Marshall School of Business
University of Southern California
Southern California Edison
Teaching Note
Purpose of Case
The Southern California Edison (SCE) case motivates a discussion of whether companies
should make adjustments for uncontrollable factors that affect the results measures on which
Suggested Assignment Questions
1. The SCE board and managers made a number of special compensation-related decisions in
response to the significant set of uncontrollable factorsthe California Energy Crisisthat
the company faced in 2000 and 2001.
a. Identify those decisions.
b. Evaluate those decisions. What were the SCE board and managers trying to achieve
with these special decisions? Were those the right objectives? Were those the right
decisions to achieve those objectives?
Introduction Lecture
In some settings, we find it useful to preamble the case discussion with a short lecture, derived
from Chapter 12 in the textbook in which we make the following key points.
1. Textbooks typically provide the following guidance:
Employees should be held accountable only for that which they alone can control (The
Controllability Principle), or,
Employees should be held accountable only for that over which they have significant
influence (The Influencability Principle).
The rationales for these principles are:
Uncontrollable factors distort performance measures and evaluations;
Uncontrollable business risks are best borne by shareholders (who are better able to
diversify the risks); and,
If managers bear the risk:
2. Major choices that must be made include:
Purpose(s) for which the adjustments are made:
Salary raises;
Incentive pay (short term, long term); and
Job retention.
Types of uncontrollables for which adjustments are made:
Economic and competitive factors;
Acts of nature; and
Interdependencies; i.e., uncontrollables due to decisions made by personnel in other
parts of the organization, such as higher organizational levels or other organizational
entities.
Who makes the adjustments?
Immediate superior;
Upper management;
Which method is used to make the adjustments?
Variance analysis;
Flexible performance targets (e.g., flexed budgets);
Should the adjustments be total or partial?
Should the adjustments be for negative uncontrollable factors only (i.e., bad luck) or
should adjustments be made in either direction, both positive and negative?
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3. How to decide?
Costs vs. benefits:
For some types of adjustments, the benefits clearly outweigh the costs:
Factor is totally uncontrollable;
Manager is not expected to respond to the factor; and
The effect of the uncontrollable factor can be calculated objectively.
The benefits of making these adjustments are:
More accurate performance evaluations;
What if the company wants the managers to respond to an uncontrollable factor?
Should not buffer them completely from the effects; and
What if the effect of the uncontrollable factor can only be estimated?
Subjectivity enters in;
Subjectivity introduces another form of risk; that of evaluation bias.
What if the factor is only partially uncontrollable?
Consider not making adjustments:
Performance measures provide some information about managers performance;
Consideration of adjustments leads to the creation of an excuse culture:
If adjustments are made where they should not be made:
Bad decisions; managers fail to consider relevant factors in their decision
4. Summary:
Consider costs and benefits of making adjustments
Benefits exceed costs if:
Factor is clearly uncontrollable and do not want managers to respond (they have no
influence); and
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Case Analysis
Incentive System Design
Before listing the special compensation-related decisions in response to the significant set of
uncontrollable factors that SCE faced, it is useful to clarify the facts about performance-
Employees (Results Sharing Program)
The RSP is essentially a bonus program designed to focus all permanent SCE employees
(except the top executive group, see below) on activities that have an impact on the companys
success. Target bonuses under this program vary from 4 to 15% (with a maximum of 630%) of
base salary depending on employee category.
RSP payouts were determined by both business unit (entity) and SCE (company) performance.
Entity performance (i.e., the performance of the entity to which the employee was assigned) was
measured in terms of the degree of accomplishment of a balanced scorecard comprised of
goals in five areas. Performance on the financial dimension (typically accomplishment of the
Executives
The executive compensation program at SCE was designed for executives at vice-president
levels and above, just over 30 individuals (although some lower level managers participated in
some elements of the program as well). The program had three elements: base salaries, bonuses,
and long-term incentives. The award levels for all three elements were targeted at median levels
for comparable jobs among industry peers (a group of 13 deregulated, diversified electric
utilities).
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For the top executive group, the long-term incentive awards were comprised 75% of 10-year
nonqualified stock options and 25% performance shares. The long-term award amounts were
not formula driven; i.e., based on performance. The stock option grants were quite standard; that
Timeline of Events
Next, it is useful to clarify the timeline of events:
Sept. 1996 Governor of California signed the power deregulation plan into law
After stating these facts, instructors may want to ask whether the power crisis (of May 2000)
was indeed an uncontrollable event for SCEs management. Many, even most, students will
indeed conclude that it was, although some students are more critical of such a conclusion.
Those who conclude that the crisis was totally uncontrollable by management will, for example,
argue that management indeed has no control over the size of the population in California. But
students in the other camp will counter by arguing that while population size is not controllable
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SCEs Response to the Energy Crisis
SCE made the following special compensation-related decisions in response to the power crisis:
1999
2000
Due to outstanding performance in 1999, salaries for senior management were increased 8%
over 1999 levels at the beginning of the year 2000. By the standards of the RSP, company
performance in 2000 was also excellent, even though 2000 marked the first year of the energy
crisis.
(As an aside, it might be interesting to note that despite the statement that 2000 was a good year,
2001
RSP bonus payouts for 2000 were delayed because SCE was teetering on the edge of
bankruptcy; in MayJune 2001, only minimum bonus amounts were paid. There were no
bonuses paid to executives for the year 2000; except that there was a special bonus payment
to two executives for retention purposes.
There was a lay off (700 employees) and a hiring freeze. There were no salary increases for
executives for 2001, and minimal salary increases of about 4% for lower level employees only,
but these were delayed by 34 months.
All long-term incentive awards that had been granted suffered dramatic decreases in value and
in March 2001 the Board changed the bonus plan into a retention incentive plan. These
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2002
The crisis was over and the companys performance returned to normal. Incentive awards return
to good levels.
Evaluation
Was SCEs response to the power crisis wise? Various arguments, both positive and negative,
can be listed:
(+) SCE saved cash when it most needed it.
(+) SCE retained key people. (But was that hard to do? The whole industry was in crisis
and so labor mobility of key executives might have been curtailed anyway.)
Shareholders did suffer (at least in the crisis years), but did managers? Their bonuses were cut,
but then paid later. Their stock options became worthless, but were exchanged. However,
almost all of the replaced compensation became deferred, so managers had an incentive to turn
Pedagogy
As with most case classes, instructors must make a decision as to how structured to make the
discussion. However, we recommend following roughly the same structure as presented in this
teaching note as the sequence of events in this case is quite important; that is, it helps to first
understand the base-line incentives provided; then to focus on the timeline of events and discuss
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If time permits, instructors may also choose to end the class on a rather rhetorical note by posing
the following question: Most companies seem prone to protect managers from the effects of
negative uncontrollables (i.e., bad luck), but they dont worry much, if at all, if managers benefit