Impact of outside option on managerial compensation contract and environmental strategies in polluting industries

Abstract

To unveil how a manager’s outside option affects managerial compensation contracts and environmental strategies in polluting industries, this article studies an agency problem in which a risk-averse manager has private information about his ability and type-dependent outside option. A compensation contract is designed to incentivise the manager to truthfully report. Meanwhile, the firm makes an optimal choice between end-of-pipe strategy and pollution prevention strategy to maximise its profit. Based on the principal-agent theory, we establish a managerial compensation contract model and derive the optimal contract mechanism by solving its equivalent optimal control problem. The results indicate that without an outside option, the manager receives a constant bonus share rate and no information rent under the end-of-pipe strategy, whereas he obtains a downward distorted incentive and high information rent under the pollution prevention strategy. Considering outside options, the manager may receive information rent under the end-of-pipe strategy while receiving a pooling distorted incentive under the pollution prevention strategy. In a certain circumstance, the managers are pooled with the same bonus share rate and information rent. However, due to the interaction between the countervailing incentives, it is difficult to identify the change in total information rent and the pollution prevention strategy decision.

Keywords:

• Asymmetric information
• environmental strategy
• compensation contract
• outside option
• optimal control

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 As reported in F. Wang, Cheng, Keung, and Reisner (2015), only 33.5% of managers have a high level of environmental awareness and environmental behaviour in heavy-polluting firms in China’s Shaanxi Province.

2 Berrone and Gomez-Mejia (2009) summarise some characteristics of the pollution prevention strategy: (1) it requires structural investments in new cleaner technologies; (2) it would increase the firm’s performance; (3) it can reduce costs through better use of inputs, reduction of waste disposal costs; and (4) it contains a firm-special part since rethinking of products and process based on the firm’s properties, which cannot be easily imitated by other firms.

3 In Equation (1), γx may be seen as the profit caused by the pollution prevention strategy level, such as the governmental special funds for local cleaner production, according to the Cleaner Production Promotion Law of the Peoples Republic of China.

Additional information

Funding

This work is supported by the National Natural Science Foundation of China under Grant Nos 71471126 and 71771164.