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E-MailRoss Levine is a Senior Fellow at the Hoover Institution at Stanford University. This post is based on a NBER working paper by Seungho Choi, Professor Levine, Raphael Jonghyeon Park, and Simon Xu.
Foundational theories of the firm suggest that (1) shocks to expected cash flows influence shareholder preferences toward corporate risk-taking, and (2) shareholders may respond by altering the risk-taking incentives contained in the compensation packages they give to their executives. For example, shocks that lower expected cash flows might lead shareholders to prefer that their firms undertake less risky corporate investments to mitigate bankruptcy risk, leading these shareholders to reduce the risk-taking incentives in their executives’ compensation packages. However, shareholders of sufficiently financially distressed firms might react oppositely. When firms close to bankruptcy receive adverse shocks, shareholders might alter compensation pay to induce their executives to shift toward higher-risk strategies to generate the returns necessary to avert bankruptcy. Furthermore, the relationship between cash-flow shocks and executive compensation is further complicated by the effectiveness of the firm’s corporate governance structure: the effect of shareholder risk preferences on executive compensation depends on shareholders’ ability to shape corporate decisions. Thus, the impact of expected cash flows on executive compensation is an empirical question that may depend on firms’ financial conditions and governance structures.
Despite the importance of understanding how firms respond to shocks, researchers have yet to fully examine the impact of cash-flow shocks on the risk-taking incentives contained in executive compensation packages. Specifically, there is a lack of evidence on how different corporate financial conditions and governance structures modulate the effect of cash-flow shocks on executive compensation.
To address this gap, we examine the effects of shocks to environmental regulations that alter firms’ cash flows on executive compensation while differentiating firms by their pre-existing financial conditions and governance structures. Although existing work demonstrates that environmental regulations significantly affect firms’ cash flows, researchers have not previously explored how these regulations influence shareholder preferences toward their firm’s risk-taking or the compensation packages they offer executives. Thus, besides providing novel evidence on how cash-flow shocks influence executive compensation, we assess a potentially significant unintended consequence of environmental regulations: Changes in the risk-taking incentives contained in executive compensation packages.
We leverage a unique feature of the U.S. Clean Air Act (CAA) to evaluate the effect of environmental regulations on executive compensation. The CAA requires the annual designation of counties as either in attainment or nonattainment with National Ambient Air Quality Standards (NAAQS) for ground-level ozone. Nonattainment designations lead to more stringent environmental regulations, increasing production costs and reducing expected cash flows of ozone-emitting facilities in “treated” counties. We exploit this regulatory setting to explore the effects of shocks to the stringency of environmental regulations on the design of the incentive contracts provided to Chief Executive Officers (CEOs).
To measure the risk-taking incentives of CEOs’ compensation packages, we primarily use Vega, which is the sensitivity of CEO wealth to stock return volatility. A large body of research suggests that Vega is positively associated with increases in corporate risk-taking. We explore how environmental regulatory shocks reshape Vega. Our sample covers the 1993-2019 period and comprises over 2,700 publicly listed U.S. firms with over 30,000 firm-year observations.
We discover that more stringent environmental regulations that squeeze cash flows reduce Vega, i.e., adverse cash-flow shocks induce corporate boards to reduce the risk-taking incentives in CEO compensation packages. We also address two more granular questions about CEO compensation. First, what accounts for the fall in Vega? Vega can fall because corporate boards change executive compensation packages or because CEOs change their corporate securities holding, e.g., by exercising options. We find that shocks to environmental regulatory stringency alter CEOs’ compensation packages; the shocks do not affect CEOs’ decisions to exercise options. Second, we examine whether environmental regulations change other features of CEO compensation, including overall compensation. We find that shocks to environmental regulatory stringency reduce new option grants and increase bonuses but have no significant effect on overall compensation. This is consistent with the view that more stringent environmental regulations induce corporate boards to restructure executive compensation to incentivize lower-risk investments.
We next evaluate a crucial prediction from fundamental theories of the firm: the impact of adverse expected cash-flow shocks on the risk-taking incentives contained in executive compensation packages depends on firms’ pre-shock financial conditions. For example, adverse shocks are more likely to push financially distressed firms into a negative net equity position, incentivizing shareholders with limited liability to favor higher-risk projects that could push the value of shares above zero.
Consistent with this prediction, we find that the impact of shocks to environmental regulatory stringency on the risk-taking incentives contained in executive compensation packages becomes less negative and sometimes positive among more financially distressed firms.
Finally, we examine the prediction that the impact of expected cash-flow shocks on executive compensation depends on the effectiveness of firms’ corporate governance structure. While past research shows that corporate governance influences executive compensation, we evaluate whether adverse cash flow shocks triggered by environmental regulations reduce Vega more among firms with more effective corporate governance systems.
We discover that shocks to environmental regulatory stringency reduce the risk-taking incentives contained in executive compensation packages more among firms with stronger corporate governance structures. The results are consistent with the view that (1) environmental regulatory shocks that shrink expected net cash flows diminish shareholder preferences for corporate risk-taking, and (2) with stronger corporate governance structures, those shareholders can more readily reduce the risk-taking incentives of executive compensation packages to align CEO risk-taking incentives with their preferences for lower corporate risk-taking.
