5 Steps for Tying Executive Compensation to Sustainability

Blair Jones and Seymour Burchman are Managing Directors at Semler Brossy Consulting Group, LLC. This post is based on their Semler Brossy memorandum. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here) and Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

The final link in the chain of improving corporate accountability for sustainability is to tie improvements to pay. In a November 2018 article, we explained that companies should use incentives to motivate executives to tap big strategic opportunities related to environmental, social, and governance (ESG) goals.

Now we want to describe how these incentives should be designed. What implementation steps do you take? And how can you overcome the challenges that deter executives and directors from changing how company incentives have traditionally been designed?

The challenges are easy enough to identify. For one, the number of possible sustainability improvement goals grows by the day, which makes it increasingly hard to know which to pursue: sourcing resources more wisely, managing waste and CO2 emissions responsibly, acting as a good citizen, celebrating diversity among workers, and so on. For another, the years-long efforts to realize payoffs from most ESG initiatives rarely fit typical annual or three-year incentive timeframes. That’s particularly true when you’re working to achieve indirect or intangible payoffs such as burnishing your brand and reputation. Results can build over decades.

Perhaps the most significant challenge is that directors and management teams remain reluctant to base incentives on sustainability results that will show up in the financials. Why, they ask, should we squeeze nonfinancial sustainability measures onto the limited real estate of executive incentive plans if they’re going to boost returns or profits that are already measured in those plans? They don’t consider it appropriate to cut back the weighting of incentives based on standard measures of revenue, profit, and returns while increasing the weighting of less traditional and often nonfinancial ones.

Our experience suggests that there are five steps to designing sustainability incentives that effectively address these challenges. When taken in sequence, the steps allow boards and management teams to create incentives that signal their commitment to sustainability. Well-designed incentives can respond to internal and external stakeholders’ priorities as well as reinforce that sustainability efforts can have both financial and nonfinancial results. The steps are:

  1. Reexamine the context. Confirm that your company’s situation calls for explicit sustainability measures.
  2. Clarify the organizational scope. Determine which parts of the organization the incentives should apply to.
  3. Quantify the duration. Decide on the time horizon of your initiative, which will affect how your incentives are structured.
  4. Consider the means and the ends. Do the processes and behaviors used to achieve your ESG goals matter as much as, more than, or less than the results?
  5. Structure the incentives. Integrate the relevant metrics and payouts in designing your plan.

Now let’s look at each step in turn.

Reexamine the Context.

Analyze the business case for your initiative. In the context of advancing your business financially, does it promise a significant impact? In addition to any direct financial results, will the initiative contribute to intangible, off-balance-sheet assets like brand and reputation enhancement? Will it signal to your workers and investors that you are committed to sustainability? Remember, sustainability incentives are the most powerful when they tap into strategic opportunities that promise a good return.

The opportunities for a good return are increasing as customer needs and demands change. A fast-food company that aims to deliver more health-conscious food, for example, could enact recipe reformulations. As a plus, achieving that goal may not require incentives much different from the financial incentives already in place around periodically shaking up the product line to stay in sync with customers’ evolving tastes. On the other hand, if the company’s strategy for growth is to amass share in new markets by going beyond healthier food—for example, by building the brand and attracting new customers by making food more sustainably—the context is different.

Next, the company may launch initiatives to support sustainable agriculture, improve public health through plant-based food, or mitigate global climate change by choosing less-carbon-intensive commodities. In that case, as the company expands its sourcing from sustainable farms or adopts marketing that highlights its sustainability goals, metrics different from the financial ones are required. Fresh revenues would presumably come directly from sales of more desirable products, but they would also come from attracting customers to its newly sustainable brand.

To be sure, many companies’ license to operate depends on operating sustainably no matter the immediate effect on revenues—whether for extractive industries whose methods risk harming the environment, apparel industries whose supply chains raise questions about workers’ rights overseas, or tech companies whose presence contributes to increasing the cost of living in local communities. These kinds of contexts, regardless of strategy, demand that sustainability results figure strongly into companies’ future success.

Clarify the Organizational Scope.

Examine how broadly sustainability incentives should be applied—companywide or by business unit, team, or individual. If you’re a maker of building products, for example, the role of incentives depends on the particulars of your strategy. Are you making a major shift toward more responsible products across the entire company—perhaps shifting to using only sustainably harvested wood, in a total transformation of your business? Or are you merely addressing a niche market by focusing on sustainable sourcing in a single residential-flooring product line? In other words, do you want to refashion incentives for executives in that niche business or for all of your managers?

Quantify the Duration.

Should the initiative be addressed with annual incentives, long-term incentives (typically a three-year timeframe), or very-long-term incentives (perhaps five or seven years)? If benefits will not be realized for even longer periods, consider requiring higher stock-ownership levels with a decade-long holding restriction, as the benefits of sustainability actions should eventually boost long-term stock performance.

The answer is often a function of how quickly you can act and how big the change will be. If the market demands an urgent change—to eliminate a toxin discovered in a product, for example—you would choose an annual (or even shorter) timeframe. But a big initiative that requires substantive R&D or engineering, even when addressing an urgent issue like greenhouse gas emissions, will often take time. Can you accomplish your goal in one year, or do you need many? Is it incremental or transformational?

You could be like Shell Oil, which recently announced it will tie incentives to carbon emission targets. Shell produces the same types of fuels it has for decades, to power vehicles and industrial plants, even as it has tested the waters with lower-carbon options. But it recently committed to an “energy transition” strategy to cut both its internal carbon footprint and the footprint of customers consuming its products. Its goal is to reduce its carbon footprint 20% by 2035 and 50% by 2050, shifting away from oil and toward natural gas, biofuels, electricity, and hydrogen.

Shell’s former incremental approach, which targeted carbon emissions only from its own operations, might call for payouts of performance-based stock based on traditional three-year timeframes. The new one—once the announced incentives are implemented in 2020—might call for much longer-term payouts based not just on carbon-emission reductions but also on technology advances, pilot programs, and market penetration for the new products and services.

Consider the Means and the Ends.

Is how your company gets to its results as important as achieving those results? If unintended consequences are to be avoided, for example, you may need to hitch awards to the milestones or behaviors you expect of executives, in addition to the final results.

Drug maker GlaxoSmithKline, for example, recently declared that it would improve global health for children in developing countries by targeting more R&D to address infectious diseases like HIV, malaria, and tuberculosis. It will also develop new ways to reach 800 million underserved people in Africa and elsewhere, and it will measure and report on both efforts. Such an approach, documented with a scorecard of progress, can allow directors to initially base the awards on outcomes and later to use the scorecard to inform discretionary adjustments.

Structure the Incentives.

Once you’ve clarified the context, scope, time horizon, and means versus ends, you will have isolated the specific sustainability goals that are relevant for your incentive plans. The final task is to determine what your incentives will be, in particular whether you need to move beyond traditional targets and timeframes.

Let’s illustrate how the five steps work with two situations.

First, imagine you’re running a health care enterprise committed to sharply raising quality. You have no plans to change your business model, but you do plan to deliver markedly better results. Although the effort is not transformational, its scope is companywide. The time horizon for measurable progress is a single year. And in health care, the means obviously matter as much as results.

You might adopt tighter patient-safety goals, such as correctly identifying all patients and reducing medication errors, infection rates, and surgical mistakes. You would then structure incentives to insert goals into annual plans to reward corporate executives when the organization as a whole performs better relative to industry benchmarks. You would also insert goals into plans for business unit executives and facility managers, rewarding them based on performance in their facilities. In all incentives, you would need to guard against unintended consequences, such as facilities transferring sicker patients to other facilities as a way to falsely improve mortality results.

Second, let’s say you work for an auto company that is adopting emerging technologies in order to address environmental needs and consumer preferences around the vehicle-sharing economy. Your transformation aims to reduce greenhouse gas emissions, improve safety, and reduce traffic congestion. You are planning for a transformational change, like many auto companies today, seeking to move from being a vehicle maker to offering “sustainable transportation solutions.” You’ll provide societal benefit with electric, connected, autonomous vehicles and ride-hailing.

The context of your transformation is disruptive. Its scope extends across the organization, affecting each unit in different ways. The duration will certainly be more than three years. Means versus ends requires that you set a high bar for safety. For senior executives you might structure new long-term incentives with three-year or longer companywide goals, based on meeting game-changing milestones and creating cash flows to fund the new business. Given the degree of change and the time needed, you might also increase equity ownership requirements and holding periods.

As for managers in the new business, you need them to meet not only milestones for strategic change but also financial goals over one- and three-year periods. The milestones might cover introducing key technologies. The financial goals would probably include meeting budget goals for the initiatives. Over time, you might transition to revenue and profit goals for the new businesses. For executives with a foot in both the corporate and new-business efforts, you might also adopt a combination of corporate- and business-unit-level incentives. Meeting safety requirements might be a threshold condition.

Of course, even incentives based on these five steps will never, on their own, be sufficient to motivate executives to achieve ESG objectives. But given that incentivizing sustainability to date has largely been limited to varying payouts based on subjective individual goals or punishing sustainability “failures,” the incentives we propose are a powerful way to send management a fresh, unmistakable signal about where to focus. When combined with leadership commitment, a supportive culture, and training, the five steps provide a systematic way to overcome barriers that make directors hesitate to sort out the measures, goals, and payouts for advancing sustainability.

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