Transcript: Paying for Net Zero webcast

Phillippa O’Connor
Good morning and welcome to today's virtual event. I'm Philippa O'Connor, a partner here at PwC, an exec comp specialist and part of our ESG leadership team. I'm delighted today that we're launching our report Paying for net zero. It's been written in collaboration between PwC, London Business School and Cevian Capital. And in doing this, as we've seen ESG rise up the agenda, and carbon as part of that being a real top focus area, we've really wanted to focus on that as a specific for today. Many investors have seen executive pay as a key method to force companies and executives to change and to increasingly focus on ESG targets. And on that, and in previous research, we've seen companies respond. With more than 80% of the FTSE 100 now having ESG within their executive pay. But at the same time, this is not simple and there are risks and potential unintended consequences. And so we really wanted to look, in this research, at whether it's working, how companies are using carbon in executive pay, and how they can do it really well. Our paper, Paying for net zero looks at the implementation of carbon executive pay measures, to try and answer some of those questions. I'm absolutely delighted to be joined today by Tom Gosling, from the Leadership Institute at London Business School, and Harlan Zimmerman, senior partner at Cevian Capital - a leading European activist investor and a vocal advocate for the use of ESG and carbon measures within executive pay. Thank you both so much for joining us today. As we go through, we want to make this as interactive as possible. We've got a chatbox that hopefully all of you can see on the screen. Please do use that and we will get to as many of your questions as we can as we go through. Tom, can I turn to you first as we begin to dig into the details of the report. Perhaps you could give us a brief overview of the work that we've done here and how the researcher has played through.

Tom Gosling
Thanks Phillippa, delighted to. So, we looked at carbon targets in the 50 largest European companies. And people will be aware that this is the third in our series of reports on putting ESG targets in pay. And we thought that given the maturity of climate change as an issue, the number of external reference points that there are around the trajectory of required change, and given that Europe is probably the region taking the leading action on climate change - we did feel that if we were going to find best practice in linking pay to ESG targets, we should find it here. We compared the approaches against investor expectations, which we'll come back to a little bit later on. And we also looked at some of the tricky design issues that boards need to cope with. So, in a very, very brief summary, what did we find? Unsurprisingly, all of these 50 companies are talking about carbon in their strategy in some way, shape, or form. And all of them have a statement, at least, that they plan to reduce carbon emissions. And actually, most of them at least mention it in relation to executive pay. But there is a very, very wide spectrum on how that's done. From at one end, carbon emissions just being one of a whole sort of alphabet soup of metrics in a bonus plan, through to very specific and well-defined separate carbon measures. And what we did then was to look through various statements that investors have made on what they want to see from carbon targets in ESG targets and also based on our interviews, surveys, and experience with them - and this is also where Harlan and Cevian were incredibly helpful, given the work they've been doing, coalescing investor opinion. And we came up with four key criteria that we feel investors want from carbon measures. Which are that measures should be significant, measurable, transparent, and also linked clearly to the company's long-term carbon goals. And we'll go into all of these in a little bit more detail later. But I guess, spoiler alert, there’s progress to be made, I think it's fair to say. We then also looked at some of the tricky challenges that companies face when putting in place carbon measures, given that there is, in some cases a trade off, at least in the short-term, between carbon and value creation. We are used to measures where just more is better and now we're throwing in this measure that's counterbalancing where less is better. There are also some tricky technical issues around things like scope three emissions, how you deal with acquisitions, and so there's a lot of devil in the detail of setting carbon targets and in the report we explore some of those. So that's a very brief summary of what we did and what we covered.

Phillippa
That's great, Tom. And I think we're going to dig into a number of these issues over the course of the next hour or so. Before we do that, just coming to you Harlan. It's been really fantastic to work with you on this report and to get your insights into the researcher, as an investor. Perhaps at a high level to kick us off, you could give us a view on your perspectives on the issue and the report.

Harlan Zimmerman
Sure. Well, it's been a pleasure to work with you on this and it's a fantastic and important report, in our view. It's very simple really, like most investors we’re interested in having companies that create long-term value for shareholders and other stakeholders - they need to do so in a sustainable way. For many companies, climate change is probably the single biggest issue that they will be facing over the next five, ten, fifteen years. Boards, generally speaking, and management teams, are great dealing with significant challenges. But this is a particular type of problem because of its long-term nature. And we are dependent on making progress today, which means we need executive teams doing the right things today and over the next few years to have a hope of getting to 2030, 2040 targets et cetera. But of course, those execs are going to be long gone by then. And therefore, we have quite a lot of experience. We've seen the impact of using incentives to change thinking and behaviour - and so when it came to how to address this time horizon conflict, we came to the view that executive incentives should be used to create appropriate incentives to direct management teams over the next three to five years to make the progress that is needed, as well as to have accountability for not making it. So, we went public with this view and we've spent a lot of time coalescing, as Tom said, other investors on this and it seems to be very strong and building consensus that this is the appropriate way to deal with it, at least for companies that have significant carbon challenges in the future. And then we came on also to a view that it's not good enough just to have metrics. The metrics need, of course, to be very well thought out and they need to have certain characteristics to be effective over time. And just to say further, we've suggested to other investors that we all have very strong say on pay rights in most of our geographies. And since this is for many companies, an existential matter over the medium and long term that we should be prepared to use our say on pay and other governance rights to enforce the thinking on this.

Phillippa
Thanks Harlan, that's a great introduction to how important I think this topic is. If we begin to pick into a little bit more detail into those investor expectations that you've outlined and how we've thought about those in the research. Tom, if we can move the slides forward, perhaps you can take us through the four investor expectation principles and how we feel thought about those in terms of definitions within the reports.

Tom
Yeah, sure. And of course, all investors have slightly different views on what they're looking for. And so, what we've gone for here are four measures that we think reflect the invested consensus, but also those that we would support as being sensible criteria if you're going to put a carbon target into pay. So first of all, we think that the measure needs to be significant. And I think one of the challenges and problems with ESG measures have been a multiplicity of measures with fairly small weightings. And so, we think that a separate and meaningful percentage of incentives linked to the issue in pay is important and we'll come back to exactly what we mean by that. It's also important to know what we're trying to achieve. I think that climate targets in pay have been somewhat bedevilled by criteria such as “show climate leadership”, which are difficult to measure, it's difficult to know really what is meant by that, and evaluations can end up being lists of good efforts and things well done rather than any sense of being objectively measured against a target. So we do think that the measurability in terms of objective and quantifiable targets is increasingly what's expected. Transparency is very, very important and I'm just going to come to Harlan in a minute as well because I know that that's something that's been particularly key for Cevian, but this isn't just about transparency after the event. It's also about transparency prospectively to enable that kind of process of dialogue, discussion, and even if you like negotiation between companies and their investors. And then finally, we looked at the extent to which the measures were clearly linked to companies’ long-term goals because there's a danger if there's a disconnect between what a company is saying it's going to do by 2035, 2040, 2050, and the actual short-term targets that are being met. And given Harlan's point that this is really a significant part about overcoming a time horizons problem. That connection between the shorter-term pay targets and the longer-term trajectory is particularly important. But Harlan, maybe you want to add a little bit on transparency because I know that this is something that you said before in your engagements with companies, you've come to see as being increasingly important.

Harlan
Absolutely. And it's maybe the stickiest issue for many companies to deal with beyond the design of the actual metrics. If you want to convince investors that you are setting appropriate targets, that your ambition level is sufficiently high, and obviously to demonstrate alignment with the goals that you have set out, well the targets need to be transparent. And there may be some exceptions where a climate target is truly commercially sensitive. But in the vast majority of cases, that wouldn't be the case. So even if you are not providing transparency around other metrics, there is not an argument in the vast majority of cases for not providing better or full transparency on the climate metrics. And investors are very sceptical. It's interesting as the research has shown, while investors on the one hand are very enthusiastic about using pay to grapple with this huge challenge, on the other hand there's a huge amount of scepticism. And those remuneration committee members listening in will know about that scepticism. And particularly when investors can't see the targets or the targets are seen as non measurable, we know the payout ratios are much higher than in other cases. So number one, if you want to demonstrate that you really are setting ambitious targets and you want investors to give you credit for that, and other stakeholders to give you credit for that, then they must be transparent. Now the absolute bare minimum is to do retrospective transparency. But there's really no excuse in most cases for not having prospective transparency. So when there's a say on pay vote, when you're presenting your pay plans, you're able to tell investors and other stakeholders exactly what the numbers are that need to be hit in order for the bonuses to be paid. It's really quite a simple concept. And we can talk about how this is evolving over time. Tom, I don’t know if you want me to say a word about the alignment as well?

Tom
Yeah, go ahead.

Harlan
I can't believe there are many of you on this call who would think it would be fine for a company to have a stated EBIT margin target of say, 15%. And then set the top of your CEO’s bonus range at a 10% margin target. Investors would see that as ridiculous. And it's pretty much the same thing with the long-term carbon goals. Now, we know that there was a lot of pressure to get these goals out there. In many cases, of course, the goals were put out there without having the entire road map to get there. Now is the time. If you have not already broken down your long-term targets into a roadmap, then you're already late in doing that. And others are doing it, and next year even a higher percentage will do it. So they're really must be clear alignment between what you have said is your target and what you are paying your executive team for. And so if you're not already doing that, you'd better hurry up. Because it's something that investors and other stakeholders are going to be demanding more and more frequently.

Phillippa
Thanks Harlan. And I think a really clear call to action there in terms of some of the research, but actually the position that Cevian has taken, which I think has been incredibly clear. I think to be fair, and you referenced the Remco chairs, that I'm sure we've got on the call today. It's fair that not all investors have been quite as clear about these views. There is in that scepticism, some balancing between the value creation and the broader ESG, and specifically carbon targets piece, that I think companies are trying to reconcile and that make this issue even more challenging as they get to grips with it across their range of investors. So let's turn to the research now and look at how well we saw companies do against these principles. We’ll take the first two in terms of significant and measurable. And the way that we did this within the research was by defining a ‘basic’ level of performance that we were looking for and then a ‘better’ level. And on making sure that measure was significant under ‘basic’, that looked at separate weightings on carbon being a specific measure rather than in the bucket that Tom referenced earlier. And ‘better’ was that that referenced at least ten per cent, either in the annual bonus or in the long-term incentives. Just coming back to what Harlan was just talking about in terms of making sure that it's measurable. We looked at whether there was an objective measure that was ‘basic’, but ideally that that was quantifiably accessible.
Tom, how do we think companies did in terms of setting those significant and measurable carbon outcomes?

Tom
Yeah, one of the things that we did, as you'll see here on the slide, is that we split the sample into around one-third of companies that were subject to engagement with Climate Action 100+ and the two-thirds of companies that were not just to see if there are any differences there. And indeed there were and actually overall, and this is maybe not a great surprise, that the Climate Action 100+ companies, subject to that investor engagement, were more likely to have significant carbon targets, were more likely to have explicit carbon targets, separate carbon targets in pay, and they were more likely to be at a material level of more than 10%. So that was about two-thirds of those companies and around half of those outside of Climate Action 100+ had such targets. That does seem to suggest two things. One is that those companies for whom carbon is kind of a more existential issue are more inclined to include these targets in pay. But it also means that the investor engagement around Climate Action 100+, which includes efforts on pay, is probably having an impact. And indeed the weightings were slightly higher. So, overall we saw that for Climate Action 100+ companies, if the measure was in an LTIP, on average it was 10%. If it was in the bonus, it was 13%. Whereas that measure the bonus dropped to 6% for companies outside Climate Action 100+. I mean, it's worth saying that in the separate work that we did earlier in Paying for good for all, where we did a global survey of investors views on ESG targets in pay. The 10% benchmark that we set is actually, if anything, slightly on the low side for what they're looking for. More like 15 to 20 was what came out from investors as a kind of weighting that they're looking for. And indeed, if you look at the highest 25% of weightings in the Climate Action 100+ group, within LTIPs, that was as high as 25%. So, there are some companies that are putting very material weightings on carbon targets in their pay plans. When people are putting these targets in, the good news is that generally they're measurable. So once they've gone to the step of having an explicit separate target, rather than a vague mention within a bucket of measures, that target does tend to be both objective and quantitatively assessable.

Phillippa
Thanks Tom. I think let's move straight onto the second set of principles and then perhaps come back to the discussion in terms of what we think about it all in the round. If we then move on to the next slide and ask about the next two principles here. One was around transparency, and the other is this disclosed link to long-term goals. Here, on making sure that the measure was transparent, there was a piece, exactly to Harlan’s point earlier, around was it disclosed and whether that disclosure was retrospective or prospective in terms of the way that we thought about the quality of the outcomes. Then in terms of the link to long-term goals, we're looking at whether the company made the connection between pay targets and the wider company strategy. Tom, do you want again just to summarise the results and then we can maybe open up to discussion.

Tom
Yeah, and this really gets to Harlan's points. And I would say that transparency in both of these dimensions was generally the weakest part of practice that we observed. So we see here that it's broadly the same between the Climate Action 100+ companies and the rest of the group that fewer than half are doing prospective disclosure of targets. And actually we've got around a third who aren't really disclosing targets adequately, even retrospectively. And so, that does create this problem around trust and credibility. Then also very interestingly, there are very, very few companies that create any kind of pathway that is clearly explained to the outside world between the shorter-term pay targets and the longer-term climate aspirations. I think this is a potentially easy win in both of these areas actually. I mean, as Harlan said, carbon targets are frequently not going to be terribly commercially sensitive. And so, I think the opportunity for prospective disclosure, even where those targets are in a bonus plan as opposed to an LTIP, it’s clearly something that companies could be considering. But also this link to longer-term goals and that I'm sure that many of these companies that actually haven't drawn an explicit link with the long-term goal, actually did have that in mind when they set the target. I'm sure companies aren't just plucking these things out of the air. But I think to Harlan's point, I think investors are very keen to understand the extent to which these targets are assuming a hockey stick of progress at the end of the period as we get to 2045 or something, or the extent to which companies are leaning into accelerating progress early on. And I think there's some work that could very easily be done actually to show how these interim targets map on the company's expected longer-term trajectory. I think the growing emphasis on transition plans that we're seeing coming through, generally around climate, will mean that companies will be doing a lot of the work that makes it much easier to make this mapping, but it does seem a bit of a missed opportunity not to make it clearer.

Phillippa
Lots of questions coming through on this, and I think I might just pick up a few while we're in this section. An interesting one around whether we think that the consequences of voluntary prospective disclosure could either build business sensitivity in the round or whether we think it might align them to expectations of prospective financial targets being disclosed in terms of future business performance. Interesting to see what you see as the consequences of that. Harlan, you've advocated strongly for prospective disclosure in this space. Do you think that that could have unforeseen consequences in terms of a knock-on impact?

Harlan
It shouldn't. I mean, we have quite strong capitalistic credentials, so to speak. And I can say that we absolutely support certain financial targets in particular, not being disclosed, especially prospectively. There's a completely different argument when it comes to say, an EBIT margin target, and something like this. Have the confidence that you can withstand that, it doesn't mean that no financial targets should ever be made transparent. Everything needs to be looked at on a case-by-case basis. But it is absolutely not the case that just because you're going to make one target transparent, that you will need to make everything transparent. And there are lots of companies that have partial transparency and they've had that for many years. So that is an understandable concern. It might be one that your general counsels are making, but it's not one that investors are going to be comfortable with.

Phillippa
Great, thanks Harlan. And then another one for you Tom, just on the research itself. So we've been asked a question around what do we mean by objective. So does that have to be aligned to an accredited SBTi or an equivalent or actually can it be objective in, and I like this language, ‘the normal sense of the word’.

Tom
Yeah, it's definitely objective in the normal sense of the word. I mean, we chose not to use Science Based Targets as the definition of objectivity because there is room for disagreement on how Science Based Targets actually are. And I think in general as well, throughout this research, and we'll come on to payouts I think a little bit later on, but on the whole we shied away from attempting to evaluate the stretch in company climate targets. I mean, that's really something that investors will obviously want to do given their view on what's feasible for the company and how they see the trade-off between decarbonisation and value creation. Our main interest here was on the alignment between what companies were saying they were doing over the long term and what they were actually doing over the short term. So, objectivity was simply that there was sufficient clarity and transparency to tell what they were really aiming at.

Harlan
Maybe we should say a brief word about verification. Because in addition to objectivity, verification is going to become more important. I think you can get away without having external verification at the moment in some industries, but more and more that is going to be required. So someone is going to have to do it.

Phillippa
Thanks, both. When we step back from that in the round, there are some positive things coming out from the research. And certainly from what I'm hearing for both of you, is that there's a lot to do. There's a clear journey on this issue that companies are continuing to be on. Also that there are some relatively easy wins in terms of how improvements can be made in the way that, that connection between pay and carbon targets is happening at the moment. I think we think that that's particularly around three areas. One feels it's like it's the weighting. One, exactly to your point Harlan, is the transparency piece. And then, I'm absolutely with you Tom, this link to the stated long-term carbon reduction goals. You know, we have to believe that's happening in the background, it wouldn't make sense effectively unless that was the case. But the disclosure does seem really poor around that at this point in time.

Harlan
One would like to think that in a few years time, we're all looking back on this and saying that it was obvious that we should do it. But where we are today is quite worrying. Although of course, it reflects the fact that these are complex issues. And they've only become really important for most companies over the last few years. Can I just say one thing about the weightings. Although we, Cevian, and some others currently believe that all companies should have some ESG metrics in their pay plans. They should be metrics that are really crucial for the company. So I just want to make clear, it's not the case that every single company in our view needs to have a carbon metric in their plan. If they have a stated goal to hit 2030, 2040, whatever it is, and that's more important than absolutely that should be anchored in pay. But for companies that really don't have emissions or don't create emissions, it does not need to be 20% of the LTIP for something that is tied to the emissions goals. So just to be clear. That's not at all meant to be a free pass. It's meant to just say that if those companies that are really exceptions, they probably have other ESG metrics that are important. They don't need to have a minimum of 10%. In our view.

Phillippa
Yeah, and I think that’s echoed in the discussions that certainly we're having with organisations. Which is, as with any other connection between incentives and strategy, you have to pick those things that are most important. To either, visibly demonstrate externally the key focus areas you’re driving at or use these levers internally to change performance and behaviour. I think that has to be true on ESG as much as it is on any other goal and we'd completely be aligned on that. So we've had a bit of a look there at what companies are doing and potentially how they could do it better. But as you touched on earlier Tom, as companies begin thinking about this, actually, there are quite a significant number of design and calibration challenges that they really need to consider. To make sure that particularly in the carbon context, that calibration and that work around carbon measures works well. Can you just begin to elaborate a bit on those issues Tom and then again, we'll open up to discussion.

Tom
Yeah, I mean, it's a whole bunch of issues when you really get into this. As any company or board that has gone about assessing carbon targets in pay will be well aware of these, and I'm not gonna go through all of them, but I'll just pick out a few. And I think at the heart of the issue here for a lot of companies is how do we go about setting carbon targets in pay when the economic incentives in the economy are not always aligned with long-term carbon reduction. That does create real challenges for boards to think about how they balance the responsibility that they feel they have for the shareholders, for creating value, and the short-term carbon goals. And Harlan described it earlier as a time horizon issue. And I think it is partly a time horizon issue, but it's also partly an externality issue. And we've seen this play out, the recent example with BP, where they had set certain carbon goals, these were strategic goals rather than goals in pay, and then relaxed those a little bit in light of changing circumstances. And that was rewarded by pretty significant share price pop. So that fundamental challenge between value creation and carbon reduction gets at the heart of a number of these difficulties. And it does also lead them to have, for example, should companies be thinking about scope three emissions, which is probably one of the biggest challenges around setting carbon targets. So it's partly a challenge because downstream scope three emissions all around demand for your product. And you can have a control over them. You can look at shifting your product mix, but that's much tougher to control without there being a revenue consequence. I think if we look at upstream scope three emissions, It's much more common for them now to start coming in to plans in terms of reducing emissions in supply chains. But there is a general problem that with scope three, there's a lot of uncertainty around measurement. And sometimes that uncertainty can overwhelm the calibration of the measure. So that's maybe one, and I'll maybe just pick out a second one here, which is the growth of regulations. So I think that we would hope at some point that regulatory frameworks developed such that we have the right economic signals around carbon. And arguably, once we get there, the need for all of this goes way. I think there may be a few companies who have sufficient of their emissions covered by, for example the European Emissions Trading Scheme, who might make that argument, although I think right now it's sufficiently patchy, sufficiently leaky, the carbon border adjustment mechanism isn't up and running yet, that I think there are many companies that would make that argument. But I think the growth of regulation should in some respects render this exercise a little bit redundant.

Phillippa
Thanks Tom. Harlan, could you please share the investor perspective?

Harlan
Yep, I’m urgent to pick up on those points. So I agree, in almost all respects. Definitely, there can be cases where there's a conflict between short-term financial interests and the long-term existential interests, which is also a financial interest of the company. And that's exactly why a separate metric needs to be used to bridge that gap. Because the directors and shareholders and stakeholders should be thinking about what's going to happen in 2030, 2035, and 2040. And make sure that the CEO is doing that. There is a time horizon gap. And in some cases, absolutely there can be a time horizon conflict. Some of these issues are not going to show up in EPS and the TSR of the CEO during his or her tenure. And therefore, we need to create scaffolding to make sure that they're doing the right thing. I'll link that also to carbon pricing, Tom's point. Yes, indeed, there are magical solutions, in a way, that might make all of this obsolete at one point. But two important factors. Number one, we don't have time to sit around and wait for that. Who knows when it's going to happen. We feel a super high sense of urgency, I think society does, notwithstanding over the last year the increased importance to energy security and things of that nature. We have to address these issues. We can't sit around and wait for the regulation to be perfect. In any event, if you believe that regulation is coming in at some point, then the companies themselves need to be preparing for that. It's just like in the car industry, when a country or a union says we're not going to allow a certain type of engine after a certain year. You don't just sit around and continue what you're doing until you hit that deadline. Then so, these efforts to use incentives to make the situation better for the company are actually preparing for the regulation and the financial costs that the companies are likely to bear in the future. So there is actually a direct link between doing things that today, which might not seem so economic, and making sure that there's good long-term value creation and continuing existence of the company.

Tom
Yeah. Can I just come back on one part of that, Harlan. Because one of the one of the challenges in this is around the fact that there is a spectrum of objective you can have around when we get to net zero, how aggressively we pursue it. And one of the things that I see really bubbling up as an issue for companies is that we have initiatives like the Science Based Targets initiative, for example, which is locked on to 1.5 degrees with limited or no overshoot, the race to zero criteria, which, if we as a society are going to hit that requires almost a hand brake turn now in a number of respects. And it seems pretty clear that actually that isn't the scenario that's going to come about, right? If we get to net zero, it's going to be later, it's going to be slower than that Science Based Targets pathway. So how should companies think about reacting to the pressure they're getting from some stakeholders to set a carbon target trajectory and therefore pay targets that are in line with this Science Based Targets view of the world. When actually the economy in the world is moving on a different path. Which means that they're getting, as boards, very different economic signals about what they should be doing which might be more aligned to two degrees, net zero 2060, or something. How would you recommend the board's think about that dilemma?

Harlan
Sure, well, in our 20 years of working with companies, I think we've found giving up is not a very good strategy in most cases. Just because it doesn't look like we're going to hit the target. That doesn't mean that we should be moving away from it. And indeed the picture doesn't look good. But there are things that can help us along the way. Technologies, whatever that will develop. It's not that those are going to save us. We need to do the hard work. We can't depend on them. But I don't think any of us are at the point where we should say, well we're just not gonna do it so let's just continue to live life as we've been living.

Tom
Yeah. I guess that's what I'm suggesting. I mean, I think it's a question of pace of change, isn't it. And that's what we're seeing in certain cases, companies are having to make a choice between carbon trajectory and returns for shareholders. And it's not obvious that that's just short-term returns for shareholders. So I think it's one of the things that we need to recognise in this pay debate. That we're trying to use in a way pay here, partly as a sticking plaster for an inadequate regulatory frame around this. But it's very difficult to use pay entirely to countervail against these very strong economic incentives. So I just think, I understand why boards are grappling with this. I think it's tough.

Harlan
Yeah, there’s no question that these are tricky issues, but I don't think it's a good strategy for companies or investors or other stakeholders ever to sit around and just wait for regulations to provide all the guidance and do everything that's necessary. And particularly with something as complex as this and something that is potentially existential for the company. So we and other shareholders know these issues are difficult. That's why we have very clever, very experienced, relatively well-paid people sitting in the boards of these companies. And it is your job to figure these things out using people like PwC to help you and come and explain them and make, make the case. And use the financial incentives as a way to help you deliver and a way to help you build the credibility of shareholders and other stakeholders.

Phillippa
Thanks both. I'm going to stop you there because we have lots of fantastic questions coming in from clearly a very well read audience on these topics. I want to make sure that we get to some of those before we run out of time. Some are very relevant to what we're just talking about. So let me pick up on one of those first around M&A. A really good question, and you touched on this at the beginning Tom, in terms of how do we think about designing pay structures in the context of carbon that deliver reductions that are within a company's control versus divesting emissions. How much do we think is possible to manage small versus large transactions in that context? Tom, perhaps you’d like to start us off on that one.

Tom
So, I think there are a couple of dimensions to this. One is that we don't want these carbon targets in pay to be creating an incentive for just offloading emissions. Because we know that's a problem that's happening. The listed sector portfolios are decarbonising while the world isn't. And there is definitely a shifting that has been going on over the last five years. But on the other hand, we don't want to disincentivise companies from buying brown assets and greening them. And so, I think there needs to be an element of common sense in these targets that adjusts for acquisitions. I think on the whole, carbon targets that are set in pay should be adjusted when there is a disposal or an acquisition, because it would be rare for that disposal or acquisition to be the trigger of a real-world change in carbon emissions. So I think on the whole, we should be adjusting for them. But it's a real communication challenge for companies because I think that the path to net zero emissions will not always be linear and downwards. And actually, we almost want some of our best companies buying and cleaning up and figuring out how to transition some of our most difficult sectors.

Phillippa
Thanks Tom. Then just coming back on the scope 3 point, to you Harlan. Great question here in terms of scope three, clearly what you're paying for is primarily performance that's outside of management's direct control. And typically in measures, that's something that you want to avoid in the context of financial measures. Is that something that investors worry about in terms of that scope three component?

Harlan
So just before I answer scope three, just one quick word on adjusting for acquisitions. I fully agree. Companies are already used to making adjustments for acquisitions to the financial targets that managers have. And so, I don't think that it should be significantly difficult here, although there are some additional complexities. So just to say that. On scope three. First off, for the moment, we fully understand that companies will most likely, or in most cases want to base their pay targets on scope one and scope two. The data is better. For those that don't yet have the data, you should have it soon. And it is under the control of the management team. But in theory, in a way, so are scope three emissions over time. Because your company chooses what products and services to provide and who you're going to provide them to. And so over time, definitely the expectation is going to be that the companies care about scope three, and the incentives should be aligned with that. Because that's what we as broader shareholders and stakeholders and all of us need to worry about.

Phillippa
Fantastic, thank you. I'm just gonna pick up two more here and then we'll probably move to close because I'm conscious of everybody's time. So, one is around short-term versus long-term incentives. And you both touched on some of the timeframe challenges that exist within carbon. We've had a number of questions from people around, does that mean it needs to be long-term rather than short-term, and how do we think about that in the carbon context? Harlan, you talked about this earlier in terms of timeframes and CEO tenure. Great to get your view first.

Harlan
Sure. So I do think these naturally live in the long term and it's pretty hard to hit a series of annual targets exactly when you're doing your forecasting. And therefore, to me, it seems you should have a bit more comfort in having a target that's three years out there, rather than a series of one-year targets when you're setting those. But at the same time, we understand that if you set a target that is a bit off course, then over three years that's going to lead you to somewhere that's too far away. So, what we have seen is companies often beginning, like with other incentive metrics, by putting targets into the short-term and then they move into the long term, once they've had a little bit of familiarity with them. But naturally, in most cases, these live in the long term. And if you have the comfort, and I would say best practice, is putting them into the long term and get there as soon as you can.

Phillippa
Thank you.

Tom
I would just add a comment on that. I think, in a way it’s less crucial which plan it’s in, and it does come down to the quality of the target. And one of the reasons why a lot of investors like to see these targets in long-term plans is that there's much more of a culture of prospective disclosure, objectivity, not moving the goalposts. Whereas actually, with annual plans, there's a lot more flexibility and sometimes they're a little bit more opaque. So I do think if you're putting these targets in an annual plan, I still think there's an onus to think about the prospective transparency and there's no particular reason why that shouldn't be put in place, even for that target within the annual bonus plan, even though bonuses typically contain many more measures that aren't prospectively transparent.

Harlan
Yeah, good point Tom.

Phillippa
And then, final question Tom, Harlan talked about the increasing importance of verification. And we've touched on the SBTi question, a couple of questions coming through in terms of other verification frameworks that are considered appropriate. And as companies move in that direction, what does good look like? I know that’s something we've debated at length. It would be great to get your perspective on that one before we close.

Tom
So I think that there are two dimensions to verification here. So one is, and I think this is what Harlan was referring to, was actually verifying the admissions numbers that go into the calculation for the target. And that of itself is quite a complicated area and particularly once we get into scope three. And at the moment companies are pretty much left to their own devices on that and the levels of assurance are very variable. I think that problem is going to just solve itself over time with the development of the ISSB standards around various of these metrics, the audit profession is developing methodologies for applying assurance to these. And I think that Harlan's exhortation is simply don't necessarily wait for this to become a mandatory auditable item. Think about ways in which you can lean into that trend by getting independent assurance on the components of it that you can recognise that today it may not be perfect. There's then this other question which is, how do we tell the targets are tough enough? And I think this is really difficult and the Science Based Targets initiative is probably the leading one for establishing a methodology for 1.5c alignment. I mentioned briefly before that there are some issues and problems with that. I actually think that the development of transition plans is going to really help us here. So, we've had the Transition Plan Taskforce in the UK come up with a framework for how companies need to think about the risks and opportunities of the transition and how they're addressing them. And I think that increasingly we will see investor engagement around those plans because for companies where this is a really material strategic issue, investors will be engaging on that issue with those companies. And that process should establish plans that are appropriately stretching and challenging. And it will then be a question of demonstrating the link of the pay targets to those plans. I mean, after all, we don't generally go around asking for an external verification standard on the level of stretch in a company's strategy. It just doesn't appear. So I think we're going to soon have the tools for investors to do that job around whether it's stretching enough and then it's about the consistency and connection.

Harlan
Yeah, I agree. Although I think the market is already pretty good at judging the stretch in a company's strategic targets. And it has the information to do that. And part of the problem is that the market doesn't yet have the information in them with the same veracity for the climate targets and emissions that the companies are producing. So I agree with you Tom.

Phillippa
Thanks very much, both. That's a great note for us to close on. I think we've heard across the last 15 min that there is real growing momentum from investors, and from companies, to tackle a carbon transition. And we see carbon commitments now being widespread. And this is increasingly being reflected in carbon targets coming through and to pay. But it's clear from the research that we've done, that only 14% of companies have targets that meet those goals of being significant, measurable, transparent, and with a disclosed link to strategy. That combined with average payouts for climate targets, this point in time, potentially suggests that at the moment there's a too modest level of ambition. And I think that's really where Tom and Harlan were just alluding, to the currently being included potentially within those pay goals. The good news I think here though, is that there are some easy wins for improved targets, notably around prospective transparency, and also really clearly explaining that link in terms of the long-term carbon goals. And there are some really great examples of companies doing this well. I think we all expect to see significant improvements coming through shareholder engagement and companies moving forward on this issue in the coming years. Just before we close, I'd like to thank Tom and Harlan immensely for all of the work and support on this report that we've done. They've been fantastic partners for us in doing this work. And I'd also really like to thank Duncan and Matt from my team for the fantastic work that they've done as well. Thanks to all of you for joining today. Fantastic set of questions. And I really hope giving some challenge to us as presenters in addressing those. I think we feel this is such an interesting and important area. And we need to ensure that doing it right and supporting organisations that we work with to do that right, ensures that we can have the impact that everybody wants to see. The report goes live today and the link to the download should appear on your screen when this call closes. In summary, just before we end, I think linking executive pay climate goals is never going to be a panacea. And executive pay targets can't overcome the fact that carbon isn't properly priced. But done well, and I think in the right circumstances, it really can enforce executive accountability, and I know we had a question on that as well, to meet the short-term targets towards long-term goals. And therefore, we think that if executive pay is part of that solution, there needs to be a bit more ambition to implement those targets robustly. To use the power of incentives to give us to support that push for net zero. Thank you all so much for joining today, and no doubt see you soon.