To Harvest Green Business, Feed Eco Incentives to the Decision Makers

Incentive-based pay isn’t new; it’s been around for centuries. Ship captains transporting prisoners from England to Australia were once rewarded, not on passenger counts, but on how many survived the journey. Nowadays with major companies, it’s usually linked to financial performance. But unless companies begin to connect compensation to sustainable environmental and social performance, they will continue to sacrifice long-term value creation and competitiveness for short-term, unsustainable gains.

So argued Andrea Moffat recently. She was also involved in the creation of The CERES Roadmap For Sustainability 2010, a comprehensive summary of the changes companies should put into effect by 2020, when involvement in sustainability will be an even more important factor for competitiveness than it is today.

This article deals with remuneration for environmental performance. Do CEOs get a financial reward if their companies take a step toward becoming green? If so, in which companies? On the basis of which indicators? When employees increase their companies’ energy efficiencies and help reduce emissions, are compensation structures effective in rewarding them? What studies are there and which conclusions did their authors draw?

Far From Best Practice

Companies that increase their environmental performance are good for the environment; that goes without saying. But this improvement also brings crucial benefits to the company itself – a view increasingly popular among business makers. In order to increase awareness of this performance advantage, and of the performance itself, the instrument of remuneration is gaining in popularity. Apart from environmental benefits, remuneration incentives lead to improvements in corporate decision making, better and less time consuming shareholder relations, better risk management and, above all, employees that focus on the long-term success of the company. This is what the Eurosif theme report Remuneration states. At the same time, it says a “significant gap [between] best and current practice” continues to exist.

Current Remuneration Not Effective

One argument against environmental performance based remuneration for CEOs is its lack of impact. Empirically, there is no notable difference in environmental performance – be there, or be there not, compensation. This is the conclusion reached by Andrew Williams, who cited an American study in a two-year-old BusinessGreen article. The study concludes a failure of effectiveness, because compensation for achieving environmental indicator goals is often only symbolic:

[A] 2009 research paper written by academics at IESE Business School and Arizona State University found that in general, “firms with an explicit environmental pay policy and an environmental committee do not reward environmental strategies more than those without such structures, suggesting that these mechanisms often play a merely symbolic role”.

Pollution Prevention Possible Through Long-Term Pay

However, looking closely at the study itself, we find support for three other hypotheses that all deal with the correlation of executive pay and environmental performance:

Relying on institutional theory, agency rationale, and environmental management research, we hypothesize that, in polluting industries, good environmental performance increases CEO pay; that environmental governance mechanisms strengthen this linkage; that pollution prevention strategies affect executive compensation more than end-of-pipe pollution control; and that long-term pay increases pollution prevention success. Using longitudinal data on 469 U.S. firms, we found support for three hypotheses.

Internal Compensation or External Auditing?

As a possible alternative to compensation, the authors proposed auditing in order to increase manager motivation. This is what the study showed, according to a summary by Pam Laughland:

Rewarding managers for environmental performance can motivate them to undertake environmental initiatives. However, holding CEOs accountable for environmental performance may be better achieved through tools like external audits (especially if environmental committees are only symbolic).

Remuneration Pioneers: Xcel, Alcoa, National Grid

We can say that, in practice, environmental performance related compensation is not as effective as we would like it to be. How come? Well, a likely issue is that, even if there is a certain type of compensation, it may not be large enough. Short-sighted remuneration mechanisms, such as quarterly dividends, can easily outweigh a low level of compensation for environmental performance. In order to resolve this, there has to be an instrument that guarantees the long-term success of environmental policies. Some pioneer companies translate this thinking into action, providing their CEOs with long-term goals, like Xcel Energy:

[O]ne-third of the CEO’s annual bonus is tied to environmental performance, as measured by renewable energy, emission reduction, energy efficiency, and clean technology. Environmental sustainability is also taken into account in long-term incentive awards, as 25 percent of restricted stock units granted have a performance-based vesting schedule related to Xcel’s position as a leader in environmental conservation.

The Role of Environmental Sustainability in Executive Compensation, a Forbes blog article from April 2011, provides us with information about some companies that realize remuneration measures for environmental action (like Xcel, mentioned in the paragraph above). The article highlights two more companies: Alcoa Inc, a major aluminum producer; and Dean Foods. Alcoa has concrete environmental goals that affect up for 20% of the CEO’s bonus:

With 80 percent of the bonus plan tied to traditional financial metrics, 20 percent is reserved for non-financial goals including safety, diversity, and environmental health, as indicated by reducing CO2 emissions by 400,000 tons in 2010 (weighted 5 percent).

Whereas Dean Foods only calls one EO to account:

The Chief Supply Chain Officer is measured on the basis of saving water, improving energy efficiency, and reducing waste output in the supply chain.  With the aid of such goals, Dean Foods has cut water use by 5.6 percent over the last year, and has reduced greenhouse gas emissions by 6 percent over the last three years.

Good Practices: Danone, Intel, SCA Hygiene

Andrea Moffat, Greenbiz.com guest author, also mentioned Intel and Danone. These big players reward their CEOs for achieving environmental performance goals, but precise information on their remuneration schemes is not made public. The same applies to SCA Hygiene, Sweden, which received the German Energy Agency (dena) Efficiency Award 2011, and for National Grid, USA. However, Mindy Lubber, in her article Tying Compensation & CSR-Performance, also for greenbiz.com, found noteworthy emission reduction goals:

National Grid has tied CEO and other executive compensation to performance on the company’s greenhouse gas (GHG) reduction goals. But what’s most interesting here is how aggressive those goals are: an 80 percent reduction by 2050, with 45 percent by 2020. That’s a lot of executive pay at stake — and this from a major electric power utility.

“Mainstream Eco Compensation” in 29 Percent of European Companies…

There is a report which concludes that not only individual pioneers, but also a large number of Europe’s biggest companies (those listed in the FTSE Eurofirst 300 index) are committed to including environmental, social and governance (ESG) performance in remuneration. Almost one third – 86 companies or 29% – link ESG to remuneration, according to Eurosif’s Remuneration theme report already mentioned in the third paragraph. However, ESG measures lack clear definition. Ranging from customer satisfaction to risk management, what companies define as ESG commitment is disappointingly vague:

For example one multi-utility company links their executive remuneration with performance around employee and customer satisfaction whilst a power generator has set performance on climate change issues as one of the parameters for determining directors’ variable pay. Approximately half of the companies that link remuneration to ESG issues do not clarify which ESG areas are linked to the remuneration.

Referring to this issue, Eurosif called for a clarifying effort by stating that “ESG targets should be quantified, time-bounded, verifiable and stretching”.

… And in Ten Percent of the American Ones

Another source (The Role of Environmental Sustainability in Executive Compensation, a Forbes blog article from April 2011) reported a tenth of the biggest American companies rewarding their employees. Ten percent of the S&P 100 factor “environmental issues into their incentive compensation plans, either as strategic objectives or quantifiable goals”, according to Robin Ferracone.

However, as mentioned above, the goals are vague. Andrea Moffat drew a negative conclusion concerning sustainability:

Although a growing number of U.S. companies are integrating ESG factors in their governance structures – through board oversight, dedicated committees or by hiring key managers with environmental and social performance roles – relatively few are directly linking sustainability performance and compensation.

Her call for a “new set of incentives” is correct:

In a world of mounting economic risk from climate change, water scarcity, poor labor conditions and other environmental and social threats, it’s time for a new set of incentives.

It is not only time for a set of environment related incentives, but also for a set that is truly challenging and truly effective, one that gets to the core of sustainability: an orientation to the long-term.

Further Reading

• Berrone, Pascual, & Gomez-Mejia, Luis. (2009). Environmental performance and executive compensation: An integrated agency-institutional perspective. Academy of Management Journal, 52(1): 103-126. Read-only version available online.
• CERES Roadmap For Sustainability 2010
• Remuneration: Eurosif theme report

Article image by 401K.