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©2009 Hay Group. All rights reserved

So are the reward and incentive structures that were put in place during times of record-high oil prices still appropriate? This report suggests some alternatives that may better serve companies’ needs in the current climate and beyond.

The current state of playIt is tempting for Remuneration Committees to follow the crowd. After all, it makes life easy with investors and means that the Board agenda can move on rapidly. However, there are always dangers with the ‘one size fits all’ approach and the metals and mining sector is no different. The reward and incentive model that most companies in the sector adopted during the upturn was based on comparisons with peer companies facing similar strategic, operational, market and economic challenges. Given that the share prices of the industry players are strongly correlated with current and future expected commodity prices, this makes sense as a way of assessing the value added by management.

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The sudden collapse in the demand for commodities that occurred in the second half of 2008 has had a huge impact on the mining sector. Output reductions, project cancellations or deferrals, reviews of capital programmes, debt repayments and a significant decrease in exploration and development have changed the nature of the metals and mining sector as we know it. At the other end of the scale, operators with stronger balance sheets are positioning themselves to take advantage of the upturn, when it occurs.

There are always dangers with the ‘one size fits all’ approach.“ “

Taking a different perspective

An alternative approach to executive reward in the metals and mining sector

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2 Taking a different perspective

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The chart below illustrates how the share prices of companies in the FTSE Mining Index closely follow metal prices, as measured by the London Metal Exchange Index.

When voting on remuneration, traditional UK investors like to see relative total shareholder return (TSR) as a long term performance measure as they believe this ensures rewards are linked to ‘superior’ returns. Generally, in assessing returns, investors will look at similar businesses that are competing for capital with each other and which are exposed to external economic and cyclical factors: typically this means companies in the same sector. It is therefore not surprising that 80 per cent of long term incentive plans in the metals and mining sector use relative TSR against a peer group as a measure of performance (87 per cent when absolute TSR measures are also included). Around 30 per cent of long term incentive plans use either earnings or other financial metrics and just one company uses specific conditions relating to its business development and strategic plans.

* The London Metal Exchange (LME) Index is a weighted average of the six primary non-ferrous metals traded on the LME: aluminium, copper grade A, standard lead, primary nickel, tin and zinc.

* These percentages add up to more than 100per cent as some plans use more than one measure.

Just one company in the sector uses specific conditions relating to its strategic plans as performance measures.

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An alternative approach to executive reward in the metals and mining sector Given the cyclical nature of the metals and mining industry and the significant impact of external market and economic factors on performance, relative TSR can be a good measure of performance in the sector – if properly used. There are, however, a number of issues which we examine in turn below.

Volatility

One issue with relative TSR is that rankings measured over rather short time periods (such as the three year period which is now used by virtually all UK companies) can be very volatile and may thus bear little resemblance to actual performance. This will be particularly exacerbated for companies in the metals and mining industry that tend to have very volatile share prices. The chart overleaf illustrates that the FTSE 350 Mining Index has the highest price volatility (measured over the past three years) compared to any other grouping in the FTSE 350. This means that peer selection becomes even more important, as extending the comparator group beyond the closest peers could produce arbitrary results.

Timescales

In accordance with ‘standard’ UK practice, long-term incentive awards are typically structured to pay out depending on performance over a three-year period. Mining is a long-term industry and a standard three-year period may not be sufficient time to judge whether management has succeeded or not.

Some of the larger companies in the sector have already started to use periods longer than the typical three years (e.g. five years in BHP Billiton and four years in Rio Tinto). Of course longer time horizons may mean bigger awards in order to remain competitive, however this ‘deal’ should be possible to sell to investors who have often expressed a preference for longer performance periods.

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Mining is a long-term industry and a standard three year period many not be sufficient time to judge whether management has succeeded.“ “


One size fits all?

The current recession has thrown a number of players (particularly small explorers and developers) into survival mode, as the industry became polarised between those with cash and those without. Indeed, there are now around 150 metals and mining companies listed on the AIM market (as at July 2009) down from about 175 just three months earlier.

For a company in trouble, using a relative TSR metric may not focus executives on critical business issues. Remuneration Committees and their advisors therefore need to identify those factors (e.g. cash generation/conservation, cost cutting, reduction of debt levels) that will turn round the business. In such situations, it is difficult to see why a relative TSR metric would be appropriate: with the focus on survival, the performance of other businesses becomes irrelevant. However, companies need to exercise caution not to neglect long term value drivers. Looking at absolute TSR in conjunction with a business/operational metric (or relative TSR where appropriate) would be an alternative way of doing this.

The nature of a business also becomes important when determining performance metrics. For the large, mature, diversified miners at the top of the FTSE 100 it makes sense to look at performance in comparative terms. But for smaller explorers and developers it makes more sense to consider the progress made and the absolute level of performance.

Looking to the future

Metals and mining companies are inherently global businesses, competing for resources, talent and finance on a truly global level. However, those listed in the UK have often adopted ‘plain vanilla’ UK reward arrangements in relation to:

n the structure of reward and the balance between fixed and variable pay (see chart below)

n the timescales over which performance is measured

n the choice of performance metric.

Using a relative TSR metric may not focus executives on critical business issues.

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At Hay Group we believe that there are alternative ways to create better longer term alignment to value creation, better suited to the individual needs of each business.

Examples might include:

n implementing an added value plan

n reintroducing share options alongside performance shares (although these have become out-of-fashion they have a much stronger link to absolute value creation and can therefore be particularly effective in certain situations)

n combining performance metrics in a more sophisticated way (e.g. in an interdependent matrix)

n making peer groups more relevant by looking at an index (which may be weighted by relevance rather than market cap) or weighted ranking

n considering qualitative (non-financial) performance metrics that will drive future value or reward the achievement of specific corporate objectives/milestones

n implementing longer vesting periods and/or requiring executives to hold a portion of vested shares for significantly longer periods of time.

Balance of reward elements

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We believe that there are alternative ways to create better longer term alignment to value creation.“ “


We believe that reward should reflect the individual nature of each business, its strategic position, its funding situation and the executive team running it. We recommend that remuneration committees invest in getting reward right.

Strategy and business funding

n Refinancing has become more difficult. Even good, well run businesses risk going to the wall.

n Strategies need to be highly commercial.

Reward that does not reflect these realities will increase risk for the company.

Executive perspective and history

n Executives do not always value their long term incentives.

n Companies with ‘compliant’ but sub-optimal structures have failed. Would a focus on cash and the business itself not have worked better?

Executives need to feel reward is meaningful and specific to their business.

Investor expectations

n Good fund managers want reward to reflect what the business needs to do to be successful.

n The ABI and Risk Metrics have been at pains to emphasise their willingness to be consulted.

Investors will listen to well thought through proposals.

Pay markets

n Pay practice in all markets is varying more from company to company than it has done for a decade.

n There are potentially richer rewards available in environments other than the UK plc listed sector.

Pay levels need to be appropriate and performance targets must be achievable for policy to work.

Breaking down the barriers to change

There is a belief amongst some advisers and Remuneration Committees that change is not possible because shareholders will veto it. This is not our experience. The risk of shareholders voting down a well thought through, properly communicated proposal that takes account of the factors shown in our strategic review model (see table opposite) is actually very low. Our conversations with non-executive directors tell us that they overestimate this risk, sometimes encouraged by their advisers. And the voting advisory bodies do not necessarily expect an ‘amber top’ or ‘vote against’ ranking to lead to a plan or Remuneration Report to be rejected.

We have put in place highly bespoke, company specific reward structures that have passed the ‘shareholder’ test. For example:

n In the mining sector – Xstrata plc

n In the oil and gas sector – Heritage Oil plc

In any case, the declining ownership of UK plc by the traditional institutions and the changing nature of investors mean that intelligent proposals often meet an intelligent response. To provide some perspective, traditional institutional investors now own just one quarter of the UK market, (down from approximately 50 per cent a decade ago). This proportion will be even lower in the mining sector, where a larger part of equity will be owned by foreign investors than is typically the case for a UK plc. Another barrier to change is the commonly stated belief that there is no need or appetite to change what we are doing. Our use of the strategic model, applied in this difficult economic time, tells us that this is simply not the case, as illustrated below.

Strategic review model


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Reward benchmarking

Explicitly stated or otherwise, much reward benchmarking in your sector is based on the relative market capitalisation of one company versus others, and a comparison being made with other executives with similar titles rather than similar jobs. The main problem with this is that market capitalisation can vary significantly at different times and an increase or decrease in market capitalisation does not mean that a directly proportional increase or decrease in job complexity has occurred.

The following tables show annual reward levels in the UK for metal and mining businesses for the latest available financial year. Market data has only been shown where there are sufficient data-points available.

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CEO 930,000 392,000 1,042,000 868,000 463,000

Other executives 642,000 – 664,000 563,000 346,000

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CEO 1,640,000 600,000 2,182,000 1,293,000 807,000

Other executives 870,000 – 1,120,000 762,000 546,000

Total Direct Compensation (£)

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CEO 3,078,000 1,172,000 3,709,000 1,855,000 1,008,000

Other executives 1,781,000 – 2,348,000 762,000 546,000

At Hay Group, we combine the use of executive market data sorted on the basis of company size with our world leading job evaluation methodology to ensure that reward levels for executives reflect not just job title, but also the complexity of the job an executive does. In our opinion, too many companies base their reward levels solely on market capitalisation, which in turn is dependent on a potentially volatile share price, as is particularly the case in the metals and mining sector.

Furthermore, the talent market in the metals and mining sector is genuinely global. Recruiting and retaining talent, from specialist engineering roles to senior executive positions, is a constant challenge for the global industry within a relatively scarce talent pool. Whilst in the short-term these pressures are weakening with lower demand and suspension of projects, the competition for talent will intensify when the global economy bounces back.

Our pay databases and methodology give you the opportunity to make comparisons with the right talent markets in different geographies and sectors and better deal with the differences in reward structures in different countries (as illustrated earlier in this paper).

As well as country-focused market data for main board and other top executive roles, Hay Group runs a Global Mining Compensation Review (MCR) which provides comprehensive intelligence on quantitative and qualitative compensation and human resource topics. The MCR includes:

n a range of geographic markets, specifically Argentina, Australia, Canada, Chile, Mexico, Peru and USA

n approximately 400 participant business units in both major multinational and local companies

n compensation data from over 29,000 incumbents including over 1,900 executives

n in depth research on the relationship between CEO variable pay and corporate performance, and executive succession planning

n regional pay analysis and job family analysis for country reports, where applicable.

Hay Group’s MCR is recognized as the most comprehensive and authoritative information source globally and in each of the countries indicated.

About Hay Group Hay Group is an independent global consulting business. Our UK executive remuneration team advises the Remuneration Committees of a wide number of companies, ranging in size from FTSE 100 to AIM, to those backed by private equity. Our consultants have worked on reward arrangements at Acambis plc, BTG plc, Sinclair Pharma plc, Skyepharma plc and others.

We have over 2600 employees working in 85 offices in 47 countries. For over 60 years, we have been renowned for the quality of our research and the intellectual rigour of our work. We transform research into actionable insights. We give our clients breakthrough perspectives on their organisation, and we do it in the most efficient way to achieve the desired results.

AuthorsPeter Boreham | Jon Dymond | George Makris

For further information please contact:

Peter Boreham | UK head of executive reward t 020 7856 7146 e [email protected]

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