A more holistic approach will be developed to link executive pay to climate-change metrics across the supply chain, says a new study by Dr Robert Ritz of Cambridge Judge Business School.
A central challenge in designing executive-pay plans linked to climate-change targets is whether to design incentives based only on a company’s own carbon emissions or to also include its supply chain.
A new study published in California Management Review by Dr Robert Ritz, Senior Research Associate in Economics & Policy and Assistant Director of the Energy Policy Research Group at Cambridge Judge Business School, suggests that a more “holistic” approach will become more attractive over time as emissions measurement improves across the supply chain.
“Unlike traditional metrics like TSR (total shareholder return), climate-linked incentives in the energy industry so far do not include evaluation against a peer group,” the study says. “As the practice becomes more widespread, the scope for relative performance evaluation will increase – to better reflect management contribution rather than pay for luck”.
Three principles identified for linking pay to climate targets
The study outlines how executive incentive tied to climate-change targets has become more widespread since the 2015 Paris Agreement to limit global warming, led by several high-profile energy companies such as oil giant Shell and mining company BHP.
The study – entitled “Linking executive compensation to climate performance” – then addresses the what, the why, and the how of linking executive pay to climate metrics.
Three principles identified in the paper for such linkage are:
- Align executive pay with corporate strategy and value creation over the long term.
- Use actionable performance measures that reflect the added value that management can bring to influence them.
- Balance incentives across multiple tasks and objectives that may compete, to prevent an excessive focus on a particular subset of tasks.
Beyond such broad principles, the study details how management incentives linked to climate metrics can be formulated in several different ways: narrowly to focus on individual business units or more broadly to cover the entire company; directly in terms of carbon emissions or indirectly in terms of the development of low-carbon businesses, products and technologies; and as a reduction in absolute emission levels or the emission intensity of a product or business.
Caution against non-linear design
The study cautions, however, against a non-linear design because this can distort management incentives. “Consider a sales target under which a manager receives a fixed bonus if the threshold is met at year-end and gets no bonus otherwise. Incentives to try hard are very weak if the target looks unattainable, very strong when the target is almost reached, and zero if the sales target is locked in before the year is over.”
While energy and mining may have led the way in linking executive pay to climate metrics, the issue will become increasingly acute for other energy-intensive industries such as airlines, steel and cement, the paper says.
“In a way that would have seemed surprising even five years ago, carbon emissions are emerging as a key performance indicator,” the paper concludes. “So far, the use of climate-linked incentives involves a degree of experimentation, and there will be scope for refinement over time. This is good business practice: see what works and then make adjustments so as to avoid unintended consequences.”