Despite conflicting messages about climate change from U.S. government leaders, sustainability is getting more and more attention at American companies. Shareholders are ratcheting up their demands on environmental and social issues. Consumers are registering their concerns about how companies make their products. And talented Millennial employees are voting with their feet by leaving laggard companies behind. Meanwhile, new technologies are making it easier for sustainability investments to pay off in the middle to long term.
A similar phenomenon happened in the 1980s, when quality became a significant issue for manufacturers. Many of them responded by including quality metrics in their compensation incentives. These moves helped to focus executive attention and ensure that quality initiatives actually got carried out. Over the next decade, quality levels improved substantially. It’s time for companies to start doing the same thing for sustainability.
As any compensation consultant will tell you, comp plans can address only so many metrics. Most plans have fewer than six: one or two financial metrics, such as sales growth or earnings per share, and two or three nonfinancial metrics, in areas such as quality or innovation. Having any more than that risks diluting executive focus. So for a compensation committee to justify a new metric, it needs to have a strong business case.
Fortunately, the business case for sustainability is broad, if not always easy to measure:
- A strong commitment to sustainability can boost a company’s reputation with customers and employees.
- It can generate political capital with government regulators, who may then grant the company greater freedom of movement.
- It isn’t just about limiting downside risk; the company can also create profitable new products and services to address the urgent global needs such as those associated with scarce water supplies, hunger, and greenhouse gas emissions.
- Finally, some sustainability investments can pay for themselves through reduced energy consumption and waste over the long term.
These factors will likely remain even if governments in the United States and elsewhere reduce their regulatory intervention, which we believe is unlikely in the long term.
Shareholders are seeing these connections and speaking up. So far in 2017, our firm, Semler Brossy, has identified 200 shareholder proposals on the environment among the Russell 3000 companies, already exceeding 2016’s total. Average investor support for such proposals has reached a new high of 29%. Four proposals received majority support, more than in the previous six years combined.
Institutional investors are helping to drive these proposals. BlackRock, the largest asset manager in the world, recently said, “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.”
That phrase — “relevant to a company’s business” — is a key condition. Rather than aiming at all 17 of the United Nations’ Sustainable Development Goals, for example, companies will likely tailor their sustainability efforts to their commercial priorities. Coca-Cola devotes many resources to creating cleaner water supplies in developing countries. Barrick, a large mining company, works to preserve the local ecosystems where it digs. Since the tragic collapse of the Rana Plaza factory in Bangladesh in 2013, garment retailers such as Walmart have contributed to improving working conditions for workers. Almost all the major car companies are investing in electric vehicles.
Moreover, not every company should expect to add sustainability to its core compensation metrics, at least not right away. Only those with clearly articulated business cases and specific plans for improvement should take that step. From what we’ve seen, most companies haven’t yet done the work to get there. Without well-defined metrics tied to concrete plans, sustainability becomes a vague goal that’s easy for executives to game — often with unintended consequences.
In the absence of a sustainability metric for compensation, boards retain the right to reduce incentive awards in case of substantial damage to the company’s business or reputation. So irresponsible actions that have a negative effect on sustainability can still affect bonuses on the back end. Most companies tend to keep this option implicit. To make it more effective, we recommend explicit “do no harm” language about reducing payouts in case of sustainability failures, such as an oil spill caused by inadequate precautions. Such a clause can be a useful reminder that sustainability is a major corporate concern even in the absence of metrics.
We believe that in the near term only a substantial minority of companies will likely add sustainability metrics to their corporate compensation programs, although more will likely add them at the divisional level. These companies will typically have big upside opportunities from trailblazing or large downside risks for falling behind the pack. But even this large minority is still a big jump from the current situation.
In our research on the S&P 500, only 2% of the companies tied environmental metrics to executive compensation, and 2.6% had a diversity metric. The most common sustainability metric was for safety, at 5% of companies — often those with much to lose from accidents. Indeed, by far the largest sector for sustainability metrics was the energy industry, which accounted for 25% of companies that had them. Now that sustainability has become a broader pressing issue, more industries need to do the work of assessing the potential business case.
Skeptics may say that sustainability is too fuzzy to work as a compensation metric, but the research suggests otherwise: Separate studies of American, Canadian, and German firms found that creating executive incentives for sustainability was effective in boosting those firms’ efforts on environmental and social concerns.
Five years ago a global consumer products company made a bold commitment to phase out all greenhouse gas emissions from its plants by 2037. Management sought to create direct energy savings and a stronger brand that would be well-regarded by owners, employees, and consumers. It was an ambitious but concrete plan.
To drive this big commitment, the board linked senior-level compensation to the steps along that 25-year path. The incentive provided the necessary teeth to enforce the commitment, ensuring that adequate resources were put on this industry-leading initiative. After five years, the company is well ahead of schedule, leading it to expand its commitment by reducing emissions along its entire supply chain.
While the federal government may be backtracking on sustainability, American companies are increasingly recognizing its importance as a business issue. As the prominence of sustainability grows, our colleagues at Semler Brossy are fielding more calls asking about linking sustainability to executive compensation. It’s not for every company. But for those that are ready for the concrete commitment, it can pay off in long-term market leadership.
Seymour Burchman, Barry Sullivan