The Change in Operating and Regulatory Environment and the CEO Compensation-Performance Sensitivity : An Empirical Analysis of Electric Utilities

This study tests whether firms in the electric utility industry alter their compensation policies in response to the recent and dramatic changes that the 1992 Energy Policy Act imposes on their operating and regulatory environment. The 1992 Act intensifies competition in the utility industry by opening up the generation and wholesale markets for electric power, thereby providing greater managerial incentives to improve utilities' operating efficiency. Our evidence shows that utilities significantly increased (by almost 70%) the CEO cash compensation-earnings performance sensitivity in the post-1992 period compared to the pre-1992 period. Additionally, an analysis for non-utility firms does not indicate such a high increase in the CEO cash compensation-earnings sensitivity over the same period. Further, electric utilities that diversify into unregulated operations and that operate in a less severe regulatory environment exhibit an even greater increase in the CEO cash compensation-earnings sensitivity over the same period of time. Unlike the generation and wholesale sectors of the utility industry, however, rate-setting, capital investments, and retail operations remain regulated, thereby limiting managerial discretion in exploiting future investment opportunities. Consequently, we find that the sensitivity of utility CEO stock-based compensation (stock option compensation and stock ownership) to stock performance does not increase in the post-1992 period relative to the pre-1992 period. Finally, our comparison of electric utilities to independent power producers (IPPs), which have less constrained investment opportunities, shows that the average proportion of CEO stock option compensation for IPPs is six times greater than that for electric utility CEOs