Executive Compensation: “we’ve had the carrot, is it time for the stick...?”
Over the last few years, ‘ESG’ has become a hot topic within business. With increasing public pressure and regulations companies continue to look for improvements in sustainability (E), social fairness (S) and good governance (G). In turn, to reflect this shift in priorities, remuneration committees have integrated ESG targets into executive incentive plans. In 2022, over 90% of FTSE 100 have ESG performance measures in one of their incentive plans and over 50% of companies include carbon emissions reduction metrics.
Has this been effective? The answer is hard to determine. Transparency around sustainability has been a matter of debate with concerns around greenwashing and misleading targets. Despite recent progress, we’re still behind target. For example, Diageo have been trying to halve their value chain carbon emissions by 2030, yet saw an increase of 4.7% in kilotons of CO2 emissions in 2022. Additionally, Unilever, who are trying to halve the greenhouse gas (GHG) impact of their products across the lifecycle by 2030, have only reduced 19% in 12 years, which puts them behind schedule. These are simply examples, and don’t necessarily represent the entire UK economy, but they do point to some underperformance. The UN suggests the 1.5C limit set out by the Paris Agreement is already out of the window and the UK is far behind its 2030 NDC targets in terms of GHG emissions.
So, what is the issue here? Yes, lack of transparency is one problem but is there a lack of motivation? A PwC report found a rift between CEO and investor outlooks on climate action. Results suggested that CEOs saw climate change as a less urgent issue compared with investors. They assume this is because investors are more concerned about the business impact of climate change – in terms of financial risk and opportunities. If this is the case, then recent ESG performance measures might not be doing an adequate job. Looking across the FTSE 100 companies with ESG measures in their plans, the median weighting is 10%. In cases where the ESG performance measures are in the annual bonus plan, this will likely equate to 5% of remuneration received or less. It’s very possible that the carrot isn’t big enough. Why would executives prioritise this minority target at the expense of their financial targets such as profit, cash or shareholder return etc, which hold weightings closer to 80% of their bonus plan. One way to address this might to dangle a bigger carrot by increasing the weighting – or even consider the possibility of negative leverage being incorporated into executive compensation.
A paper published in the US National Library of Medicine looked at the effectiveness of positively and negatively framed incentives using a sample of undergraduate students and working adults. They found that individuals were more motivated when an incentive was framed to avoid a loss compared with the same incentive framed to accrue a gain. A known scenario used to illustrate this would be: if a £20 note falls out of your pocket, it hurts more than the happiness one might feel if you found a £20 note on the ground. To take one step further, a study presented the opportunity to win $150 or lose $100 with equal probability and found that many people chose to avoid taking the risk - losing $100 was too great - even though, in reality, the expected return in this case outweighed the cost. Perhaps this is what we’re missing when it comes to non-financial executive compensation; a stick to complement the carrot, enabling a better control of incentives. Bringing this back to executive compensation, rather than make executives bleed for a lack of progress in climate efforts, perhaps the opportunity to enhance incentive design would be more effective. One suggestion is using negative framing as a useful tool to drive the effectiveness of incentives.
How would this work in practice? The most realistic idea would be the use of an ESG multiplier. This is essentially a separate incentive plan consisting of exclusively ESG targets with an outcome which is, let’s say, a value of between 0.75x and 1.25x. This would then be applied to an annual bonus plan or long-term incentive plan (‘LTIP’), which would be based on standard metrics (profit, revenue, total shareholder return, etc.). This offers both carrot and stick as extraordinary performance is rewarded with a bigger pay-out, whilst not diluting important financial performance measures. By framing it as a multiplier, it offers a negatively framed incentive as executives don’t want the multiplier to diminish their financial performance opportunity. This could even be further hammered home if the executive is shown a comparison illustrating what the multiplier has deducted.
The idea of a multiplier isn’t new in incentive design - particularly amongst mining companies. For example, FTSE250 mining company, Polymetal International set out a health and safety multiplier which is applied to their 2022 annual bonus plan, based on actual safety outcomes. Ranging from maximum to minimum, this plan offers a 1.2x to 0.5x multiplier. In 2022, they paid out 1.2x as they encountered zero casualties and zero fatalities.
In theory it makes sense, but it would be unrealistic to assume that there would be no unforeseen consequences. So, speculating through a few potential issues:
Firstly, the balance between these non-financial metrics against traditional financial metrics. The main reason why a multiplier would work in the first place is that it reflects the true importance of these ESG areas on the performance and profitability of the business. However, this could lead to an over prioritization of non-financial issues at the expense of fundamental financial performance. This would require the remuneration committee to find the balance between tackling long-term obstacles and maintaining short-term performance. However, as it stands, longer term priorities remain under-prioritised.
Another potential area for consideration is the importance of target setting. This is where the lack of transparency in sustainability reporting, touched upon at the beginning, comes into focus. If we are unable to determine whether these targets are adequate or have been achieved, the target itself loses credibility. Executives shouldn’t be paid more for achieving targets which aren’t stretching. Target setting is also important as it needs to enable the negativity bias. Ordinarily, the rule of thumb is 25% of maximum for threshold performance and 50% for target performance. However, these are for positively framed incentives. A 1x performance for the multiplier should be treated as the bare minimum, where executives are chasing this performance rather than settling for a smaller carrot. If the bare minimum target was defined as being on target for 2030 halving GHG emissions, executive would experience loss aversion and chase target performance. On the flip side, extraordinary performance would be rewarded in kind.
Lastly, it’s important to look at the potential effect on the talent market for executives. Whilst this ESG multiplier might better align incentives with the shareholders’ interests, it raises the bar for executives in terms of expected sustainability. In a market where top executives are in high demand; the concept that despite delivering good financials you could still be paid less is possible. This is hard to know until tried – but could equally have the opposite effect.
If you’re still reading this far, I’m glad the use of ‘stick’ and ‘leverage’ hasn’t scared you off. I do believe as we are approaching 2030, there is the opportunity to enhance executive incentive design. Executive compensation currently works by trying to offer a bigger and bigger carrot to the executive to pull them towards a decision which I feel is the equivalent to having one hand tied behind your back. Negative bias is nothing new in behavioural economics and so I feel it at least deserves a conversation in respect to executive compensation. However, if we were to try to integrate this into incentive plans, we would need to fix the issues with inadequate sustainability reporting. This requires establishing standard environmental industry targets and having greater transparency when it comes to individual performance of these targets.