Show Me The Incentive & I'll Show You The Outcome

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The world runs on incentives. Mostly, these are obvious. But whenever there's something that doesn't make sense, listen to Munger

Honestly, this is one of the golden rules of life. Put a salesperson on a solid bonus scheme and they're more likely to outperform than if they're on fixed pay with no commission.

Reward someone for buying from your shop, and they’ll come right back and keep spending.

Incentives like those are pretty self-explanatory. But if you really dig into it, the world literally runs on incentives.

Apps and algorithms have been designed to hack the human operating system.

Reward us with a little hit of dopamine every time we hear that 'ping', or someone 'likes' our post, and we're all yours...

Everyone wants to be liked.

So, do we want to keep talking about these boring, obvious incentives?

Nope. We LOVE the ones that have unintended consequences.

And the perfect example cropped up a few weeks back:

Drax has allegedly cost consumers more than 600 million pounds.

But how?

The back story: Taking full advantage of the UK's green energy subsidy program since 2016, Drax has received £1.4 billion in public aid for a unit at its Yorkshire power station.

Essentially, the UK government subsidises biomass generated power that otherwise wouldn't be viable. Burning wood pellets for power isn't very efficient. It's also not that green as it turns out.

According to a report by Ember, it's actually...

Shocking I know.

So, what did Drax do wrong to cost the British public over 600 million quid?

By the letter of the law, absolutely nothing.

We know this because...

Ah yes, the ‘spirit’ of the agreement. Arguing on a morality basis is the first sign that you’ve already lost.

(Also why "less government" is generally a good thing. The best and brightest don't choose careers in politics)

The government had completely ignored the incentives.

The deal was simple.

How much will it cost Drax to produce biomass electricity?

Take that number (let’s call it 80), add in a reasonable profit expectation (say 20), and Drax can now produce biomass electricity and receive a guaranteed price of at least 100.

So far, so good.

Incentives aligned.

The problem was the other side of the deal. Basically, the agreement included a kind of inverse subsidy as well.

Bloomberg has some great charts to explain how it worked.

When the yellow line is below the orange line, Drax is doing well out of the deal.

When the yellow line is above the orange line, Drax is doing no better out of the deal.

They were supposed to keep on producing and send any difference back to consumers.

Instead, they simply shut the generators down, sold biomass pellets for a healthy markup, or diverted them to power generators that didn’t have a profit cap/inverse subsidy.

You can argue the morals, but the incentives are clear.

If Drax won’t earn extra for producing electricity above the ‘strike price’, why do it?

Sort of like the salesperson on a fixed salary. Doesn’t matter how much effort you put in, still not gonna earn a bonus. So why work harder?

Incentives run the world.

Speaking of which….