Some phrases become part of popular culture in a way that defies rational explanation. When Tom Cruise’s last remaining client tells him to ‘Show me the money’ in Jerry Maguire, I doubt anyone expected it to become an enduring catchphrase. Somehow, it captured the essence of a modern, money-driven world.
I have been looking into the opaque world of environmental, social and governance (ESG) targets and executive compensation recently, and this phrase kept popping into my head. In my experience, financial incentives are very effective, but not always in the way that they are intended.
Metrics have to be carefully designed to minimise unintended consequences. One can argue that the global financial crisis was largely caused – or at least exacerbated – by badly designed incentives.
Variable pay is just one of the ways to burnish your environmental credentials
Rash claims?
Many companies now proudly trumpet that their executive compensation plans incorporate ESG metrics. Superficial analysis certainly backs this up. I have looked at about 30 companies in detail over the past 12 months, and most have 10-20% of their incentive plans with some sort of ESG linkage.
As with so many ESG issues, the detail is much less impressive than the headlines. There are many ways to burnish environmental credentials without falling foul of greenwashing rules; variable pay has become just another example.
You might think that it would be simple to analyse whether a company’s executives are incentivised to behave sustainably or not. In reality, it is amazingly complicated, even for an experienced analyst.
Competing goals
The first problem is the sheer complexity of a modern compensation plan. There will usually be a short-term incentive (typically one year) and a longer term one (typically three to five years). Both plans tend to have three to five individual goals, often with a cap on total payout. Wading through 20-odd pages of dense text is neither easy nor enjoyable, and I almost always find that some key information is missing.
Growth-based targets are often inherently environmentally unfriendly
The second problem is what you tend to find in the detail. The 80-90% that is not ESG related is usually based around some measure of growth; it might be sales growth, margin expansion, total shareholder return or performance versus peers. As I wrote recently, growth-based targets are often inherently environmentally unfriendly. If, say, a chemical industry executive can trigger 90% of their bonus by selling more virgin plastic at the expense of crimping the other 10%, then it seems pretty obvious to me that growth will seem more attractive.
When you look inside the ESG component, it often turns out to be a subjective assessment by the compensation committee. I have seen ‘targets’ such as developing an ESG strategy or improving sustainability.
There are plans where the CEO can trigger a maximum bonus while missing all the ESG targets
Where there are objective targets, they are usually based on reducing direct carbon emissions over the next few years. This is laudable but missing the point. Improving production efficiency almost always reduces carbon intensity. The executive is being rewarded for doing things that are simply good business practice with a three-to-four-year payback.
I have also seen plans where the overall incentive is capped, and the CEO can trigger a maximum bonus while totally missing all the ESG targets. This may be rare, but to me it’s just inherently wrong.
Scope 3 absent
The last problem is what is always missing. For most companies, Scope 3 emissions from suppliers and customers make up 80-90% of total greenhouse gas emissions. I have yet to see a plan that incorporates Scope 3 emissions, even when they are an inherent part of the supply chain. I have also yet to see a plan that goes beyond 2030, where most net-zero aspirations dissolve into fuzzy nonsense.
Incentivising executives to behave sustainably is a great idea. Someone should try it some day.
