Impact of outside option on managerial compensation contract and environmental strategies in polluting industries

Abstract To unveil how a manager’s outside option affects managerial compensation contracts and environmental strategies in polluting industries, this article studies an agency problem in which a risk-averse manager has private information about his ability and type-dependent outside option. A compensation contract is designed to incentivise the manager to truthfully report. Meanwhile, the firm makes an optimal choice between end-of-pipe strategy and pollution prevention strategy to maximise its profit. Based on the principal-agent theory, we establish a managerial compensation contract model and derive the optimal contract mechanism by solving its equivalent optimal control problem. The results indicate that without an outside option, the manager receives a constant bonus share rate and no information rent under the end-of-pipe strategy, whereas he obtains a downward distorted incentive and high information rent under the pollution prevention strategy. Considering outside options, the manager may receive information rent under the end-of-pipe strategy while receiving a pooling distorted incentive under the pollution prevention strategy. In a certain circumstance, the managers are pooled with the same bonus share rate and information rent. However, due to the interaction between the countervailing incentives, it is difficult to identify the change in total information rent and the pollution prevention strategy decision.