Say on Climate? Aligning Compensation and Incentives With Climate Risk
By Don Delves, Shai Ganu and Michael Siu

A new governance landscape emerged in corporate America during the first half of 2021. Climate risk and transition considerations rose to the top of investors’ and regulators’ priorities, including Larry Fink’s statement that “Climate transition presents a historic investment opportunity” and President Joe Biden’s May executive order calling for the development of a comprehensive climate-related financial risk strategy.

Recently, oil companies have also encountered regulatory and investor challenges, with courts in the Netherlands ordering Shell to reduce its emissions by 45% by 2030 and activist investors staging a proxy coup and gaining three board seats at Exxon Mobil targeting the company’s lack of commitment to renewable energy. More and more, board members are expected to help manage a company’s climate risk and, as a business imperative, be stewards of the company’s climate transition into a low carbon economy.

At a recent roundtable hosted by Willis Towers Watson, board members expressed concerns about climate issues and risks, specifically physical, liability and transition risks. Because risks and their relative importance vary considerably by company and industry, organization leaders and board members are sorting through which risks are most appropriate for their companies to address. Board members also see both managing risk and driving performance as key to creating value for all stakeholders, including regulators, shareholders, employees and consumers. How well the company addresses these issues also is considered a way to attract and retain employees, customers and investors (which, ultimately, equals more capital).

From risk management to climate transition

Climate risks typically are viewed in three broad categories:

•               Physical risks: These risks arise from weather-related events and slow-onset climatic changes that can affect a company’s assets, people, infrastructure and supply chains.

•               Liability risks: These include product liability claims brought by states, cities and activists, as well as claims against businesses for failing to adapt to a transition to a low-carbon economy or failing to heed professional advice on physical risks’ impacts on supply chains, infrastructure and processes.

•               Transition risks: These arise from regulatory and policy requirements (e.g., mandatory carbon pricing policies that increase a company’s cost of capital). They also include risks that can lead to reputational harm and/or technology obsolescence and lost opportunities because the company failed to address consumer and employee preferences or neglected climate transition in its long-term business strategy.

Climate risk is viewed in the context of the many other risks that boards regularly consider and address, but it is a newer topic with unprecedented challenges as well as new opportunities. There aren’t centralized risk committees in most companies (with the exception of financial services companies), so different enterprise risk categories are handled by different committees, with major risks (e.g., cyber) most often addressed at the board level. Climate risk is a newer — or less developed — topic for many U.S. boards, and board committees do not have a clear remit to address it. As such, climate risks typically are addressed by the full board and appropriately reflect their importance as a company’s key business imperative.

Increasingly, boards and companies are engaging with shareholders to discuss climate risks and mitigation strategies. Some companies, like Unilever and Moody’s, have taken an extra step in adopting a voluntary, non-binding “say on climate” resolution at their annual general meetings. The intent is to get explicit approvals from shareholders for climate-related transition strategies and the potential impact on the company’s earnings profile. Companies are beginning to realize the tangible financial benefits of focusing on climate change disclosure and priorities, including greater access to capital, higher valuations, preferential interest rates, lower carbon charges and cost of capital, and stronger acceptance from employees and customers.

The extent of board members’ concerns varies greatly by industry.

One board member from a large electric power producer noted that her company was concerned about greenhouse gas (GHG) emissions as well as releasing other pollutants into the air and water.

Another, from a plastics manufacturing company, expressed concern about the volume of non-biodegradable plastic produced, how little is recycled and the amount of plastic in oceans and landfills.

The value of climate goals

Depending on the industry, there may be several climate-related goals for companies, including GHG emissions, carbon intensity, water security, waste management, circular economy, biodiversity and renewable energy consumption. However, the most pressing goal is related to GHG emission reductions. In some industries, environmental impacts are at the core of business strategies and companies are transforming their portfolio or product mix accordingly. For instance, an important measure for energy companies is to increase renewable energy as a proportion of overall production. Witness the activist investor action at Exxon Mobil.

Board members often place a company’s climate initiatives into three categories:

•               Value-added: Initiatives that add value by helping reduce company-specific risk, lower the cost of capital, help enhance the brand, amplify purpose and drive value.

•               Compliance: Initiatives that are expensive, with little perceivable payoff, where the company meets the expectations of regulators and investors.

•               Trade-offs: Initiatives that require significant displacement of products, production facilities and other operations, but will generate significant revenue and profit over time in a way that has more positive environmental impact and sows the seeds of future growth.

Board members also understand the critical role of human capital in any climate or other ESG efforts. As noted, successfully cascading goals down the chain is critical to moving the entire organization forward to embrace climate transition.

One director told us that climate transition “links back to the role of human resources to ensure that the targets are embedded into the culture and values of the group, shaping how employees view climate targets.” 

Driving meaningful climate initiatives also will require companies to hire or develop people with different skill sets and capabilities, reorganize key functions and processes, build new metrics into incentive programs and incorporate climate issues into corporate governance. Strong climate/ESG commitments will be instrumental in attracting, motivating and retaining employees and customers. Active listening and communication are a top priority for companies seeking to ensure employees understand the company’s commitment to curb climate change.

Risk-reward alignment

A key human capital initiative is the use of incentives to shape behavior. Executive compensation can serve as an important change agent to accelerate climate transition priorities. Principle 6 of the World Economic Forum’s Principles for Climate Governance specifically calls out incentivization: “The board should ensure that executive incentives are aligned to promote the long-term prosperity of the company. The board may want to consider including climate-related targets and indicators in their executive incentive schemes, where appropriate. In markets where it is commonplace to extend variable incentives to non-executive directors, a similar approach can be considered.” Increasingly, compensation committees view climate and other ESG issues as top business priorities and are incorporating these goals in performance management and executive incentive plans.

Nearly four of five respondents (78%) planned to change how they use ESG with their executive incentive plans in the next three years, according to a 2020 Willis Towers Watson global board member survey. Directors also listed environmental and climate issues as their No. 1 priority; 41% planned to introduce ESG measures in their long-term incentive plans in the next three years and 37% looked to add ESG measures into their annual incentive plans.

More companies are beginning to include hard targets related to climate measures. In this area, U.S. companies are trailing their European counterparts. Our analysis shows that, while around 33% of the top 350 European companies have environmental and sustainability metrics in management goals and incentives, only 14% of U.S. S&P 500 companies do. Additionally, 11% of European companies have GHG emission reduction targets, compared with only 2% of S&P 500 companies. There is more work to be done to move the needle on this important issue, and we are beginning to see more discussions among U.S. boards on how best to make climate priorities the management’s priorities.

Given the long-term nature of climate transition goals and the relatively short CEO tenure at U.S. companies, developing an incentive plan with a sufficiently long tail can be challenging. One institutional investor suggested, “The company needs to have a transition roadmap with clear management outcomes and milestones for 5, 10, 20, 30 years. This provides clarity for management to take actions today that will deliver longer-term targets long after their tenure. For the transition roadmap to be achievable, there should be milestones for a specific time period. The milestones can be converted into management inputs and expected outputs/outcomes that would lend itself to appropriate [incentive] targets.”

This can be particularly challenging given that typical performance periods for long-term incentive plans are three to five years. If executive incentives are used to drive climate resilience, compensation committees will need to put in place incentive plans that incorporate a company’s commitments long after the current management team retires. A shift in mindset may be required — it is equally important to deliver short- and mid-term results as it is to set up a legacy that will continue to support climate transition.

There is a spectrum of incentive practices ranging from the lowest to highest impact on the executive’s incentive outcomes. As companies become more comfortable embracing climate transition priorities, we expect to see more boards and management teams adopt climate and/or environmental and sustainability measures into the executive incentive framework.

Although this is a new and emerging area, there is a considerable opportunity for companies to lead the charge on climate resilience. It is important for companies to develop a good understanding of current GHG emissions associated with different scopes:

•               Scope 1: Direct emissions

•               Scope 2: Emissions attributable to energy source

•               Scope 3: Emissions associated with entire supply chain

Boards may set ambitious long-term goals, as well as realistic short- to medium-term transition plans.

Boards will need to deploy all tools at their disposal, including disclosures and incentives, to encourage efforts toward a climate-resilient future. Board members we have surveyed indicated they could use hard, unbiased, fact- and science-based information on climate-related risks and opportunities. This will allow them to make intelligent, informed decisions, identify tradeoffs for their companies and focus on tracking the right metrics. Boards find that discussions of trade-offs are more productive at the strategic level and recognize these discussions can be difficult when the priorities cascade down to middle managers, who often are held accountable for financial and operational results despite headwinds imposed by climate priorities. To be truly successful, climate priorities need to be part of the company’s sustainability strategy. Executive compensation can be an important tool to drive the company’s sustainability strategy and, indeed, balance the risk-reward profile.

Boards can play a pivotal role in slowing down climate change and the business community bears responsibility to reduce direct and indirect GHG emissions. Hard targets and alignment of executive compensation would help accelerate efforts toward these goals. As one director told us, “Business is going to be the main lever of change in this battle to curb climate change.” 

Don Delves is a Managing Director and Practice Leader for Executive Compensation, North America for Willis Towers Watson’s Rewards Line of Business. Shai Ganu is a Managing Director and Global Leader for Executive Compensation for Willis Towers Watson’s Rewards Line of Business. Michael Siu is a Director for Executive Compensation for Willis Towers Watson’s Rewards Line of Business.

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