October 13, 2017

Finding and Avoiding Perverse Incentives – Directorship Magazine

By Mark Hodak

How to pair the right metrics with the right goals to incent superb results.

EDC was an American energy company that successfully financed, developed, and operated power plants around the world. It made large investments in complex projects and recouped them by leasing the plants to its customers. The company paid bonuses to its senior managers based on each plant’s operating profits above a 25 percent return on capital. This plan provided a useful set of incentives, including keeping a lid on capital costs and building the plant so that it could begin operating profitably as soon as possible, and for a long time to come. In 1990, the company promoted a new leader. She had noticed, and perhaps resented, that the bankers that provided the capital for these projects were paid handsomely as soon as they closed on the financing, while her managers, who made those rewards possible, had to wait. So she changed EDC’s incentive plan to pay her and her managers like the bankers, i.e., based on a percentage of the capital raised for the projects. This new incentive plan was consistent with her strategy of ramping up the number of deals.

If you step back from the sizzle of the strategy, it is easy to see that the company’s incentives were now completely reversed. Management became indifferent to the amount of capital expenditures in new plants. In fact, more investment could translate into higher bonuses. Similarly, post-construction operating efficiency was no longer of any consequence to their pay. They were rewarded far more for chasing new deals than for paying attention to projects that had already been funded. This altered the company’s focus, which, combined with its prior track record, enabled it to do many deals in the ensuing years. As the quantity of deals surged, however, the quality of the deals dropped precipitously, and the company found itself increasingly bogged down with complaints about plant completion and operating performance as returns deteriorated. Seven billion dollars later, EDC’s cumulative investment in new projects had become a major drag, not just on its own returns, but on the overall returns of its corporate parent—Enron.

While most of the Enron story is appropriately focused on the accounting shenanigans that top management used to hide its underlying financial problems, it is worth considering the perverse incentives that were at the root of those problems. By the time Jeff Skilling became president and, to his credit, promptly cancelled EDC’s incentive plan, it was too late. Declining returns were baked into Enron’s financials for at least the next several years. Management pay was about to be severely hit by those declines. When Andrew Fastow, Enron’s enterprising CFO, offered a solution to this problem, Skilling was unfortunately ready to hear him out.

The Enron example highlights two factors that figure prominently in compensation-induced governance risk: defective incentives, and a high sensitivity of pay to performance consistent with those incentives.

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