Sustainable Finance Under Regulation
Abstract
It is well acknowledged that human activities contribute to climate change and, hence, firms need to reduce their emissions to mitigate it. In response to this challenge, there has been a dramatic increase in socially responsible investing in financial markets. However, emissions are externalities, and so actions of investors alone are unlikely to fully resolve this issue. Therefore, government interventions are necessary. The co-existence of the private and public approaches to address climate change raises fundamentally important questions: How do socially-concerned investors respond to environmental regulations? What is the optimal regulation in the presence of such investors?To this end, we build a model analyzing optimal environmental regulation in the presence of socially responsible investors. Investors care about sustainability of their portfolios but cannot fully resolve the pollution externality. Regulations, such as pollution tax and subsidies to clean firms, reduce dirty firms' size but also reshape firms' shareholder compositions. Under the regulations, dirty firms' shareholders become on average less averse to holding polluting shares and hence these firms are less willing to adopt green technologies. We show that pollution can increase with regulation stringency. Optimal regulations do not always fully correct the externality and can deviate from the Pigouvian benchmark.