Powering Incentive Compensation

Abstract

Steven Hall & Partners recently completed a study of incentive compensation programs at 73 of the largest utility companies in the United States. Utility companies face unique challenges when designing incentive compensation programs, due to the greater number of stakeholders to whom they must be responsive, intense media scrutiny, stringent regulatory constraints and the need for regular public approval of rate cases. Although fixed compensation in the form of base salaries does represent a greater percentage of total compensation among utilities, this is not to say that utilities have ignored incentive-based compensation. In fact, utility companies pay for a broader range of performance than many other public companies. In addition to common performance metrics like earnings and shareholder returns, utilities also consider nonfinancial performance metrics such as safety and customer service, which serve as strong public demonstrations of a commitment to performance objectives shared by customers and shareholders alike.

Keywords

incentive-based compensation performance-based compensation utilities performance metrics pay for performance

Paying for performance is not a new concept. Companies have been following this mantra for years. However, companies in the utility industry face a unique set of challenges when designing incentive compensation programs. Given their role, utilities have a greater number of stakeholders to whom they need to be responsive, and operate under a media microscope and far stricter regulatory standards than many general industry companies. As organizations with explicit missions to serve the public, compensation paid to executives is under greater scrutiny at utilities and can be a factor in the periodic process of seeking approval for increases in rates. Additionally, many utilities are held to operating performance standards and may have all or a portion of their profits regulated by federal, state and local municipalities. Interest rates, unpredictable weather patterns and modest growth expectations and their related impact on stock price further affect the design of incentive compensation programs at utility companies. Given these challenges and constraints, incentive compensation programs at utilities are unique from those in general industry.

The discussion of incentive compensation design which follows relies on an analysis of 73 companies in the utility sector with revenues greater than $500 million. The study sample was comprised largely of electric utilities (28%) and multiutilities (29%). A full breakdown of the study sample is provided in the following table.

			Median ($ millions)		Median TSR, %
GICS industry	Number Of companies	% Of total	Revenue	Net income	1-Year	3-Year	5-Year
Electric utilities	28	38	2,631	176	+20	+14	+4
Gas utilities	17	23	1,887	115	+11	+17	+10
Independent power producers and energy traders	4	6	6,347	−66	−19	−16	−20
Multiutilities	21	29	4,709	387	+24	+15	+7
Water utilities	3	4	712	143	+1	+5	+2
Total sample	73		2,943	177	+18	+15	+6

Note. GICS = Global Industry Classification Standard; TSR = total shareholder return. Data relate to proxy reporting period.

Pay Mix: Fixed Versus Variable Compensation

All decisions regarding incentive compensation program design begin with a basic question: How much of the total compensation package should be based on performance? Although there is no universal right answer to this question, the answer often depends on the stage of development and the anticipated growth trajectory of the organization. Perhaps not surprisingly, due to the predictability of the business model and the constraints on growth, pay for top utilities executives, regardless of subindustry, is less variable than pay for top general industry executives, with a higher concentration delivered in base salary.

Interestingly, among larger companies in the utility space, we observed a significantly greater focus on incentive-based compensation, perhaps suggesting that larger companies may be more likely to conform to general industry practices. Among the smallest companies in the study group, just 61% of CEO compensation was performance based compared to 84% for the largest companies.

When compared to the other named executive officers (NEOs), CEOs receive a greater percentage of their overall compensation in the form of incentive-based compensation (74% for CEOs vs. just 62% for other NEOs). This trend is consistent with general industry and generally reflects the belief of shareholders and compensation committees that the CEO should be held most accountable for corporate performance.

Revenue range, $ billion	Number of companies	Average CEO pay mix, %			Average other NEO pay mix, %
		Fixed	Variable		Fixed	Variable
		Fixed	Short-term	Long-term	Fixed	Short-term	Long-term
<$1	10	39	23	38	55	20	25
1-3	27	29	25	46	40	23	37
3-5	13	23	21	56	35	22	43
5-10	8	20	21	59	31	20	49
>10	15	16	18	66	26	19	55
Total sample	73	26	22	52	38	21	41

Note. NEO = named executive officer.

Pay Mix: By Compensation Element

When designing compensation packages, it is generally preferable to benchmark pay elements on a total compensation basis. Targeting the median of each compensation element can lead to total compensation levels far in excess of the median, as different companies allocate their compensation dollars in different ways. However, the question of how much to allocate to different compensation elements is a critical one. The answer should be company specific and depend on the strategic objectives of the organization and, barring changes in strategy, is likely to remain relatively constant over time. In instances where short-term objectives are critical for the success of the organization, there may be a greater focus on annual incentive opportunities. For most companies today, the single largest element of compensation is long-term incentive compensation. This reflects a desire to align the interests of executives with those of shareholders over time. Additionally, well-designed compensation programs balance short- and long-term incentive compensation elements with complimentary performance objectives, such that over time the achievement of short-term performance-objectives builds toward the creation of long-term value.

For utilities, with relatively stable and predictable business models over time (although not perhaps in any one specific year—when weather can play a big role in the “success” of the business), and the need for consistent investment in the underlying infrastructure supporting the reliable delivery of services, the strategic objectives tend to be longer term in nature. For CEOs, where the bulk of the compensation package is incentive based, long-term incentive compensation forms the single largest component of compensation (52%). But evidence of a more stable compensation structure remains. Unlike their general industry peers, where annual incentive compensation is typically the second largest pay element, followed by base salary at a distant third, among utility company CEOs, base salary represents the second largest component of compensation (26%) followed by annual incentives (22%). This trend is echoed among the other NEO population, although base salary represents a comparatively large percentage of the total pay package.

Annual Incentives

Although not the dominant form of incentive-based compensation among utilities, annual incentives still represent an important part of the total compensation package for executives of utilities, representing 22% and 21% of the total target package for CEOs and other NEOs, respectively.

Target Annual Incentive Opportunities

Among CEOs studied, the median target annual incentive was 100% of base salary, with opportunities ranging from 50% of base salary on the low end to 125% of base salary on the high end. Although there was little variation in this range between subindustries, opportunities were higher for CEOs at larger companies. Among the smallest companies studied (those with revenues of less than $1 billion), the median annual incentive opportunity was 70% of base salary.

There was greater differentiation in target annual incentive opportunities for other NEOs. On an overall basis, median incentive opportunities ranged from 50% to 70% of base salary. However, we observed greater differentiation based on the size of the company. The larger the company, the higher the target incentive opportunity.

These trends are consistent with those observed in general industry, where the size of the target opportunity is generally correlated with the size of the company.

Target Annual Incentive Opportunity as a Percentage of Base Salary.

Revenue range, $ billion	Number of companies	CEO, %		Other NEO median range^a (%)
Revenue range, $ billion	Number of companies	Median	Range, low-high	Other NEO median range^a (%)
<1	10	70	50-125	40-45
1-3	27	91	62-115	45-61
3-5	13	100	75-100	50-75
5-10	8	100	100-110	60-70
>10	15	100	95-125	65-75
Total sample	73	100	50-125	50-70

Note. NEO = named executive officer.

Represents median of minimum and maximum target bonuses among other NEOs.

Leverage

Leverage reflects the amount of upside opportunity and downside protection imbedded in an annual incentive program. Consistent with trends observed in general industry, executives at utilities had threshold opportunities equal to 50% of target and maximum incentive opportunities of 200% of target.

Performance Metrics

Annual incentive performance metrics are an important way to communicate an organization’s priorities, to both internal and external audiences. For utilities, they can be particularly important for publicly demonstrating support for performance and initiatives directly related to the customer’s experience. By incorporating nonfinancial, operating metrics into the annual incentive program, even in relatively small overall weightings, utilities can use annual incentive performance metrics to enhance public relations and win rate cases. For this reason, most companies studied used multiple performance metrics in their CEO annual incentive program, with four performance metrics being most prevalent.

Among the utilities studied, earnings metrics were by far the most prevalent and the highest weighted among all CEO performance metrics studied; 97% of companies used at least one earnings metric and 69% of these companies weighted the metric 50% or higher, with a median weighting of 60%.

Number of performance metrics in CEO annual incentive plan.

However, unlike the alternatives used in general industry, the next three most prevalent metrics were safety (used by 42% of companies studied), other utility-related metrics (a general category including items such as system-wide performance, regulatory and legislative advocacy, operational excellence and power supply availability and reliability used by 35% of companies studied) and customer satisfaction (34%). The selection of these metrics is not arbitrary. Each of them speaks directly to the desire of utility companies to focus executives on metrics that matter to their customers, and to be able to demonstrate this focus to external audiences.

Performance metric prevalence.

Median CEO performance metric weightings.

*Other Utility Related includes metrics such as system-wide performance, regulatory and legislative advocacy, operational excellence, power supply availability and reliability and so on.

Long-Term Incentives

Long-term incentives represent the largest component of the total compensation package for both utility CEOs (52%) and other NEOs (41%). Utilities have been leaders in the trend away from options and time-vested restricted stock and toward performance-based equity. On an overall basis, performance-based awards represent the most prevalent and largest component of long-term incentive compensation, followed by time-vested restricted stock and stock options in distant third. This allocation reflects the desire on the part of utility companies to be responsive to pay for performance concerns of shareholders and other stakeholders, as well as the impact of interest rates on stock price of dividend-paying utilities that influence price and the absence of rapid stock price growth that would make options an appropriate vehicle. It is also a remarkable shift from a historical industry practice in which long-term incentive awards were more likely to be comprised of time-vested restricted stock supplemented by options. Although restricted stock remains a component of long-term incentive compensation programs at over half of the companies studied, it reflects less than one quarter of the total long-term incentive compensation package.

Vehicle Selection

Today, most companies grant multiple types of long-term incentives. This creates an incentive compensation program that rewards on several performance metrics, including longer term financial or operational goals as well as stock price appreciation, over differing periods of time. It also helps to ensure that at any given point in time, there is sufficient glue on critical executives to retain them. Even if stock price performance has lagged, time-vested restricted stock and, depending on the performance metrics, performance-based awards, can provide some downside protection and ensure that executives remain motivated to work through challenging times for the longer term benefit of shareholders.

Performance-based awards were by far the most prevalent among the utilities studied, granted by 93% of companies studied, whereas over half of companies granted time-vested restricted stock and just a quarter of companies made option grants.

Prevalence of annual long-term incentive vehicles.

Vehicle Mix

How companies allocate their long-term incentive dollars between different vehicles has changed dramatically over the past several years. Time-vested restricted shares remain plagued by the critique that they merely represent “pay for pulse” and options have recently been tarnished by shareholder advisory firms who have refused to label them performance based. Coupled with a stated preference for “performance-based” compensation programs, this has resulted in a greater weighting on performance-based awards. Of course, the “right” mix again varies by company, and should reflect a balanced consideration of longer term strategic objectives, realistic assumptions regarding stock price appreciation and retention needs.

Among utility companies generally, performance awards are the most heavily weighted component of long-term incentive compensation, comprising 69% of the total long-term incentive component, whereas time-vested restricted stock represent 21% of the total and options just 10%. Notably, among smaller companies, restricted stock represented a greater percentage of the total, although performance shares were still the largest component.

Vehicle Mix by Revenue.

Revenue range, $ billion	CEO				Average other NEOs
Revenue range, $ billion	Sample size	Performance awards, %	Time-vested restricted stock, %	Stock options, %	Sample size	Performance awards, %	Time-vested restricted stock, %	Stock options, %
<1	10	58	37	5	10	53	37	10
1-3	20	77	13	10	22	74	18	8
3-5	12	72	23	5	12	72	23	5
5-10	8	70	20	10	8	70	20	10
>10	15	64	21	15	15	70	15	15
Total sample	65	69	21	10	67	69	21	10

Note. NEO = named executive officer.

Performance-Based Awards

Although performance-based awards can be designed to motivate and reward myriad longer term strategic performance objectives, most utility companies do not take advantage of this versatility. In part because of the many challenges of accurately projecting performance over the longer term, particularly given significant unknowns regarding rate cases, weather and the need to maintain dividend levels, 88% of utilities included in our study utilize relative total shareholder return (TSR) as the sole or dominant performance metric in their performance-based award program (77% of companies using TSR weighted it 50% or higher for CEO long-term performance).

Although relative TSR is beloved by shareholder advisory groups, can easily be explained to shareholders and results in totally defensible payouts, it is not without its shortcomings. It can penalize steady performers at the expense of poor performers who “rise from the ashes” and exhibit remarkable stock price performance off of a low base, often of the company’s own making. Additionally, it can put undue emphasis on the beginning and end of the performance period, with little recognition for performance during the interim.

The second most prevalent performance metric observed among long-term performance share programs was earnings. But it was a distant second. Only 38% of companies utilized the metric, and only 23% of these companies weighted it greater than 50% for CEO awards.

CEO long-term performance metrics.

Despite the advantage of using multiple performance metrics to provide balance in the long-term incentive program, companies studied were most likely to use only one performance metric.

Number of performance metrics in CEO long-term incentive plan.

Consistent with general industry practice, performance periods were typically 3 years in duration and payouts were overwhelmingly in stock.

Time-Vested Awards

Full value time-vested awards represented 21% of the total long-term incentive package among companies studied and had a median vesting period of three years, with the majority of awards vesting incrementally over time (“step” vesting).

Stock Options

Stock options reflected 10% of the total long-term incentive package among companies studied. The awards had a median vesting period of 3 years, again vesting ratably over time, and a median term of 10 years.

Conclusion

Although utility companies face a unique set of challenges when it comes to designing and implementing incentive compensation programs, well-designed programs can both motivate and reward desired behavior on the part of executives while demonstrating strong commitment to performance objectives shared by customers and shareholders alike. Although this study shows utilities provide more fixed compensation to their executives than other industries, it should not be interpreted as a lack of focus on paying for performance. In fact, the shift in long-term compensation from service-based awards to performance-based awards and the annual incentive plan focus on multiple financial and nonfinancial metrics highlights how committed utilities are to ensuring that their compensation programs are aligned with the short- and long-term strategic objectives of the company; the provision of safe, reliable, and affordable products for customers and consistent returns for shareholders

Footnotes

Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author(s) received no financial support for the research, authorship, and/or publication of this article.

Author Biography

Steven Hall Jr., Consultant, has over 7 years of experience advising companies on executive and director compensation matters. He leads Steven Hall & Partners’ client outreach efforts and serves as the firm’s liaison to members of the press and industry professional organizations. Additionally, he supports the firm’s market pricing activities of both executive compensation and Board remuneration programs. He holds a BS in business administration from Boston University’s School of Management.

Nora McCord, Managing Director, Steven Hall & Partners, has over 10 years of experience in researching and consulting on executive compensation matters. She advises clients on a variety of matters, including benchmarking compensation levels and practices and proxy disclosure, in addition to supporting the firm’s litigation and expert witness practice. Prior to joining Steven Hall & Partners, she served as Senior Manager in charge of research operations with Equilar, Inc. She holds a master’s degree from the Georgetown Public Policy Institute and a BS from Georgetown University’s Walsh School of Foreign Service.