Corporate Environmental Responsibilities and Executive Compensation: A Risk Management Perspective

• Date: 01 March 2019
• Author: Fei Kang,Jongyu Paula Hao
• DOI: http://doi.org/10.1111/basr.12166
• Published date: 01 March 2019

Business and Society Review 124:1 145–179

© 2019 W. Michael Hoffman Center for Busi ness Ethics at Bentley Univer sity. Published by

Wiley Period icals, Inc., 350 M ain Street , Malden, MA 0 2148, USA, and 9600 Ga rsington

Road, Oxford OX4 2DQ, U K. DOI: 10.1111/basr.12166

Corporate Environmental

Responsibilities and Executive

Compensation: A Risk

Management Perspective

JONGYU PAULA HAO and FEI KA NG

ABSTR ACT

In this ar ticle, we exami ne how firms design exe cutive

compensation in light of their r isk environment. Prior l it-

erature shows that corporate envi ronmental responsibil-

ity (CER) of a firm invers ely affects fir m risk. We argue

that firm s with better CER performa nce benefit from the

reduced firm ri sk, and therefore are more likely to provide

greater manager ial risk-takin g incentives to encourage

the risk-averse managers to underta ke risk-increasing

but positive net present value (NPV) invest ments.

Consistent with our hypotheses, we fi nd that a fir m’s CER

rating is positively asso ciated with its CEO risk-tak ing

incentives (vega) in the followin g year. We also document

cross-sectional va riations in the CER-vega relationship,

that is, a weaker association i n the controversial indus-

tries. This study contr ibutes to the literature by investi-

gating the role of CER on executive compensation design

from the perspective of risk ma nagement.

Jongyu Paul a Hao is an assist ant professor of Acc ountancy at Ca liforn ia State Universit y,

Long Beach, CA . E-mail: P aula.Hao@csulb.edu. Fei K ang is an a ssociate profess or in

Accountin g at, California Stat e Polytechnic Universit y, Pomona, CA. E-mail: kan g@cpp.edu.

146 BUSINESS AND SOCIETY REVIEW

INTRODUCTION

Corporate social responsibilit y (CSR) can be broadly defined

as voluntary f irm actions designed to improve socia l or

environmental conditions ( Mackey et al. 2007). In the past

decade, companies have significa ntly increased t heir sustainable

and socially re sponsible investment. Specifically, among a fir m’s

effort in mana ging stakeholder relationship, corporate envir on-

mental responsibility (CER) is playin g an increasing ly import-

ant role. As suggested in Capelle-Blanca rd and Petit (2017), the

importance of indiv idual CSR dimensions mig ht be different and

the environmenta l dimension of CSR has been underweig hted in

previous assessments. Consistent with this v iew, empirical works

document the importance of CER and show th at CER is positively

associated with f irm fi nancial perfor mance and reduces fir m risk

(Cai et al. 2016; Kim and Statman 2012; Klassen and McLaugh lin

1996; Russo and Fouts 1997). Moreover, CER is important not only

to academics but also to practitioners. As suggested in t he Shelton

Group’s 2013 Eco Pulse study, CER is more appealing than CSR

from the perspective of the general public, imply ing that consum-

ers perceive CER as one distinct dimension from CSR a nd value it

differently. Despite the important role of CER on firm per formance

and consumer perception, research focusing on CER is li mited.

More importantly, studies on CER have predominately focused

on the relation between CER and fir m fina ncial outcomes as well

as firm r isk; however, whether and how firms design executive

compensation in response to their CER engagement is an underex-

plored area in the literature. T his art icle fills the void by focusing

on the benefit of risk reduction of CER and exam ining t he rela-

tion between CER and CEO compensation design in l ight of the

reduced f irm r isk.

The incentive alig nment perspective of compensation suggests

that equity-based compensation can better a lign the interests of

managers wit h those of shareholders by incentivi zing the ri sk-

adverse managers to invest i n high-risk, high-retur n projects

on behalf of the risk-neutral shareholders (Hi rshleifer and Suh

1992; Jensen and Meckling 1976). In particular, Guay (1999) finds

that the convexity i n the relation between mana gers’ wealth and

firm per formance (i.e., vega) is positively related to stock return

147HAO AND KANG

volatility, suggesting that convex incenti ve schemes encourage

manageria l risk-taking. A long this line of resea rch, prior studies

using vega as the independent variable document that vega is posi-

tively associated wit h firm leverage and risk-increasing investment

decisions (Ha gendorff a nd Vallas cas 2011; Rajgopal and Shevl in

2002; Xue 2007).

CER engagement can reduce firm r isk by creating a form of

goodwill t hat acts as insurance-li ke protection for firms, improv-

ing informat ion transparency bet ween firms a nd investors, and

reducing fina ncial constrai nts of firms (Cai et a l. 2016; Godfrey

et al. 2009; Shar fman and Fernando 2008). Given the reduced firm

risk by CER engagement, boards of directors a re likely to design

and adjust their manageri al incentives according ly. Specifically,

risk-taking is impor tant and reducing f irm risk ca n have negative

impact on shareholder wealth (DeFUSCO et al. 1990; Gilley et a l.

2002; Low 2009). Therefore, we argue that f irms wit h better CER

performance ar e more likely to provide higher vega to encourage

manageria l risk-taking behav ior in response to the reduced fir m

risk by CER engagement.

Based on the previous discussion, we measure CEO r isk-taking

incentives by vega, which is a widely used prox y for risk-taking

incentives in the literature on e xecutive compensation (Coles et al.

2006). We use the Kinder, Lydenberg, and Domini Research a nd

Analy tics (KL D) database to construct our measure of envi ron-

mental responsibility (Hoi et al. 2013; Strike et al. 2006; Waddock

and Graves 1997). Employing a sample of S&P 1500 firms f rom

1996 to 2013, we find that CER perform ance of a firm is po sitively

associated with vega in t he following year, suggestin g that firms

take into account the reduced fir m risk by CER engagement when

designing thei r executive compensation. Furt hermore, the relation

between CER and vega is weakened for fir ms in the controver-

sial industries, which suggests t hat the association is li kely to be

context-specific (Baron et al. 2011; Coles et al. 2006; Ser vaes and

Tamayo 2013). Our results are robust to alter native research de-

signs, to alternative mea sures of CER performance, and to a lter-

native proxies for CEO risk-taking i ncentives.

This study contributes to the ex tant literature in t he following

ways: First, despite the important role of CER to academics and

practitioners, research on CER still rem ains a relatively underex-

plored topic (Cai et al. 2016). Prior empirica l works suggest that