Eliminating the incentive to “let it ride”: A suggested approach for compensating energy risk managers

Abstract

Purpose

Many energy firms currently compensate their risk managers with bonuses based on their ability to outperform a budget benchmark. This creates the incentive for a manager to “let it ride” (LIR) when prices move adversely to the benchmark, thus exposing the firm to further adverse movements. The purpose of this paper is to present an alternative compensation model based on the adherence to a risk control system utilizing value at risk (VaR). The model is designed to reward the risk manager for staying within the prescribed risk limits, which effectively rewards the manager for taking actions that decrease the deviation from the budget benchmark.Design/methodology/approach – The days within limits (DWL) compensation model is developed with a demonstration of how it works through an illustrative example.Findings – The DWL method of measuring risk and compensating risk managers effectively reduces the potential conflicts of interest from the LIR mentality by establishing strict rules for the risk manager and providing a compensation structure that rewards the manager's ability to stay within the prescribed risk limits.Practical implications – These results should be of great interest to the managers of energy traders as well as to investors in firms participating in energy risk management. Clearly, it is important for energy firms to structure the compensation incentives of its traders such that they act in the best interests of the firm and its investors.Originality/value – This paper develops a compensation model for energy risk managers based on the number of days their DWL remains below their prescribed VR limit.

Citation

Balakrishnan, A., Clark, J.M. and Salter, S.P. (2007), "Eliminating the incentive to “let it ride”: A suggested approach for compensating energy risk managers", Managerial Finance, Vol. 33 No. 4, pp. 270-280. https://doi.org/10.1108/03074350710721514