Managerial Incentives and Environmental Compliance

This paper uses a principal-agent model to analyze the role of monetary incentives to implement corporate environmental policy. The model assumes that the agent has to split a limited amount of effort between two tasks: profit enhancement and environmental risk reduction. We find that when the agent's effort constraint is not binding, wages should increase with performance in each task. Moreover, the sharpness of the optimal monetary incentives for a given task should depend positively on the principal's eagerness to influence performance on this task, and on the accuracy of the monitoring technology. When the agent's effort constraint is binding, however, the necessity for the principal to provide insurance to the agent may make it inefficient to link managerial effort expended on environmental risk reduction to the corporate compensation system.