Sustainable Finance under Regulation

Abstract

We study how sustainable investing interacts with environmental regulation. Green investors are willing to sacrifice returns to invest in cleaner firms, partly substituting for policy, but they do not internalize the full social cost of emissions, so regulation remains necessary. Standard tools such as pollution taxes shrink dirty firms but also reshape their shareholder bases: the most pollution-averse investors exit first, leaving behind shareholders less willing to sacrifice financial returns for pollution reduction. This shareholder-base effect weakens dirty firms’ incentives to adopt green technology. Consequently, tighter environmental regulation can increase pollution, and optimal policy may depart from the Pigouvian benchmark.

Keywords: Environmental regulation, socially responsible investment, pollution externality, shareholder composition

JEL Classification: G11, G23, G32, H23, H41, Q58, M14