Socially responsible investment VOX, CEPR Policy Portal

Responsible investment – the practice of incorporating environmental, social and governance (ESG) issues into investment decisions – is becoming increasingly mainstream. In 2006, the United Nations established the Principles for Responsible Investment (UN PRI) for Responsible Investment, a responsible investment commitment, signed by 63 investors operating a total of $ 6.5 trillion. By the end of 2021, it had grown to 4,375 investors, representing 121 trillion.

The ‘brown’ industry – such as tobacco, gambling and fossil fuels – is often seen as the purest and most efficient form of responsible investment. The expelled capital keeps these industries starving, the argument goes, preventing them from doing further harm. Accordingly, practitioners and the public can hold investors accountable for holding their brown firms. In 2020, extinction rebel protesters dug a lawn outside Trinity College, Cambridge, to protest investments in fossil fuel companies, and many asset owners asset managers to assess whether they operate a ‘Net Zero’ portfolio. Outside of the climate, Morningstar’s ‘Globe’ fund’s ratings are based on the Sustainability ESG ratings of the stocks they hold, and thus by their separation from brown stocks. Hartzmark and Sussman (2019) see that the flow of funds is significantly affected by these ratings. The academic study of asset managers greenwashing similarly analyzes their portfolio holdings (e.g. Gibson et al. 2022, Kim and Eun 2021, Liang et al. 2022).

But investing doesn’t really deprive a company of capital. An investor can only sell if someone else buys it. Investments are often compared to consumer boycotts, but this is a false metaphor: boycotts deprive a company of revenue if no one else takes action.

A more subtle argument is that investing does not immediately default a company, but lowers the share price and makes it difficult to sell shares in the future. However, it is not clear how strong this force is. Brown companies are not raising much capital to start, as they have little opportunity to grow in yesterday’s industries. In addition, in the United States, Gilchrist and Zakrajsek (2007) and Melolina et al. (2018) In the UK, the impact of capital expenditure on investment is minimal. There is so much uncertainty about cash flow from investments that cash-flow forecasting dominates capital expenditure.

Arguably the strongest argument for investing is that the value of the stock is important for reasons other than the cost of capital. Even if a company does not raise capital, low stock prices tarnish the CEO’s reputation (Narayanan 1985, Scharfstein and Stein 1990), increase the risk of takeover (Stein 1988) or termination (Edmans 2011), reduce the CEO’s equity value (Stein 1989). ), And demotivates staff.

However, our new paper (Edmans et al. 2022) shows that the best strategy might be to tilt (avoiding the industry altogether) rather than ‘tilting’ (leaning away from a brown sector but willing to retain an industry leader). The focus of our research is the observation that Brown companies can take corrective measures that reduce the losses they create – for example, fossil fuel companies may develop renewable energy. The problem with blanket exclusion is that it does not provide any incentive for a brown company to take corrective action: even if it invests in renewables, a fossil fuel company will still be classified as a fossil fuel company and will be excluded. Conversely, since a tilting strategy is intended to buy a brown firm if it is top-class, it motivates it to make sure it is indeed top-class. This echoes the Admati and Pfleiderer (2009), Edmans (2009), and Edmans and Manso (2011) models of ‘rule by exit’, where an investor’s transaction reflects the performance of a manager in the share price.

There is a close resemblance to the executive salary. Many investors support linking pay with ESG performance to provide incentives to CEOs to improve sustainability. However, the exclusion of blankets means that their capital flow is independent of ESG effectiveness, and does not provide any incentive to strengthen it.

We create a model where responsible investment affects social welfare through both of the above channels. There is a single brown firm that emits a negative appearance. The manager may take a corrective action that reduces both externality and firmness. The firm also raises capital which it uses to finance an expansion, increasing both firm value and externality. We show that investing is most effective in counteracting a company’s hunger and expansion, but is also more powerful in persuading a tilting correction. The best strategy is a trade-off between the two forces, and if the corrective action is particularly effective in reducing externalities, tilting is involved, as this consideration precedes trade-off. This result suggests that exclusion may be optimal for industries such as controversial weapons, where it is relatively difficult to reduce the damage produced. Conversely, tilting may be preferred for fossil fuels, where managers can take corrective action.

In the original model, the corrective action was universally observable, so the investor could be committed to a tilt strategy that rewards a brown company to be top-notch. We extend the model to cases where the corrective action is not observable; Instead, only an incomplete signal such as an ESG rating is observed, so the investor can only base it on his trading rating. Even if the manager takes corrective action, it may not be reflected in the rating, so he is not rewarded for the action. Thus, to provide adequate incentives for reform, the investor must promise more purchases on a positive ESG rating to compensate for the fact that corrective measures will not always be reflected in higher ratings. These purchases allow Brown Farm to expand and do more damage, so tilting may no longer be optimal.

Many responsible investors claim that they go beyond the ESG rating and conduct their own analysis. By doing their own research, they can find out if the company has taken corrective action and buy shares if it exists. However, doing so could lead to the investor being charged with green washing – buying a brown company even though it has not reformed the market outlook, which only monitors ratings. If the responsible investor incurs a large enough reputable cost to buy such a company, he will not do so. This diminishes his motivation to do his own research and actually implement the tilting strategy in the first place.

A common criticism of investing is that hedge funds can buy brown stocks at disappointing prices, reversing the impact of investments (Burke and Van Beinsburgen 2022). In another extension, we add a hedge fund to the model whose sole purpose is to maximize trading profits. We show that hedge funds prefer to buy half shares which are not bought by the responsible investor. If he buys more than half, he pushes the price too high and reduces his profit. On the one hand, it makes tilting less effective – since the hedge fund partially offsets the investor’s transactions, he has to promise bigger purchases to persuade him to take corrective action, making the tilt more expensive. On the other hand, hedge funds also make boycotts less effective, as they buy lower priced stocks and reduce the impact of boycotts on capital expenditure. Since the hedge fund buys half of the free float, its effect is greater on exclusion (where the responsible investor owns zero and the free float is the outstanding total shares) than tilting (where the investor owns a positive number of shares). Thus, the presence of a hedge fund makes the tilt more effective than the exclusion.

Our model has important implications for how asset managers should practice responsible investing and how their clients and the public should evaluate them. It is common for an asset manager to hold green stock and evaluate his responsibilities and accuse him of washing green with brown firms. Such a simplified assessment is detrimental. They discourage responsible investors from tilting strategies, which can change behavior more effectively than exclusion. Such assessments discourage investors from collecting personal information about whether companies have taken corrective action – if they do, but their actions are not yet publicly monitored, the investor will not be able to buy shares because he or she may be accused of laundering. He will follow the ESG rating instead of doing his own research.

Our concerns about investment effectiveness are completely different from the general counter-argument that ‘investment is bad because you can’t get involved’. True, this can be bypassed-but not unless you’re a techie who knows what he’s doing. For example, Engine No. 1 has spent $ 30 million to select three climate-friendly directors on the board of Exxon. Even for investors who are rarely involved, our research shows that exclusion may not be the most effective investment strategy.


Admati, AR and P Pfleiderer (2009), “The ‘Wall Street Walk’ and Shareholder Activism: Exit as a Voice Form”, Review of Financial Studies 22: 2645–2685.

Edmans, A (2009), “Blockholder Trading, Market Efficiency, and Managerial Myopia”, Journal of Finance 64: 2481–2513.

Edmans, A (2011), “Short-term termination without hindering long-term investment: a theory of debt and purchase”, Journal of Financial Economics 102: 81-101.

Edmans, A and G Manso (2011), “Governance through Trade and Intervention: A Theory of Multiple Blockholders”, Review of Financial Studies 24: 2395–2428.

Edmans, A, D Levit and J Schneemeier (2022), “Socially Responsible Distribution”, CEPR Discussion Paper 17262.

Gibson, R, S Glossner, P Krueger, P Matos and T Steffen (2022), “Do Responsible Investors Invest Responsibly?”, SSRN Working Paper.

Gilchrist, S and E Zakrajsek (2007), “Investment and Capital Expenditure: New Evidence from the Corporate Bond Market”, NBER Working Paper.

Kim, S. and AS Eun (2021), “Analyzing the Promises of Active Managers in the ESG: Evidence of UN Policy for Responsible Investment”, SSRN Working Paper.

Liang, H, L Sun and MTO (2022), “Responsible Hedge Fund”, Money reviewUpcoming

Melolina, M. H. Miller and S. Tatomir (2018), “Business Investment, Capital Expenditure and Uncertainty in the United Kingdom – Evidence from Strong-Level Analysis”, Bank of England Working Paper.

Narayanan, MP (1985), “Management incentives for short-term results”, Journal of Finance 40: 1469–1484.

Scharfstein, D and JC Stein (1990), “Hard Behavior and Investment”, American Economic Review 80: 465–479.

Stein, Jesse (1988), “Takeover Threats and Managerial Myopia”, Journal of Political Economy 46: 61-80.

Stein, JC (1989), “Skilled Capital Markets, Inefficient Companies: A Model of Invisible Corporate Behavior”, Quarterly Journal of Economics 104: 655–669.

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