By Dylan Minor
The recent passage of the Paris Agreement generated by the 2015 United Nations Climate Change Conference highlights the global consensus on the importance of reducing our environmental harm. A significant part of the problem, and thus solution, is business. Companies generate large amounts of pollution. Indeed, Trucost (2013) made the provocative claim that most industries produce such a large quantity of environmental toxins that were the firms to be fined according to law, they would no longer be making a profit.
Meanwhile, managerial incentives play an important role in firm outcomes. After all, managers are steering companies to their outcomes. Thus, it seems that managerial incentives could also have an important role in generating environmental impacts by firms. In my recent Harvard Business School working paper, I study this exact question: to what extent does executive compensation push firms into misconduct, and, in particular, to harming the environment?
For a motivating example, consider the case of BP: They have shown signs of skimping on safety expenditures even before the Gulf of Mexico spill. For one of BP's large oils spills, the Prudhoe Bay spill, we have some details regarding executive compensation and misconduct, and the tradeoff it generated for executives. Managers could increase their compensation by increasing profits almost instantly through cutting safety expenditures, but this would increase the potential of an environmental accident. BP leadership decided to accept the risk of this tradeoff, which ultimately resulted in an oil spill; the primary cause of the spill was deemed to be poorly maintained pipes. This allegedly arose from BP's dogmatic adherence to cost-cutting, which was encouraged by the CEO's implementation of cost cutting incentives for top managers. With roughly 250 of BP's top managers, the CEO created an annual "contract" that was based on the short-run annual profits of each respective manager's division. Prosecutors estimated that subsequent lax safety standards saved the firm some $9.6 million. The government fine alone for its Prudhoe Bay spill was $20 million, and additional costs, of course, far exceeded this amount. Hence, the firm enjoyed roughly $10 million of almost certain profit, yet faced a potential $20 million cost (or more). The next BP CEO, Tony Hayward, was also committed to a policy of indiscriminately shaving costs: almost immediately upon becoming CEO, Howard emailed associates about the importance of continued cost cutting. Soon after, the Gulf of Mexico spill occurred.
To study this issue more broadly, I constructed a measure of executive compensation that measures how high-powered incentives are effective in terms of generating firm profits. Using this measure, I found that high executive compensation can increase the odds of a firm breaking environmental law and causing environmental harm by 40-60 percent. Further, I found that the same measure shows that high powered executive compensation also increases the magnitude of environmental harm by over 100 percent.
It turns out that high-powered executive compensation can be linked to harm more generally. I also found that, similar to environmental harm, high executive compensation is linked to greater likelihood and greater magnitudes of financial accounting misconduct.
To be sure, high-powered incentives can also be an important mechanism for increasing firm productivity. Thus, in the end, there is a tradeoff that needs to be carefully balanced. That is, we need to consider how executive compensation can best be structured to enhance firm performance without placing the environment at risk. I hope to see greater attention to creating such holistic performance management in the future, both in research and practice.
Reference: Trucost. (2013, April 1). Natural Capital at Risk: The Top 100 Externalities of Business.
Dylan Minor is Assistant Professor of Managerial Economics & Decision Sciences at the Kellogg School of Management, Northwestern University. He is also on the ARCS Board of Directors.