In a previous article, How to Survive and Thrive, I addressed why innovation is important to the continued relevance to the Canadian extractive energy industry. This is because, in a changing landscape, cost pressures and environmental sensitivities have increased. Stakeholders, which include all Canadians, are likely to demand a reasonable return on the extraction of resources, while insisting that impacts, including environmental harm, be within reasonable bounds relative to the benefits society derives from extraction.
To improve benefits while reducing negative impacts, companies need to innovate. I now turn to address how energy companies can seek to improve their innovation performance, with a focus on oil sands participants.
Barriers to Innovation
In 2016, Monitor Deloitte released a report titled “Innovation in Oil & Gas: Canada 2016”. Following its title, the report focused on innovation in the Canadian oil and gas industry. Of the ten respondents to Deloitte’s survey, most “indicated they presently do not have the resources, capabilities or leadership commitment to innovate to the degree they know they should.” Deloitte’s report found a “realization that the industry is not doing enough is emerging and the call to convert awareness into action is getting louder. ” Thus, it is important to consider barriers to innovation faced by the Canadian energy industry, and how to overcome them.
The Canadian extractive energy industry operates in difficult conditions. In the oil sands, massive infrastructure is required to effectively exploit the resource, driving high capital costs with significant construction lead time. Canada’s high labour costs increase both capital and operational spending. The considerable regulatory burdens faced by extractive companies – addressing everything from well spacing to noise pollution and, recently, carbon emissions – increase the cost and time to build new projects.
The considerable capital required for extractive projects means that companies, before embarking on a project, must look forward many years in an attempt to predict market conditions. At the same time, since they sell commodities, these companies compete principally on volume of production and margin.
Short Term Incentives
While extractive energy projects are long term endeavours, decision makers benefit from showing results in fiscal quarters, not years. An executive may not remain with a company long enough for the benefit from an investment in innovation to flow to the financial statements. Similarly, by the time an innovation initiative results in financial performance improvements, the executive’s support of the innovative initiative may be forgotten. Yet, a failed investment may be perceived as potentially terminal to an executive’s career. At the same time, competitors may simply move in lock-step to match progress.
Accordingly, even a small risk of failure can be considered too much risk to take, regardless that a project has great upside potential. So, why be the first? No one was ever fired for buying an IBM. Executives in the energy industry are incentivised to make marginal low risk improvements in operations and to keep pace with or marginally surpass, but not leap frog, competitors on capital markets. They are incentivised to adopt strategies already known and proven, such as adding incremental production capacity.
Continued Need for Innovation
Yet, against this background, there is the continued and ever-present need for innovation. A failure to take risks on innovation simply guarantees that your performance will not materially improve. Like leaving money under a mattress, excessive aversion to risk taking may provide comfort against perceived downsides, but guarantees a loss relative to competitors. For the Canadian extractive energy industry, competitors include other jurisdictions and energy forms.
Incentivising Innovation
If high costs, long lead times, minimal perceived upside for decision makers, and exaggerated downside perceptions drive excessive conservatism, it is important to consider how to tackle these factors.
Much has been written about how to spearhead innovation within an organization, but that misses the point if leaders of the firm aren’t motivated themselves to take economically rational risks because their short-term incentives are misaligned with a company’s long-term success. We must incentivise top-level decision makers so that, rather than being punished for taking any risk, they are rewarded for taking smart risks.
Executive Incentives
In the conservative and long-term focus of extractive energy companies, an ineffective executive compensation model can excessively reward an executive based on short term performance rather than long term performance.
Researchers who have studied executive incentive plans have argued that incentive pay is misplaced and ineffective, failing to effectively measure performance, causing fixation on the wrong goals, and even incentivising cheating (Dan Cable and Freek Vermeulen, “Stop Paying Executives for Performance”, Harvard Business Review, February 23, 2016). Yet, the problems identified appear to stem largely from over-emphasis on large portions of pay being tied to short-term incentives.
Other researchers support the argument that incentive pay remains relevant, but should be tied to the long-term performance of the company (see, for example, Alex Adams, “Performance-Based Pay for Executives Still Works”, Harvard Business Review, February 23, 2016″). Even critics of incentive pay recognize the value of requiring leaders to hold substantial equity (“The Case Against Long-Term Incentive Plans”, Harvard Business Review, October 2016).
To incentivise long-term innovation projects, companies should require executives to hold a considerable stake in the company for a period matching or exceeding the development and adoption cycle for new processes. This should be held regardless of whether the executive remains with the company, and may supplement a reasonable fixed pay. Resource extraction is a long-term play and executives should be in it for the long haul.
With long term incentive pay, an executive is encouraged to put in motion those projects which are likely to deliver value past their completion. At the same time, the executive is also incentivised to consider future developments – such as regulatory and public perception changes – and plan for them. As well, workers are more likely to view the executive as a team member who is committed to the team.
Investors
Investors have a considerable ability to direct a company, reward strong management, and discard ineffective leaders.
Investors should seek to understand a company’s strategy and efforts to innovate. Understanding that each investment represents only a portion of their portfolio, they should be open to, and reward, smart risks which represent good value. Likewise, they should recognize that companies failing to take an active approach to innovation will likely fall behind relative to their competitors (whether domestic, foreign, or solar/electric), and should discount the value of companies which fail to have an effective innovation strategy, or an effective long-term executive compensation scheme.
Institutional investors and analysts are particularly well suited to demand effective disclosure on innovation strategy along with meaningful executive compensation schemes that provide long term rewards. Institutional investors and analysts should consider interviewing companies, and the use of technical advisors, to assess the practicality of an innovation strategy or a prospective technology.
Companies may choose to help investors make sound investment decisions by providing detailed information on their innovation strategy. Effective disclosure should reward companies with solid innovation plans.
Conclusion
Innovation in the Canadian extractive energy industry is needed. To get there, companies and executives need the right incentives. Executive compensation should mean participation in the long-term success or failure of a company, and investors should have the knowledge to assess innovation strategies.
Together, we should incentivise an active and dynamic extractive energy industry, which strongly seeks to improve total value provided to society – improving benefits and reducing burdens.