Trends in Trader Compensation: No "Magic Bullet"

Deck: 

When it comes to pay levels, knowledge is power.

Fortnightly Magazine - December 2006

Ask any group of energy trading managers to name its biggest problem and you will get a surprising answer. Sure, they are worried by bouts of extreme volatility, Amaranth-like P/L destruction, and limit violations. But something unrelated to their trading positions worries them even more— trader compensation and retention.

Although compensation and retention always have been challenges for utilities and other companies not traditionally involved in trading, the advent of hedge funds and other non-energy-based participants has intensified the problem.

Traders are demanding ever-increasing compensation, while a perceived “brain drain” of the best and brightest continues. For many utilities and energy traders, this has led to questions about how to properly pay and retain their traders in the face of market trends.

Trader compensation has been an issue since the early days of power deregulation and the development of trading operations in many utilities. Recruited from natural-gas or petroleum trading rooms at traditional energy companies, traders were accustomed to compensation levels above and beyond what the utilities were willing to offer. Since trading talent at the time was scarce and the desire to develop an unregulated merchant organization was strong, a more generous incentive structure emerged.

Following Enron’s collapse, many utilities “repositioned” their trading business to a more defensive posture or disbanded their trading shops completely. The softening of the market led to lower compensation demands and minimal retention issues: Traders simply could be replaced at similar or lower compensation if they left.

Compensation issues resurfaced as the market began to recover in 2004 and non-traditional participants began to enter the market. Soon, available talent began to dry up and compensation levels began to rise accordingly. Trader retention again became an issue as traders moved to better opportunities.

Currently, many organizations feel they have no choice but to accede to the demands of the market: As compensation levels go up, their best traders leave for better opportunities. Companies then must pay market levels to replace them, and as they do, their current employees demand higher compensation, driving their cost base ever higher. As costs increase, higher trading profits are required to maintain margins: In order to get those profits, good trading talent is required, forcing companies to pay market levels. And the cycle continues until the market cools.

Magic Bullet

With good reason, most companies in this situation are looking for the “magic bullet” that will enable them to have a stable trader base without constant retention issues.

If only it were that simple! A few general comments are in order.

1. Know what business you’re in and what skills are required.

Energy trading is not uniform: It includes many levels of risk and return that require different trader skills and compensation levels. For example, traditional, regulated, investor-owned utilities are least risky. Generally, their most important financial objective is to pay dividends to their shareholders. As such, they are very risk-averse and interested only in balancing load obligations with reliable supply. Trading generally is short-term or limited to long-term supply acquisition. Trading talent is required but is of a very different nature than for those more interested in optimizing their assets or in discretionary trading.

To see this more clearly, examine hedge funds. Their objective is to make a sufficient rate of return to maintain their investor base and attract new capital. Unlike a utility trading operation, hedge funds usually don’t have physical assets to maintain or customers to serve. The traders are involved in large-size discretionary trading and are expected to take risks accordingly.

Obviously, this type of trading is different from what a utility would require, and involves considerably different skills. For a utility to compete for that hedge-fund-caliber talent is, in most cases, unnecessary because the market for talent goes in cycles. Don’t get caught up in bidding wars for talent you might not need or can’t afford.

2. Know what reward structures your competitors are offering, and know what you can offer that they can’t. In other words, figure out what is really motivating your traders to stay or go. The answers may surprise you.

Trader compensation schemes are almost as varied as the number of participants in the market. In theory, salaries and bonuses are inversely proportional, with bonuses calculated either as a percentage of trading profits or expressed as a percentage of salary. As the risk tolerance of the organization increases, bonuses tend to become uncapped and could involve several multiples of salary levels. In recent years, as retention issues have become more pressing, the use of retention payments or restricted shares have become more prevalent.

Contrary to popular belief, most traders are not all about money. Of course, compensation is one of the most important factors in a trader’s decision to leave.1 According to Towers Perrin’s 2006 Compensation Survey of Energy Trading and Marketing Positions, the highest bonus paid to an individual energy trader was well in excess of $5 million, but money certainly is not the only factor. Location, internal career-advancement opportunities, and general working conditions also are important and should not be underestimated. If senior management actively involves the traders in the management of the business and treats them fairly, retention will be less of an issue.

3. Review your compensation scheme to make sure it’s fair and equitable and doesn’t contain any incentives that are not in the best interests of the company.

No incentive program is perfect, especially when physical assets are included in the mix. In general, as management tries to make incentive plans more equitable, they grow increasingly complex. The level of complexity in optimizing a large portfolio of physical assets is equal to or greater than simply engaging in speculative trading.

Utilities often presume, mistakenly, that “trading around the assets” requires a less qualified front-office staff. With potentially billions of dollars at risk, nothing could be further from the truth.

Designing an incentive program for trading organizations that focus primarily on asset optimization is challenging, as many of the information and reporting systems (i.e., book structure and transfer pricing) required to measure “value added” do not exist. Additionally, with complexity comes unintended consequences. For example, if a trader bonus pool is funded with a percentage of profit or value added, the “deal” appears to be equitable—the more the traders make for the company, the more they are paid.

However, it’s not that simple. The incremental costs and the amount of risk taken also must be considered. Otherwise, the company could be rewarding behavior that is inconsistent with the company’s strategic mandate. Additionally, a purely quantitative allocation of bonus pool dollars often overlooks important, subjective factors that also should be taken into account, including teamwork, infrastructure development and leadership abilities.

Not Easy, or Cheap

There is no perfect solution to determining trader compensation. Each company must define “the deal” for traders based on the company’s business strategy and the role the trading organization plays within that strategy. The cold fact is that retaining traders in a hot market is not going to be easy or cheap. But with effective leadership, a thorough understanding of the competitive marketplace, and a compelling total rewards package for commercial talent, it need not be so expensive or painful.