No. 227: Carbon Taxes and ESG Compensation

This paper analyzes how ESG-linked executive compensation interacts with carbon taxation in a multitask principal-agent framework. A risk-neutral principal with financial and environmental preferences incentivizes a risk-averse manager to exert productive and abatement effort while facing an exogenous carbon tax on emissions. We show that, in the absence of ESG incentives, carbon taxes reduce emissions mainly by lowering production. In contrast, ESG-linked compensation shifts emission reductions toward increased abatement, allowing the principal to raise expected payoff while simultaneously reducing emissions, both with and without carbon taxation. However, carbon taxes narrow the range of feasible ESG preferences and, at high levels, may induce excessive abatement, potentially leading to negative net emissions. Our results highlight the importance of aligning internal incentive design with external climate regulation. The interplay of ESG compensation and carbon taxes should also be considered from a regulatory perspective.