As climate change issues become increasingly material to businesses, organizations everywhere are struggling to keep pace. Many are setting net-zero targets and revealing new long-term business plans for achieving those goals.
This has led some businesses to wonder whether tying climate-related metrics to executive compensation could help them on their new paths to net-zero.
Executive Pay and Climate and Environmental, Governance and Social (ESG) Metrics
In December 2020, insurance firm Willis Towers Watson and the non-governmental organization the World Economic Forum published a study analyzing the integration of Environmental Social Governance (ESG) metrics in executive pay. Their research, based on a survey of boards of directors, found that 78% of respondents had plans to change how they use ESG in their executive incentive plans over the next three years. In the same time frame, more than 41% of boards of directors plan to introduce ESG measures into their long-term incentive plans and 37% plan to introduce ESG measures into their annual incentive plans.
However, as of 2021, the number of companies using climate metrics to calculate executive bonuses and incentives was still low. ISS ESG, the responsible investment arm of proxy adviser Institutional Shareholder Services, revealed that only 24 companies in the FTSE 100 and only 20 in the S&P 500 had rolled out such measures.
Nevertheless, tying executive compensation to ESG metrics, of which climate is a subset, is slowly but surely becoming more popular, particularly in the energy sector. ISS ESG reported that 39% of energy companies in the world’s largest indices had introduced climate metrics into their executives’ pay by 2020.
The purpose of tying executive compensation to key ESG and/or climate metrics should be to improve a company’s climate performance. To fulfill this purpose, companies should avoid the following:
- Failing to focus on strategic, long-term goals such as emissions reductions.
- Using qualitative goals and measures of progress that cannot be properly evaluated or independently verified. Climate goals are best when they are meaningful and measurable.
- Not being transparent when executing these goals.
Manifest Climate studied oil supermajor Shell’s climate-linked remuneration scheme and derived the following key lessons on how to tie executive compensation to climate-related metrics:
- Engage leaders focused on systems and strategy: Climate performance metrics can accelerate decarbonization efforts by getting management to think about the practical ways they can impact their lines of business. Because climate issues cut across different functions within businesses, executives with a top-level view are best positioned to drive systemic change at the scale and pace required.
In 2021, Shell tied executives’ bonuses and long-term incentive plans to its emissions reduction targets, which include both an emissions intensity reduction target and an emissions abatement target for key business lines. The latter was a new addition to the bonus calculation for 2021. Taken together, these targets incentivize executives to focus on the ways in which emissions cuts can be achieved across each and every division within Shell, which in turn ensures the organization moves as one towards the same goal.
- The size of the carrot matters: In order for climate-related incentives to work, they need to be proportionate to other executive financial incentives. Incentives (e.g. bonuses) that are large enough to motivate climate action will vary depending on the established remuneration structure. There’s no one-size-fits-all solution — firms will need to assess on a case-by-case basis how large a part climate-related metrics should play in their incentive schemes. This will also likely need to be revised periodically.
In 2021, Shell revised its executive bonus structure to increase the weighting assigned to climate action in its bonus calculation scorecard. Achieving set climate targets now accounts for 15%, rather than 10%, of the overall scorecard.
In addition, Shell has introduced an “energy transition condition” to its long-term incentive plan linked to its emissions intensity reduction target. This component was assigned the same weighting (20%) in the incentive plan as those components linked to traditional financial metrics.
- Take a long-term view: Rewarding bonuses based on multi-year performance incentivize executives to take actions for the long-term instead of for short-term financial gain. Including climate metrics that measure performance over an extended period of time encourages executives to enact more ambitious climate actions that may lead to long-term benefits and maximize the probability that the businesses’ overall climate strategy will be fulfilled.
Shell uses carbon intensity reduction metrics in its long-term incentive plan. These metrics align to its net-zero emissions by 2050 target, and its interim 2035 target. Importantly, these metrics are further broken down by year, so that executives know step-by-step what they need to achieve to maximize their long term incentive packages. This helps make Shell’s long-term targets relevant to executives in the here and now.
- Incentives should reflect a holistic view of an organization’s priorities: It is important to remove pay incentives that do not align with a company’s climate objectives. Doing so gives executives a clear indication of the business’ priorities and enables them to take decisive and timely action on climate.
Shell used to reward executives for increasing production of liquefied natural gas (LNG) volumes. Prior to 2021, this target accounted for 25% of their potential bonuses, as opposed to the 10% allocated to reductions in emissions intensity. In 2021, Shell announced the removal of bonuses linked to volumes of LNG production, while it increased the weight of climate-related metrics used to calculate executive bonuses (10% to 15%). In doing so, Shell better aligned its remuneration structure with its climate strategy.
- Climate-related metrics should align with climate science: Linking climate metrics to pay incentivizes executives to carry out a company’s climate priorities, and demonstrates to shareholders and other key stakeholders that it is prioritizing the net-zero transition. For climate-related metrics and targets to have an impact on the real world, however, they need to align to the latest climate science and address the most material elements of a company’s climate impact.
Shell’s largest source of emissions is its Scope 3 emissions, which includes the emissions produced when its customers use the oil and gas it sells. Shell’s net-zero strategy includes a target for its operational emissions (Scopes 1 and 2) and a target for its emission intensity (Scopes 1, 2, and 3). All emissions are therefore covered by Shell’s climate-related metrics linked to executive pay, meaning they cannot simply focus on Scope 1 and 2 emissions and ignore Scope 3 if they want to maximize their remuneration.
Shell uses a series of scenarios to project its performance against these targets. Whether these scenarios are aligned to the latest climate science and technically feasible can be debated. The existing executive compensation targets are informed by these scenarios and can be easily updated by the company while retaining the current remuneration framework, enabling flexibility in staying in line with the latest science.
Following these five steps can help organizations of all kinds incentivize climate action by tying the financial rewards of its leaders to performance against climate-related targets. Better yet, this approach can be replicated across industries by using metrics most relevant to the industry in question.
How Manifest Climate Can Help
If you are new to introducing climate-related remuneration schemes and are uncertain about how to properly approach the endeavor, we can help. We have long-standing experience in helping some of the world’s biggest companies in executing well-thought-out and effective climate journeys and have supported businesses in creating the processes that allow them to successfully disclose and identify their climate-related risks and opportunities.
We are a climate intelligence SaaS platform that combines cutting-edge technology, an industry-leading database of climate disclosures, and ongoing support from climate experts to deliver best-in-class climate guidance at scale. We provide an easier, faster, and more cost-effective way for organizations to build climate competency, stay on top of key climate trends and the climate-related performance of peers, understand how to improve their climate actions and disclosures and build resilience to the impact of climate change on their business. Wherever you are on your climate journey and whatever you want to achieve, we can help.