EMISSIONS TAX AND EXECUTIVE COMPENSATION: A PUBLIC–PRIVATE JOINT MECHANISM TO PROMOTE ENVIRONMENTAL AND ENERGY MANAGEMENT

Abstract

It is widely accepted that a market-based instrument such as a tax on greenhouse gas emissions is effective in motivating firms to improve energy efficiency, environmental management and invest in environmentally-related research and development (R&D). However, modern corporations tend to separate ownership and management, and decision-making executives who are myopic may not share the firm owners’ concern about their firm’s exposure to long-run costs and risks associated with climate change. Hence, executive wage contracts should include rewards for environmental performance, particularly in energy efficiency and developing R&D to reduce emissions. This paper examines the effect of implementing executive compensation that is partially indexed to abatement in a monopolist firm, in which decision-making is delegated to a manager under an emissions tax policy. In equilibrium, it is shown that the new wage compensation leads to more abatement, greater production of output, and higher wages for the manager compared with a conventional wage scheme where wages are solely indexed to profits. Hence, the government imposes a lower emissions tax on the firm. More importantly, this public–private joint mechanism results in net social welfare improvement in equilibrium. However, whether the monopolist’s profit is higher in the new wage scheme depends non-monotonically on the abatement efficiency technology and the extent of wage indexation to profitability.