The penny still has not dropped. Our current pay structures – even with tweaks for climate factors – are rewarding climate harm and this needs to stop.
As long as this is true, no amount of cajoling, grand ambitions, or Task Forces on Climate-Related Financial Disclosures will get us to net-zero greenhouse gas emissions. We cannot ask company leadership to do one thing, while paying them to do another.
The importance of linking pay to climate performance is widely appreciated. Mark Carney, the UK government’s financial adviser for COP26 and the former governor of the Bank of England, has underlined the need to link bankers’ bonuses to their climate impact, and this is a key pillar in the recently launched Glasgow Financial Alliance for Net Zero road map.
The problem is that current efforts to address this dangerous flaw with corporate incentives risk reducing, rather than increasing, pressure for decarbonisation. This is because they tend to apply to a small fraction of the overall pay package, say 10% of the long-term incentive plan, and thus give a sense of net-zero alignment when in fact the other 90% of pay is pushing executives in the other direction.
Even the 10% is often misdirected, focusing on a narrow element of net-zero alignment such as operational emissions rather than how to shift the core business activity onto a net-zero pathway.
Take HSBC, which made a welcome commitment this year to align all its financing with a net-zero outcome by 2050 or sooner. As one of the largest financiers of carbon-intensive activities globally, deploying an estimated $110bn in financing to fossil fuel-related activities since the Paris Climate Agreement was signed in 2015, a meaningful move by HSBC to drive decarbonisation amongst its clients would matter.
The problem is that, despite the inclusion of some climate metrics in the CEO’s incentive scheme, pay is driven above all by earnings, strategic reallocation of capital to Asia, and total shareholder returns.
Where climate metrics are included in the long-term incentive plan, only 12.5% relates to growing green financing.
Critically, there is no target to reduce harmful carbon-intensive financing. Higher earnings based on financing non-Paris aligned heavy industry, transport or agriculture will be rewarded, not sanctioned.
The picture is repeated, not just for most banks, but for most carbon-intensive companies. Even in oil and gas companies, where we’ve been told by the International Energy Agency that we must stop new investments in reserves, we continue to see bigger bonuses paid for expanding fossil fuel production.
This is true even for those that have made net-zero promises. The tweaks we see companies making to pay policies are an exercise in air-brushing; they give the impression of action on climate change, while hiding the less attractive truth.
This poses risks to the planet but it also threatens shareholder capital, staff, supply chains and many others who are dependent on resilient businesses. By incentivising more capital to be invested into declining activities, the risks of future write-downs mount.
Central banks are voicing their concerns more loudly over banks’ rising exposure to such stranded assets. A recent stress test for the Euro area’s systematically important banks by the European Central Bank indicated that 35% of bank loans were exposed to transition risks. The dangers of broader macro-economic harm are clear.
Two levers exist that can fix this problem without the requirement for new regulations.
The first offers a stopgap. The second provides a longer-lasting solution that would re-wire company incentives to align with a safer planet.
With immediate effect, companies should introduce a net-zero underpin for all senior executives’ bonus and long-term incentive schemes. The concept of an underpin is well-established, normally as a financial condition that must be met before any performance-related pay can be dispersed. A net-zero underpin would set a minimum net-zero alignment requirement before bonuses or long-term incentives could be awarded.
In listed companies, the remuneration committee would have both the authority and responsibility for making this assessment. They would explicitly affirm in the published annual report that all awarded discretionary pay met this net-zero test, and they would publish supporting evidence. Shareholders, in turn, would hold remuneration committee directors accountable through their routine annual general meeting votes.
Companies should introduce a net-zero underpin for all senior executives’ bonus and long-term incentive schemes.
The second, more powerful, lever to stop rewarding executives for climate harm is to ensure the 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 in the vast majority of cases are leaving out the costs of climate change and associated energy transition.
A recent review of 107 carbon-intensive companies’ financial statements by Carbon Tracker made this abundantly clear. For the most part, we have radio silence on climate impacts in company’s accounts.
Pay based on flawed numbers will be misdirected. If, for example, a coal-fired power company’s accounts ignore the need to phase out coal by 2030, as is demanded by the global goal to keep temperature increases to 1.5°C, then the entity can continue to project cash flows and asset lives out to, say, 2040 or later; permitting it to reduce its annual depreciation charges for these assets, thereby pushing up reported profits.
Similarly, any associated clean-up costs or asset retirement obligations will be pushed out to the distant future, and the liability reported on the balance sheet diminished in present value terms. Carbon taxes and carbon capture and storage costs could be left out altogether.
This power company will report a far healthier capital position and level of profitability than if it reflected the true costs of decarbonisation in its accounts. Its executives would thus tend to get bigger bonuses, and be encouraged to keep growing their business, irrespective of any harm to society.
The danger of accounting misrepresentation extends to any company reliant on carbon emissions in their production or consumption process. As long as these emissions are not costed and the energy transition ignored in determining critical forward-looking assumptions in accounts, there are risks of misguided incentives.
The parallels with the financial crisis are striking and should ring alarm bells.
Bankers were paid multi-million-dollar bonuses on the back of accounts that suggested strong performance. In fact, many had built up disastrous levels of bad debt and overpriced assets that led to unprecedented tax-payer bailouts. Executives were rewarded for illusory profits, with the costs hidden off balance sheet, and ultimately born by the public.
We must not allow these mistakes to be repeated with the climate crisis. Implementing pay clawbacks, a requirement introduced for banks where executives repay ill-founded bonuses after the event, will not right irreversible damage.
Paying for failure is not a new problem. But this time, misdirected incentives are fuelling a fire that we may not be able to contain. If there was ever a case for re-setting executive remuneration, surely this is it. The most enduring way we can do this is to fix our accounting numbers.
However, to ensure no time is lost while these accounting adjustments are implemented, Remuneration Committees should institute a net-zero underpin for all executive remuneration packages; no executive should be rewarded for harming the planet.
If we fail to act, we will get what we pay for.