Sustainable Investing and Market Governance

This paper examines how sustainable investing affects the traditional governance role of financial markets. We show that stronger pro-social preferences among informed investors can reduce price informativeness about managerial effort toward improving financial performance, thereby increasing the cost of incentive provision. While this creates an agency cost, it can paradoxically generate positive real effects: because firms generating negative externalities face higher agency costs, purely financially motivated shareholders have incentives to reduce externalities to enhance price informativeness for governance purposes. Our results reveal an inherent link between firms’ environmental and social (the “ES” of ESG) and governance (the “G” of ESG) outcomes. We also identify a novel complementarity between voice and exit in reducing firm externalities—pro-social investors’ exit decisions prompt financial investors to exercise voice—in contrast to the conventional view of these strategies being substitutes.