Incentive Compensation in Energy Firms: Does Regulation Matter?

• Author: Laura Rondi,Carlo Cambini,Sara De Masi
• Date: 01 July 2015
• Published date: 01 July 2015
• DOI: http://doi.org/10.1111/corg.12114

Incentive Compensation in Energy Firms: Does

Regulation Matter?

Carlo Cambini, Laura Rondi*and Sara De Masi

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: While regulation reduces the discretion of CEOs, it is also expected to prompt effort and eff‌iciency.

This paper develops a link between regulation and thetwo main competing theories of executive compensation (eff‌iciency vs.

entrenchment) and investigates whether CEO pay-performance sensitivity differs across alternative regulatory regimes in the

European energy industry.

Research Findings/Insights: Usinga panel of energy utilities from12 EU countries tracked from2000 to 2011, we f‌ind thatman-

agerial compensation is sensitive to performanceonly if the f‌irm is subject to incentive regulation, not in the case of cost-based

contracts. We also f‌ind that incentive regulation makes managerial entrenchment less likely, while CEOs subject to cost-based

regulation appear to be more entrenched with the board, obtaining compensation that may even increase when (accounting)

performance deteriorates.

Theoretical/Academic Implications: We derive a conceptual framework that enables us to investigate the interplay between

the strength of corporate governance (incentives vs. board monitoring) and the type of regulatory contracts.

Practitioner/Policy Implications: Our f‌indings suggest that in industries where competition looms –mimicked by the

regulatory framework –CEO compensations are more responsive to stock-based and accounting performance mea-

sures and managerial entrenchment is les s likely. Hence, corporate gover nance (monitorin g and/or compensati on)

and regulation complement each other. In contrast, where regulation is not eff‌iciency oriented, the adoption of

performance-re lated contracts s eems to bring no advantage to f‌irms and on ly additional co sts to shareholder s, also

due to CEO entrenchment.

Keywords: Corporate Governance, Managerial Compensation, Incentive Contracts, Regulation, European Utilities

INTRODUCTION

This paper studiesthe functioning of a hotly debatedmech-

anism of corporate governance –incentive compensation

of CEOs –in publicly traded companies operating in the

European energyindustry. Drawing on corporate governance

theories on executive compensation (the “eff‌iciency”versus

the “managerial entren chment”views), we investigate dif-

ferences in the structure of compensation contracts associ-

ated to changes in regulatory regimes, in particular the

switch from low-powered (cost-based) to high-powered

(incentive) schemes.

The European energy industry is interesting because until

the early 1990s, it consisted of vertically integrated, state-

owned companies that were a good approximation of

textbook “natural”monopolies. From then on, it became sub-

ject to a sweeping wave of reforms, which started with the

unbundling of operations. On the one hand, the generation

segment was deregulated and f‌irms privatized and pub-

licly listed, on the other hand transmission and distribu-

tion operators were partially privatized and became

regulated by newly established national regulatory au-

thorities. This process changed much, if not all, of the

market structure of the energy industry and, more inter-

estingly for us, of the internal organization of these

companies, which are now more oriented to maximize

their shareholders’wealth. At the same time, the consid-

eration of investors and f‌inancial markets for these f‌irms

steadily increased and, in parallel, their interest in any

governance tool s or mechanisms tha t might boost their

eff‌iciency and market value. The introduction of corpo-

rate governance guidelines by the OECD (1999) and the

European Commission as well as the growing attention

by the media and public opinion

1

have highlighted the

importance of CEO compensation and incentives, but

the effects of regulatory schemes and corporate gover-

nance have so far been analyzed separately.

2

This paper

contributes to t he study of these two topics joint ly by inves-

tigating whether regulatory and internal governance mech-

anisms interact to ensure a better governance structure. Our

*Address for correspondence: Laura Rondi, Politecnico di Torino –DIGEP,

Department of Management, Corso Duca degli Abruzzi 24, 10129 Torino, Italy;

E-mail: laura.rondi@polito.it

© 2015 JohnWiley & Sons Ltd

doi:10.1111/corg.12114

378

Corporate Governance: An International Review, 2015, 23(4): 378–395

results indicate th at internal corpo rate governance me cha-

nisms differ across f‌irms subject to different regulatory

mechanisms that, among other things, imply different

eff‌iciency-enhanci ng pressures as well as d ifferent charac-

teristics in terms of monitoring. In particular, when f‌irms

are subject to eff‌iciency-enhancing regulatory schemes, we

f‌ind evidence of complementarity between monitoring

and compensation-related instruments. These results provide

a positive indicationnot only for European but also for North

American policymakers, where a large variety of regulatory

regimes, from cost-based to performance-based/incentive

regulation, are in p lace.

Among corporate governance mechanisms, CEO compen-

sation and its sensitivity to performance are among the most

widely studied topics (Goergen & Renneboog, 2011; Murphy,

1999; Shleifer & Vishny, 1997). According to the “eff‌iciency”

view, remuneration contracts can be designed as an incentive

mechanism that affects the way in which individuals behave,

turning into a corporate governance instrument that aligns

interests between managers and shareholders, when share-

holders do not have complete information about the CEO’s

activities and the f‌irm’s investment opportunities. These

contracts link CEO pay to shareholder wealth via perfor-

mance indicators, pushing the CEO to make decisions that

maximizeshareholder value. Alternativeto this, the “manage-

rial entrenchment”view argues that entrenched managers

exploit theirpower to obtain compensationarrangements that

raise their salary and protect them from performance pres-

sures (Bebchuk & Fried, 2004; Cyert, Kang, & Kumar, 2002;

Hu & Kumar, 2004).

Incentives for managers, and in particular for CEOs, may

also originate from the external environment, i.e. by product

market discipline and national corporate governance. For ex-

ample, through its structure and dynamics, the product mar-

ket has a strong inf‌luence on managers’behavior. In

competitive markets, managers have to take decisions that

improve f‌irm eff‌iciency and performance in order to make

prof‌its and stay in the market (Giroud and Mueller, 2010;

Hart, 1983). In cont rast, in non-comp etitive markets, m an-

agerial slack an d agency problems are pervasive as man -

agers are more likely to maximize their own self-interests

rather than those of shareholders, increasing the likelihood

of entrenchment between the CEO and the board of

directors.

The public utility sector, which provides public services

through a network infrastructure, is one of these non-

competitive markets where economic regulation plays a

strong inf‌luencing role by setting a variety of constraints

on f‌irm behavior and decisions. Regulators, on the one

hand, are expected to prompt eff‌iciency and investment of

regulated f‌irms, as if they were in a competitive market

(Armstrong & Sappington, 2006). On the other hand, by re-

ducing the complexity of CEOs’tasks and the discretion of

their decision-making power, or even imposing constraints

on the level of the compensation, regulation may dampen

the CEO’s internal incentives, thus making regulated f‌irms

less attractive to most talented managers (Joskow, Rose &

Shepard, 1993; Palia, 2000). The overall implications for

CEO incentives are thus uncertain, a nd we draw on the

corporate governance and regulation literatures to develop

testable predictions about the relationship between

“external”(the regulatory scheme) and “internal”(the com-

pensation contract or the board of directors) mechanisms

expected to align managers’and shareholders ’interests.

To test our hypotheses in a suitable empirical framework,

we focus on a panel of European publicly traded f‌irms oper-

ating in a single industry –the energy sect or –but in differ-

ent segments, as re cent reforms unbun dled generation ,

transmission and distribution activities, and implemented

different regulatory regimes, i.e. incentive or cost-based

schemes. The focus on an intra-industry case study allows

us to isolate the effect of different regulatory contracts on

pay-performance sensitivity and to explore, ceteris paribus,

the contribution of alternative corporate governance mech-

anisms that may differ across f‌irms. Because the wit hin-

industry interplay between regulation and managerial

compensations is not (or less) inf‌luenced by the impact of

other industry- specif‌ic factors on CEO pay-performance

sensitivity, we can better develop the link between regula-

tory schemes and the “eff‌iciency”or the “managerial en-

trenchment”views.

Under cost-based contracts (like the so-called rate-

of-return regulation typically applied to state-owned

monopolies), regulators f‌ix the rate of return the f‌irms can

earn on their assets, deciding the price that they have to

charge, considering all the main operating costs that need

to be covered. Evidently, by guaranteeing the f‌irm’sf‌inan-

cial integrity, cost-based regimes do not provide any spe-

cif‌ic incentives for eff‌iciency-seeking managerial practices.

We argue that this in turn might enhance managerial

entrenchment and l ead to situations w here managers may

obtain compensation arrangements that raise their salary

independent of f‌irm performance. Under incentive re gula-

tion, regulators apply f‌ixed-price contracts for a multi-year

period, leaving f‌irms to choose a price below or equal to a

certain threshold. By pursuing cost savings, managers can

then generate higher prof‌its and benef‌it shareholders, who

are, under this scheme, the actual “residual”claimants of

their performance, more than under the cost-plus contract.

Hence, incentive regulatory schemes are expected to re-

duce managerial slack and make managerial entrench-

ment less likely.

Among regulatory mechanisms, the search for eff‌iciency-

enhancing schemes led many European energy regulators to

switch from low-powered to high-powered incentive schemes.

Differing regimes provide us with the within-sector cross-

country heterogeneity that is needed to test whether incentive

compensation contracts are an additional, or an alternative,

source of eff‌iciency-inducing behavior. To our knowledge, this

is the f‌irst paper to investigate CEO pay-performance sensitiv-

ity in the public utility sector in Europe, testing the effect of

different regulatory regimes and their link with competing

corporate governance theories. Our results contribute to the

existing literature in several ways.

First, we f‌ind that European energy utilities link CEO

compensation to f‌irm performance. Second, we f‌ind that

pay-performance sensitivity for CEOs operating under

incentive regulation is signif‌icantly higher than in f‌irms

under cost-based regulation. These results suggest that

whenever residual prof‌its may derive from eff‌icient mana-

gerial practices, shareholders rely on effective corporate

governance mechanisms to reduce managerial slack. Third,

379INCENTIVE COMPENSATION IN ENERGY FIRMS

© 2015 JohnWiley & Sons Ltd Volume 23 Number 4 July 2015