’s research follows the US Securities and Exchange Commission’s (SEC) adoption of ‘pay versus performance’ disclosure rules, which will require listed US companies to disclose how they pay their top executives according to the company’s annual performance, outlining the list of financial performance measures it links to these schemes.