When the EPA is in play, risk-taking goes away: The effect of environmental regulations on CEO compensation

Abstract

We examine the impact of environmental regulations and firms’ polluting behavior on CEO incentive compensation. Using the application of the National Ambient Air Quality Standards as an exogenous source of variation in regulatory stringency, we find that noncompliance prompts boards to reduce risk-taking incentives by decreasing the convexity of compensation payoffs. Higher regulation intensity and operating risk amplify the decrease in risk-taking incentives, while financially distressed firms exhibit a less pronounced reduction. Existing governance structures including CEO entrenchment, institutional investors, bargaining power, and overconfidence moderate the relationship between regulatory exposure and risk-taking incentives. Our findings highlight the active role of boards in adjusting incentive contracts to align the risk preferences between shareholders and managers in response to environmental regulations.