Introduction
The example of Nike illustrates perfectly how business is changing (Berrone, 2009). Under social and media pressure for breaching human rights in its affiliates, Nike changed completely its strategic orientation to corporate responsibility by improving work conditions, carbon neutrality, etc. The same apply for Mac Donald's who faced strong critics for its human resources policy (referred as junk jobs). To address those problems, the firm developed a strong career development program and was able to integrate in a few years the "Great Place to Work" ranking.
Literature background
2.1 The definition of environmental performance
Although there is a lot of discussions and researches about environmental performance (green label, ecological ranking, etc.), there is today no understanding about the right definition of what is environmental performance. Regarding the growth of ecological concern by all the stakeholders of a company (shareholders, consumers, governments, environmental groups through ecologic rakings, the public in general), the need for disclosure has become crucial. The challenge for such companies is to target their CEOs' effort on the relevant environmental performance criteria, those valuable for the company (internal management and external reporting) but also for all the other stakeholders (third-party environmental performance evaluation). A complete understanding of the environmental performance's components and its dimensions is decisive, especially in the design of proper incentives systems. What information can we compare? How do we benchmark such performance among the different industries? The problem of measuring environmental performance comes from the variables. "Environmental performance measurement requires measurement of non-financial performance, measurement under tremendous uncertainty, and aggregation of multiple types of metrics." (Illinch et al., 1998). The following three models below explain the component and different categories related to environmental performance.
2.1.1 Henri and Journeault's Model (2009)
We often reduce environmental performance to one dimension, the environmental impact (pollution, wastes, toxic leak, etc.). However, as financial performance, it has more than one aspect. Henri J. (2009), modelled the concept of environmental performance through two dimensions, results vs process and internal vs external.
Figure 1
Environmental impact & Corporate image
Stakeholder relations
Process & Product improvement
Financial Impact
Results
Process
External
Internal
The "results oriented" dimension focus on the ends: the accomplishment of financial or environment outcomes.
The "process oriented" dimension focus on the resources and systems needed to attain specific objectives. It also gives importance to the relation with the stakeholders regarding environmental questions.
Internal dimension focus on the business-oriented view of the environmental performance. (Gray,R.,& Bebbington 2000)
External dimension focus on the sustainability-oriented view of the environmental performance (Gray,R.,& Bebbington 2000)
The different views of environmental performance gave us four different aspects when computing the possible focuses. Achieving suitable environmental performance, the company should combine all the four different aspects.
Environmental impact & corporate image: evaluation of the company's reputation and its capability to comply with standards, laws and regulation or to exceed them.
Stakeholder relations: The capability of the company to manage good relationships with its stakeholders affected by ecological questions.
Financial Impact: This aspect asses the financial consequences resulting from environmental procedures (waste recycling, energy saving, diminution of regulatory costs etc.).
Process & Product improvements: This aspect evaluates how environmental issues are linked into the operations of the company to get a competitive advantage (enhanced quality, promote innovation and gain of productivity). The integration of environmental criteria in the compensation system is in this category
2.1.2 Xie & Hayase (2007) and Illinch (1998) Model
Xie and Hayase (2007) developed an interesting concept of corporate environmental measurement. Their model is an adaptation of model developed by Illinch et al. in 1998. Most of the studies on Environmental Performance Measurement (EPM) are focused on the development of Environmental Performance Indicators (EPIs) and eco-control to enhance internal management and external reporting. Yet, most of their conclusions cannot be generalized. There are often "case specific" or too much related to an industry. There is a disagreement on what, in which way and where to measure. This is why the researches on standardized EPM model are appropriate to demonstrate all dimensions, regardless the industry, of environmental measures and the important EPI's.
The previous literature (Ilinitch et al. 1998), but also ISO 14031:1999 "Environmental management - Environmental Performance Evaluation - Guidelines", built a hierarchical classification with all the key components of a Corporate Environmental Performance (CEP). Based on Figure 2, we distinguish two principal dimensions of CEP, the management performance processes and the operational performance as the results.
The two variables are interdependent. Indeed, "MPIs are leading indicators of EOP because the company can tell whether appropriate management systems are in place before it sees whether these systems are having desired effects" (Xie, S., Hayase, K. 2007). On the other hand, Operational Performance Indicators will show whether the environmental management practices have positively affected the environment or not.
Organizational System
Stakeholder relations
Operational countermeasures
Environmental tracking
Inputs
Outputs
Corporate Environmental Performance
EMP
EOP
Figure 2
A complete and effective environmental management system should contain:
An Organizational system that is environmentally oriented and organizational processes designed to improve environmental performance. The system should integrate all ecologic issues within its ordinary operations. For example: ecological policies, environmental goals, employee coaching and sensitization, environmental accounting, auditing, etc. Thus, environmental audit programs should be regularly performed in the company. Also the results of those audits should be linked with employees' compensation. Accounting choices could also have an impact on environmental performances. For example the firm could assign the environmental expenses directly to the activities or products instead of distributing those costs in the overhead charges account. A dedicated department to environmental issues could be relevant. Being proactive in designing the organizational processes surely improves the environmental outcomes and results.
The stakeholders' relationships are also a key component in how the company deals with environmental management. We measure here, for instance: the level of environmental performances disclosures, the communication or others eco-marketing campaigns, etc. By disclosing information, the company reviews the indicators, improves its image or reputation and that could stimulate its willingness to achieve better environmental performance. The accountants have the responsibility of the disclosure process. They must choose descriptive and financial information that are pertinent and significant for the users. The type of environmental data is not standardized among the companies, and their choice could be problematic. Also, the measure and interpretation of stakeholder relations indicators are not an easy task. Examples of indicators: adoption by the company of industry or general standards (ISO for instance), the quantity and quality of environmental information disclosed, etc.
Operational countermeasures contained all the set of measures taken by the firm to reduce environmental losses in its daily activity. Some examples: A systematic verification procedure of the suppliers' environmental performance, countermeasures against global warming or ecological risks, improvement in the process/product design, etc.
Environmental Tracking measure the practice of the company in recording its environmental results. "Without tracking, measuring and evaluating its environmental results, the company will have no basis for decision making" (James, 1994). Also this variable is linked to the stakeholder's relationships because you cannot communicate numbers you don't have. The type of information disclosed should be related to the categories of stakeholders.
Most of the indicators related to Environmental Management Performance are qualitative. Thus there is always a problem of trust with the company measurement systems.
Contrary to the previous dimension, the Operational Performance Indicators are all quantitative results. There are less manageable even if the choice of the measurement unit can be subjective.
Inputs are the resources and energy exploited by the firm. The link between inputs and environmental impact is simple: the wastes and pollutant emissions increase with the level of consumption. If the firm take its energy/resources efficiency into consideration, it can surely increase its production efficiency that impacts directly financial performance.
Outputs are what the company releases during its activities. For instance: industrial wastes, water release, toxic substances, but also all the releases into the air (CO2, etc.). Those factors can be easily observed and measured.
In conclusion, the researches agreed on the two dimension of environmental performance, Results/Process and External/Internal for Henri and Journeault (2009) and EOP/EMP and Operations-Organization/Tracking-Stakeholders for Xie & Hayase (2007) and Illinch (1998). The type of compensation system is integrated in the Environmental Management Performance set within the subcategory of Organizational system for Xie & Hayase's Model and in the Process Improvement for Henri and Journeault's Model. Consequently, we will see in the following chapters how compensation systems can affect this organizational process and achieve the desired level of environmental performance.
Achieving Financial performance through Environment
There are many reasons why the board of directors would pay attention to environmental issues: their concern for environmental improvement, business strategy based on non-performance criteria (to access the green market for example), strong pressure with regulation compliance from external stakeholder, etc. (Cordeiro, J., Sarkis, J., 2008). However, the challenge of tying environmental responsibilities to the manager depends on the understanding of the benefits of sustainability strategies by the firm. If the shareholders capture the advantages that represent a good environmental performance, then, they will have a strong justification for the implementation of environmental policies such as an eco-oriented compensation system (Figure 3). Yet, the link between environmental and financial performance is still not clear, and numerous of studies found positive (Klassen & McLaughlin, 1996; Judge & Douglas,1998), negative (Cordeiro & Sarkis, (1997) or insignificant (Watson et al., 2004) relationships.
Figure 3 from compensation to Financial Performance
Compensation systems
Environmental Performance
Financial Performance
Wagner et al. (2001) found several reasons to explain the lack of unanimous results on the relationship between economic and environmental performance. First, empirical studies on the subject are often based on specific industries and use small samples. Second, the time collection of the data seems to play a role in the findings. The relationships changed over the years with the growing interest of the stakeholders for ecologic issues. Today, it appears to be easier for companies to unlock value of green investments than ten years ago. Third, there is a lack of homogeneity among the environmental performance variable used in the different readings (environmental ranking, Toxic Release Inventory, amount of environmental penalties, etc.) as well as economic performance (stock-market, financial statement based data, etc.). Finally, studies are often not precise enough on the different level of environmental performance (i.e., end-of-pipes solutions or preventions) and forgot to take important moderators factors on the relationships like: firm size, country, regulations, etc.
The outcomes of the different studies let appear three different types of relationship. Wagner et al. (2001) called the first category the "Traditionalist view". This view was the first predominant theory. It argues that pursuing environmental strategy has always a bad repercussion on the financial performance and especially its competitiveness. Eco-investments are seen as an extra-cost (Cohen et al., 1995). Investment in better environmental production processes increases the total production costs and the marginal costs. The result is illustrated by a uniformly negative link between financial and environmental performance: low environmental performance leads to high financial performances and vice-versa (see figure 4 below). In this situation, the optimum point for the firm is represented by the minimum level of environmental performance required by legal regulations.
Economic performance
Environmental performance
Figure 4 Traditionalist view (Wagner et al., 2001)
Porter (1991) and Porter & Van der Linde (1995) were the first to criticise the traditionalist view. The revisionist trend supports the "Porter Hypothesis" that the costs' increase associated with environmental performance is not systematic and can be balanced by substantial benefits and efficiencies such as: access to markets, products differentiation, less regulatory cost, saves in materials and energy, etc. (see the following section for complementary information). In this situation, the curve is uniformly positive: environmental improvements result in better financial performances with a decreasing positive marginal effect (see figure below).
Economic performance
Environmental performance
Figure X Revisionist view (Wagner et al., 2001)
The last possible relationship is a mix of both, traditionalist and revisionist view (Schaltegger & Figge, 2000). It argues that "The benefits reaped from increased environmental performance increase continuously for low levels of environmental performance. (…)Beyond this [optimum] point, the relationship is likely to be represented by a downward sloping curve (which in a first approximation is considered to be fairly linear)." Wagner et al. (2001). The mixed view assumes that an unlimited number of environmental protection activities won't always increase the financial return of a firm. The mixed relationship is illustrated below.
Figure X Mixed view (Wagner et al., 2001)
Economic performance
Environmental performance
Empirical studies on the relationship between environmental and financial performance can be classified in three categories of methodology. The first category of readings includes all studies that model the link by multiple regression analysis. Those studies try to measure the impact of various variables (including environmental performance) on economic performance (profitability, growth, etc.) and vice-versa on the long run. The overall results of multiple regression studies are mitigated, but positive relationships seem to be dominant among the researches (Ambec & Lanoie, 2007). However, regression analyses face a direction problem of causality. Indeed, companies with good financial performances can have additional resources to invest in environmental issues: good economic performance lead to high level of environmental performance. On the other hand, companies having high environmental performance can save energy or materials and thus enhance financial performance.
The second group includes all studies comparing portfolio of firms that implement pro-active or reactive environmental strategies (Bauer et al. 2005, Cohen et al., 1995). Those studies found also mitigate results. Most of the portfolio studies didn't find any support for the traditionalist view or the revisionist view. The relationship is characterized by small levels of significance explained by the minor impact of environmental performance on portfolio economic returns (Bauer et al. 2005).
The last set of readings evaluates the impact of good or bad ecologic events on the capital market (Schaltegger & Figge, 2000). Most of those studies found significant evidences for abnormals positive (negative) returns when positive (negative) environmental news were published (i.e. Klassen & McLaughlin, 1996). Events studies are the only methodology category that clearly finds significant evidences on the link between environmental and financial performances (stock-market return).
The nature of the relationship between environmental and financial performance is complex. "The variability of results based on different methodological approaches raises the question of whether the variability encountered in the above findings represents more an artefact of the methodology or the research design or more the intrinsically wide variance in the relationship between environmental and economic performance resulting from various initiating factors at the firm, industry and country levels." (Wagner et al.,2001).
Schaltegger & Synnestvedt (2002) give another explanation to the conflicting views: it is not the level of environmental performance that impacts financial performance, rather the way environmental management is implemented in the company. The implementation of efficient environmental strategies depends on the managerial decision. "The managerial challenge then includes two interrelated dimension: (1) Choosing the optimal level of environmental performance which potentially results in the highest economic success and (2) obtaining that level of environmental performance at the lowest possible costs in order to realize the maximum of conomic success" (Schaltegger & Synnestvedt, 2002). Therefore, economic performance would not be impacted by the level of environmental performance (as previous relationships empirical studies supported with traditional or revisionist view) but by the way the strategy is integrated in the company. This could be the main reason why "classic" empirical studies on the relationships failed to find a clear answer to the relationship. Instead of correlating two samples (economic with environmental performance), researchers should explore the impact of different types of environmental management on eco-performance by case studies approaches. Indeed, companies with the same environmental management systems (eco-control, compensation systems, etc.) could have different economic and environmental outcomes. An efficient environmental management system is the major moderator for financial performance and environmental performance (figure 5). This statement emphasizes the importance of management tools such as compensation for the success of both, environmental and economic outcomes.
Environmental Management Efficiency
Financial
Performance
Environmental Performance
Eco-efficiency
Figure 5 Management as the trigger between environmental and economic performance (adapted from Schaltegger & Synnestvedt, 2002)
If causality between the environment and financial performance is not systematic and depends on the environmental management efficiency: What are then the potential benefits of high environmental performance for the firm? The scholars seem to agree on one point: "social actions improve corporate image and reputation, create intangible assets, and positively influence long-term organizational survival" (Berrone, 2009). Ambec & Lanoie (2007) based on the work of Lankoski (2006) review the main benefits of pro-active environmental strategies in two topics: (a) increase in revenues and (b)cost reductions.
Access to specific markets
Eco-efficient firms can have access to specific markets. First, a growing part of consumers pays attention to eco-friendly firms. This new phenomena is called "green consumerism". A firm which is able to report and market its green oriented business will therefore improve its image and enforce customers' loyalty. Second, it becomes more and more common that public institutions are required to respect minimum environmental performance criteria in choosing their suppliers, called as Green Public Purchasing (Kunzik, 2003). This trend seems to develop also in private companies in choosing their suppliers or partners and will increase in the future.
Product differentiation
Regulatory Cost
Keantinge and Eaton (2012) examined the relationship between US companies that linked the compensation with environmental performance and those who did not regarding the frequency and the amount of environmental penalties. They found a strong link. Companies that linked environment and compensation faced less regulation penalties and the fines were lower. Therefore, companies that are exposed to high regulatory penalties should link the CEO's pay with non-financial performance, even when financial benefits are not evident.
The uncertainty of the financial benefits is often the main cause of the non-application of environmental-related compensation systems. Empirical researches found opposite results when assessing the financial outcomes subsequent better environmental performance. However, they all agree that an irresponsible environmental policy is punished one day.
Eco-oriented Compensation systems
We review in the following chapters the theoretical and practical approaches in the implementation of eco-oriented compensation. Then, we see what are the empirical results and the consequences of environmental oriented compensation on the business. The study focuses its attention on top managers' compensation because they are known to be a key element for the implementation of new organizational process, especially new environmental policies (Daily & Huang, 2001). CEOs have enough capacity to impact and support environmental strategies and their performance in the company (Orlitzky & Swanson 2002). "Top management support can affect environmental management system success by promoting employee empowerment, altering organizational culture and instituting rewards and incentive systems to affect employee behavior, provide training and increase communication throughout the organization" (Cordeiro, J., Sarkis, J., 2008). In his sample, Tonnello (2012) found that almost half of the companies delegated the responsibility of sustainability goals achievement to the CEO, when the other half concerned the board of director or one of its committees. This result emphasizes the importance of the CEO and the board commitment in the environmental questions. Pay is a major instrument to align CEO interest and stakeholders' expectations and is used to focus managerial efforts on desired outcomes. Hence, an efficient compensation system is crucial to enhance environmental performance.
4.1 Introduction
Since the 70's, it has been widely accepted that managers compensation should be linked with the overall company performance. Therefore, performance-based incentives such as bonuses or stock options have become the rule. Whereas rewards for financial performance continue to be the base for most of the companies, a new trend claims the introduction of sustainability performance criteria in the compensation measurement. Following the Schaltegger & Synnestvedt (2002) theory, a high quality of environmental management is the key to combine environmental and economic performance and compensation is one of the major managerial tools to successfully implement strategies. Tonnello (2012) in his study shows the increasing interest of the shareholders in sustainability questions. Based on all the shareholder proposals during the annual general meetings of the SEC members companies, the part of proposals linked to social or environmental issues increased from 29% in 2007 to 35% in 2011. The percentage of vote for such proposals also increased significantly over the years. However, the report of Ceres (2012) showed that even if the eco-concern is growing, only 39 out of 600 public firms had formally linked their CEO compensation with environmental criteria, and 53 more had such compensation systems without formally reporting it (Annexe 1). This gap is problematic regarding the growing concern for sustainability issues and its benefits and let a big field of studies.
4.2 Theoretical Approach
Few academic studies investigated the question of linking compensation with environmental performance in a theoretical way (Cordeiro & Sarkis, 2008). Still, the implications of the question lead to some issues with the rich accounting, management and human resources literature. The consequences on the agency theory or the incentives-based compensation theory have to be taken into account before going further in the implementation of eco-oriented compensation systems.
4.2.1 Multi-Tasking agency problem
As the agent has the power of decision-making, the owner must influence him to focus on firm long-term profitability and not only his own private interests (bonuses and salary). The principal can choose to monitor every actions of the manager in is daily work, but it is practically too difficult and very costly. Incentive-based compensation helps to solve the agency problem without spending resources in expensive monitoring systems: by an effective compensation system, the board is able to direct managers' effort to the desired outcomes. However, the traditional view of the agency theory does not completely fit with our subject because here, the agent must face two responsibilities: financial and environmental performance.
Holmstrom and Milgrom (1991) worked on the agency problem when the agent must comply with two or more owner's requirements. When the financial and environmental performances are strongly linked (no conflict) and lead to the same outcomes, the compensation system can be based on only one dimension (for instance, companies where financial performance can be achieve only through better use of energy). Therefore, eco-oriented compensation is not useful and Environmental Performance Indicators (EPIs) are not needed: even if the compensation system focuses only financial performances, the manager will have to achieve environmental performance.
Yet, there is often a conflict between economic and environmental goals, especially in the short term (Wagner & Wehrmeyer, 2002; Hart & Ahuja, 1996). Maximizing the production with cheap but polluting materials can improve short term financial performance at the expense of the environment, when investment in advanced green technologies can represent negative net present value because it is very difficult to assess the future returns and the potential additional costs. In case of conflict between the two performances, the incentive-based compensation has to be adapted in consequence and differentiate the two different dimensions in the performance measurement. The risk arising from multi-tasking comes from the inducement for managers to focus their work only on the "easy to measure task", the one that is directly, objectively related to reward and the most observable: financial performance (Dodge, 1997). The incentives system must address this conflict by forcing the manager to focus his effort on both performances. "The incentive system is no longer a pure motivation and risk sharing device (as in the one-dimensional case), but also serves as a tool for allocating effort between tasks" (Lothe and Myrtveit, 2003). This statement emphasizes the importance of the environmental performance's weight in the compensation systems and the choice of relevant EPIs.
4.2.2 Academic framework
Lothe et al. (1999) and Lothe & Myrtveit (2003) developed interesting compensation's frameworks for companies facing different levels of financial-environmental conflict.
As we saw, the integration of environmental dimension in the organizational processes is crucial to achieve environmental performance (Xie & Hayase, 2007). Compensation is a key organizational process. Unfortunately, studies showed that managerial effort is often redirected from environmental to financial performance. Studies found that even if the concerns on environmental issues are rapidly growing over the year, companies fail to implement proper compensation systems (Tonnello, 2012). The main reason is explained by the lack of rewards for such performances. The link between eco-performance and compensation is frequently too low "There will often exist incentives for profit-maximizing firms to seek short or medium term financial rewards rather than focusing on ethical obligations towards environmental management" (Welford, 1995). The absence of direct relationship between rewards and environmental performance mainly explains why most of the eco-policies are not translated into action.
Another source of problems come from the difficulties faced by the companies to detect and implement proper controls and EPIs or simply because environmental performance conflicts with financial performance. A survey of Lothe and Myrtveit (2003) on all the companies' members of the Open Source Ecology Europe found that even if 80% of them possessed a clear environmental strategy, only 50% of them had a pro-active strategy that exceed legal minimum requirement, and "None reported a variable pay based on environmental performance indicators, EPIs, not even the ones that did have such metrics in place. None of the companies had changed their compensation or incentive systems after introducing an environmental strategy». Yet, they all agreed that environmental performance was valuable on the long term. This fact emphasizes the lack of guidance and standards in this field.
4.2.2.1 Lothe Model (1999)
Lothe et al. (1999) suggested a model to design the compensation package regarding the company environmental situation. The situation depends on whether the firm faces a conflict between financial and environmental performance (on the long or short term), and whether the firm can provide environmental performance indicators or not.
The firms cannot always link environmental strategy with its financial performance. It depends on whether the company can balance the cost or the investment of implementing environmental strategies with business performance. Even if studies proved in some cases that environmental performance leaded to financial results, it cannot be generalized for all firms (Wagner & Wehrmeyer, 2002),. "A conflict does not exist when the environmental strategies save on raw materials, reduce government penalties, make waste into positive gross margin products or increase sales because green is marketable. (...). A conflict does exist, however, when the environmental strategies require extra investment (in dollars or managerial effort), especially with long or uncertain payback periods (...)."Lothe et al. (1999). Then, the challenge for conflicting companies is to implement an environmental strategy in accordance with the already existing profit-oriented one.
Also, the compensation system must take into account the changes in the relationship between environmental and financial performance over the time. Indeed on the long run, environmental performance can in some cases lead to financial performance even when a conflict arises in the short run (i.e. high initial cost but competitive advantage after several years). The opposite situation, conflict on the long run but not in short term, can also occur (i.e. investment in short term cheap solutions make the companies out-of-date for advanced ecological technologies on the long term).
Figure 3 Type of companies
Relation between Environmental and Financial performance
Type of compensation system
Short term
Long term
Type 1
No conflict
No conflict
EPI's not needed
Type 2
Conflict
No conflict
Multiplier based compensation
Type 3
No conflict
Conflict
Multiplier based compensation
Type 4
Conflict
Conflict
Multiplier based compensation
The categorization of the firm is crucial to design a proper compensation system and ensure manager's effort on environmental strategies. "With compensation systems that forces managers to focus on both profit-related activities and activities related to environmental performance, sustainable management can be achieved." Lothe et al. (1999). If the incentives are badly implemented, the manager will continue to focus his work on financial performance only.
Analyse of figure 3
As said before, for type 1, non-conflicting firms, the existing incentives system based on business performance is enough. The manager knows that improving ecological processes will automatically enhance financial performance. The only challenge in this situation is to balance the short and long term incentives weight in the compensation package and pay attention to any change in the relationships over the time.
For type 2 and 3 firms, the compensation system must focus on the conflicting period. For instance, in type 2 firm, the incentives system should target environmental short term results as a condition for bonuses: if the short term environmental goal is not met, the bonus is zero. This solution would force the manager to concentrate his effort on both tasks, financial and environmental performance on the short run. Lothe et al. (1999) suggest a multiplier based on an environmental performance score for the conflicting period:
As there is no conflict on the long run, the firm doesn't need long term environmental incentives measures. This system is also well designed for type 4 firms. Of course the success of this compound compensation system depends on the quality of EPI's.
To be efficient, compensation systems require very good performance measures that should reflect as well as possible the effort of the managers. In our case, the choice and design of environmental performance indicators will directly impact the success of the incentive-based compensation. Unlike financial indicators, it is more difficult to capture the environmental performance of the manager because many external factors can lead to incompleteness, imperfection and problem of controllability. For instance, the temperature can increase energy consumption during the winter. The indicators taken for the measure of environmental performance follow the same criteria as financial indicator. They must be relevant, comparable, overtime, quantifiable, totally disclosed. Firms must exclude metrics that are too imprecise and general. They should choose indicators that are related to their core business. Thus, taking only specific indices to evaluate the global environmental performance is not recommended (Dow Jones Sustainability Index, Toxic Release Index, level of compliance with the regulation, etc.). Instead, the company must design indicators that are directly linked with its strategy and direction. "Linking sustainability performance to executive compensation must be seen as strategically important to the entire corporate enterprise, not only parts of it. Sustainability metrics should contribute to the achievement of overall corporate goals" (Singer 2012).
When EPI's cannot be collected or are not relevant, Holmstrom and Milgrom (1991) suggest fixed wage compensation to achieve environmental goals and not incentive-based compensation that leads managers to focus on the easy measureable and rewarded task (financial performance). Of course fixed wage compensation system must be supported by others means such as: enhancing motivation, efficient monitoring systems, good corporate culture, etc.
The challenge of environmental oriented compensation systems comes from the need to assess the quality of green investments. When such investments result in short-term economic return, the performance is easily measured. However, most of the green investments can take time before appearing in the financial statement, or can never appear. It is the case for initiatives that reduce environmental risks, improve corporate image, etc. A compensation systems based on traditional cost accountings theory may not properly capture the benefits of manager's decisions. It is problematic because even intangible, a company's improved image can last years. To measure the cost/benefits of green investment, the company must change its accounting systems. The challenge for the company will be to separate and distinguish the costs related to environmental performance on every stage of the operational processes. For instance, by choosing only ISO 14001 certified supplier, the company will pay more its materials. In this case, the cost of raw materials should be divided into two categories: the uncertified market price and the premium cost. By tracking/categorizing/reporting systematically and precisely all the direct and indirect cost related to environmental performance, the owner will have a tangible basis to evaluate the manager effort. Also, this will help the manager to efficiently allocate resources and support him in decision-making.
4.1.2.2 Non-parametric Compensation system
Lothe and Myrtveit (2003) proposed the implementation of non-parametric compensation systems to solve the multi-tasks conflict. Their approach was particularly relevant for companies willing to complement their already existing financial oriented incentives systems with an environmental one and is complementary to the previous model.
The non-parametric compensation system is designed to help companies that don't know which weight must be assigned between the two performances. Nor have they clear strategy to focus environmental output rather than financial results. This situation occurs in most of the firms. Lothe and Myrtveit (2003) suggest an approach based on benchmarking the different units, sectors, department of a group. This non-parametric benchmarking method is called Data Envelopment Analysis (DEA) (Tyteca, 1997). By taking the best performance within the different units, we can define "a non-parametric best practice frontier" (see figure below). The units on the line are efficient in using their resources in both performances, for the others, the distance from the frontier states the level of inefficiency. The method has the advantage of not depending on a particular functional form/shape for the frontier and take financial and environmental aspects together, however it does not offer a general link (equation) relating output and input. It shows to the firms' units how they could reduce their input to produce the same level of output. Or, the increase of output they could have achieved with the same level of input if their resources would have been used efficiently. In general input reflects labor, capital, material, energy when output reflects the production, sales, emission, pollution, etc. Again, the big advantage is to reflect both environmental and financial variables in the same axes.
The figure 4 demonstrates clearly the method. If you are C, then you should reduce your input to reach the efficiency frontier (point B) defined by units 21 and 22 (the reference units).
Figure 4: Non-parametric best practice frontier
Figure from Lothe and Myrtveit (2003).
This ranking method can easily serve for a compensation system based on financial and environmental performance. By using an overall performance indicator (including environmental and financial performances), any potential conflict is solved. Also, as the performance is calculated on relative and not absolute measure, it helps to avoid controllability problems and others external factor that impact environmental performance indicators (as well as financial indicators). "All units are compared with observed best practice, not some theoretical norm that is influenced by external factors. (…) This is a strong argument in favor of the DEA as basis for compensation." Lothe and Myrtveit (2003).
However, the DEA methods require some precautions. As the frontier is constructed only on the best units (in contrast to regression models that exclude outliers), only concrete and reliable data must be taken into account. This means that all the EPIs are not suitable for the model (quantitative and observable data only, for instance, level of emissions). It should be no error or interpretation in the evaluation of those indicators because the extreme performance units highly affect the frontier. To insure a proper frontier and exclude false outliers, it is required to collect a large sample of observations. The other limit concerns the notion of profitability. This model takes financial and environmental input and output but do not provide the profitability of the units. It wouldn't make sense to put a unit on the frontier when it is efficient but not profitable. The last limits relates to the weight of the input and output. This model doesn't let you choose the weight of an input or output. However in real cases, some polluting output can be more damageable than others. "The real challenge using DEA is to specify the model that is choosing the right variable to include as inputs and outputs. This is the critical part in practice" Lothe and Myrtveit (2003).
In conclusion, DEA numbers linked with compensation provides a strong basis to integrate an environmental dimension in a peer comparison system. It also gives the opportunity to the managers of less efficient units to compare their strategy with the references on the frontier.
4.2.3 Practical framework
Recently, an organization backed by the United Nations, the Global Compact LEAD published a guidance on how implement an Environmental and social oriented compensation system. Based on discussions with experts, investors and NGO, they issued a set of recommendations and case studies to help companies in the design of sustainability linked compensation systems. Beside all academic researches on the subject, it is interesting in the framework of this study to see how the business world deals with this issue. Moreover, it is the first draft of international standards on the subject.
The organization found several benefits of integrating sustainability factors into managers pay which support the relevance of this guidance. First, as long term economic returns are expected by the shareholders, sustainable factors fit perfectly with long-term compensation systems. Second, it signals clearly to the managers that social and environmental issues are under their responsibilities. Third, by analyzing the relevant sustainable metrics, the company will discover new business and market opportunities.
The guidance points out several challenges when linking sustainability to managers' pay. First, top management cannot rely on international standards to identify risk and opportunities of this system. Second, the integration of environmental or social dimension in the compensation should not be another way to pay more managers. On the contrary, it should support real sustainable strategies. Finally, the board should pay attention to not include easily measurable variables rather than relevant component.
The guidance is divided in three parts (United Nations Principles for Responsible Investment, 2012): (i) how to identify the appropriate Environmental, Social and Governance (ESG) factors, (ii) how to link them with manager's compensation, (iii) how properly disclose those information.
Identifying relevant sustainable metrics
The first requirement is to analyze factors that have a direct link with shareholders value and support the long-term firm strategy. In doing so, the new indicators will help the CEOs to manage more efficiently resources and investments in those sectors. Moreover, clear indicators will help the company to involve all employees in the process. Those metrics should contain indicators that protect value (as pollution level indicators), and indicators that create value (as energy efficiency indicators). Targeting appropriate metrics require the consultation of all stakeholders. Consequently, the company will efficiently focus their efforts on what interests the community. The characteristics of environmental metrics are the same as financial measures: clear, replicable, forward looking, comparable, attainable and time-bound. Lastly, in the linking process, the compensation committee must pay attention to several points. The non-financial metrics must be varied enough to avoid a focus of the manager efforts on only one environmental aspect. However, too much measures lead to compensation dilution and is not suitable. The second problem comes from the difficulty in measuring environmental performance. Choosing the right criteria is not an easy task. But as all non-financial performance, it is open to manipulation by the managers. Consequently, control and information systems must be carefully designed.
Link with managers' compensation
Studies show that most of the companies, that already link compensation with sustainable factors, include them into short-term incentives programs such as cash annual bonuses. However, environmental performance is a long-run process and should be integrated within the long-term incentives strategy. Second, the incentives systems should allow the board to suppress or decrease incentives when crucial environmental or social goals are not attained. The second requirement is well illustrated by the Transocean Ltd Swiss company example (Keatinge and Eaton, 2012). This company was in charge of the offshore drilling rig that exploded and spilled million barrels of oil in 2010 into the Gulf of Mexico. During this year, the managers still get 67% of their compensation based on safety even if the company was found guilty of not having a proper and efficient safety system in place. Moreover, they got a 57% total compensation increase for the 2010 period. This event would have been disasters for the reputation of the firm if the managers did not decide to donate their share of pay to the victims' families. This problem could be solved by introducing a principle of inter-conditionality in the compensation systems: if managers don't realize their financial goals, they should not get any bonuses (or a significant diminution), the same applies for environmental goals. Finally, the implementation of peer comparison is also advised (for example, the approach of Lothe & Myrtveit).
Disclosure of Compensation Practices
The guidance recommends reporting as much information as possible on the compensation systems in the official pay disclosures. It is the only way to clearly explain to the shareholders and stakeholders that the implementation of the system really adds value and is not another "trick" to pay more the executives. The firm should pay attention to make the performance variables and objectives understandable and clear to justify the awards paid during the year.
In conclusion, a good incentive system alone is not sufficient to achieve the desired level of environmental performance. The commitment of all employees is needed to support the environmental strategy by appropriate human resources programs. Such programs can include: orientation, training, technical help, advices, etc. The company must prove to the employees that the new green orientation is not a marketing concept for consumer but really a durable strategy.
Berrone (2009) give an interesting check list of principles for the practical implementation of environmental related compensation.
Knowing that environmental and social objectives do not always lead to financial benefits. The firm must carefully evaluate the cost and benefits before designing its new strategy.
Classify the expectation of the stakeholders by importance and consequently, choose the key environmental criteria. Then, the firm must define precise goals for the next years.
Define how environmental criteria will be measured and design effective EPIs.
Measurement of environmental components is often complex and partially based on qualitative criteria, which make them manageable by the CEO. To address the problems related to manipulation, the company must conjointly implement relevant control and reporting systems.
In order to involve all employees, it is important to regularly communicate the results and the objectives to the entire organization.
Pay attention to public releases information. The relationship with the communities must be carefully managed. The company must avoid only symbolic actions and focus on substantive actions.
4.3. Results
After reviewing the benefits of environmental performance and what researchers or experts propose for the implementation of eco-oriented compensation systems, it is now interesting to focus on the results. Many empirical studies have been conducted on the different relationships between environmental performance and compensation systems: the structure and its consequences on the firm overall performance, the results for the CEO pay, etc. Some independent analyst companies investigate the practice in the business world (Keatinge & Eaton, 2012).
4.3.1 Empirical results
4.3.1.1 Relationship between CEO Compensation and Environmental Performance
If many empirical studies found links between compensation and financial outcomes (size, sales, etc.), only few explored the relationships between the top-managers compensation and the company's commitment to social and environmental performance. The following chapter reveals the difficulties that face researchers to demonstrate empirically the benefits of eco-oriented compensation on environmental performance.
According to the "stakeholder mismatching" theory, Stanwick and Stanwick (2001) argued that "stakeholders who would benefit from a strong environmental reputation (e.g., the community at large) may not be stakeholders who evaluate the organization's performance (e.g., stockholders)". Consequently, the compensation system designed by the board of directors may not target environmental performance as a primary goal. Seen as highly uncertain investment and financial burden, green strategies may not be included in the performance evaluation. Also, shareholders generally prefer to base the performance evaluation on stable variables. Regarding the difficulty when selecting right environmental variables (reputation, emission, etc.), this aspect could be omitted. Therefore, Stanwick and Stanwick (2001) expected to find negative relationships between CEO's total compensation and environmental reputation but positive link between compensation and financial performance. Their sample was based on the annual reputation index by the Fortune Magazine of 1990-1991.
The conclusion of the test strongly supported the hypothesis. Managers' compensation of firms with good environmental reputation was lower. It means that managers are encouraged to not gain environmental reputation. However, there are some important limitations on the study. First, the period could be problematic in two ways: the short lapse of time (only two years) and the period of the early 90's may not reflect how companies act today. The study took only the reputation index as environmental performance. However, reputation is only one dimension of such performance (compliance, outcomes, etc.). Finally, the researchers made the strong assumption that there was no link between environmental and financial performance. However, the advantages of green oriented strategies have been proven to conduct to financial results in many cases (Judge & Douglas, 1998). They asked good questions, but solved them poorly.
Russo & Harrison (2005) tested the same relationship between environmental performance and eco-oriented compensation. Based on a sample of electronics plants (indexed in the Toxic Release Inventory of 2001), they analysed the emission levels of companies that integrate or not compensation systems with an environmental performance dimension. Their results contrasted those of Stanwick and Stanwick (2001). They found a marginal level of significance. Companies with eco-oriented compensation systems had slight better environmental outcomes.
The most recent study from Cordeiro and Sarkis (2008) also tested the relationship between environmental performance and the top manager compensation. With their sample of 500 US firms during 1996, they tried to prove that companies with environmental oriented compensation system had better ecologic performances: "Top executive compensation will be more significantly and positively related to environmental performance in firms that explicitly link environmental performance factors to top executive compensation than in those that do not.". Their sample was based on 172 US firms' data from the 1996 IRRC Investor Responsibility Research Center. They took for the model three different environmental performance independent variables: 1. Emission index, 2. Spill index and 3.Compliance index (one per regression). The assumption received partial support only. The results showed that there was no clear significant link between environmental performance and explicit environmental incentives compensation except for the compliance index. The study distinguished three main justifications. First, the conclusion could be explained by the fact that boards of directors design environmental compensation systems principally to prevent personal and corporate litigations resulting from non-compliance. The second explanation could come from the period of the sample (1996) when environmental issues were less important and the firms acted more reactively rather than proactively as today. Last but not least, they could have found the proof that there is not necessarily a relation between environmental performance and executive compensation even for the firms claiming explicit relationships between these two variables. This conclusion could have several reasons. The managers could have enough influence on the compensation committee to lower the weight of difficult and less controllable variables such as environmental measures in their performance assessment. Moreover, regarding the difficulty and non-transparency of environmental performance measurement, the CEO might have the capacity to manage those indicators. Finnaly, it could be a consequence of corporate "greenwashing" (developed in chapter XXX). This concept occurs when companies improve their reputation by eco-marketing or others communication campaigns instead of improving their real impact on the environment. By claiming an explicit link between CEO compensation and environmental performance, the company gives the appearance of its environmental concerns without really implementing it (Ramus and Montiel, 2005).
4.3.1.2 Relation between high Environmental Performance and CEO Total pay
The empirical study conducted by Berrone and Gomez-Mejia (2009) presented the relationship between environmental performance and the CEO level of compensation. They tried to prove that good environmental performance was recognized by the company and rewarded consequently. They tested their main hypothesis: Environmental performance has a positive effect on CEO total pay. More in details, they tested several sub-hypotheses explained below.
The first sub-hypothesis links the type of environmental strategy chosen by the manager and the reward. CEO can adopt two types of environmental strategies: eco-control and prevention. Eco-control (pollution control) relies on end-of-pipe practices. The aim is to measure and treat all polluting components at the end of the company's processes with an objective of compliance. Compared to the prevention, it doesn't require important investment or special expertise. On the other hand, prevention strategies are completely integrated in the different processes and focus on reducing or eliminating environmental issues. Those pro-active measures require important investments in new green technologies. "Pollution prevention efforts provide organizations with unique advantages and may even increase manufacturing performance because they require a fundamental rethinking of products and processes that can create opportunities for improvements and innovation" (Berrone and Gomez-Mejia, 2009). Studies also found that only prevention strategies could lead to competitive advantage when eco-controls were easily copied. The prevention strategies offer better returns and advantages for the firm performance and should be preferred than eco-control (Christmann, 2000). Therefore, pollution prevention strategies should be rewarded more than end-of-process controls.
The second sub-hypothesis tested whether the existence of an environmental committee had an impact on the compensation. The incentives system of a firm should integrate environmental performance as well as financial performance. The environmental compensation policy must be explicit and clear for the CEO. To improve the efficiency of such compensation, studies found that an environmental committee, within the board, was more capable in assessing the effort of the CEO on environmental issues. "Delegating environmental issues to a committee made up of knowledgeable board members should reduce the information asymmetries between principal and agent, allowing for a more accurate assessment of the executive's environmental performance and a tighter linkage between that performance and total pay." (Berrone and Gomez-Mejia, 2009). Therefore, the presence of a clear environmental compensation policy and an environmental committee should fully improve environmental performance.
Berron and Gomez-Mejia (2009) studied 469 publicly traded polluting companies to prove the previous assumptions. They found evidences for all the hypotheses except the impact of environmental committee and policy. It could be explained by the symbolic role of those components. Companies use policy and committee to signal their involvement about ecology when they don't make the fundamental investments. External environmental audit could be more appropriate than a committee to measure environmental performance.
