Managerial Incentives and Corporate Pollution: Evidence from Relative Performance Evaluation

The purpose of this paper is to provide evidence on the relation between CEOs’ compensation contracts and their firms’ environmental pollution. Because many corporate environmental issues are idiosyncratic (i.e., business model-specific), we focus on relative performance contracts that remove the systematic component from CEOs’ performance and provide an unambiguous incentive to improve idiosyncratic performance. We develop a reputation risk hypothesis based on the idea that excessive environmental pollution tarnishes a firm’s idiosyncratic reputation. We test this hypothesis using facility-level data on production-driven chemical waste and facility-, firm-, and CEO-level proxies for reputation risk. Consistent with this hypothesis, our key finding is that relative performance plans are negatively associated with environmental pollution in the presence of reputation risk. Collectively, this paper brings in the perspective that CEOs’ compensation contracts need not necessarily include explicit environmental metrics to motivate CEOs to make more environmentally friendly decisions.