Incentivising Corporate Accountability for Climate Change

Author: Adriana Rejc Buhovac, Full Professor of Management and Organization at the University of Ljubljana, School of Economics and Business in Member of the Working Group of Chapter Zero Slovenia

The World Economic Forum has developed a set of eight principles to guide the development of effective climate governance. To make these principles useful and tangible, each of them is accompanied by a set of guiding questions. These questions help organisations to identify and address potential gaps in their existing climate governance strategies.

As Chapter Zero Slovenia is committed to ensuring that its board members pursue climate governance, we have produced a series of monthly articles explaining the eight climate governance principles, which are designed to increase their climate awareness, embed climate considerations into board structures and processes and improve navigation of the risks and opportunities that climate change poses to business.

As part of setting up an effective climate governance on Corporate Boards, incentivization plays a key role. Steven Kerr’s seminal work ‘On the folly of rewarding A, while hoping for B’ depicts the importance of rewarding decisions and impacts that matter.

What happens when the desired behavior—such as care for the natural resources, is not being rewarded at all? Or worse off, when the types of behavior rewarded are those which we are trying to discourage—such as focus on short-term financial performance? The first outcome is a misalignment of the interests of the corporation and managers. Instead of, for example, channelling managers’ efforts towards choices to maximize company’s environmental performance, their focus is on cost savings. The second outcome is failure to hold managers accountable for their contribution to climate change.

While intrinsic motivation—motivation from within—which builds on positive ideals and beliefs remains the ‘first-best’ solution for motivation, corporate incentive and reward systems often play a critical role in increasing climate awareness, boosting environmental performance and communicating the payoffs of climate governance to the organization. Where do we start?

1. Bonus Pool: Bonus incentives, i.e. additional rewards for successful achievement of objectives, are usually paid out of a bonus pool which is determined by some reference to business or corporate-level financial performance. For example, a certain percentage of annual corporate profits may be set aside in a bonus pool to fund incentives.
2. The Allocation Formula: There are three categories of performance relevant for managers that can be used to allocate bonuses: corporate performance, business unit performance and individual performance. For each manager, we must decide how to allocate weights across these three levels of performance. For an executive director with a wide span of control, a higher weight should be given to corporate performance. Alternatively, for a manager at a lower hierarchical level and with few interactions with other business units, a higher weight should be given to individual performance.
3. Alignment with Corporate Strategy and Materiality: Performance reviews and measures underlying incentives must be aligned with corporate strategic objectives. It is of utmost importance, however, that these include material issues identified through simple materiality or double materiality matrix. Various aspects of environmental performance are typically a major material concern for most companies. A simple test of a good measure is to ask the question: If we looked at the measure for which a manager is accountable, could we accurately infer the strategic objective that we want the manager to focus on?
4. Performance Measures: Choose performance measures (1) that are responsive, i.e. that reflect actions that a manager can directly influence, and (2) that can be objectively measured and verified. Exhibit below lists examples of non-financial environmental performance measures and monetary environmental performance measures. Some of these can be measured at the level of individual performance, other at the business or corporate level.

5. Frequency of measurement: Determine how often you will measure and reward performance (monthly, quarterly, annually).
6. Weights: Distribute weights assigned to individual performance, business unit performance and corporate performance to specific performance measures within each of the three categories. For example, if 40 % of an executive director’s incentive program is allocated to corporate performance measured by two performance measures, CO2 emission reduction and income from recycled products, each of the two may have an equal weight (20 %/20 %) or different weights (e.g. CO2 emission reduction—30 %, income from recycled products—10 %).
7. Calculate the actual amount of payments: The final decision must be made about how to calculate the actual amount of payment. Typically, a formula specifying thresholds for each performance measure determines the size of the bonus. 

To make an incentive system effective, managers must focus their energies on a small number of variables that are truly critical—and that they can recall from memory. As a rule of thumb, seven (plus or minus two) performance measures can be assigned to any individual to ensure focus and prevent information overload.

On a final note, performance objectives and incentives must be cascaded throughout the organization. After setting the tone at the top, associates at lower hierarchical levels should be invited to help develop an aligned system of climate-related incentives for the whole organization. They can even be used for subcontractors.

For more on aligning performance goals and incentives see:

Epstein, M. J., & Rejc Buhovac, A. (2014): Making Sustainability Work: Best Practices in Managing and Measuring Corporate Social, Environmental and Economic Impacts. Sheffield: Greenleaf Publishing & San Francisco: Berrett-Koehler Publishers.

Kerr, S. (1975): On the Folly of Rewarding A while Hoping for B. Academy of Management Journal, 18(4).

Simons R. (2000): Performance Measurement and Control Systems for Implementing Strategy. Upper Saddle River: Prentice Hall.