Incentives Had Better Be in Sync

"Whatever you subsidize, you get more of."

"Whatever you subsidize, you get more of."

Referring to government incentive and assistance programs, that quote was attributed to Milton Friedman, the Nobel Prize-winning economist from the University of Chicago.

The business version of that statement is:

"Whatever you incent, you get more of."

All too often, however, functioning incentives — both official and unofficial — of different parts of companies are not aligned so as to mutually reinforce what is best for the parent firm. Sometimes such incentives actually may work against each other.

My first encounter with such problems occurred when I was with Shell in the 1960s, in trying to coordinate exploration data needs with the goals of our drilling department. We needed rock data — cores or sidewall samples — to calibrate our borehole logs, seismic and cuttings records.

From the viewpoint of the drilling engineer, however, our request represented increased costs, time and hole-integrity risks.

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"Whatever you subsidize, you get more of."

Referring to government incentive and assistance programs, that quote was attributed to Milton Friedman, the Nobel Prize-winning economist from the University of Chicago.

The business version of that statement is:

"Whatever you incent, you get more of."

All too often, however, functioning incentives — both official and unofficial — of different parts of companies are not aligned so as to mutually reinforce what is best for the parent firm. Sometimes such incentives actually may work against each other.

My first encounter with such problems occurred when I was with Shell in the 1960s, in trying to coordinate exploration data needs with the goals of our drilling department. We needed rock data — cores or sidewall samples — to calibrate our borehole logs, seismic and cuttings records.

From the viewpoint of the drilling engineer, however, our request represented increased costs, time and hole-integrity risks.

We were being rewarded for making a successful new play, which required us to locate the correct reservoir facies, whereas he was being rewarded for drilling a trouble-free well as cheaply as possible.

Our respective reward systems were not aligned.


Here's a second example:

During the 1980s and early 1990s, several companies reported drilling an embarrassing number of obligatory dry holes in international contract areas. Many of these dry holes, at the time of drilling, were recognized as having no chance of finding oil or gas, but the contracts which had been signed several years earlier before additional data had been acquired required them to be drilled anyway.

How did this happen?

The business folks who obtained international concessions were being rewarded by how much acreage could be acquired in certain nations or regions, and sometimes they were not in effective liaison with the regional explorationists and play-makers, who were mapping future potential trends based on geotechnical criteria.

The result? The company was acquiring a lot of land — some under very attractive terms — but much of it was not very prospective.

Naturally, low historical success rates by the company's exploration department did not encourage the management to award incentive bonuses to geoscientists! Once again, key incentives were not aligned.


As E&P companies of all sizes seek to become more efficient (and thus optimize their economic performance), they inevitably come to grips with the necessity of central coordination of their portfolios. The reason is straightforward: Individual business units simply cannot have the perspective to select those projects that are best for the parent organization, to maximize the likelihood of meeting its goals for cash flows and growth.

Sometimes this sets up tensions between the operating business units and headquarters. Understandably, business units want to maximize their autonomy, whereas headquarters wants to be sure project selection optimizes portfolio performance.

Commonly, the problem is that whereas the incentives for the headquarters staff are aligned with corporate performance, incentives for business units are focused more on local performance metrics than on corporate goals.

A third example: At the local business unit level, the goal might be "to get three exploratory wells drilled this year."

Such a goal focuses on activity rather than adding value. All too often, this sets up a "dash for cash" that results in business unit A's good projects not getting drilled because available budget went to business unit B's prospects, which were rushed through, overestimated and oversold.

Result: the corporate portfolio underperformed, even though business unit B may have achieved its own goals of getting more of the drilling budget.

Solution? Take a hard look at your stated incentives (as well as the unstated ones!). Are you really rewarding the behavior you want? Are you just rewarding activity, or actual creation of corporate value?

The goal of everyone should be, "What's good for the portfolio is what's good for the company — and my business unit is just one cog in that wheel."

Whenever I'm asked to help client companies correct chronic under-delivery of promised E&P reserves, I ask, "What are your geoprofessionals being rewarded for — creating value, or getting wells drilled?"

In all our discussions with senior managements, one of our key counsels is: "Take a hard look at your incentive systems, both stated and unstated — be sure you're really rewarding behaviors that are aligned with your corporate goals."

Remember: "What you incent, you get more of!"


Recommended Reading: The Clash of Civilizations and the Remaking of World Order, Samuel P. Huntington (Simon & Schuster, 1996).

In one of the most important books of the last decade, Huntington provides the thesis and documentation that a globalized, integrated world economy along the Western model will not eventuate in the 21st century, because the other seven dominant world cultures will be able to hinder and suppress free-market functions. Very strong stuff.

Read it, you'll like it!

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