Executive pay and climate change

On climate and ESG matters, performance metrics aren’t always stretching enough, or are used tactically to smoothen out executive pay-outs, as indicated by high vestings globally. Non-financial metrics are given a small weighting, while climate metrics are grouped with broader ESG metrics, diluting executive priorities.

The key question is: are we asking the right questions on executive remuneration?

Laying the regulatory foundations

The Transition Plan Framework, TCFD, the FCA Discussion Paper 23.1 on Sustainability, and the PRA’s 2022 guidance on climate risk collectively establish that climate-related business risk and opportunity should be integrated in a company’s strategy, risk management, and remuneration policy.

Proposing 5 climate-focused remuneration principles

• Strategic and Material; executive rewards should be linked directly to the company’s most strategic and material climate issues which require a step change in executive performance.
• Measurable, Significant, and Congruent; incentives should be quantitative, discrete, and internally consistent, accounting for a significant portion of total variable pay.
• Included in the STIP (short-term incentive plan) and LTIP (long-term incentive plan); remuneration should be aligned to short and medium-term climate performance targets, commit executives to act now, and provide for performance shortfalls.
• Transparent and Prospective; rewards should provide clear, complete, comparable, and forward guidance to the company’s stakeholders on climate performance.
• Cascaded to the Company’s Workforce; incentives should be set for senior managers and employees who have the biggest influence on climate-related performance.

Recommendations for directors and officers

Governance for climate-focused executive remuneration is shared coherently across board sub-committees, executive management, and key functions and departments. This apportions accountability across the entire organisation. Decision-making is based on company-specific evidence and data.

The board remuneration subcommittee has resident climate skills, ensuring a high-quality discourse. It coordinates closely with the board risk, audit and talent subcommittees, to cover coherently the company’s climate agenda on capital planning, risk management, the internal control environment, and meaningful disclosures. It prioritises simplicity and clarity, and the full alignment of executives with the long-term climate-related interests of the company. It works closely with the HR function to build capabilities, lateral climate talent, and a skills-map to address the company’s future climate needs. The chair focuses a very practical mindset on outcomes and drives resolve.

The CEO’s individual impact on a company’s performance has been measured on average at less than 5%! Consequently, climate remuneration metrics should be cascaded across the organisation to match divisional climate targets. Companies should also consider rewarding key staff with share-based bonuses, to encourage a long-term mindset. Companies should also aim to adopt a robust monetary framework to track their climate performance, including an internal carbon price, and green-weighting their balance sheet and capex plans.

Remuneration advisers’ input is stretched for its relevance, assumptions, and granularity. Advisers propose credible market comparables that reflect the company’s business model, exposures, stakeholder dynamics, and idiosyncratic climate challenges. They create composite benchmarks from climate leaders in other industries. They are not there to defend, validate or be an outsourcing service for a company’s remuneration strategy.

Checks and balances are established through effective systems and processes. Climate performance is tracked in quarterly business reviews and rolling forecasts. A dedicated executive remuneration committee validates climate-related performance and oversees fair executive payouts. The statutory auditor provides external assurances. The internal audit function performs regular checks and the executive committee discusses material findings.

Remuneration disclosures are meaningful; they signal good governance practices, provide evidence of climate commitments, raise trust with stakeholders, and strengthen the shareholder base. Directors and officers take lessons from landmark climate litigation cases and demonstrate consistent performance of their fiduciary duties.

Recommendations for stewardship

The company’s remuneration narrative is a high-level summary of its climate-related corporate strategy. It guides meaningful investor engagement, and helps to prioritise shareholder demands and manage conflicting expectations.

Investors understand better how executive remuneration influences the behaviour of senior managers, and how this is disseminated to the wider workforce. They appreciate that climate and ESG metrics are leading indicators of financial performance. They engage substantively on the principal climate-related factors behind corporate profitability and value creation. They look for financial stress-testing, asset longevity, product and service life-cycle re-calculations, and probability-adjusted cash-flow projections. They track green EBITDA, return on green capital, and green cash per share. They increase the 15% threshold on non-financial metrics, and dilute the dichotomy between financial and non-financial metrics.

Investors have more active and direct engagements with company boards and executive management. They make informed decisions at AGM votes on pay and the re-election of directors, as demonstrated by the 2023 protest votes at Shell, Unilever, and Toyota. This is a trend that is accelerating in the US and the UK, and universal owners are looking to support it further.

Investors use proxy advisers’ services more thoughtfully, and gear up their internal resources and governance structures to increase scale and impact. They abstain from votes they are not prepared for. They use investment trade bodies to bolster their understanding and analytical capabilities.  They focus on industry trend-setters to influence the market. They coordinate their stewardship, voting and investment records coherently.

Companies analyse the engagement patterns and market feedback that are implicit in their shareholder base. They build an investor following that supports their sustainability value creation targets. They take lessons from successful multi-generational companies on their governance practices, including longer-term incentive plans, meaningful board impact, and better alignment between executive pay and the fate of the company.

Regulatory considerations

The jury is out on the efficacy of regulating climate-related pay. Regulators can provide more guidance on critical issues, like climate scenarios and credible transition plans. Stronger enforcement measures should also help to uphold market integrity.

In conclusion, executive pay is a material tool for corporate leaders and investors to help integrate climate risk and opportunity in commercial value creation.

Read the full paper and recommendations here.

Tina Mavraki is a portfolio director of Mytilineos SA and FBX LLC, as well as a strategic advisor on climate and ESG governance to Whiteoak Global Advisors and the Children’s Investment Fund Foundation. Tina is a C-suite executive with 25 years of experience in global capital markets, private finance, and global supply chains, with a track record of building successful multi-billion dollar businesses globally. Tina is Chartered Director, member of the EU EcoDA Director Circles, and Fellow of Chapter Zero UK. She holds an MA and BA from Oxford University and a MSc in finance from London Business School.

This is a guest blog and therefore does not necessarily represent the views of the Institute of Directors.