Executive Incentivization and Climate Governance

Executive compensation can be an effective governance tool and align management to the organization’s climate transition goals. Incentivization is one of the World Economic Forum’s guiding principles for effective climate governance, and this article outlines guidelines to implement this principle.

“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.”

Principle 6, How to Set Up Effective Climate Governance on Corporate Boards
World Economic Forum

Drivers for actions: Public sentiment, investor expectations, and the regulatory landscape

The momentum behind tying executive incentives to climate transition is propelled by public sentiment and investor expectations for companies to demonstrate their commitment to climate action through robust governance and management accountability. Executive incentives are recognized as an effective mechanism for creating accountability for actions using robust, measurable, and quantifiable targets for key climate transition objectives such as emissions reduction, to the extent it’s directly related to the business model and long-term strategy. In the United States, institutional investors generally follow a principles-based approach when it comes to the specifics of climate KPIs and incentive design, rather than being prescriptive on what exactly those goals should be, recognizing that incentive metrics should be company specific and strategically aligned—first and foremost.

Boards should be aware that regulatory pressure will continue to drive accountability in climate transition. The Corporate Sustainability Reporting Directive (CSRD) in the European Union (EU) will apply to US businesses with large European operations. Specifically, CSRD will require disclosures related to executive compensation, including these:

• Disclosure of whether and how sustainability-related performance metrics are considered as
  performance benchmarks or included in remuneration policies
• Disclosure of the proportion of variable remuneration dependent on sustainability-related
  targets and/or impacts
• Disclosure of whether and how climate-related considerations are factored into the
  remuneration of members of the administrative, management, and supervisory bodies

Connecting executive compensation to climate transition goals

WTW’s research covering more than 1,100 companies in more than 15 countries and markets showed continued support in the use of ESG metrics in executive incentive plans, including in the United States. The prevalence of companies who included environmental and climate metrics across the S&P 500 almost quadrupled between 2020 and 2023, rising from 12 percent to 44 percent. Among these companies with environmental and climate metrics are all 23 energy companies and 97 percent of the 30 utilities companies in the S&P 500. Within the environmental and climate category, the most common metrics used in the United States were carbon emission reduction, energy consumption/transition, and other environmental sustainability goals. According to WTW’s 2023 survey findings, in the United States, ESG metrics are primarily used in short-term incentive (STI) plans with long-term incentive (LTI) plans tripling since 2019 yet only appearing in 10 percent of the US market. While STIs can allow for more flexibility in navigating unknown territory, LTIs can help organizations remain accountable to their climate and sustainability goals, especially for organizations with ESG embedded in their strategy.

The decisions on whether and how climate priorities are incorporated into executive incentive plans should lead with integration to business strategy and how climate fits into the enterprise risk and opportunities framework. However, one challenge facing many organizations is the quality of the metrics used to measure accountability and action against climate objectives. Metrics can be measured either quantitatively through numerical values (absolute amount, percentage growths) or qualitatively through a judgment-based process (“improve x" or "develop y”). In the United States, qualitative metrics of ESG performance is considered the norm regarding STI payout while two-thirds measure ESG quantitatively in their LTI plans. No matter the preferred method in tracking performance metrics, across all markets, the most common approaches in tying ESG metrics into incentive plans is through KPIs, or less commonly, through modifiers and underpins.

The compensation committee has a critical role to play to ensure the effective design of these metrics; and, in doing so, should keep in mind five principles when evaluating any incentive metrics related to climate and sustainability priorities:

1. Materiality: Select metrics that are material to the business, i.e., those that contribute to long-term value creation and systemic risk mitigation. Metrics should also be material to the incentive plan participant to drive behaviors.
2.  Measurability: Use metrics that can be reliability measured, quantified, and scaled, potentially allowing for independent audit of performance achievement. Consistency also allows for comparison across peers and industries and over time.
3. Breadth: Take a strategic and rounded approach to climate performance and measurement—as it relates to the business—instead of simply defaulting to carbon emission reduction, which may not be appropriate for all sectors. Some alternatives include goals relating to industrial or commercial milestones, adoption of renewable energy and limiting energy consumption, investment or innovation that supports climate solutions, or engagement with counterparties to steward their climate transition.
4. Comparability: Where possible and relevant, define metrics using standardized and widely adopted methodologies so that they can be benchmarked against industry peers.
5. Clarity: Ensure that climate incentives are accompanied by robust disclosure on metrics and targets to provide clarity, transparency, and consistency. It is important that shareholders and other stakeholders understand how interim goals within climate incentives are connected to the organization’s long-term climate ambition through disclosure. Ongoing engagement with shareholders and stakeholders is essential.

Questions for Boards to Consider

As boards oversee the management of climate risks and consider the use of climate incentives in executive compensation, here are a few important questions to consider:

• Are management and the board aligned on how climate risks are managed and the organization’s climate transition strategy?

• Do management and the board have a shared understanding of how the sustainability goals are integral to the company’s short-term and long-term strategy?

• Does the organization have confidence in its ability to measure scopes 1, 2, and 3 emissions reliably?

• Can the organization translate its long-term climate transition objectives to meaningful interim goals to be measured in a short-term (annual) and mid-term (three to five years) horizon?

• Can the organization confidently disclose how short- and mid-term goals are set to show investors and other stakeholders that these goals are challenging and connected to sustainable, long-term value creation?

• What is the appropriate balance between financial and nonfinancial metrics in executive incentives, and how does climate transition fit into the overall category of nonfinancial metrics material to the business?

• How are other industry players incorporating climate incentives into executive compensation?

• Does the board have a well-defined process in place to refine and evolve executive compensation design over time?

• Can sustainability performance metrics be included in the compensation plans for the C-suite and the level of management directly below it?

• What methods does the board use to link ESG metrics to executive compensation?

The World Economic Forum (WEF) has developed a set of 8 principles to enable directors to embed climate considerations into board decision-making and risk and opportunity oversight. This article is part of the 2024 series that adapts those principles for the US context. Click here to learn more about NACD resources for effective climate governance.