Optimal Dynamic Contracts with Environmental, Social and Governance Criteria

We examine dynamic contracts when output has negative environmental effects and the manager (agent) can invest to build up ESG capital and mitigate the externality. The incentive component of the optimal contract rewards based on cash flow and ESG capital when the principal is risk neutral; and it additionally loads on the production externality when the principal has CARA. Optimal ESG contracts are less sensitive to traditional pay-for-performance measures, and ESG investment is determined by the ratio of capital to cash flow exposure in the contract. We identify conditions under which ESG investment is optimal and improves welfare. We also examine constrained contracts controlling the agency friction associated with ESG investment