How to make climate progress: Tie it to CEO pay

Experts say climate-related goals should be firmly rooted in science, with targets that are clearly achievable and measurable. ILLUSTRATION: ROB DOBI
Experts say climate-related goals should be firmly rooted in science, with targets that are clearly achievable and measurable. ILLUSTRATION: ROB DOBI

Summary

More company boards are doing just that. But the key is to do it right.

Should corporate executives’ pay be tied to climate-related goals?

More company boards think so, as awareness grows that climate change could have an impact on corporate bottom lines. Some 54% of S&P 500 companies incorporated climate-related metrics into their executives’ compensation plans in 2023—more than double the figure from two years earlier, according to a January report from the Conference Board and ESGauge, a data analytics firm.

But experts say how a company ties pay to climate is crucial, with some methods more effective than others. Here’s a look at some of those approaches.

Use science-based metrics

For starters, climate-related goals have to be firmly rooted in science, says David Larcker, a professor and director of the Corporate Governance Research Initiative at the Stanford Graduate School of Business.

Companies that are serious about rewarding for climate goals should also break down their long-term targets into smaller, clearly achievable and measurable goals, says Larcker, who is also a distinguished visiting fellow at the Hoover Institution, a public-policy think tank. Companies should be sure to audit reported metrics for accuracy, he adds.

The metrics will differ by company, depending on where the biggest impact can be made, says John McCalla-Leacy, head of global ESG at KPMG International. He has clients, for instance, that focus heavily on reducing emissions within their supply chain, while others focus more on reducing emissions within their own operations.

“We believe that the best metrics for sustainability initiatives have a clear tie to the underlying business model and strategy," says John Borneman, managing director of compensation consulting firm Semler Brossy. So, for example, an energy or distribution company will have a significant focus on carbon emissions, while a real-estate company will focus on energy efficiency, or a consumer-products company on sustainable sourcing and waste reduction, he says.

Quantitative, not qualitative

Once goals are set, compensation should be tied directly to them, not to some vague broader aspiration beyond the metrics, compensation experts and climate advocates say. Offering incentive pay for goals like “adhering to the company’s climate plan" can risk rewarding executives who don’t take any action.

As You Sow, a nonprofit foundation that promotes corporate social responsibility, scored 100 of the largest U.S. companies by market capitalization, across 11 sectors of the economy, on their climate-rewards programs. It gave its highest grade, a B, to Dow. The company moved up from a D-minus in 2022 by replacing an “unmeasurable climate-related metric" with a quantitative emissions-reduction metric in its CEO’s long-term compensation package, according to the foundation. A Dow spokesperson says the company’s long-term compensation program is aligned with its emissions-reduction targets.

Think long term

It’s more common for companies to build incentives into executives’ annual compensation plans rather than their long-term plans. About 86% of companies in the Russell 3000 index that incorporated ESG performance metrics in incentives used annual incentives in 2023, according to data from the Conference Board and ESGauge. Only about 8% put ESG measures in their executives’ long-term plan last year, and about 5% did both.

Some critics say annual incentives aren’t enough, since long-term incentive programs typically represent the majority of CEOs’ variable pay. Climate incentives should be a significant part of long-term compensation, they say.

As You Sow recommends that companies aim to make at least 5% of the total “performance shares" in their CEO’s long-term incentive plan relate to climate goals. Performance shares are an incentive-based form of stock compensation paid to executives for meeting certain benchmarks. “It can’t be so small in comparison to other payouts that it would not incentivize action," says Danielle Fugere, president and chief counsel of As You Sow.

Of the 100 companies studied by As You Sow, Xcel Energy stood out with the highest weighting of climate-related long-term incentives, at 30% of total incentives. Three other companies—PPL, Dow and Valero Energy—assigned a weight greater than 10% to climate metrics, while five companies—Ameren, Southern, American Electric Power, Dominion Energy and EQT—gave climate incentives a 10% weight.

Build in flexibility

Even companies that are moving toward their climate targets can have setbacks due to reasons beyond their control, so there needs to be some flexibility built into compensation plans, says Paul Washington, executive director of the Conference Board ESG Center.

He offers the example of an acquisition in which the target company has significant greenhouse-gas emissions. As a combined company, overall emissions will be elevated, at least temporarily. In such cases, companies could exclude the acquired company’s emissions for compensation purposes, allowing executives to be paid for the things within their control, he says.

Companies can also be flexible by giving executives partial rewards for efforts that fall short of the established goals. For instance, a compensation plan could call for an equity bonus of 100,000 shares for a 10% reduction in the company’s carbon footprint but fewer shares for a smaller reduction, Larcker says.

Forge ahead

Some advocates of corporate action on climate issues urge companies to at least start feeling their way toward tying executive compensation to climate metrics.

“We don’t think you should let perfect get in the way of good," says Steven Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets. “If they have a good plan, but it’s not a perfect plan, we think they should start implementing that plan and update it as necessary."

Cheryl Winokur Munk is a writer in West Orange, N.J. She can be reached at reports@wsj.com.

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