As executive compensation returns to pre-COVID-19 levels and the pay gap between CEOs and employees widens, business leaders are under pressure to design financial incentives that reflect companies’ broader societal responsibilities while creating long-term value for investors and other stakeholders.
Executive compensation plans have typically encouraged short-term profit maximization over ESG considerations. According to SemlerBrossy, 70% of S&P 500 businesses included ESG goals in their CEO incentive plans last year, up from 57% in 2021.
Such companies must combine profitability and sustainability. Even though inactivity is more expensive, cutting greenhouse gas emissions may raise expenses and slow growth in the short run.
Companies owe shareholders and others fiduciary duties. How many terrible quarters before investors and the board fire a CEO? Emmanuel Faber’s death illustrates the dangers.Faber “toppled the statue” of Milton Friedman, a free-market economist, by changing the company’s legal standing to reflect its social mission. Nine months later, Danone’s investors criticized Faber’s poor share performance.
Keeping investors satisfied discourages top executives from investing in long-term social issues. They’re drawn in many directions. Other stakeholders—customers, staff, regulators—pressure many organizations to consider more than profit.
Executive compensation strongly influences executive behavior, therefore a more balanced mix of targets, incentives, and accountability structures would help organizations improve investor and social outcomes.Reward Value, a non-profit, presented three ethical remuneration principles at the World Economic Forum this year.
Performance benchmark
Financial performance determines executive remuneration. Companies should consider long-term stakeholder value in their performance targets.
Long-Term Investor Value Appropriation (LIVA) uses share price data to calculate shareholder value creation or destruction.
LIVA shows cash returns from share price appreciation, buybacks, and dividends, minus the opportunity cost of investing in a company.If you invested $10,000 in Apple shares in 1984 when it released the Mac, you would be $3.8 million richer today.Apple’s LIVA is $3.8 million.
Without accurate data, measuring non-financial performance is difficult.Impact Weighted Accounts (IWA) can value a company’s social impact, such as carbon emissions. This simplifies financial-nonfinancial comparisons. IWA and LIVA can measure long-term stakeholder value creation.
Pay-for-performance
KPIs relevant to the enterprise, such as an airline’s environmental impact or a mining company’s worker safety, can assist embed such performance data into CEO pay plans.The C-suite is financially motivated to safeguard stakeholders.
The compensation model must contain fixed annual salary and a longer-term incentive.Executives must meet “absolute goals” to receive bonuses in most compensation packages. These goals usually last a year. Even when bonuses are based on peer company success, the typical time horizon is three years.
Short-term compensation plans often allow executives to “game” their pay, hurting shareholders.To maintain cash flow targets until their incentive, executives may delay payments or R&D investments.
The former Bank of England governor Mark Carney called the climate situation a “tragedy of the horizon,” and short-term ambitions may conflict with long-term goals to address it. Global warming’s impacts are beyond most leaders’ time horizons.
Extending bonus vesting beyond the executive’s tenure can combat short-termism. Post-crisis regulation made elite bankers do this, but not others. Change that to compensate leaders for long-term value generation instead of annual performance benchmarks.
Greener pay plans
Corporate governance is needed to implement these new targets.Consider how involved stakeholders should be. ESG issues should be included in compensation plans, upheld, and defended by remuneration committees.That may also prevent executives from using their influence to have their chosen candidates on remuneration panels.
Another difficult topic is whether to include a “clawback” clause, which can be used to recoup pay or suspend future payments in the event of a serious social or environmental concern. In an age of greenwashing, such a provision is crucial.
Finally, although climate issues dominate ESG considerations, corporations should explore how CEO pay might advance equity goals.
Executive pay increased last year because to bonuses for reduced pandemic targets. But that seems to contradict the premise that companies should improve society. Remember the boss-worker compensation ratio. Deloitte reported the FTSE 100 ratio increased to 1:81 last year from 1:59 in 2020.Companies seeking pay equality must prevent the gap from widening.
