Introduction

The paper examines how corporate governance influences firms’ production decisions when these activities create negative externalities. Many production choices—such as environmental pollution or workplace safety risks—are difficult for regulators to observe, allowing firms discretion to prioritise profits over social welfare. The authors propose that governance mechanisms designed to improve firm performance can unintentionally increase socially harmful production. Using theoretical modelling and empirical evidence, the study evaluates how monitoring and managerial incentives affect socially costly firm behaviour. Evidence focuses primarily on the US coal industry, where production generates measurable external costs such as workplace injuries and fatalities.

Hypotheses development

The authors develop a theoretical framework linking governance, managerial incentives and externalities. The model assumes that managers choose production methods that influence both firm profitability and social costs. When monitoring of managerial effort is costly, shareholders rely more heavily on performance-based compensation to align incentives. However, such compensation encourages managers to prioritise profit-maximising activities, even if these increase negative externalities.

The framework predicts that stronger governance mechanisms—particularly those emphasising profit performance—can increase socially harmful production decisions. Conversely, weaker monitoring or less performance-sensitive compensation may reduce incentives for managers to pursue socially costly practices.

Governance mechanisms

Two primary governance mechanisms are analysed: managerial monitoring and performance-based compensation. Monitoring refers to the oversight activities undertaken by boards or shareholders to observe managerial actions. When monitoring becomes more expensive or difficult, firms increase the use of performance-based pay such as equity incentives.

The theory predicts that stronger equity incentives encourage managers to increase output or adopt cost-saving practices that raise externalities. As a result, firms with governance structures that strongly link compensation to financial performance may generate greater social costs.

Optimal governance framework and firm policies

The model identifies trade-offs between monitoring costs, compensation design and socially harmful production. When monitoring is efficient, shareholders rely less on performance-based incentives, reducing pressure to increase harmful output. When monitoring is costly, firms substitute towards performance-linked pay, intensifying profit-oriented decisions that raise externalities.

The framework also predicts that governance reforms designed to improve shareholder value may unintentionally increase social costs if they strengthen incentives tied to production or financial performance.

Other governance factors

Additional governance features may influence production externalities. For example, managerial ownership aligns managers with shareholders, potentially strengthening incentives to increase profits through higher production or cost reduction. Institutional investors may also influence governance structures and monitoring intensity, affecting managerial incentives and resulting externalities.

These factors can amplify or moderate the relationship between governance and socially harmful production depending on how they shape managerial incentives.

Empirical setup

The empirical analysis tests the theoretical predictions using firm-level data. The primary empirical context is the US coal industry, which generates measurable externalities through mining accidents and safety violations. Governance characteristics such as managerial ownership, monitoring intensity and compensation structure are linked to production practices and safety outcomes.

Data

The study combines several datasets including Mine Safety and Health Administration (MSHA) records on workplace accidents, safety violations and fatalities in coal mines. These data are merged with firm-level governance information such as managerial ownership and compensation structures. The dataset allows the authors to measure firm production activity alongside social costs generated by mining operations.

Empirical measure of externalities

Externalities are measured using indicators of workplace harm, including safety violations, injuries and fatalities reported in mining operations. These measures capture socially costly outcomes associated with production decisions. Higher accident rates or safety violations indicate greater negative externalities arising from firm activity.

Empirical strategy

The empirical strategy links governance characteristics to measured externalities while controlling for firm size, production scale and other factors. The analysis examines whether firms with stronger performance incentives or different monitoring structures exhibit higher levels of socially costly outcomes.

Baseline empirical results

The baseline results show that stronger performance-based incentives are associated with higher levels of negative externalities. Firms with greater managerial ownership or stronger profit-linked incentives exhibit higher accident rates and safety violations. These findings support the theoretical prediction that governance structures designed to maximise shareholder value can increase socially harmful production.

Summary statistics

Descriptive statistics highlight variation in governance structures and externality measures across firms. Mines with stronger managerial incentives tend to report higher accident and violation rates. The data also show substantial differences in monitoring intensity and ownership structures across coal firms.

Alternative forms of monitoring

The study tests whether different monitoring mechanisms alter the relationship between governance and externalities. Evidence suggests that stronger monitoring can mitigate socially harmful production by reducing reliance on performance-based incentives. However, when monitoring is weak or costly, firms rely more heavily on incentive pay, increasing negative externalities.

Coal divestment initiatives

The paper analyses coal divestment initiatives as a natural experiment affecting investor monitoring and governance pressure. Reduced investor oversight following divestment may weaken monitoring incentives, altering managerial behaviour and production decisions. The results provide additional evidence that changes in governance structures affect socially costly production outcomes.

Alternative explanations and robustness

Robustness tests address potential alternative explanations, including differences in mine characteristics, production scale and regulatory enforcement. The results remain consistent across multiple specifications and controls, supporting the causal interpretation that governance incentives influence externalities.

Conclusion

The study concludes that corporate governance mechanisms designed to improve firm performance can increase negative externalities. Performance-based incentives and shareholder-oriented governance may encourage production practices that impose social costs. The findings highlight tensions between shareholder value maximisation and broader social welfare in corporate governance design.