Leveraging Incentives and Consequences for Enhancing Corporate Conduct

 

Leveraging Incentives and Consequences for Enhancing Corporate Conduct

Within the recently released Qantas annual report, there's a subtle shift that reflects a broader trend in how corporate boards are approaching the often contentious issue of executive compensation.

This shift isn't solely about the decision to reduce former CEO Alan Joyce's pay by half a million dollars or the mention of a possible "claw back" of even more. These appear to be tactics to gauge investor sentiment in the upcoming weeks.

What's noteworthy is Qantas' adjustment to its executive bonus scheme, aligning it with a less exclusive focus on profit maximization. Much like several banks, Qantas has reduced the prominence of "financial" metrics in determining bonuses, opting instead to place greater importance on customer satisfaction and corporate reputation.

At first glance, this might seem insignificant. However, this trend is gaining traction among major corporations, mirroring the growing emphasis on Environmental, Social, and Governance (ESG) concerns. While executive bonuses are still predominantly tied to shareholder returns, "non-financial" metrics, encompassing aspects such as customer satisfaction, employee engagement, or carbon emissions reduction, are gaining prominence.

Nonetheless, convincing investors to embrace this shift has been challenging. Some argue that executives shouldn't be rewarded for fulfilling their fundamental duties like preserving the company's reputation or engaging employees since these are integral parts of their roles. Others worry that "soft" targets are susceptible to manipulation compared to hard financial metrics.

So, can bonuses genuinely motivate ethical corporate behavior and encourage profit-seeking simultaneously? Do "carrots" like ESG-linked bonuses complement the "stick" of bonus reductions or claw-backs, especially in crisis-stricken companies like Qantas?

Regulators, with the banking sector as a reference point, suggest that the answer is yes. Following the Banking Royal Commission led by former High Court judge Kenneth Hayne in 2018, regulatory authorities advocated not only for stricter enforcement but also changes in incentive structures. Banks were encouraged to include "material" weightage to non-financial measures when awarding bonuses, a recommendation now adopted by the Australian Prudential Regulation Authority (APRA).

This trend is not confined to banks and insurers; it extends to companies like Woolworths, which ties long-term bonuses to reputation, or South32, which links bonuses to its low-carbon portfolio objectives. According to consultancy Guerdon Associates, 86 percent of ASX 100 companies now incorporate ESG metrics into their bonus structures, with this proportion steadily increasing.

However, skepticism persists among some investors, concerned that executives could manipulate metrics related to reputation or diversity. A recent study analyzed annual reports from ASX-listed firms utilizing non-profit targets for CEO bonuses and found that companies tended to restate past metrics to show improved performance when rewarding corporate social responsibility (CSR). This suggests a need for well-defined, transparent, and objectively measured CSR targets.

Vas Kolesnikoff, head of research at proxy adviser ISS, has expressed skepticism about non-financial targets, often citing poor disclosure and questionable links to performance.

Still, ESG targets aren't the only metrics vulnerable to manipulation; financial metrics can also be gamed through share buybacks and financial engineering.

The Australian Council of Superannuation Investors, advising investment giants managing $1 trillion in assets, supports "non-financial" measures as long as they are "objective, transparent, measurable, and truly at risk." In reality, the "non-financial" label may be misleading, as issues such as customer treatment can profoundly affect financial outcomes, as Qantas shareholders have experienced.

AMP, a major casualty of the Hayne Commission five years ago, illustrates this point. Neglecting non-financial risks can lead to financial consequences, emphasizing the need for comprehensive risk management.

However, these measures should not replace boards' accountability for executive actions or regulatory action against corporate misconduct. They are complementary tools that send a clear signal about a company's values, influencing behavior from top executives to staff.

Ultimately, what gets measured gets done. To encourage better corporate conduct towards customers, it's logical to incentivize executives to focus on this aspect alongside the bottom line.