This is an excerpt from a CNN Business commentary written by Olin’s Radhakrishnan Gopalan, John Horn, and Todd Milbourn, applying their research and conclusions from a Harvard Business Review article to a current news story.
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.
Gopalan is professor of finance at the Olin Business School and academic director of the IIT-Bombay-Washington University Executive MBA program. Horn is a professor of practice in economics. Milbourn is vice dean and Hubert C. & Dorothy R. Moog Professor of Finance.