RIEB Discussion Paper Series No.2026-25

Title

Sustainability-Linked Debt and ESG-Linked Executive Compensation

Abstract

We study the optimal design of sustainable debt when a for-profit borrower raises capital from socially responsible investors and incentivizes managerial sustainability effort through ESG-linked executive compensation. We characterize when fixed-rate debt suffices and when sustainability-linked debt is necessary. The optimal contract depends on investors' investment structure, the borrower's ability to commit to ESG-linked compensation, and the project payoff in the success state. When ESG-linked compensation can be adjusted appropriately, fixed-rate debt can replicate sustainability-linked debt's incentive effects under some conditions, whereas explicit ESG-contingent payments are optimalunder others. Sustainability-linked debt and ESG-linked executive compensation are potentially substitutable incentive instruments.

Keywords

ESG; Executive compensation; Managerial incentives; Sustainable debt; Sustainability-linked debt

JEL Classification

D86, G12, G20, G32, M14

Inquiries

Meg ADACHI-SATO
Junior Research Fellow, Research Institute for Economics & Business Administration, Kobe University
Faculty of Business Administration / Institute of Small Business Research and Business Administration, Osaka University of Economics
E-mail: m-sato@osaka-ue.ac.jp

Hiroshi OSANO
College of Business Administration, Ritsumeikan University