We get what we pay for. Nowhere does this have graver consequences than in the case of climate change. But while the importance of linking pay to climate performance is widely appreciated, current efforts are grossly inadequate.
This is because they normally apply to a small part of an overall pay package, say 10% of a long-term incentive plan. This amounts to air-brushing – a pay package that suggests climate-alignment but continues to reward climate destruction.
Even the 10% may be tokenistic, focusing on a narrow element of net-zero alignment rather than on shifting all business activity to a net-zero pathway. Reducing an auto manufacturer’s production emissions is positive but what matters is that the cars produced are carbon-neutral.
Last year HSBC committed to aligning all its financing with a net-zero outcome by 2050. Given HSBC has deployed an estimated $110bn to fossil-fuel-related activities since the 2015 Paris Climate Agreement, a move to decarbonise its financing would matter.
However, despite climate metrics appearing in HSBC’s CEO incentive scheme, pay is still driven primarily by earnings, reallocation of capital to Asia and shareholder returns. Where climate metrics are included, only 12.5% relates to implementing and developing green financing.
Critically, the pay scheme does not have a target for reducing carbon-intensive financing, so earnings based on financing carbon-heavy industry, transport or agriculture are likely to be rewarded rather than sanctioned.
This picture is repeated elsewhere across the banking sector and beyond, posing risks to the planet and the resilience of businesses. A recent stress test for the Euro area’s systematically important banks by the European Central Bank suggests 35% of bank loans are exposed to transition risks. The dangers of broader macro-economic harm are clear.
Net-zero underpins can provide a rapid stop-gap
With immediate effect, companies should introduce a net-zero underpin for senior executives’ bonus and long-term incentive schemes.
The concept of an underpin is well-established, normally as a condition that must be met before any performance-related pay is paid. A net-zero underpin would set a minimum net-zero alignment requirement before bonuses or long-term incentives could be awarded.
In listed companies, remuneration committees have the authority and the responsibility to make this assessment. They would affirm in their annual report that discretionary pay met the net-zero test, with supporting evidence. Shareholders, in turn, would hold remuneration committee directors accountable through their AGM votes.
This approach would prevent executives facing contradictory incentives. It would also reinforce the requirement that boards define net-zero strategies in clear terms and ensure pay is aligned with them.
Re-wiring company incentives for the long term
A more powerful lever to stop rewarding climate harm is to ensure performance numbers on which executive remuneration is based properly incorporate climate costs. Today they do not.
This is because the key performance indicators – metrics like earnings per share, cash flow or leverage – normally come from companies’ financial statements, which usually omit the costs of climate change and energy transition.
Pay based on flawed numbers will be misdirected. For example, a coal-fired power company’s accounts that ignore the need to phase out coal by 2030 will continue to project cash flows and asset lives to a later date. This assumption reduces its annual depreciation charges on these assets and pushes up reported profits.
Similarly, clean-up costs and asset retirement obligations will be pushed out to the distant future, with liabilities reported on the balance sheet diminished in present value terms. Carbon taxes, carbon capture and storage costs could be omitted completely.
Our power company will report a healthier capital position and level of profitability than if its accounts reflected the true costs of decarbonisation. Its executives are more likely to receive higher bonuses and will be encouraged to grow their business.
The danger of accounting misrepresentation affects any company that produces carbon emissions. If emissions are not costed and energy transition is ignored in company accounts, there are risks of misguided incentives.
Learn from mistakes
The danger of misleading accounting and incentives is not new. Accounting numbers drive decision-making: if the numbers are wrong, so too will be capital allocation.
The parallels with the 2008 financial crisis should cause us all to sit up. When executives are rewarded for illusory profits, the costs are ultimately born by the public.
This time around, misdirected incentives are fuelling a fire that we may not be able to contain. Implementing pay clawbacks, whereby executives repay ill-founded bonuses, will not correct irreversible damage. If there was ever a case for re-setting executive remuneration based on prudent accounting, surely this is it.
