ISSUES OF CORPORATE GOVERNANCE IN THE RELATIONSHIP BETWEEN THE NORWEGIAN OIL COMPANIES AND THEIR GOVERNMENTAL OWNER

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1 ISSUES OF CORPORATE GOVERNANCE IN THE RELATIONSHIP BETWEEN THE NORWEGIAN OIL COMPANIES AND THEIR GOVERNMENTAL OWNER Master of Science Thesis Aarhus School of Business, Denmark MSc. in EU Business and Law ASB Student no th of December

2 ACKNOWLEDGEMENTS This thesis has been written as a part of my Master of Science Programme in EU Business and Law, at the Aarhus School of Business, Denmark. I chose to write about the petroleum industry to increase my insight and knowledge about this industry which have for the last 30 years been the driving force for the development of the Norwegian economy and our welfare society. This thesis has also given me the opportunity to learn more about the business of the two largest Norwegian companies, Statoil and Norsk Hydro, and the State s position in the Norwegian economy. This Master of Science thesis has been both demanding and time consuming, but also informative and fascinating. I would like to thank all the people that have helped me and in other ways contributed to the making of this thesis. I am very thankful to my supervisor at the Aarhus School of Business, Kurt Pedersen, for his contribution of good advices, constructive critics and his always helpful attitude. My family has showed me support and patience throughout the whole thesis period, and I am very grateful to them all. Finally, I owe deep gratitude to Silvia for her kindness, helpfulness and support during this sometimes difficult and demanding time. 06 th December, 2004 Oslo

3 TABLE OF CONTENT PAGE 1.0 INTRODUCTION Purpose of the Thesis Theoretical Framework Hypotheses Formulation Case Study Method Primary and Secondary Sources Reliability and Validity Organisation of the Norwegian Petroleum Sector Statoil ASA Norsk Hydro ASA CORPORATE GOVERNANCE Principal-Agent Theory Agency Relationship Agency Costs Managerial Slack Risk Contracts Incentives Information Asymmetry Moral Hazard and Adverse Selection The State as a Principal Corporate Governance Mechanisms Market Competition Ownership Type and Ownership Concentration Insider Ownership Board Characteristics Financial Policy State Ownership A Critique to State Ownership Managerial Objectives THE CASE STUDY The Norwegian State The Beginning of the Norwegian Oil Adventure The Best Agent Decision Norwegian Government s National Oil Strategy 44 3

4 PAGE 3.2 Statoil ASA The 1970s The Instrument and Domestic Focus The 1980s The NCS Reform and the Scandinavian Positioning The 1990s The Expansion Abroad Norsk Hydro ASA The 1970s Diversification and Growth through Acquisitions The 1980s International Growth and Expansion The 1990s Focusing on Core Business Activities DISCUSSING THE HYPOTHESES Hypothesis no Question of Ownership Concentration Indirect Instrument Summary Hypothesis no Market Competition Ownership Type Ownership Concentration Insider Ownership Board Characteristics Financial Policy Summary Hypothesis No The Diversification Strategy Internationalisation Strategy Summary INTERACTION MODEL Phase 1: Legal Framework and Agent Selection ( ) Phase 2: High Degree of State Participation ( ) Phase 3: Reduced Governmental Control ( ) Phase 4: Internationalisation ( ) Phase 5: Privatisation and Reduced Ownership ( ) CONCLUSION 93 LITERATURE LIST APPENDIX : Norway s 10 Good Corporate Governance Principles for State Owned Companies 4

5 ISSUES OF CORPORATE GOVERNANCE IN THE RELATIONSHIP BETWEEN THE NORWEGIAN OIL COMPANIES AND THEIR GOVERNMENTAL OWNER 5

6 1.0 INTRODUCTION The Norwegian State has throughout the years been extensively involved in the industrial and commercial development of the country, and it has often used state ownership as a direct mean to accomplish public objectives. The use of state ownership has been significant in banks, energy and manufacturing companies and in the telecom industry. The different Labour Party Governments that steered the country for most parts between 1950 and 1980 had an overriding ambition to modernize and enhance the Norwegian welfare society through promoting industrial development. Oil is the most important commodity in international trade if measured by value, and because of this the Norwegian State considered the control of the domestic petroleum industry to be the key to economic growth and to the development of the welfare society. The State is of the opinion that the natural resources located at the Norwegian Continental Shelf, are the property of the society and should be administrated in a way that benefits the society as a whole. The State was afraid of loosing control over the natural resources to the powerful multinational oil companies. Therefore it adopted a national oil strategy based upon tight Governmental control, where the State operated as a tax collector, an industry regulator and an active participant in the development of the petroleum industry. State ownership was considered to be the correct measure to ensure that national interests were secured and administrated in the most efficient way. Through state owned companies the Norwegian State could actively shape the development, the structure and the function of the petroleum industry. The two central players in the State s strategy were Statoil and Norsk Hydro. Statoil was established as a wholly state owned national oil company, while Norsk Hydro was a partly state owned company (the State owned 51 % of the shares). Because of their favourable positions, Statoil and Norsk Hydro have controlled around 80 % of the total activities at the Norwegian Continental Shelf, and they are today among the biggest companies in the world. This case study follows the development of the Norwegian petroleum industry. 6

7 1.1 The Purpose of the Thesis The aim of this thesis is to analyse the relationship between the two Norwegian oil companies and their governmental owner in the perspective of corporate governance theory. The paper will be based upon a theoretical review and discussion of existing literature combined with study cases using secondary data analysis. The problem statement is centred around three main questions, the answer will result in the elaboration of a dynamic model illustrating the interactions between the two oil companies and their governmental owner through time. Yin (2003) states that the construction of hypotheses is important in terms of bringing clarity to the research problem. The stated objective of this thesis is to provide an answer to the following three hypotheses: 1. Did the Norwegian State use its ownership positions in Statoil and Norsk Hydro as an instrument in order pursue public objectives? 2. Did the corporate governance mechanisms available for disciplining the oil companies help the State to control Statoil and Norsk Hydro? 3. Did the management of the oil companies use specific strategic moves in order to avoid the control of the Norwegian State? This problem statement will be addressed in three sections composing the thesis: - A theoretical review of existing literature on the topic of corporate governance and principal agent theory and its implications in the particular case where the public authority figures among corporate owners. - An analysis of the interactions between the management of the two national oil companies in Norway and their governmental owner in the last 35 years. - An application of concepts from corporate governance and the agency-theory literature to the specific context of the Norwegian oil sector, leading to the elaboration of a dynamic model illustrating the interaction process between the oil companies and the State. 7

8 1.2 Theoretical Framework Collins et al (2003) refers to a theoretical framework as a collection of theories and models from the literature which underpins a qualitative research study. The theoretical framework of this thesis will consist of corporate governance theory, principal-agent theory and more general theory of state ownership. The term governance refers to the arrangements for managing or controlling a firm. Corporate governance theory is concerned about the separation of ownership from control, and it addresses the issue of the relationships between the shareholders, the management and other stakeholders whose conflicting interests should be considered. The main objective of the corporate governance system in a firm is to align the interests of the management with those of the shareholders, and thereby motivate the management to maximize shareholder value. However, this is more complicated in the perspective of state owned companies as they often have been established in order to fulfil multiple objectives, ranging within economical, societal and political dimensions. Corporate governance is traditionally seen as a principal-agent relationship, and in this thesis the principal is represented by the Norwegian State (shareholder and owner of the natural resources), and the decision making agents are represented by Statoil and Norsk Hydro. The term state owned company is in this thesis used as a concept describing public enterprises or corporations, and it includes both wholly state owned companies (Statoil until 2001) and partly state owned companies (Norsk Hydro). Norsk Hydro was established by private interests and has through the years provided products and services connected to natural resources that the Norwegian State has been highly dependent upon. 1.3 Hypotheses Formulation The first hypothesis is based upon the assumption that the State used its ownership position in Statoil and Norsk Hydro as a mean to achieve public objectives. State ownership has normally a wider function than the traditional narrow concept of shareholder maximization theory which is concerned about maximizing shareholder profits. Public objectives are in this thesis refer to the combination of economic, societal and political objectives of the State. I assume that the State used Statoil and Norsk 8

9 Hydro as instruments in order to fulfil objectives that were beneficial for the welfare society, on both a macro level (i.e. securing full employment, enhance economic and industrial growth etc) and on a micro-level (i.e. an efficient use of the natural resources, securing political votes). Hypothesis no.1: Did the State use its ownership position in Statoil and Norsk Hydro as an instrument in order to pursue public objectives? The second hypothesis is based upon the assumption that the principal (the State) has certain corporate governance mechanisms available for disciplining the agents (represented by Statoil and Norsk Hydro). The use of corporate governance mechanisms can reduce agency problems arising between the supplier of the finance (the owner) and the delegated decision makers (the managers). The mechanisms can help the principal to control and monitor the behaviour of the agents, and they can also be used as means to align the agent s interests more closely to those of the principal. Hypothesis no.2: Did the corporate governance mechanisms available for disciplining the oil companies help the State to control Statoil and Norsk Hydro? The discussion of this hypothesis will be based upon Bøhren and Ødegaard s categorization of corporate governance mechanisms; market competition, ownership concentration, type of ownership, insider ownership, board characteristics and financial policy. My third hypothesis is based upon the assumption that when ownership is separated from control and incomplete contracts exist, the firm s management will strive to set the firm s objectives rather than letting the shareholders do it. While the owners (shareholders) are typically interested in profit growth and total shareholder return (dividends), the managers are more interested in pursuing objectives that increase the size of their power, prestige, perquisites and pay. Following this train of thought, the 9

10 management of Statoil and Norsk Hydro will use strategic and tactical moves/techniques aiming at reducing the State s control and monitoring possibilities. Reduction of control will increase the managerial discretion and increase the probability of the fulfilment of self maximizing objectives. Hypothesis no.3: Did the management of the oil companies use specific strategic moves in order to avoid the control of the Norwegian State? 1.4 Case Study Method A case study is a multi-perspective analysis, where the researcher considers the voice and perspective of the individual players, but also the interaction between them (Tellis 1997). A case study does not require the researcher to be in control of his/her surroundings, and it is a well suited method to analyze change in complex situations were it is necessary to use several sources of data and methods to describe these changes. Case studies can be used by researchers to build upon theory, to generate new theory, to dispute or test theory, to explain a situation, to provide a basis to apply solutions to situations, to explore, or to provide description of an object or a phenomenon 1. Eisenhardt refers to case study as a research study which focuses on understanding the dynamics present within a single setting (1989b:534). The influential research writer, Robert K. Yin, defines case study as an empirical inquiry that investigates a contemporary phenomenon within its real-life context; when the boundaries between phenomenon and context are not clearly evident; and in which multiple sources of evidence are used (1994:13). Yin (1994) states that evidence for case studies originates from six sources: documents, archival records, interviews, direct observation, participant observation and physical artefacts. The evidence may be qualitative, quantitative or both. Qualitative methods are used when the aim is to study selected issues in dept and detailed without being limited by predetermined categories. Quantitative methods 1 Based up on the work of Eisenhard 1989b, and Tellis

11 demand that the researcher has a larger degree of control of the object or phenomenon than in qualitative methods. Standardization of the measurements is required as the information collected have to be fitted into a limited number of predefined response categories (Tellis 1997). Qualitative methods are used when the researcher is interested in analyzing the relationship between phenomenona or analysing a specific phenomenon. Qualitative method is criticized for being to general as the results are nonmeasurable. Yin (2003) divides case studies into three groups: explorative, descriptive and explanatory. In an explorative case study the field work and data collection is often done prior a successive study, in order to develop the necessary hypotheses, questions and definitions in the successive study A descriptive case study presents a complete description (and must cover the depth and scope) of a subject or a phenomenon within its context. Descriptive case study is build upon qualitative data. Explanatory case study attempts to clarify why and how there is a relationship between two aspect of an object or a phenomenon. It presents data bearing on cause-effect relationships, and focuses on explaining how events happen. My study case contains a mix of the three above mentioned designs. 1.5 Primary and Secondary Sources Ghauri et al (1995) distinguish between primary and secondary information and sources. Primary data refers to new data that is collected specifically for a project. Secondary data refers to data that is gathered and recorded by someone else prior to, and for a different purpose than the current needs of the researcher. The most common problems with secondary data are: outdated historical information, variation in definition of terms, different units of measurements, and lack of information to verify the data s accuracy. The main advantages with secondary data are that they reduce time and costs as the data is already assembled and the researcher doesn t require direct access to respondents or subjects. It is fully possible to carry out a case study using only one type of evidence source, however the best result is achieved by using multiple sources (Yin 2003). This thesis is the subject of time and space constraints so I will only use secondary data, in form of documents as academic articles, journal and newspaper 11

12 articles, administrative documents, official documents, working papers, books and memoranda. 1.6 Reliability and Validity It is important to keep in mind that qualitative research methods are a mixture of rational, explorative, descriptive and intuitive forms of research where the skills and the experience of the researcher influence the analysis of the collected data (Ghauri et al 1995). When conducting a research study reliability and validity are central issues in controlling the quality of the study (Tellis 1997). Reliability refers to the stability, accuracy and precision of the measurement used in the research. Reliability implies that the different measures should be reliable in the sense that different independent explorations should get the same results every time they are repeated (Aaker 1998). Qualitative data has a less degree of accuracy than quantitative data which implies that the data has a lower degree of reliability (Tellis 1997). Validity (truth) refers to the extent to which a source accurately represents the social phenomenon to which it refers to. Yin (1994) divides validity into three groups: Construct validity requires the researcher to establish the correct measures for the phenomenon that is being studied, and this form of validity is especially problematic in case study research. The problem of construct validity can be reduced by using multiple sources of evidence (such as documents, interviews and observations). Internal validity is only of concern in explanatory case studies, and it demonstrates that certain conditions lead to other conditions and requires the use of multiple parts of evidence from multiple sources in order to discover convergent lines in the investigation (Yin 1994). External validity is concerned with whether or not the results of the research are generalizing the phenomenon. The more applicable the results are to other cases, people, events and variations in places, the higher the external validity will be. The researcher can use methods such as cross examination and within-case examination combined with literature review in order to increase the external validity of the study (Tellis 1997). 12

13 Aiming at enhancing or confirming the validity of my case study I have used a triangulated research strategy, which involves using multiple document sources to control the validity of the data. 1.7 Organisation of the Norwegian Petroleum Sector The Parliament is the highest political authority in the petroleum industry on the Norwegian Continental Shelf, and it develops the framework for the petroleum operations. The application of the Parliament s guidelines is ensured by The Oil and Energy Department (OED) which was established in 1978 and has since been the highest administrative authority for the petroleum industry in Norway. Administered under the OED, The Norwegian Petroleum Directorate was established in 1972 with the primary functions of administrative and financial control. The Petroleum Directorate aim is to ensure that exploration for and production of petroleum are carried out in accordance with the legislation, regulations, decisions and licensing terms that are laid down by the Ministry. The State s direct participation in the Norwegian oil sector is today operated through the State Direct Financial Interest (SDFI) and the two companies, Petoro and Gasco, both which are 100 percent state owned. Petoro AS was established in 2001 by the Parliament as a consequence of Statoil s privatisation. Its primary function is to manage the State s Direct Financial Interest (SDFI) which was established in 1985 again as a consequence of the Statoil reform. The SDFI arrangement means that the State pays a share corresponding to its direct financial interest of all investments and costs in projects and thereby it receives a corresponding share of revenues on the same terms as the other licensees. Petoro is financed by appropriations from the Government, and receives no revenues of its own from the SDFI s assets, as the SDFI assets are managed for the State s account. Gassco AS was also established in 2001 and is a separate neutral company for the transportation of and operatorship of all leading pipelines of natural gas at the Norwegian Continental Shelf. The State is today indirectly participating in the Norwegian petroleum industry through its majority ownership in Statoil (76,3 %), and its minority ownership in Norsk Hydro (43,87 %), Statoil was partially privatised and listed on the Oslo and New York Stock Exchanges on 18 th of June 2001, with 23,7 per cent of the company sold to private 13

14 shareholders in Norway and abroad. The Parliament has opened for further reductions in the State s shareholding, down to two-thirds of the company s value. Norsk Hydro is listed on the Oslo and the New York Stock Exchange. 1.8 Statoil ASA Established in 1972 Statoil is a world leading oil and gas company with a workforce of employees and operations in 28 countries. Statoil had a turnover of NOK 249 billion and a net income of NOK 16,6 billions and is the world s third largest net seller of crude oil (Annual Report 2003). Statoil has through the years gone from being a privileged wholly state oil company to become a partly privatized multinational energy company. The company is mainly focused on the petroleum industry where it operates in all levels of the value creation chain, from exploration to marketing. The high level of integration achieved by this company is clearly stated in its mission statement, according to which Statoil s objective is either by itself or through participation in or together with other partner companies, to carry out exploration, production, transport, refining and marketing of petroleum-based product, as well as other business (Annual Report 2003:5) Operating 20 oil and gas fields domestically and internationally, Statoil plays a key role for the energy market in Norway where it markets 2/3 rd of the total gas volumes and ½ the overall output of the Norwegian Continental Shelf. With a similar share of the domestic energy supply, Statoil has to be accountable not only to its shareholders but also to Norwegian society, whose welfare it can considerably affect. In the last annual report, the company addresses its stakeholder as follows: Statoil s fundamental objective is to create value for its owners through profitable operations and sustainable commercial development. Good management and control will ensure the effective use of the group s resources and the greatest possible value creation. Value created in Statoil will benefit shareholders, employees and society. (Statoil s Annual Report 2003:53). 14

15 In this communication, Statoil underlines the importance of good management and control to ensure effective resource allocation and shareholders value maximization; at the same time though it specifies that value creation will positively affect not only owners but also other constituencies such as employees and society. According to this view, the goal of shareholder wealth maximization would not conflict with the welfare of other stakeholders but would rather result in long term benefits for them too. 1.9 Norsk Hydro ASA Norsk Hydro ASA was established in 1905 and the company used electricity from waterfalls to extract nitrogen from air to produce fertilizer. Hydro is today the second largest publicly traded industrial company in Norway and the company had a turnover of NOK 172 billion in 2003, and a net income of NOK 10,7 billions 2. Listed on the Oslo Stock Exchange and the New York Stock Exchange, Hydro is a leading energy and aluminium supplier with employees and operations in over 40 different countries. Norsk Hydro grew to become a conglomerate during the 1960s operating in four business segments; aluminium, agriculture, food, and oil and energy. However, today the company focus on its core activities; aluminium and oil and energy. Hydro s mission statement is to create a more viable society by developing natural resources and products in innovative and efficient ways. (Annual Report 2004:2). Norsk Hydro regards corporate governance as not simply a matter of compliance with rules and regulations but rather as a driver of performance as it recognizes that sound and transparent corporate governance contributes to value creation, drives performance, builds respect and promotes ethical and sustainable business conduct (Annual Report 2003: 42). Already in this statement the company seems to adopt an ethical business conduct as it specifies that beside performance and value creation it also pursues sustainable growth and ethical business practice. This attention to other stakeholders beside the shareholder is further to be found in the annual report stating that Hydro intends to build on its tradition of creating value by combining commercial focus with socially responsible business operations (Annual Report 2003:42.) 2 Information in this paragraph obtained from Norsk Hydro, Annual Report

16 THEORY The term corporate governance has been created to indicate how corporations, firms and organizations are owned, managed and controlled. It involves a set of relationships between a company s management, its board, its shareholders and other stakeholders. Corporate governance is traditionally seen as a principal-agent problem, as it addresses the agency problems that are developed as ownership and control is separated. Corporate governance mechanisms are mechanisms that can be used in order to limit agent costs caused by the agent s self-serving behaviour. The theory part will consist of four parts: corporate governance, principal-agent theory, corporate governance mechanisms and finally a section about state ownership. 16

17 2.0 CORPORATE GOVERNANCE The primary meaning of governance involves that decision-takers (in the firm) must be accountable to someone for their actions 3. In the narrowest sense corporate governance can be described as the formal system of accountability of senior management to the shareholders 4. This definition is based upon the view that good corporate governance is concerned with correctly controlling the behaviour of managers in a firm, and that there must exist a structure of governance that motivates managers to increase the wealth and performance of the business and firm activities. Jensen and Meckling (1976) are renowned advocates of shareholder value maximization theory, in which the manager of a company pursues a single objective, namely the maximization of the value of the firm. The agent s behaviour is regulated by a contract, according to which the agent is entitled to a fixed pay or incentive compensation tied to corporate performance, while the value he creates in the firm goes to the shareholder after paying wages and debts (Fama and Jensen 1983). This makes the shareholder a residual claimant as this actor is entitled to get any free cash flow generated in the firm in which he has invested. Considering the uncertain nature of inflows of resources in the firm the shareholder bears the risk of paying the agent even though his performance does not provide sufficient returns on the investments. According to traditional economic theory, it is the agent s (the management s) duty to maximize value for the shareholder who bears the residual risk of the difference between uncertain future cash flows and contractual payments accorded to the management. Shleifer and Vishny s definition of corporate governance is another example of the traditional narrow concept of corporate governance as a system for maximizing the market value of stockholders claims: Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment (1997:737) The above outlined definitions of corporate governance focus only on the shareholder perspective and are not concerned with the way in which corporate behaviour affects the 3 Quote from Peter J. Buckley published in Keasy et al 1997:201 4 Quote from Keasy, Thompson, Wright 1997:2 17

18 environmental and societal interests of the communities it operates in. According to the OECD Principles of Corporate Governance report (2004) corporate governance does not simply address the issue of the relationships between shareholders and management, but includes also other stakeholders whose conflicting interests should be reconciled. The Nørdby Report and Recommendations 5 has the following definition of the term corporate governance: Corporate governance is the goals, according to which the company is managed, and the major principles and frameworks which regulate the interaction between the company s managerial bodies, the owners, as well as other parties who are directly influenced by the company s dispositions and business (in this context jointly, referred to as the company s stakeholders). Stakeholders include employees, creditors, suppliers, customers and the local community. Carmichael (2002) identifies besides the traditional principal-agent problem also two other aspects that are necessary in order to establish good corporate governance, namely the principal-principal problem and the principal-stakeholder problem. The principalprincipal problem is an internal corporate governance problem that occurs when conflicting interests arise among different group of principals. The most common example of an interest conflict is between majority shareholders and minority shareholders. Other examples of principal-principal problems may be related to the rights of shareholders in voting procedures, in receiving information, and in liquidation. The principal-stakeholder problem arises because of the existence of other constituencies besides shareholders who have a stake in the activities of the firm, and is based upon the argument that companies also have a social responsibility to take care of. Following the same line of thought Tirole (2001) argues that the designer of a corporate governance system must consider how all stakeholders (creditors/financiers, employees, suppliers, customers, and other parties) are affected by the behaviour of the firms. 5 Published in Denmark December

19 The above outlined extension of the corporate governance concept is based upon Freeman s stakeholder theory of the firm, dismissing traditional economic theory and arguing that corporations should achieve the balanced satisfaction of demands from all its constituencies and not exclusively aim at the maximization of shareholders wealth 6. According to classical economic theory managers are hired with the unique aim of maximizing profits and thus returns for their employers (the shareholders), on the contrary stakeholder theory argues that the purpose of the firm is the satisfaction of the claims from a multitude of constituencies including employees, the environment and society in general. Freeman (2002:2) definition of stakeholders as any group or individual who is affected by or can affect the achievement of an organization s objectives implies a two-way relationship between the firm and its several constituencies. Criticizing this view Jensen (2001) argues that stakeholder theory lacks quantitative measurable performance criteria, which makes it hard for the principals to evaluated the performance of the managers. Stakeholder theory also increases the managerial discretion and leaves managers empowered to pursue their own interests and preferences in spending the firm s resources, at the cost of the firm s financial claimants and the society 7. Jensen concludes that stakeholder theory with its multiple objectives leads to increased agency costs, because of the increased managerial discretion. Finally, corporate governance is also influenced by macroeconomic factors and the degree of competition in product and factor markets, in addition to the legal, regulatory and institutional environments. 2.1 Principal-Agent Theory Principal-agent theory is concerned with situations in which ownership and control are being separated. The corporate assets are owned by the shareholders, however the control over the corporate resources is held by the managers of the firm. This means 6 See Freeman This paragraph is based upon Michael C. Jensen s article Value Maximization, Stakeholder Theory, and The Corporate Objective Funtion from

20 that the consequences of the line of actions taken by executives are not only carried by the individual manager but mainly by the shareholders (or in a broader view the stakeholders) of the firm. The basic idea in the agency theory is a situation where the principal (the owner) and the agent (manager or employee) are engaged in cooperative behaviour, but have differing goals and interests 8. If both the principal and the agent engaged in the cooperative behaviour are utility maximizers, there is an increasing chance that the agent will not always act in the best interest of the principal 9. This may lead to problems of managerial entrenchment and rent extraction by the managers (agents), as the managers have ended up with residual control rights and discretion to allocate investments as they choose (Maher and Anderson 2002). Agency problems arise whenever the principals wish to exercise control differently from the manager in the charge of the firm. Examples of agency problems can be situations where the managers exert insufficient efforts by; over-committing to external activities, accepting overstaffing, ignoring internal control, building unprofitable businesses aiming at benefiting own private benefits, over consuming perks, and when executives entrench themselves by; investing in declining industries because that is where their competence is, diversifying business to reduce unsystematic risk, and by resting value-enhancing takeovers that threatens their positions in the firm (J. Tirole 2001). In this thesis the agent will be a manager of an oil company running the company on behalf of its principal(s) e.g. owner represented by the government, and other stake / shareholders Agency Relationship A principal-agent relationship is developed as a contract in which the agent is delegated some decision making authority to perform some tasks or services on behalf of the principal 10. The typical case of agency relationship is the one that exists between an owner of a firm (the principal) and the manager of the firm (the agent). When the agent is about to execute the task given to him, the manager chooses an action, which results in an outcome, having an influence upon the welfare of both the principal and the agent. Since principals and agents most often have different interests and goals, the result of the action may be of a conflicting nature. 8 Eisenhardt 1989a 9 Jensen and Meckling Quote from Jensen and Meckling 1976:5). 20

21 2.1.2 Agency Costs The divergence of interests between the principal and agent results in a cost or a deviation between the principal s instructions and the agent s actions. Agency costs are a result of a situation where the management of a firm pursues it own economic selfinterests instead of maximizing the wealth of the shareholders. Drawing upon Fama and Jensen s paper 11, agency costs can be divided into two brad categories according to their origin. Monitoring and enforcement costs arise from the devotion of resources to the aim of structuring, monitoring and bonding a set of contracts among agents with conflicting interests, and to value of output lost because the costs of full enforcement of contracts exceed the benefits (1983:5). On the other side opportunity costs refer to the loss borne by the principal when the agent does not adequately pursue his interests. For example when a manager in a corporation fails to make a decision or take an opportunity that would have produced a better net return than the decision it does not in fact make, the lost revenue is an opportunity cost (Pass et al 2000). The larger the firm (agent) becomes the larger will the agency costs be for the owner (principal), as the monitoring function will become more difficult and expensive in a larger organisation than in a small one Managerial Slack Behaviour inconsistent with the principal s demands can be termed shirking or managerial slack. Agency costs arise in a situation where the manager of a firm has an incentive to slack. The manager does not want to perform the delegated duties as precisely as the principal would like, because of diverging interests between the parties, but also because the agent possesses more information about how it has performed the task than the principal does (Eisenhardt 1989a). Generally speaking managerial failure or slack can be divided into two types. It is these types of slack that hinder managers from acting as perfect agents for their principals (shareholders): 11 Fama and Jensen Argued by Jensen and Meckling (1976) 21

22 1. Failures of managerial competence stems from non-voluntary mistakes on the part of agents in the execution of their managerial tasks. 2. Failures of managerial integrity originate from voluntary behaviour of executives having a negative influence upon business results, thus compromising corporate assets value. To reduce the agency costs and managerial slack the shareholders of a firm can use ratification, monitoring and sanctioning mechanisms (Fama and Jensen 1983). Ratification mechanisms are instruments that are used in order to validate the decisions taken by the agent, for instance giving the (final) approval or veto for an action or an initiative planned by the agent. Monitoring mechanisms refer to tools that are used by the principal in order to observe, record and measure the results of the agent s performance and effort. Sanctioning mechanisms are instruments that can be used to provide selective rewards and punishments for the agent, and the most frequent used mechanism is incentives. The purpose of these mechanisms is to motivate the agent to behave and take decisions that are aligned with those interests of the shareholders Risk Eisenhardt states that the heart of principal-agent theory is the trade-off between the cost of measuring behaviour and the cost of measuring outcomes and transferring risk to the agent 13. Principals and agents have different attitudes towards risk, which often leads to increased agency costs. The risk attitude is different in the perspective of shareholders versus the managers. Managers are likely to avoid many profit-maximizing risks as these risks may endanger their careers. This is specially the case with managers that have their human capital tied up in the firm. Employees have also capital tied up in the firm and will therefore be averse to risks to the firm. Throughout the years literature and research has shown that managers historically prefer to expand their firms as expansion satisfies the manager s personal goals according to increased power, security, prestige and wages. (Roe 2001). Firm expansion often improves the security of a manager s position, as additional staff increase organisational hierarchy. However, for the shareholders, the situation is the opposite, as expansion often fails to maximize the shareholder profits. Shareholders are often in a position where they can diversify their 13 Quote from Eisenhardt 1989a:61) 22

23 investments and risks better than managers, and therefore they usually prefer the firms in which they have shares in, to maximize the expected value with less respect to risk (Roe 2001) Contracts Agency theory attempts to describe the principal-agent problem using the metaphor of a contract (Eisenhardt 1989a). In an agency relationship, the principal wants the agent to act in the principal's interest, and the principal s problem is consequently to design an incentive contract that induces the agent to undertake actions that will maximize the principal s welfare. Contracts are thereby used as mechanisms for resolving problems that arise from the two parties imperfect or conflicting positions of interests. A contract can define or specify the different agency relationships between shareholders and managers, between debt holders and managers, between shareholders and board directors and board directors and various board committees. Agency theory is concerned with how agency problems affect the form of the contract and how they can be minimized, in particular, in presence of information asymmetries and (high) uncertainty. Eisenhardt (1989a) divides the contracts between principal and agent into two main categories, behaviour oriented contract (i.e. salaries, hierarchical governance) and outcome oriented contract (i.e. commissions, stock options, transfer of property rights, market governance etc). Each kind of contract tackles a specific aspect to be taken by the agent: conduct and course of action in the case of behaviour oriented contracts, performance to be achieved in the case of outcome oriented contracts. Considering another dimension, contracts can also be divided into implicit and explicit contracts. Implicit contracts are based on unspoken mutual expectations, culture, norms, and individual roles etc, while explicit contracts are based upon written agreements that are legally binding (i.e. shareholder agreements and employment contracts) Incentives Incentives are rewards or punishments that motivate an agent to act in a specific way rather than other ways when the agent is given alternatives. Incentives can be divided 23

24 into financial and non-financial (Jensen and Meckling 1976). Financial incentives are monetary rewards that are related to the observable performance level of the agent (salary or bonus) or a set of rewards that can be turned into money (stock grants, stock warrants and option grants). Non-financial incentives are non-monetary rewards that are related to the observable performance of a manager, most common through intraorganizational aspects as power and prestige, perquisites and privileges and reputation Information Asymmetry Most business setting and conditions are characterized by uncertainty and incomplete information, and both principal and agent is faced by these challenges. The state of asymmetric information is a result of a situation where the agent holds or conceals information, and/or undertakes or hides actions from the principal 14. In situations where the agent and principal have conflicting interests, the agent may have no incentive to share its knowledge and expertise with the principal. Every act of delegation of authority includes the possibility of asymmetric information, and when information asymmetry exists, the agent may act against the interests of its principal without fear of being held accountable for its actions 15. So instead of revealing the secret information to its principal the agent may choose to use this information to pursue his own interests. In general, two types of information asymmetry can be identified. Hidden information leads to adverse selection problems and hidden action leads to moral hazard problems (Eisenhardt 1989a): Hidden Information Adverse Selection Hidden Action Moral Hazard Fig.1 Two Types of Information Problems 14 Eisenhardt 1989a 15 This paragraph refers to Lupia and McCubbins

25 The problem of hidden information is caused by difficulties in revealing the agent s private information (based on e.g. hidden knowledge, expertise, experience etc), which the agent can us to its own advantage and to the disadvantage of the less informed party to a contract (Pass et al 2000). The correct information is most often hidden either by failures of managerial integrity (lies, falsehood, misappropriation etc) or by failures of managerial competence (such as mistakes, mis-calculations etc). In order to reduce the hidden action problem the principal must design monitoring mechanisms and incentives that reward and sanction the agents (managers, board directors and employees) in accordance to their contribution to value maximization of the firm. Gaps (or agency slack) between the principal s demand and the agent s behaviour will likely increase when the agent s actions are difficult to monitor and when the agent holds back information 16. Increased information asymmetric conditions decrease the principals ability to control the agent. Agency slack varies according to the quality of information that the principal obtains about the agent s behaviour and the consequent policy outcomes that result from agent behaviour. High levels of programmability decrease the information asymmetry. Eisenhardt defines programmability as: the degree to which appropriate behaviour by the agent can be specified in advance (1989a:62). This implies that in a long-term relationship between a principal and an agent, the principal will learn more about the agent and thus be able to predict behaviour better than in a short-term relationship where information asymmetric is likely to increase Moral Hazard and Adverse Selection Information asymmetry is as mentioned the result of the uncertainty that is present between the principal and the agent in a relationship. When the principal is about to formulate a contract he will be faced with two main problems, which are referred to as moral hazard and adverse selection. Problems of moral hazard and adverse selection are often inseparable in the real life, while in the world of literature the two phrases are often investigated individually. 16 Lupia and McCubbins

26 Moral hazard problems arise because of the principal s lack of possibility to observe the agents actions after contracting. Eisenhardt (1989a:61) defines moral hazard as the condition under which the principal cannot be sure if the agent has put forth maximal effort. Moral hazard is therefore a consequence of hidden actions in transactions, and these hidden actions happen after the parties have contracted how to execute the transaction (Pass et al 2000). The hidden actions may result in a hindrance of a successful completion of the transaction. In some cases the expectation of hidden actions can prevent the parties from going through with the transaction. Moral hazard applies often in the case of employment contracts. For instance a manager of a corporation might not act in the interests of the shareholders if the monitoring or scrutiny of him is not extensive. Instead the manager may engage in activities that increase his self-maximization. Generally speaking, adverse selection problems arise from information asymmetry between the agent and the principal before and after contracting. Eisenhardt (1989a) describes adverse selection as a problem which arises because the principal cannot completely versify the skills and abilities the agent claims to have either at the time of hiring or while the agent is working. Screening is a mechanism that can be used in order to reduce adverse selection problems. The mechanism involves that the principal is using observable characteristics of the agent to predict the agent s future performance (Becht 2003). Lupia and McCubbins (1999) argue that an important aspect of principal-agent theory involves the selection and promotion of the right agents, agents that are more willing to and/or able to realize the policy outcomes favoured by the principals. Through the composition of the staff in an organisation the principal can manipulate or influence an agent s strategic direction to a certain degree. According to Padilla (2003) the principal may incite behavioural change in the agent through the screening and selecting of new personnel, through monitoring and sanctioning staff and through redesigning administrative procedures. 26

27 2.2 The State as a Principal The state has a complicated task as it has to balance political, societal and economic objectives. These multiple and complex sets of objectives are often transferred to state owned companies. The basic problem in principal-agent theory is the conflict of interests that arises between the principals represented by the shareholders (value maximization of the firm) and the agent represented by the management (maximization of self interests). The analytical focus of principal-agent theory is too narrow in order to solve the corporate governance problem (Maher and Andersson 2002). When the state is the principal, the conflict of interests broadens to include interests as the maximization of welfare, government political interests and party political interests. The problem of principal-stakeholder arises as other constituencies besides shareholders have a stake in the activities of the firm and because state owned companies often have a social responsibility. The principal-principal problem arises when the state is a principal, because the state can be divided into multiple principals as for instance the taxpayers, the parliament, the government, the ministries, the administrative state departments and agencies, funds and legates etc. The state s ownership rights are exercised through the different state institutions which increase the possibilities of any of the above mentioned problems, which results in increased agency costs. The long distance between the owner and the management in the state owned companies complicates the monitoring process. The structure of the incentives separates the state owned company from the private (Aharoni 1986). In state owned companies the reward structures are usually fixed, meaning that the employees have fixed salaries and there are no explicit bonuses. The state will mainly use behaviour oriented contracts and non-financial incentives in order to reduce agency costs. Outcome oriented contracts may not be available tools for the state if the company is wholly or majority state owned. The degree of toughness of the state s budget constraints (further explained in the State Ownership part) affects the possibilities of managerial discretion and slack in state owned companies. Soft budget constraints may lead to increased adverse selection problems and moral hazard problems. 27