28 Sep. 2017 | Comments (0)
As the dust settles on the 2017 proxy season, shareholders have once again ratcheted up their demands for broader corporate accountability. One of those demands is for more corporate commitment on sustainability: top institutional investors have spoken out forcefully. Outside shareholders have filed an increasing number of shareholder proposals—and those proposals have gained much more support than in the past.
With the pressure mounting, is it time for sustainability metrics to make their way into executive incentives? We believe that the answer is, yes, particularly for those companies with the most to gain from sustainability and for those facing the most downside risk.
Companies have actually been moving in this direction for some time. Five years ago, for example, in the wake of the financial crisis, a large global consumer products company made a bold commitment: to eliminate all greenhouse gas emissions from its plant operations within 25 years. This wasn’t a do-gooder move. Management wanted to create economic value through direct energy savings and by building a stronger brand revered by owners, employees and consumers.
Big commitments always require bold measures to make them happen. With that recognition, the company’s board and management team sought to link compensation at the senior-most levels with metrics for progress. For several years now, senior leaders have been tied to milestone-based measures – steps along that 25-year path – in their longer-term incentive program. The incentive provided the necessary teeth to carry the commitment forward by focusing attention and ensuring appropriate effort and resources were put against this industry-leading initiative.
To date, the company’s progress is far ahead of schedule, and its philosophy of operating concurrently in the interests of corporate value and environmental and societal good has become almost universally recognized as a pressing global priority. At the end of 2015, over 190 U.N. member countries supported a resolution to quickly tackle climate change (as well as poverty and inequality). The Paris Climate Agreement followed in 2016.
The business community, of course, has arguably the biggest role to play in sustainability. As evidence of that sentiment, an Economist survey of 853 senior executives globally found a large majority believed that business was an important player in addressing sustainability and helping determine whether global sustainability goals could be achieved.
Why is now the time for sustainability to get top-tier placement in executive incentives?
- Beyond a company’s social responsibility to act, a strong business case can be made that addressing sustainability creates value for shareholders.
- Shareholders are increasingly recognizing this business case and are pressing companies to support sustainability.
- Boards are starting to recognize that pay programs can help drive accountability for sustainability progress, as well as to send a clear signal to all stakeholders that they are taking the issue seriously. Recent research shows that when compensation has been used this way, it has been effective.
The business case is broad and deep, if not always easy to measure:
- Improved profitability. Over 60 percent of respondents in a recent McKinsey survey indicated that sustainability efforts have significantly reduced both energy use in operations (64 percent ) and waste (63 percent).
- Stronger reputations/brands. Roughly one-third of respondents in the McKinsey survey reported reputation as one of the top two reasons for adopting sustainability initiatives. Given the real-time sharing of customer opinions on social media, one can expect the focus on reputation to grow.
- New market opportunities. Sixty-three percent of CEOs surveyed in a UN Global Compact-Accenture study expected sustainability to transform their industries within five years. Sustainability cannot only be about limiting downside risk; it must also be about tapping upside, commercial opportunity as companies transform to more profitable enterprises.
- Enhanced employee affiliation, and attraction/ retention of talent. Sustainable operating practices are considered imperative by younger generations in today's workforce, and companies that cling to outdated models will lose out on top talent.
- Increasing political capital with regulators and governments. Getting ahead of the curve instead of "reacting and responding" is increasingly paying off in the court of public and political opinion.
A review of over 2,000 studies of the relationship between sustainability and corporate financial performance found a large majority identified a positive relationship between sustainability and corporate financial performance. Of note, a recent study of the world's 500 largest companies found strong sustainability performance correlated highly with premium market valuations, above-market growth rates, and below-market costs of capital. A 2017 report by the Bank of America found that sustainability was the best signal of future earnings volatility.
Although every company faces different risks and opportunities, leading institutional investors, including BlackRock and Vanguard, are pressing hard for companies to address sustainability. In his annual letter, Larry Fink, the CEO of BlackRock, stated: “Environmental, social, and governance (ESG) factors relevant to a company’s business can provide essential insights into management effectiveness and thus a company’s long-term prospects. We look to see that a company is attuned to the key factors that contribute to long-term growth: sustainability of the business model and its operations, attention to external and environmental factors that could impact the company, and recognition of the company’s role as a member of the communities in which it operates.”
There is also growing support for sustainability among all shareholders. To date in 2017, Semler Brossy has identified approximately 200 shareholder proposals on the environment among the Russell 3000 companies. And also to date this year, investor support for environmental proposals has reached a new high, averaging nearly 30 percent. Four environmentally-oriented investor proposals have received majority support in 2017 – that’s more than in the previous six years combined. For 35 other proposals related to other aspects of sustainability, the average support was approximately 13 percent.
How does compensation fit into the discussion of sustainability? Just as it does other corporate goals: It focuses attention, enforces accountability, and drives behaviors that deliver progress on key measures, thereby playing a significant role in sustainability performance. Academic research conducted over the past 10 years confirms this correlation. For example, the following three studies looked at German, U.S., and Canadian firms:
- A 2016 paper published by Velte in the journal Problems and Perspectives in Management found that the inclusion of social and environmental metrics positively influenced sustainability performance in German firms.
- A 2015 Harvard Business School Working Paper by Hong, Li, and Minor determined that providing executives with direct incentives for sustainability was an effective tool to increase firm social performance.
- A 2006 paper published in the Journal of Business Ethics studied Canadian firms and found that executive compensation is an effective tool in aligning executives’ financial welfare with that of the “common good,” which results in a more socially responsible firm.
So, when should a company consider including sustainability metrics in executive incentives? It depends on the upside opportunities of inclusion and downside risks of not doing so. The evidence suggests that companies and boards should review their individual cases with consideration for the following: market opportunities; profitability implications; employee affiliation; reputational risk; and political capital. With a full understanding of the strategic importance of sustainability, the question then is to what degree, if any, should sustainability appear in the performance measurement and incentive system?
At companies today, sustainability measures range from a core nonfinancial metric (vying with financial measures in importance) to more of a discretionary, “do no harm” modifier for catastrophic events like BP's Deepwater Horizon disaster. In such dire cases, the modifier can adjust pay downward—even to zero.
How prevalent are sustainability metrics today among the S&P 500? In our research of the S&P 500, less than 10 percent of companies use sustainability metrics explicitly, either in formulaic or discretionary portions of incentives. Others likely use it subjectively without disclosing.
And what metrics are companies starting to use? The most common, albeit longstanding for some companies, is safety. About 5 percent of the S&P 500 include safety metrics in incentives. Other common measures include environmental (2 percent) and diversity (2.6 percent). The industries with the biggest commitment to the measures—25 percent of companies—are energy and utilities. The focus in these sectors, not surprisingly, is on environmental, safety, and health.
The picture of future incentive pay practices related to sustainability remains incomplete. Yet the evidence to date points to a trend of sustainability incentives becoming more pervasive. If history is any guide, more issues will emerge on the menu of items concerning investors—from climate change to human rights to community health. Responding to this trend will not only be an imperative to compete—for customers, employees, and capital—but for positioning a company as a world leader with the power to set the policy agenda for the future.
The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.
 “The Road From Principles to Practice: Today’s Challenges for Businesses in Respecting Rights,” The Economist Intelligence Unit, 2015.