https://coyoteblog.com/coyote_blog/2025/03/performance-measures-and-incentives-part-1-lessons-from-a-famous-corporate-implosion.html Coyote Blog Dispatches from District 48 * Home * Climate Skeptic * BMOC * Park Privatization * AZ Parks Proposal * << New Series: Organizational Design, Behavior, and Change Performance Measures and Incentives, Part 2: What They Teach Us About Government Behavior >> Performance Measures and Incentives, Part 1: Lessons From A Famous Corporate Implosion March 1, 2025, 12:22 pm Part of a Series: Organizational Design, Behavior, and Change To understand why organizations grow senescent, get fat, and fail - whether they be public or private - there is probably no topic more important than performance measures and incentives. Many readers will know that I have spent 25 years working with government agencies in a company that privately operates public recreation facilities. Not infrequently I have had my managers, in frustration over something our agency partners have done or not done, complain that the folks they are working with in the government are "bad" people. More generally this is a common refrain of government critics, that state agencies are full of "bad" people. I always disagree with them. The people that the government hires are no different on average than the people hired in private industry. Sure, there is some self-selection as people may migrate to institutions they trust more than others or to work cultures they find more appealing, but this is true as well among private entities (e.g. choosing to work at a startup vs Exxon). My strong belief, from theory and long experience, is that when government employees appear to act "badly" or irrationally, it is not because they are (or began as) bad people but because they are working in an organization with terrible incentives and a counter-productive performance management system. This is not unique to government organizations - many or most of the great failures of once-proud private companies have come about due to issues with incentives. The difference is that when private organizations go bad, there is a culling by customers and competitors that has no equivalent in the perfect monopoly of government agencies. I will return to the issue of government incentives in the next post, but I want to reinforce the importance of incentives to organizational failure by discussing one famous private example, a company everyone thinks of as failing due to fraud and malfeasance - ie bad people - but whose downfall was at its core due to bad incentives: Enron. In what follows I don't want to take away from the criminality of various executives. But I believe the failure at Enron started WAY before the criminality and was rooted in bad incentives. The story starts with Jeff Skilling coming to Enron to implement the gas bank model he came up with at McKinsey. Having personally been on this study for a brief time (as a very junior associate), I don't think there was anything particularly wrong with the strategy. The problem was perhaps in Jeff himself. As has been reported many times, he was certainly brilliant, but my guess is that he was likely manic-depressive, and he certainly did not have a very good read on people. I won't say he was on the spectrum but had a sort of quasi-autistic inability to understand how people really tick. He could fall in love with his own intellectual creations, which might be marvelous in theory, but fraught in actual implementation with real people. Here is my theory - the downfall of Enron can be traced directly to Jeff Skilling's implementation of what he called "mark-to-market accounting" for new Enron contracts, an academically intriguing idea that met with disaster in the face of real people. To understand it, we first need to know what he meant by "mark-to-market accounting." Since the dawn of capitalism, enterprises have struggled with how to provide the proper incentives to their sales force and dealmakers. The simplest example to reward salespeople with a percentage-of-revenue commission. It certainly seems logical to reward salespeople for making sales. But even something so simple quickly becomes fraught when it encounters real human behavior. The problem is that sales people will chase the easiest sales with the highest discounts, building a book of business that maximizes their commissions but may miss the most profitable sales. The same is true for deal makers, who (if allowed) will pursue the riskiest deals with the highest potential returns, leaving the company on the hook for future potential losses. And this problem was an order of magnitude worse at Enron, where Skilling implemented a strategy in which traders are tasked with executing complicated long-term deals. Traders were executing deals as long as 20 years in which natural gas might be bought here and then sold there and then converted to electricity which is sold somewhere else all tied to a capital investment at a certain plant and sale of tax credits to other companies. Most, meaning pretty much all, companies would account for this by simply reporting the net profits from this deal in each year as they occur. But what if most of the profit in the deal was 10+ years out? Should the company, or the individual dealmaker, really have to wait 10 years to be rewarded? Would the organization even bother pursuing these contracts if that were the case? Skilling hated this traditional accounting. Companies are often criticized for not thinking about the long term - how can one reward the organization for selling business 20 years out? He believed strongly that once the deal was signed these gains were all earned and locked in, such that the present value of the contract was essentially earned at signing and should be booked at signing. Rather than waiting 20 years for the earnings to flow through, Skilling wanted to book the whole profit immediately, crediting both the company and the individual deal-maker with the entire value immediately. This is what he called mark-to-market. All the present value of profits from a multi-year contract would be booked when signing the contract. And the deal maker would be rewarded for a percentage of those profits on signing. Like much of Skilling's thinking, this was a theoretically compelling approach. Mark-to-market was a term well known at the time in the banking and securities world. It refers to the process of adjusting the book value of investments to their market price. All well and good - this was something the government was trying to get banks and financial institutions to adopt - so the government was open to approving Enron's proposal for what was very unusual accounting in the energy world. The problem for Enron was that they were, by their own admission, doing deals that were unique, that no one else was doing. So how does one establish a market price? Not everything was locked in by the contract - profits might depend on commodity prices or cost overruns or interest rates or even the bankruptcy of a counter-party. Skilling may have called it mark-to-market, but that was effectively impossible. What Enron was really doing could more reasonably be called mark to forecast. The forecasted revenue and profits for the contract would be recognized immediately on signing. And now we arrive at the disaster. Enron had the dealmakers themselves creating the pro formas or forecasts from their deals from which the present value determination was made. So, what is this forecast going to look like? The forecasts were going to be hugely optimistic -- the deal is going to make a freaking fortune with little risk, the forecast is going to be a hockey stick upwards. This does not necessarily even require fraud - every sales person and deal maker who has ever existed is optimistic about their own deals. And given that these are 20-year forecasts, the valuation of the deal might turn on the price of natural gas 20 years out. Whose to say that $5 is more or less reasonable than $3? The net effect is that all the mark-to-market valuations skewed high. [forecast-distribution-650x364] Skilling and Lay seemed mostly blind to this problem. They did (nominally) create internal agencies that were meant to neutrally review deals and these mark to market valuations. But these groups got little support from executives, particularly when deal makers seemed to be making so much money for the company (at least on this mark-to-market basis). Deal makers had become the elite of the organization, virtually unchallengeable even by staff originally tasked with challenging them. And remember that Lay & Skilling's prestige and compensation - not to mention the compensation of every manager at Enron given their compensation system -- was largely stock-based, and the stock price was being driven up by the stacking up of these skewed mark-to-market valuations of projects, causing the company to effectively pull forward years of future (potential) earnings into the current year. Anyone who started challenging project valuations was effectively attacking the entire organization's compensation. Enron eventually applied mark-to-market accounting to everything. Change in tax law? Take a one-time gain for expected net present value of decades of tax breaks. Sign a video streaming deal with Blockbuster? Immediately book profits for 20 years of hypothesized streaming revenue. Of course, if the assumptions behind a deal were to change for the worse - say a reduction in natural gas prices from those forecast - then there should have been a mark-to-market loss taken on the contract, but that almost never happened. This was Skilling's underlying ethical failure - mark-to-market was his conception, and he was responsible for making sure both halves of the process were implemented: both taking credit for future gains when contracts were signed but also taking losses for impairments on those future results as they became obvious. I am not sure the mark-to-forecast approach could ever have worked in the real world, but its only chance was to have Skilling create a strong ethics and value structure in the company around rigorous and honest evaluation of current and past marks. And that sure as hell did not happen. If anything, Skilling behaved in the opposite manner, rewarding creativity in evading any loss and eking out new gains from re-marking past projects with rosier assumptions. Enron's reported results quickly began diverging from reality. Reported results looked fabulous, as they were based on stacked project valuations that were in turn based on optimistic forecasts of dealmakers who had every incentive to be optimistic. But at the same time many of the deals were crap - some just projects where core assumptions such as natural gas prices had not played out as expected but increasingly including dumb domestic merchant investments and even worse international projects. Crap projects were being approved based on insanely optimistic forecasts that no one had an incentive to challenge. Eventually, in bankruptcy, outsiders would be staggered by how much of Enron's investments were absolute money-losing garbage. Enron's strategy went awry almost from the beginning, but that fact was hidden by the bad measurement system and so Enron kept doubling down on worse and worse investments, with the inflated mark-to-forecast numbers convincing everyone, especially themselves, that they were brilliant. At some point the divergence between mark-to-market project values and actual results could not be ignored, and with the refusal to mark project values down, some other alternative was needed. The solution they found was via corporate weasel Andy Fastow, their CFO who created off-books entities to hide losses from bad merchant investments rather than mark the losses to market. Because the bad deals created little cash, new borrowing was constantly required which again was dumped into off-books entities (which were made worse by Fastow's gluttonous self-dealing). It is these deals that get most of the historic attention, but in my mind, the off-books fraud merely delayed (and magnified) the reckoning of an organization already set up for disaster by the incentives and measurement plan of mark-to-market accounting that Skilling put in place. Tags: accounting, Corporate Fraud, enron, Government Agencies, Incentives, Jeff Skilling, Organizational Behavior, Organizational Change, Organizational Design, Performance, Performance Measures, Private Industry, US Category: General Business, Government, Organizations and Incentives | Comment (RSS) Subscribe Login Notify of [new follow-up comments ] [ ] [>] Label [ ] {} [+] [ ] [ ] Name* [ ] Email* [ ] Website [Post Comment] [ ] [ ] [ ] [ ] [ ] [ ] [ ] D[ ] Label [ ] {} [+] [ ] [ ] Name* [ ] Email* [ ] Website [Post Comment] [ ] [ ] [ ] [ ] [ ] [ ] [ ] D[ ] 2 Comments Inline Feedbacks View all comments me here 5 days ago Incentive systems and how they fail is one of my favorite topics. There's the major software company I worked at where performance and bonuses were determined by all managers selling their employees accomplishments every half year, which because everyone did such drastically different work inevitably ended up as purely political theater. Even better, nobody ever looked bad, so when flashy projects didn't deliver, that wasn't a problem for the people who had made poor decisions. The other common failure mode I've seen is empire building: spreading out rewards between the one team bringing in major revenue and the other two that are failing miserably year after year, because higher management can't make director without growing the org. 1 Erik 5 days ago A far less-sophisticated version of this has been destroying Intel for almost two decades: huge bonuses for shipping products, regardless of volume, profitability, or even functionality. -1 * Follow @Coyoteblog * Please leave this field empty[ ] Join the CoyoteBlog Community Sign up to receive regular emails of new posts [ ] [Join Now] We don't spam! Read our privacy policy for more info. Check your inbox or spam folder to confirm your subscription. * Recent Posts + A Great Example Of Coyote's Law in Action + Performance Measures and Incentives, Part 2: What They Teach Us About Government Behavior + Performance Measures and Incentives, Part 1: Lessons From A Famous Corporate Implosion + New Series: Organizational Design, Behavior, and Change + Move Fast and Break Things * Climate Summaries + Denying the Climate Catastrophe + Greenhouse Effect Basics + Matt Ridley's Lukewarmer Manifesto + Summer of the Shark - Global Warming Edition + Understanding the Global Warming Debate + Video - Climate Catastrophe Denied * Past Favorites + 60 Second Refutation of Socialism, While Sitting at the Beach + A Defense of Open Immigration + Advice for the "Reality-Based" Community + Buying a Business + Case Studies on the Minimum Wage + Corporate DNA and Value Creation + Coyote's Law + Definition of an Activist + Disney World Reviews and Advice + Funky Handbags + Health Care Trojan Horse + How to Spot a Dictatorship + Implications of A Privacy Right + In Praise of "Robber Barons" + My Current View on Global Warming + Progressives are too Conservative to Like Capitalism + Respecting Individual Decision-Making + Statism Comes Back to Bite Technocrats + The 60-Second Climate Skeptic + Trade Deficit is Not a Debt (Nor is it Bad) + Wealth Creation and the Zero Sum Economics Fallacy + Why the Right to Vote is Not What Made America Great * Archives + March 2025 + February 2025 + January 2025 + February 2023 + April 2022 + December 2021 + November 2021 + October 2021 + September 2021 + August 2021 + July 2021 + June 2021 + May 2021 + April 2021 + March 2021 + February 2021 + January 2021 + November 2020 + October 2020 + September 2020 + August 2020 + May 2020 + April 2020 + March 2020 + February 2020 + January 2020 + December 2019 + November 2019 + October 2019 + September 2019 + August 2019 + July 2019 + June 2019 + May 2019 + April 2019 + March 2019 + February 2019 + January 2019 + December 2018 + November 2018 + October 2018 + September 2018 + August 2018 + July 2018 + June 2018 + May 2018 + April 2018 + March 2018 + February 2018 + January 2018 + December 2017 + November 2017 + October 2017 + September 2017 + August 2017 + July 2017 + June 2017 + May 2017 + April 2017 + March 2017 + February 2017 + January 2017 + December 2016 + November 2016 + October 2016 + September 2016 + August 2016 + July 2016 + June 2016 + May 2016 + April 2016 + March 2016 + February 2016 + January 2016 + December 2015 + November 2015 + October 2015 + September 2015 + August 2015 + July 2015 + June 2015 + May 2015 + April 2015 + March 2015 + February 2015 + January 2015 + December 2014 + November 2014 + October 2014 + September 2014 + August 2014 + July 2014 + June 2014 + May 2014 + April 2014 + March 2014 + February 2014 + January 2014 + December 2013 + November 2013 + October 2013 + September 2013 + August 2013 + July 2013 + June 2013 + May 2013 + April 2013 + March 2013 + February 2013 + January 2013 + December 2012 + November 2012 + October 2012 + September 2012 + August 2012 + July 2012 + June 2012 + May 2012 + April 2012 + March 2012 + February 2012 + January 2012 + December 2011 + November 2011 + October 2011 + September 2011 + August 2011 + July 2011 + June 2011 + May 2011 + April 2011 + March 2011 + February 2011 + January 2011 + December 2010 + November 2010 + October 2010 + September 2010 + August 2010 + July 2010 + June 2010 + May 2010 + April 2010 + March 2010 + February 2010 + January 2010 + December 2009 + November 2009 + October 2009 + September 2009 + August 2009 + July 2009 + June 2009 + May 2009 + April 2009 + March 2009 + February 2009 + January 2009 + December 2008 + November 2008 + October 2008 + September 2008 + August 2008 + July 2008 + June 2008 + May 2008 + April 2008 + March 2008 + February 2008 + January 2008 + December 2007 + November 2007 + October 2007 + September 2007 + August 2007 + July 2007 + June 2007 + May 2007 + April 2007 + March 2007 + February 2007 + January 2007 + December 2006 + November 2006 + October 2006 + September 2006 + August 2006 + July 2006 + June 2006 + May 2006 + April 2006 + March 2006 + February 2006 + January 2006 + December 2005 + November 2005 + October 2005 + September 2005 + August 2005 + July 2005 + June 2005 + May 2005 + April 2005 + March 2005 + February 2005 + January 2005 + December 2004 + November 2004 + October 2004 + September 2004 * Categories + 2013 Shutdown + Accountability + ACME and Loony Toons + Arizona + Art + Banking and Finance + Blogging, Computers & the Internet + Books + Camping and Outdoors + Capitalism & Libertarian Philospohy + Climate + COVID-19 + Coyote's Law + Crime + Data Analysis + Drug war + Economics + Education + Energy + Environment + Equal Marriage Arizona + etc. + Executive Power + Financial Markets + First Ammendment + Gaming + Gender + Gender & Race + General Business + Good News + Government + Health Care + History + Hobbies + Home Theater + Humor + Immigration + Incentives + Individual Rights + International Affairs + International Trade + Investing + Labor Law + Liability / Lawsuits / Insurance + Media and the Press + Military and War + model railroading + Movies & Entertainment + Music + Numbers and Statistics + Organizations and Incentives + Other + photography + Police and Prosecutorial Abuse + Politics + Privacy + Private Recreation Management + Property Rights + Public v. Private + Race + Rail and Mass Transit + Regulation + Scams + Science + Second Ammendment + Small Business + Sports + Taxes + Technology + The Corporate State + Trade Policy + Trans-partisan Plans + Travel + Trend That Is Not A Trend + Trends from Single Data Points + Tripartisan Plans + Uncategorized + War on Drugs * Search [ ] [Google Search] ( ) WWW (*) Coyote Blog * Statistics + Site Admin + Coyote Blog is copyright 2004-2029 by Warren Meyer. Third parties are free to quote freely from this site as long as a link is provided back to the original article. wpDiscuz 2 0 Would love your thoughts, please comment.x () x | Reply [ ] Insert