POWER January 2014 - 18

Steven F. Greenwald
A
Jeffrey P. Gray
Financial Performance-
Based Utility Bonuses:
Unnecessary Exposure
series of derivative lawsuits has recently been filed against
the officers and directors of Pacific Gas and Electric Co.
(PG&E) based on the explosion of a PG&E gas transmission
line in San Bruno, Calif., in September 2010. The incident caused
eight deaths and destroyed approximately 35 homes.
Derivative lawsuits are brought on behalf of a company's
shareholders. They assert that management's breaches of their
fiduciary duties and other misdeeds have financially harmed the
company's owners (the shareholders) and request that the court
order the defendant management to alter their ways.
Misdirected Incentives Expose Utilities
The allegations highlight important utility industry issues that
transcend the San Bruno explosion-to what extent should bonuses
for utility management be based on financial performance?
In economic theory, correlating bonuses on financial performance
should incent utility managers to benefit ratepayers by
increasing operating efficiencies and implementing cost-saving
measures. Conversely, rewarding financial performance exposes
utility managers to claims of sacrificing safety.
The plaintiffs argue that the tragedy at San Bruno was precipitated
by the emphasis on financial performance that the PG&E
Short-Term Incentive Plan (STIP) offers management. Prior to
San Bruno, PG&E based 50% of STIP bonuses on financial performance
(the remainder reflected safety and customer satisfaction
criteria). The lawsuits contend that PG&E inappropriately reduced
maintenance and other infrastructure expenditures to meet financial
performance criteria.
Plaintiffs allege that PG&E " diverted " more than $100 million
intended for natural gas pipeline maintenance to other purposes,
including bonuses. Bluntly stated, plaintiffs accuse PG&E management
of intentionally sacrificing public safety for company profit
and personal gain. Plaintiffs contend that linking company financial
achievement and personal compensation made a San Bruno-magnitude
catastrophe inevitable: " It was not a question of if there would
be an explosion, it was only a question of when and where. "
The lawsuits accuse PG&E management of promoting " an atmosphere
and culture in which short term profits, cost cutting,
and personal profiteering was put ahead of the proper management. "
Plaintiffs ridicule a particular PG&E " backwards " incentive
program, alleging it rewarded employees for electing not to
" report or fix leaks, or otherwise report any dangerous conditions
that would cost PG&E money to fix. "
This article does not comment on the possible (or lack of)
merits of these allegations; the objective is to alert the utility industry
that it must extricate itself from the untenable position of
defending against accusations that senior executives sacrificed
safety for personal profit.
Utilities Are Different
The economic theories that cost cutting should increase profits
and that shareholders should correspondingly reward management
18
for increasing profits makes sense for most unregulated industries.
However, an initiative by Apple or Ford to cut costs to increase
profits is constrained by the reality that any resulting decline in
product quality risks a decrease in sales and revenues, and correspondingly,
profits. Thus, economically rational entities cut costs
only if they can produce the same product at a lower cost or believe
that consumers will continue to purchase a lesser product.
In contrast, the captive customer base within its exclusive
service territory enables a utility to reduce operating costs, essentially
without risk of customer loss due to product decline-
customers cannot forsake electricity and have extremely limited
alternative purchase options. Moreover, when expenditures are
cut on maintenance of infrastructure, the utility customer has no
notice of the resulting deterioration of service.
Zero Tolerance for Financial Performance-Based
Bonuses
Over the last several decades, utility compensation has tended
to mimic financial and technology companies, transitioning
pay from almost all salaries and benefits to appreciable percentages
of total compensation being bonus-based and the
bonus in part being based on financial performance. For instance,
even after San Bruno, PG&E's STIP remains based at
30% on financial performance.
The best industry practices and stringent regulatory oversight
should reduce the occurrence of accidents such as San Bruno.
However, the combination of aging infrastructure, population
growth, and increased demands on existing facilities renders it
statistically likely that a tragedy of the magnitude of the San
Bruno explosion will again occur.
In the wake of the San Bruno event, utilities must appreciate
that even the slightest nexus between " cost cutting " and
executive bonuses poses undue risk. The California Public Utilities
Commission and likely the courts will ultimately determine
liability for San Bruno. Regardless of the outcomes, plaintiffs'
arguments that PG&E's management sacrificed safety for personal
gain will continue to attract disparaging headlines, incite critical
political rhetoric, and encourage additional legal actions, whether
the financial performance component in the incentive program
is 50%, 30%, 10%, or even less.
Utilities would best serve their customers, employees, and
shareholders by eliminating company financial performance as
a criterion for bonuses altogether. Financial incentives for utility
management and employees should be based on safety, reliability,
and customer satisfaction. The public relations and legal
nightmare PG&E confronts daily in the media, legislature, regulatory
agencies, and the courts should persuade utility executives
to demand " zero tolerance " and totally delink financial performance
from incentive compensation programs. ■
-Steven F. Greenwald (stevegreenwald@dwt.com) and Jeffrey P.
Gray (jeffgray@dwt.com) are partners in Davis Wright Tremaine's
energy practice group in the firm's San Francisco, Calif., office.
www.powermag.com
POWER | January 2014
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POWER January 2014

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