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Climate issues 'heat up' in boardrooms

Executive Compensation|Future of Work
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By Shai Ganu | March 2, 2021

Boards must deploy all tools at their disposal, including disclosures and incentives, to encourage efforts towards a climate resilient future.

Prompted by institutional investors and regulators, corporate boards are placing more emphasis than ever on ESG, climate and energy transition priorities.”

Shai Ganu
Managing Director and Global Leader, Executive Compensation

Climate change is among the most pressing issues facing the world. In 2018, the Intergovernmental Panel on Climate Change warned that to avoid the catastrophic impacts of climate change, global warming must not exceed 1.5 deg C. To achieve this, greenhouse gas emissions (GHG) must halve by 2030 and drop to net-zero by 2050.

Companies across all sectors have a significant role to play in reducing GHG emissions. Prompted by institutional investors and regulators, corporate boards are placing more emphasis than ever on environment, social and corporate governance (ESG), climate and energy transition priorities. Not only is this the right thing to do, it also represents a real business benefit. According to a 2018 CDP survey of the largest 500 companies in the world, climate-related business opportunities outweighed the costs and risks by more than double.

Impact on bottom line

So why should boards pay attention to Climate issues? The impact on business operations and financial viability is undeniable. Climate change poses two main types of risk - physical and transition risks.

Physical risks are related to events such as droughts, floods, hurricanes, extreme rainfall. Businesses have borne the significant brunt of acute events; for example, floods and hurricanes disrupting operations, as well as chronic, long-term changes to weather patterns such as rivers changing courses or fresh-water levels dropping.

Transition risks include potential regulatory and policy changes (for example, mandatory carbon pricing which would increase a company’s cost of capital), market reputational impacts, technology obsolescence, supply-chain disruptions, and changing consumer and employee preferences.

Increasingly, companies are engaging with their shareholders to discuss these risks and mitigation strategies. Companies such as Unilever, Moody’s and others go on an extra step and are adopting a voluntary, non-binding ‘Say on Climate’ resolution at their annual general meetings (AGMs). The intent is to get explicit approvals from shareholders for climate risks and transition strategies, as well as potential associated impact on earnings profiles. Boards and management teams are now taking a hard look at their businesses and setting science-based targets for GHG emission reductions.

Metrics that matter

Depending on the industry, there could be several climate-related goals for companies, including GHG emissions, carbon intensity, water security, waste management, circular economy, biodiversity and renewable energy consumption. However, the most pressing goal is related to GHG emission reductions.

The six main GHG are carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride. They are converted according to their global warming impact and expressed as tonnes of carbon-dioxide equivalent (tCO2e). This is the most used and the standardised unit in carbon accounting to quantify GHG emissions, and also the unit for GHG reductions, carbon pricing and carbon credits. It provides a standard measure of emissions.

A company’s GHG emissions can be classified under three scopes. Scope 1 is direct emissions from owned and controlled resources, Scope 2 is indirect emissions from sources of purchased electricity and Scope 3 is all indirect emissions along the company’s value chain, including suppliers, customers and partners. While most companies focus on Scopes 1 and 2, which they can directly influence, progressive companies also focus on Scope 3 and influence supply-chain partners to reduce emissions.

Some companies also buy carbon offsets, which are investments in separate projects, such as planting trees, as a way of reducing their tCO2e levels. To effect meaningful change, companies should set sufficiently stretched and long-term tCO2e reduction targets, for example a 50 per cent reduction by 2030 and net-zero by 2050.

In some industries, environmental impacts are at the core of their business strategies and companies are transforming their portfolio or product mix accordingly. Not only do they need to focus on both climate impact measures such as tCO2e emission reductions, but also on climate transition priorities. For instance, an important measure for energy companies is to increase renewable energy as a proportion of overall production.

Remuneration Committee’s role

Executive Compensation can serve as an important change agent to help accelerate climate transition priorities. Principle 6 of the World Economic Forum’s principles for climate governance specifically calls out “Incentivisation – executive incentives should promote long-term prosperity including climate-related targets”. Increasingly, board remuneration committees view climate and other ESG issues as top business priorities and are incorporating these goals in performance management and executive incentive plans.

According to a 2020 Willis Towers Watson (WTW)’s Board of Directors’ global survey on aligning ESG and executive incentives, nearly four in five respondents (78 per cent) were planning to change how they use ESG with their executive incentive plans over the next three years. Directors listed environmental and climate issues as their number one priority, and 41 per cent planned to introduce ESG measures in their long-term incentive plans over the next three years, while 37% looked to add ESG measures into their annual incentive plans.

More companies are beginning to include hard targets related to climate measures. Analysis by WTW shows that while around 11 per cent of top 350 European companies had tCO2e emission reduction targets in management goals and incentives, only 2% of the US S&P 500 companies did. There is certainly more work to be done to shift the needle on this important issue.

Considerations for companies

Although this is a new and emerging area, there is a considerable opportunity for companies to lead the charge on climate resilience. Here are five ideas for boards to pursue:

  1. 01

    tCO2e baselining and target-setting

    It is important for companies to develop a good understanding of current tCO2e emissions associated with different scopes. Boards may set ambitious long-term goals, as well as realistic short to medium term transition plans.

  2. 02

    Voluntary disclosures

    Companies may voluntarily disclose their carbon ambitions, tCO2e reduction goals, as well as any potential changes to business portfolio mix.

  3. 03

    Engagement with shareholders

    It is also important for companies to explain their climate risks and transition priorities to investors. Although non-binding, it is possible that some companies may choose to voluntarily seek AGM approvals on their climate transition plans, particularly if those plans might impact earnings profiles in the short-term.

  4. 04

    Carbon pricing and cost of capital

    Progressive companies may pursue internal carbon pricing, wherein the cost of each tCO2e is added to the company’s cost of capital. This would provide for better assessment of a company’s returns.

  5. 05

    Linkages to executive compensation

    Remuneration Committees may link hard tCO2e reduction targets over a three to five-year period with their long-term incentives, and performance share plans. This is a way of ensuring strong alignment between executives’ interests and those of all stakeholders.

Call to action

The consequences of climate change have become a pressing and material issue for society. Boards play a pivotal role in slowing down climate change and the business community bears responsibility to reduce corporate GHG emissions. Hard targets and alignment of executive compensation would help accelerate efforts toward these goals. Boards must deploy all tools at their disposal, including disclosures and incentives, to encourage efforts toward a climate resilient future.

This article was first published in The Business Times Singapore.

Author

Managing Director and Global Leader, Executive Compensation

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