Shell is tying executive pay to carbon emissions. Here's why it could create real impact

Editor's Note: (Radhakrishnan Gopalan is professor of finance at the Olin Business School and academic director of the IIT-Bombay-Washington University Executive MBA program. John Horn is an Olin professor of practice in economics. Todd Milbourn is vice dean and Olin's Hubert C. & Dorothy R. Moog Professor of Finance. The opinions expressed in this article are their own. )

At a time when governments are struggling to find broad and economically workable responses to climate change, Royal Dutch Shell announced in early December that it would tie executive compensation to short-term carbon emissions targets in 2020. Whether this was a purely altruistic move aimed at corporate social responsibility or a response to investor pressure, it's more likely to affect Shell's greenhouse gas emissions than any press release or quarterly earnings statement.

As we explained in a Harvard Business Review article, data from almost 1,000 firms strongly indicate that, on average, CEOs and other senior executives manage to the targets set in their compensation packages.

The upside: Compensation incentives work. The downside: If designed incorrectly, these pay-for-performance contracts can incentivize perverse behavior. The research shows that, more often than not, executives manage up to the target and stop, and some purposefully adjust costs in order to meet the performance goal.

However, companies can take steps to minimize the downside risk. They can use multiple metrics; increase payouts at a constant rate and adjust for risk; reward performance relative to competitors; and include nonfinancial targets.

Shell is implementing two of these four with its new pay-for-performance scheme: multiple metrics and nonfinancial targets.

The principle behind using multiple metrics/targets prevents an executive from manipulating corporate performance to reach one performance goal. It's harder to adjust performance to hit multiple goals — especially if they are not all correlated. Shell's 2017 pay-for-performance package included €1.49 million, or $1.68 million, in base salary, with a target annual bonus of 150% (of base pay), measured against:

• cash flow from operating activities (30% of target)
• operational excellence (50% of target)
• sustainable development (20% of target)

That year, CEO Ben van Beurden received a 201% bonus for excellent performance. In addition, Shell has a long-term incentive plan of 340% (of base pay), which includes a vesting period beyond the executive's retirement. So, Shell is already doing a good job of making it hard for van Beurden to optimize Shell's performance with the primary goal of hitting his bonus targets.

Now, with the greenhouse gas emission targets included, Van Beurden will have to make even tougher strategic choices that balance the reduction of emissions (which could be costly to implement) against the annual and long-term goals of cash flow and return on capital, depending on how the emission cuts are implemented.

Shell's new pay-for-performance targets are also beneficial because they are non-financial metrics, which are much harder to manipulate at the end of the fiscal year since they are largely out of the CEO's control. The final accounting of Shell's greenhouse gas emissions (and hence whether the target has been reached) will likely come after the fiscal year ends — too late to manipulate the results. To some extent, the measurement of greenhouse gas emissions will be known on a daily and weekly basis, so van Beurden could try to shut off plants and stop producing certain products in the final weeks to hit the greenhouse gas target. But shutting down production in the final weeks of a year will be extremely difficult for a company like Shell, which has many processes that must run 24/7 to maintain operational effectiveness (conveniently, another metric van Beurden is evaluated against).

One piece of advice we'd offer the Shell board for future years is to reward performance relative to competitors. As other oil and gas majors begin to implement similar pay packages (and they almost certainly will, especially if Shell's stock performance responds positively in the next year), the Shell board should be deliberate about setting the greenhouse gas emission targets in light of what competitors are doing. This also makes it harder to manipulate the results, because Shell's leadership won't know how much BP or Exxon or Chevron have reduced their emissions by until well after the fiscal year's end. It will also reward the CEO only for going above and beyond, and not for riding market trends.

Regardless of anyone's viewpoint on climate change, the Shell board is demonstrating that reducing greenhouse gas emissions will be a core part of the company's strategic objective in coming years. And incentivizing compensation takes a sizeable leap toward implementing real change beyond annual statements and reports. It's putting its money where its mouth is.