Nonfinancial Performance Measures and Risk Taking: Evidence from the Oil and Gas Industry

Abstract

This study examines the relation between nonfinancial performance measures (NFPMs) and firms’ risk taking. Specifically, using CEO compensation contracts in the oil and gas industry (SIC 1311), I examine the relation between NFPMs and firms’ exploration and exploitation activities. The oil and gas industry provides an ideal setting for my study because firms in this industry are required to disclose their exploration and exploitation activities, which allows me to develop empirical measures for both activities. I find NFPMs that incentivize high risk exploration activities (exploration NFPM) lead to more investment in exploration activities. More importantly, I find that firms with exploration NFPMs also invest in more low risk exploitation activities and achieve better short-term financial performance compared to other firms. These results are consistent with my hypothesis that explicit incentives to invest in risky projects induce risk averse managers to manage the associated downside risk of failure by allocating resources more efficiently across other projects. My findings shed light on how NFPMs can potentially complement equity-based incentives and financial accounting measures to direct and motivate managers to take on risky projects as well as better manage firm performance.