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L&A Original Article: Incentive Plan Changes are Coming

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Over the past eighteen months, discussions on incentive compensation structures have been taking on a different element at a rapid clip in boardrooms across the country – as a result of investor pressures in the energy industry, annual incentive and long-term incentive performance metrics are getting the full health physical treatment.  As we move into the second half of 2018, we continue to see a growing number of companies caving to pressures from some industry investors and proxy firm advisors to incorporate new measures that will shift corporate strategy towards shareholder returns.  With companies adopting change at different degrees, we dug into the most prevalent practices for your benefit.

Annual incentive (further known as “short-term” or “bonus”) metrics in the E&P market are experiencing a shift towards returns-based measures. Rather than completely stripping traditional production or output-based measures from short-term incentive programs (that in fact generate substantial shareholder value), these changes are simply implementations or complements to already well-structured incentive plans. Laggard stock price performances of E&P companies in a bullish, albeit volatile, oil price environment is one of a few reasons we are beginning to see investor outreach demanding change. In the recent L&A article “Q&A with Highlights from Tudor Pickering Conference”, L&A’s own Chris Crawford noted he “does not believe these metric changes will have a major impact on incentive payouts in 2018 and 2019; however we do believe they will stick over the longer-term, and overall will be helpful for the industry and the market.”

While much of the media coverage in the energy industry has centered on recent changes in short-term incentive programs, the lack of correlation between stock price and commodity price movements has brightened the spotlight on long-term incentive awards – in particular, the use of relative total shareholder return as a performance measure. Given that long-term incentives make up the lion’s share of an executive’s compensation potential, and the common design element of upside leverage of performance-based stock awards (generally a max opportunity of 2x target), investors are rightly questioning a measure that is subject to macroeconomic factors. This increasingly vocal class of investors are seeking a portfolio of time-based and performance-based awards that incorporate factors that can be better controlled by a company’s managers while also aligning with longer-term shareholder returns. Performance-based equity awards built on return on invested capital (“ROIC”), return on capital employed (“ROCE”), absolute TSR, and cash return on capital employed (“CROCE”) measures are seeing increasing consideration in place of relative total shareholder return awards going forward. If commodity pricing conditions remain static (or deteriorate), we expect more companies to tweak their equity incentive programs with these considerations in mind over the next couple of years.

With equity awards (i.e. restricted stock, performance share awards and stock options) accounting for well over half of an average executive’s total direct compensation, tying these awards to investor returns sounds enticing for those investors who are pushing for more change to ”at risk compensation”.

L&A believes in the importance of both annual and long-term incentives as a means of rewarding executives and key employees from a pay-for-performance perspective and believes the upcoming metric changes that govern them will have a positive impact over the long-haul. As compensation experts and incentive plan design specialists, we at L&A are here to help assist with any incentive plan questions or concerns.