How to build an effective CEO compensation package
Rule one: Don't keep details from shareholders
For Encana Corp., 2011 was not a stellar year. A $5.4 billion joint venture with PetroChina fell through. The Environmental Protection Agency claimed hydraulic fracturing conducted by the company had contaminated a Wyoming water well. The company’s share price continued to be battered by a natural gas supply glut in North America. And it backed off previously announced production growth targets and was forced to pursue sales of non-core assets to strengthen its balance sheet.
So investors no doubt nodded their heads in agreement when Encana’s board of directors approved a six per cent decrease in president and CEO Randy Eresman’s total compensation in 2011 compared to 2010 – from $10,576,262 to $9,250,751.
“Our accomplishments were largely overshadowed by the oversupply of natural gas, which significantly reduced future prices for North American natural gas prices,” the board said in its information circular this spring. “These factors also had a significant impact on Encana’s share price performance in 2011.”
[Related: Oil and gas CEO compensation]
The question of executive compensation in the oil and gas industry is a touchy one. “It’s a lightening rod for the public at large,” says John Hammond, a Vancouver-based compensation consultant with Towers Watson. At a time when finding roughnecks to round out a rig crew is a challenge, the pressure to keep executives with the skill sets to run complex, multibillion-dollar companies with assets and operations around the world has taken on added significance.
Today’s boards and compensation committees must strike a delicate balance — between developing a program that keeps executives motivated and appropriately compensated on the one hand, and shareholders’ interests and the company’s business strategy on the other.
Striking that balance is not getting easier for the boards of oil and gas companies, who ultimately make the call on executive compensation packages. The men and women with the skills, experience and ambition to take on a president or chief executive officer role are not abundant. “Those engineers and senior executives are becoming much more scarce on the global scene, and they are a mobile bunch,” says Phil Yores, a Toronto-based partner and senior consultant at Meridian Compensation Partners LLC.
Adding to the complexity of executive compensation is the fact that investors are demanding more from boards – more disclosure and more recognition of the shareholder experience. Increasingly, the kind of investor activism that resulted in the resignation of Canadian Pacific Railway Ltd. president and CEO Fred Green and six incumbent board members this spring after a bitter proxy battle means boards and the compensation committees they oversee must take great care in how they set up these packages.
For people who don’t occupy the energy industry’s c-suite, there is little appreciation for what goes into developing a sound executive compensation program. It’s more than just a hefty base salary, and must include a pension plan, performance bonuses and short- and long-term incentives like shares and stock options.
The numbers can get big. Rick George, the retired president and CEO of Suncor Energy Inc., earned more than $14 million in 2011, for example. One trend in developing these increasingly complex packages is aligning them with a company’s business strategy.
The concept sounds straightforward, but it can be difficult to accomplish.
Yores says compensation programs can’t just be designed so that the executive is paid well if the company does well. Rather, a good program “is targeted at motivating and driving desired behaviors,” Yores says.
“The more focused they are and the more aligned those incentives are with the business strategy, you will be focusing people’s attention on the things that are more impactful on the business. Compensation is one of the things meant to drive a business strategy. But when you have a disconnect, that’s when you have a compensation problem.”
One of the ways companies try to avoid that disconnect is using non-traditional long-term incentive vehicles in their programs. “It wasn’t that long ago that most companies in the energy sector were still using stock options as the only vehicle to attract, retain and motivate and to align the executives interests with those of their shareholders,” says Kenneth Yung, a Calgary-based compensation expert with Mercer (Canada) Limited.
“Now, we see a significant number of companies choosing a mix of long-term incentives to provide a better balance in the overall program design and to better align pay with mid- and long-term performance.”
At Towers Watson, Hammond says he is also seeing companies moving from market-based measures to operational and financial measures in the long-term incentives they offer as compensation to executives that tie into the strategic business plan. This is a nod to the fact that the oil and gas industry is very cyclical. A company’s share price can rise and fall due to factors that a CEO has little to no control over.
By shifting incentives to company-specific issues like safety performance, production targets and capital program performance, executives feel they have more control over the outcomes (and thus more control over accumulating wealth). Those long-term incentives tied to company-specific performance also aid the company in executing its business strategy.
The next step in designing an effective compensation package involves telling shareholders what you’re up to. “Companies in the past have done a very poor job conveying to shareholders what’s behind these pay decisions,” Hammond says.
That’s a serious mistake, he says, because uninformed or misinformed shareholders can quickly become angry shareholders. Hammond advises boards to explain the fundamental tenets of a company’s compensation philosophy – what companies you compare yourself against and why – as well as the major elements of a compensation program and how they link to performance.
At Imperial Oil Ltd., the board devoted 12 pages in its management proxy circular to explain its compensation program. (Company chairman, president and CEO Bruce March was awarded $5,656,904 in total compensation in 2011, up from $3,856,312 in 2010).
But detailed explanations in an information circular are just the tip of the iceberg when it comes to the due diligence modern-day boards are putting into developing and communicating executive compensation programs. The time and effort being put into developing compensation programs is rising, thanks in part to the desire from shareholders for more disclosure on executive compensation.
Smart companies recognize this is time well spent. Are their programs falling short somehow? Are best practices being followed? Some firms also recognize there is value in getting advice on their compensation packages from investors themselves. The Canadian Coalition for Good Governance, which represents 46 members who manage $2 trillion in assets on behalf of Canadian investors, is a group Hammond says senior energy companies and their boards frequently meet with to see if the coalition has any concerns with how their compensation programs stack up.
Meridian’s Yores says this attention to detail and to shareholders concerns regarding executive compensation reflects how seriously boards take the responsibility of setting up best-in-class programs. “Directors are taking it more personally,” Yores says. “There is a heightened degree of reputation risk with being associated with a company that is not seen as doing its job or has a distinct disconnect between pay and performance.”