Controllability of Risk and the Design of Incentive-Compensation Contracts

We examine how executives' ability to control their firm's exposure to risk affects the design of their incentive-compensation contracts. Using the introduction of exchanged-traded weather derivatives as a natural experiment, we find that executives who became more able to control their firm's exposure to weather risk experienced relative reductions in their total compensation and equity incentives. The former finding is consistent with a reduction in the risk premium that executives receive for their exposure to weather risk. The latter finding suggests that risk and incentives are complements when executives can control their firms' exposure to risk. Collectively, our findings provide evidence that executives' ability to control their firms' exposure to an important source of risk influences the design of their incentive-compensation contracts