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New Energy Economics: Biofuel Executive Pay

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Cole Gustafson, NDSU Biofuels Economist Cole Gustafson, NDSU Biofuels Economist
Just like banks and other financial institutions, the biofuels industry has gone through a very tumultuous period of market stress, with nearly a dozen bankruptcies nationwide.

By Cole Gustafson, Biofuels Economist

NDSU Extension Service

A couple of weeks ago, I attended a conference at the Federal Reserve Bank in Chicago on the topic of restructuring financial institutions for the future. One of the main sessions discussed executive compensation at the nation’s largest banks. The general public has expressed alarm over the multimillion-dollar bonuses a number of executives have received, despite deterioration of their firm’s financial health and need for federal bailout assistance.

So, why do I write about bank salaries when the topic of this column is the biofuel industry? Well, there are several parallels. Just like banks and other financial institutions, the biofuels industry has gone through a very tumultuous period of market stress, with nearly a dozen bankruptcies nationwide.

Second, I periodically receive comments from shareholders and cooperative members of ethanol companies who question the level of executive compensation. In many cases, biofuel plant executive positions are some of the most prestigious jobs in rural areas.

There are several dimensions to the question of executive pay in either the bioenergy or financial services industry. A Federal Reserve Bank official who is leading the review of executive compensation at banks receiving federal bailout monies summarized the concerns:

  • Executive incentive pay does not always align with firm performance during the past year.
  • Executive incentive pay often is far greater than subordinates’ pay, despite similar efforts contributed.
  • Executive incentive pay substantially differs across firms that have relatively similar outcomes and financial performance.

The Federal Reserve Bank official discussed a couple of recent studies on the subject. Generally, these studies found that bank executive pay most often is tied to annual net income generated. The official felt this method of determining compensation provides powerful incentives to “game” the system by accelerating receipt of revenues, delaying payment of costs and waiting to write off bad loans. The latter was particularly problematic in the banks’ situation because delayed recognition of bad loans in their portfolios lead to an overestimation of the firm’s health and strength of the banking system. He was not critical of the level of executive pay levels, merely the myopic actions taken to improve near-term performance at the expense of long-term financial health.

Basing executive incentives on annual net income also doesn’t necessarily correlate with the firm’s long-term financial performance. Instead of basing incentive pay on a single year’s outcome, such as net income, executive incentive pay should reflect a long-term horizon because strategies made by top executives should result in positive benefits for years.

The Federal Reserve Bank official felt an even more important decision was to change the focus from net income to risk. In particular, the focus should not be on income brought in, but how executive actions impact the firm’s total risk position.

These same arguments can be applied to the compensation for biofuel executives. Risk management is the heart of the biofuel industry. Managers continually are evaluating present and future profit margins and contracting either corn or ethanol prices to lock in those fleeting profit opportunities.

The use of highly sophisticated financial trading tools makes it difficult for shareholders and cooperative members to ascertain any plant’s true risk exposure. Consequently, greater disclosure of current and future risk implications of managerial decisions should be included in a firm’s annual financial statements.


NDSU Agriculture Communication

Source:Cole Gustafson, (701) 231-7096, cole.gustafson@ndsu.edu
Editor:Rich Mattern, (701) 231-6136, richard.mattern@ndsu.edu
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