Environmental, Social, and Governance (ESG) is a set of standards that measures the environmental and social impact of corporate investments. Their purpose is to encourage enterprises not only to pursue commercial interests, but also to take into account sustainable development. However, these goals often conflict: a company’s ESG investing may involve significant costs, while the immediate business value gained may be very limited. Without proper incentives, companies may be reluctant to engage in ESG investing. Understanding how to incentivize firms and how these incentives impact ESG investment decisions is important both in theory and practice.

Yuqian Zhang, a Ph.D. graduate from the Department of Finance at the Southern University of Science and Technology (SUSTech), under the guidance of Associate Professor Zhaojun Yang from the Department of Finance at SUSTech, has published a paper that uses the financial contracting theory and securities design principles to develop a new approach for addressing incentive problems.

Their paper, entitled “Dynamic incentive contracts for ESG investing”, has been published in the Journal of Corporate Finance (JCF). JCF is one of the eight highest-rated finance journals selected by the Chartered Association of Business Schools in the UK. It is recognized in the academic community for its high-quality articles in the fields of capital structure, corporate governance, mergers and acquisitions, and international financial management.

The researchers developed a continuous-time model in which an ESG investor hires a project manager and incentivizes them to fulfill ESG responsibilities. The manager’s private efforts and ESG investments determine the project’s cash flow and ESG performance, both of which are subject to random shocks.

They derived the optimal contract and its implementation after introducing carbon credits following the cap-and-trade program in practice. By providing comparative static analysis and empirical implications, the results demonstrated that ESG investing enhances contract efficiency. The more significant the carbon emission reduction or, the less the cost of ESG investing, the higher the contract efficiency, the average q, the marginal q, and the optimal investment–capital ratios. This implies that ESG investing mitigates inefficiencies arising from information asymmetry and enhances investment values. Their model predictions are partially verified by empirical facts.

Dr. Yuqian Zhang is the first author, and Associate Professor Zhaojun Yang is the corresponding author of the paper. This work was supported by the National Natural Science Foundation of China (72031003).

Paper link: https://linkinghub.elsevier.com/retrieve/pii/S0929119924000762

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