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Pensions Week: Industry Watch: Governance

EXTRACT: Oil companies have been the first to feel the pressure, with BP and now Shell being engaged by local authority pension funds. The funds argue that factors like health and safety should affect awards under long-term incentive plans since they are long-term issues.

Tom Powdrill,
Published: May 07, 2007

What do shareholders pay directors to do? It might sound like a rather easy question to answer. Clearly, we pay directors to run the company effectively in order to generate returns that will help pay people’s pensions. The problem comes when we start to think about what we are going to measure to decide whether the company is being run properly. The push to encourage companies to focus on ‘shareholder value’ resulted in the widespread belief that linking rewards to maintenance of the share price should align the interests of directors with those of shareholders.

An executive decision?

Unfortunately things did not prove to be quite so simple. As the old adage goes, what gets measured gets managed. With directors’ rewards and reputations welded to an increase in share prices, arguably this has created a situation in which there is a very strong incentive to manage the price, and other financial factors that affect it, even if this comes at the expense of what is good for the business. This might sound unlikely but academic evidence from the US has found that, for example, executives would delay initiating a new project if it meant they would miss an earnings target. They would make this decision even if they were sure the proposed project would create value in the long term. Their focus is on managing the indicator.

The wider context

Looking broadly, the public is increasingly concerned about the social and environmental impact that companies have. The extent to which these factors affect companies’ share prices is the subject of intense, and inconclusive, debate. Many would argue that social and environmental issues do have an impact on business performance, but only when they are ‘material’. That is, only when they pose significant potential financial challenges to the business.

In these terms, while we might all agree that climate change will have a material impact on many businesses, would we feel the same about health and safety practices? And if safety is not a sufficiently material factor to influence share price, should we conclude that investing in creating a safe workplace is a distraction from creating shareholder value?

Of course this is a simplification. In addition to the moral responsibility to maintain a safe workplace, companies are subject to regulation which aims to achieve this. However the broader issue here is whether, or to what extent, management of these non- financial factors should be linked to remuneration.

A number of companies do link elements of remuneration, typically part of the annual bonus, to non-financials. But there is some pressure from investors interested in corporate social responsibility to get companies to do more. They argue that by simply tying a small element of the bonus to management of these factors does not provide much of an incentive, since it represents only a small proportion of total remuneration. Oil companies have been the first to feel the pressure, with BP and now Shell being engaged by local authority pension funds. The funds argue that factors like health and safety should affect awards under long-term incentive plans since they are long-term issues.

A brave new world

These are relatively new ideas, and as yet do not have much traction in the governance world. But they do represent the possible early signs of a change in approach. If we know which factors we want directors to manage, does it make more sense to structure remuneration to capture them, rather than simply relying on share price and derivatives from it as imperfect proxies for good corporate performance?

The AGM to watch

BAE Systems has its annual general meeting on May 9. The company has put forward six resolutions seeking authority for political donations, something many corporate governance advocates do not support on principle. In addition, coming in the wake of the halted Serious Fraud Office investigation, some shareholders might use these votes as a way to register wider concerns.

 

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