Production and Externalities: How Corporate Governance Shapes Social Costs

We study how corporate governance affects social costs, focusing on the tension between mitigating managerial moral hazards and limiting negative externalities. We develop a parsimonious principal-agent model with negative production externalities, which predicts that when monitoring costs rise, firms substitute toward performance-based compensation, leading to socially costly production decisions. Using asset-level data from the U.S. coal industry, we find that ownership dispersion—the canonical proxy for rising monitoring costs—leads to an 11% increase in production and a 33% rise in safety violations. To establish causality, we exploit politically motivated coal divestment mandates that forced key monitoring institutions to exit, generating plausibly exogenous increases in monitoring costs. Consistent with our model, affected firms raised managerial bonus thresholds and experienced higher production and more safety violations. Our findings reveal how governance choices can inadvertently amplify social costs, with implications for sustainable investing and corporate governance design.