Greening of Industry Network Conference Waterloo – June Explicit contracting as a determinant of the linkage between environmental performance and executive compensation James J. Cordeiro SUNY- Brockport Joseph Sarkis Clark University

Greening of Industry Network Conference Waterloo – June “The compensation committee annually reviews the Chief Executive Officer’s performance in light of previously established goals and objectives, a number of which relate to sustainability performance …” (Potash Corporation, 2004 GRI Governance Performance Indicators) “The shareholders request the Board Compensation Committee undertake a special executive compensation review and provide a summary report to investors by Summer The report shall supplement information in the proxy statement. Questions to be addressed in the review and report shall include…How social and environmental performance is integrated into the formula for executive compensation and whether our corporation's employee downsizing or outsourcing is considered…” (Amgen Corp, 2005 Shareholder Proposal) “We recommend that the committee study and report on the following in its review: 1. Ways to link executive compensation more closely to financial performance with proposed criteria and formula. 2. Ways to link compensation to social & environmental corporate performance (e.g. incentives given for meeting or surpassing certain social and financial performance standards; whether adequate steps are taken to clean up toxic sites…” (1999 Shareholder proposal on Executive Compensation and Environmental/Social Performance, General Electric Corp)

Greening of Industry Network Conference Waterloo – June Research Questions How do environmental performance factors impact different compensation components in: a. firms that have an explicit linkage in place between executive compensation and environmental performance? b. firms that do not have the linkage in place?

Greening of Industry Network Conference Waterloo – June Theoretical Outline Agency theory recognizes that compensation incentives can be powerful tools for shaping executive behavior Executives are typically rewarded for financial performance However, there is some evidence that environmental performance can hurt financial performance (at least in the short- run)

Greening of Industry Network Conference Waterloo – June Theoretical Outline Therefore executives have incentives to not pursue environmental performance since this might hurt their compensation by lowering financial performance (see work by Gabel & Sinclair-Desgagnes (1993), Lothe, Myrtveit, & Trapani (1999), and Lothe & Myrtveit (2003)) in Business Strategy & Environment

Greening of Industry Network Conference Waterloo – June Theoretical Outline Based on formal models by Holmstrom (1979) and Holmstrom & Milgrom (1991) the incorporation of explicit environmental performance measures in top executive compensation contracts will help shape their behavior to bring about superior environmental performance.

Greening of Industry Network Conference Waterloo – June Our Hypothesis H1: Top executive compensation will be positively related to environmental performance in firms that explicitly link environmental performance factors to top executive compensation.

Greening of Industry Network Conference Waterloo – June Model (OLS) Ln CEO Compensation =  0 +  1 (Environmental Performance) +  2 (Firm Size) +  3 (Return on Assets) +  4 (Stock Return) +  5 (CEO Tenure) +  6 (CEO Duality) +  7 (Outside Director Ratio) +  8 (Institutional Ownership) +  9 (Blockholder Ownership) + error

Greening of Industry Network Conference Waterloo – June Methods Sample –207 firms from 1996 IRRC Corporate Environmental Profile (of S&P 500 firms) that had data on whether or not environmental performance was an explicit factor in executive compensation Data Sources –IRRC (Investor Responsibility Research Center) Corporate Environmental Profile –ExecuComp –Disclosure

Greening of Industry Network Conference Waterloo – June Operationalizations Environmental Performance Measures from IRRC Emissions Index:(Total Releases of 325 toxic chemicals/Firm Sales) Spills Index: (Combined number of chemical and oil spills/Firm Sales) Compliance Index:(Total dollar amount of penalties incurred by the firm under nine environmental statutes/Firm Sales)

Greening of Industry Network Conference Waterloo – June Operationalizations CEO Compensation Measures (from ExecuComp) –Ln of Total Compensation that includes: Salary Bonus,Value of Stock Options Granted Stock Grants Controls –Firm Size (ln of sales) –ROA –Stock Return –CEO Tenure –CEO Duality –Outside Director Ratio –Institutional Ownership –Blockholder Ownership

Greening of Industry Network Conference Waterloo – June Execution of Model Regressions run for each of the performance metrics for all companies, companies with an explicit linkage, companies without a linkage. Same regressions run for relative performance of industry. A total of 18 OLS regression models were executed

Greening of Industry Network Conference Waterloo – June Findings Pay is hurt by spills, poor compliance (these might be large enough to threaten directors and executives personally (about 700 convictions over 10 year period)) but no effect of toxic emissions These effects only occur in firms that have the explicit pay-environmental performance linkage in place Thus, we have partial support for H1 Possible “symbolism (rather than substance)” at work?

Greening of Industry Network Conference Waterloo – June Conclusions One of first studies to tie corporate governance mechanisms to environmental performance Extensions: –Additional measures of environmental performance –Explore contingencies of when firms might engage in symbolism –Explore variations across industries