Working Paper: CEPR ID: DP17262
Authors: Alex Edmans; Doron Levit; Jan Schneemeier
Abstract: Blanket exclusion of "brown" stocks is seen as the best way to reduce their negative externalities, by starving them of capital and hindering their expansion. We show that a more effective strategy may be tilting -- holding a brown stock if it is best-in-class, i.e. has taken a corrective action. While such holdings allow the firm to expand, they also encourage the corrective action. We derive conditions under which tilting dominates exclusion for externality reduction. If the corrective action is unobservable to the market, the investor is unable to tilt even if she has perfect information -- doing so would lead her to hold a company that has taken the action but the market thinks it has not, leading to accusations of greenwashing. Even if managers can costlessly disclose a signal of their actions, they will only do so under certain circumstances, and even a manager intending to take the action will only disclose a noisy signal.
Keywords: socially responsible investing; sustainable investing; externalities; exclusion; divestment; tilting; exit; governance
JEL Codes: D62; G11; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| blockholder's tilting strategy (G40) | firm's stock price (G12) |
| firm's stock price (G12) | firm's ability to raise capital for expansion (D25) |
| firm's ability to raise capital for expansion (D25) | level of negative externalities produced (D62) |
| firm takes corrective action (L10) | blockholder may choose to hold shares (G34) |
| blockholder may choose to hold shares (G34) | incentivizing further corrective actions (M52) |
| exclusion fails to provide incentives for corrective actions (H23) | firm is divested regardless of its efforts (L21) |
| information asymmetry (D82) | investor may resort to exclusion (G11) |
| corrective action is effective at reducing externalities (D62) | optimal strategy involves tilting (L21) |
| presence of an arbitrageur (G19) | diminishes effectiveness of both strategies (L21) |
| tilting (Y60) | leads to lower firm value compared to exclusion (G32) |