How Sustainable Investing Reshapes Market Governance

The rise of sustainable investing has altered the dynamics of financial markets. By integrating environmental and social criteria into investment strategies, pro-social investors aim to align their portfolios with their values and potentially encourage firms to reduce negative externalities. However, the broader implications of this trend on the traditional governance roles of financial markets remain underexplored.

In our recent paper, we highlight a novel agency cost of sustainable investing that makes it costlier to incentivize managers to improve firm financial performance. Somewhat paradoxically, we show how this cost can generate positive real effects for society. Moreover, our analysis reveals an inherent link between the environmental and social performance (the ES of ESG) and governance performance (the G of ESG) of firms, challenging arguments that these components are unrelated and should not be jointly considered in ESG ratings.

Sustainable Investing and Market Governance

Traditionally, stock prices are critical signals of a firm’s financial fundamentals, allowing shareholders to monitor managerial performance and design effective incentive contracts. This link between managerial effort and a firm’s stock price is central to effective corporate governance.

We show that sustainable investing can disrupt this mechanism. Pro-social investors may prioritize environmental and social externalities over financial fundamentals when making investment decisions. As a result, a firm’s stock price may decline due to the firm’s high social and environmental externalities rather than its low financial performance. A weaker relationship between a firm's stock price and its financial fundamentals makes it harder for its shareholders to motivate managerial effort to increase financial performance, increasing agency costs and decreasing productivity. Thus, a firm’s environmental and social outcomes are intertwined with its governance outcomes.

A Real Cost and Benefit of Sustainable Investing

Unlike traditional narratives that emphasize the cost-of-capital effect of sustainable investing, we highlight a distinct mechanism. In our framework, sustainable investing affects firms by making incentive provision, rather than capital, more expensive. Firms with significant externalities find it harder to design cost-effective incentive contracts because reduced price informativeness hinders market-based governance.

This agency cost has an intriguing silver lining. A firm generating significant externalities may face pressure even from purely financially motivated shareholders to reduce its negative externalities. Why? Lowering externalities allows the market to better incorporate the private information of pro-social investors, enhancing price informativeness and ultimately reducing the cost of incentivizing managers and improving governance. 

Voice and Exit: A Complementary Relationship

A longstanding debate in corporate governance concerns the relative effectiveness of ‘voice’ (engagement with management) versus ‘exit’ (divestment) strategies. Our findings highlight a novel complementarity: the potential exit of pro-social investors due to the firm’s poor environmental or social performance can motivate other purely financially motivated investors to advocate for improved environmental and social performance, not out of altruism, but to preserve price informativeness and reduce agency costs. This insight shifts the narrative from treating voice and exit as distinct substitutes to understanding how they can interact and complement one another to drive corporate change.

Implications for Compensation Design

Our findings also provide new insights into the design of executive compensation. Purely financially motivated shareholders may tie managerial pay to the firm’s ES outcomes without intending to improve its environmental and social performance because its stock price is a better signal of its financial performance when it has better ES outcomes. This result implies that the inclusion of ES-related clauses in executive compensation need not be intended to improve the firm’s environmental and social performance.

A New Perspective on Sustainable Finance

Our research offers a framework for understanding the broader implications of sustainable investing on the role of financial markets, extending beyond the traditional focus on capital allocation. While the ES considerations of informed investors can reduce the informativeness of stock prices about financial fundamentals—diminishing the governance role of markets—this same dynamic can encourage firms to improve their environmental and social performance as a means of restoring market governance. This interplay underscores the importance of integrating ES and G considerations, with significant implications for the construction of ESG ratings, the design of executive compensation, and the effectiveness of governance strategies in driving the green transition.

As sustainable investing continues to evolve, we hope these insights will provide a more nuanced understanding of its broader implications. Far from being merely a reflection of shifting investor preferences, sustainable investing profoundly reshapes the mechanisms by which financial markets influence corporate decision-making.

The authors’ complete paper can be found here.

Alvin Chen is an Assistant Professor of Finance at the Department of Finance, Stockholm School of Economics.

Deeksha Gupta is an Assistant Professor of Finance at the Carey Business School, Johns Hopkins University.

Jan Starmans is an Assistant Professor of Finance at the Department of Finance, Stockholm School of Economics.