Tying CEO pay to carbon emissions works. More companies should try it

Opinion by Friso Van der Oord for CNN Business Perspectives

Despite decades of reform efforts by regulators, shareholders and the independent director community, CEO pay continues to grow inexorably, far outpacing any gains to workers’ pay.

Since 1993, the National Association of Corporate Directors (NACD) has said that CEO pay should be more in line with what other employees receive. Boards, we have said, should not approve pay plan elements that result in unexpectedly high compensation, such as mega stock-option awards, and plans should be expressed simply, so that shareholders know what to expect when targets are met and pay is reported.

But despite our admonitions, today’s typical CEO pay packages (the ones shareholders vote up or down as they have their “say on pay” each spring) are long documents full of initialisms justifying pay that can rise as high as hundreds of millions of dollars per year.

The situation is unfortunate, but it tends to be ignored as the world faces other serious problems, including our warming planet and subsequent climate change. Here, too, NACD aims to be part of the solution to promote “climate governance” — principles and practices that boards can adopt to respond to climate risk and help their companies transition to a net zero economy. But so far, we are not yet seeing much progress in the form of transformative, climate-oriented board approaches.

We believe that a joint solution to both problems is hiding in plain sight. Instead of following practices known to inflate pay, such as overly generous golden parachutes or “evergreen” provisions in contracts that automatically renew certain types of payments without regard to CEO performance, boards can start linking CEO pay to reductions in the carbon emissions that are at the root of climate change.

As the saying goes, “what gets measured, gets managed,” and this is especially true when it comes to the metrics of pay plans. If CEOs are paid more for decarbonizing their operations, they are more likely to focus on such matters. Besides, climate fluency can be a performance enhancer. Tying executive compensation to reduced carbon emissions could very well boost CEO pay in well-managed firms, while depressing it in firms that ignore climate risk.

Decarbonizing companies will also attract more capital than companies that maintain the status quo. A March 2021 study by MSCI showed that while share prices are slow to respond to carbon reduction, they eventually do respond, and the results are positive.

Leading firms have already begun building concrete climate performance metrics into their CEO pay design. Shell Oil made a pioneering move when it announced in 2018 that it would establish carbon emissions targets for periods of three to five years, tie executive pay to hitting those targets, and would aim to reduce emissions from customers’ use of Shell products, as well as the company’s own operational emissions.

Murphy Oil Corp.’s 2021 proxy statement disclosed that the board’s compensation committee will be adding a greenhouse gas reduction metric to the safety and spill rate components of the company’s annual incentive plan.

In a 2020 sustainability report, Valero Energy Corp. said that it had a “strategic” element to its bonuses for all employees that included Environmental, Social and Governance (ESG) efforts. The company defines various components of ESG, including renewable fuels, greenhouse gas emissions, energy efficiency and climate risk. These same ESG measures are part of the annual incentive bonus for the CEO, according to its 2021 proxy statement. This can make a difference: The bonus is 18% of the CEO’s $16 million total pay target.

It’s not just energy companies that are doing this. Ralph Lauren has named climate a “strategic goal modifier” in its short-term incentive plan for fiscal year 2022. And Clorox has tied executive compensation to the achievement of ESG goals, according to its 2020 integrated annual report.

In light of such examples, boards may want to consider including extra rewards for companies that reduce their carbon footprint; for companies that are included on a climate index (such as MSCI indices); for companies that transition to a low-carbon economy — such as phasing out fossil-fuel powered vehicles for electric vehicles in a company fleet; and for companies that report strategic, operational, financial and other metrics tied to climate.

We at NACD hope that such practices become universal. Boards can no longer rely on the excuse that climate performance is hard to quantify or that generally accepted metrics are lacking.

Climate measures can be bold, with stretch goals similar to financial goals, and they can demonstrate the real impact of doing good (vs. doing no harm). And boards can become more comfortable about penalizing CEOs for underperformance here — not just about being generous on the upside.

This is where CEO pay will start to show the force of gravity and align more closely with their employees’ pay. It can also help align pay with shareholder returns. We call upon our members and our colleagues abroad through our affiliations with the Global Network of Director Institutes and the Climate Governance Initiative to consider strengthening the connection between executive compensation and climate stewardship.

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